The Bear’s Lair: Japan reaching the end of the road

The Bank of Japan last week capped the yield on Japan Government Bonds at zero, thus allowing it to increase bond purchases beyond the current enormous amount if yields rise. Prime minister Shinzo Abe has begged Britain to minimize the effect of its “Brexit” from the European Union, and has begged the U.S. Congress to ratify the Trans-Pacific Partnership treaty. When you look at the statistics of Japan’s economy, one thing becomes abundantly clear: Japan is now very near the point at which the whole house of cards collapses. This Gotterdammerung of Keynesianism will be fun to watch – until it affects the rest of the world.

There are marginal signs that Abe may attempt to shake up the Japanese labor market, though his main recent initiative is yet another “stimulus” program of public spending. At this point however it is too late. Abe has been in power for almost four years, with repeated election victories, and at this point the markets don’t believe he will accomplish anything. The yen that he has tried to weaken has strengthened by 25%, from 125 to the dollar in June last year to 100 now. The Nikkei 225 stock index is down 20% in the past year, at a time that other world stock markets have been generally strong. Japanese prices have declined by 0.4% in the year to July 2016, while the Bank of Japan has been printing over a trillion dollars trying to push inflation up to 2%. The Japanese government is expected to run a budget deficit of 5% of GDP in 2016 in spite of record low interest rates; that will only add further to the country’s grossly excessive debt.

Most ominous Japanese productivity, which held up remarkably well in the long quasi-recession from 1990 to 2007, beating U.S. productivity over that period, is down 2.4% in the past year. That’s an extraordinary result. In spite of continuing technological innovation, a legendarily diligent and well-educated workforce, and an abundance, even a superabundance of cheap capital, Japan is actually able to produce 2.4% less per unit of labor in July 2016 than it was in July 2015. At that rate, by 2057 Japan would be entirely unable to produce anything at all, but would simply exist in a stasis, its workers’ hands poised forever stationary next to the machine tools.

Good God, how many decades is it going to take for Japanese policymakers to realize that Maynard Keynes was an incompetent charlatan? Must we really coat Japanese factories in eternal permafrost before their governments abandon this destructive mania?

Japan’s Keynesianism takes two forms. One is fiscal: the country’s rulers with the admirable exception of Junichiro Koizumi (2001-06) have believed since the late 1990s that the economy can be stimulated by running a larger budget deficit through infrastructure spending, for example. This is largely a fallacy; in general the budget deficit has to be borrowed, so the money must come from somewhere. The government is merely transferring resources from the private sector where, absent distortions caused by other government policies, they are allocated optimally, into the public sector, where they are allocated politically, not in general optimally. Thus borrowing more money to spend it on state-directed items in general reduces output and reduces the efficiency and productivity of the economy.

The other form of Japan’s Keynesianism should not technically be called Keynesianism, because Keynes himself did not explore the possibility, beyond his desire for the creation of an international “bancor” to make the Gold Standard more inflationary, which would have effected monetary stimulus at an international level rather in domestic economies. However, while using a non-Keynesian tool of monetary expansion, the policy attempts to achieve a Keynesian goal: artificial stimulus. It involves monetary “stimulus” through lowering interest rates artificially and/or massive central bank purchases of government bonds and, in Japan, other assets.

Here a similar fallacy is involved. Since the central bank does not actually print bank notes with which to buy its QE bond purchases, the money must again come from somewhere. In the U.S. case, the massive swelling of the Fed balance sheet has been matched by an increase in excess reserves held by the banks at the central bank. These clog up bank balance sheets, increase bank leverage and reduce the banks’ capacity for lending to more productive sectors such as small business. Again, just as with fiscal stimulus, resources are simply diverted, not created; in this case from productive investment to financing Japan’s unnecessary budget deficit.

Ben Bernanke’s “helicopter drop” in which $100 bills were dropped on consumers would work to an extent if Japan was at the bottom of a deep recession driven by inadequate demand, which it is not. Japan does not need more consumption; it needs more productive investment and less government spending. Japan’s government debt will be 260% of GDP by the end of this year, a level reached only briefly by a non-defaulting power, by Britain briefly in 1819, when the deflation necessary to resume the Gold Standard had shrunk the country’s nominal GDP. However, Japan’s chances of paying down its debt are much less than Britain’s in 1819; the country also has deflation, but it does not have Britain’s underlying growth, caused by the incipient Industrial Revolution.

Moreover, Abe is not the firm anti-populist Lord Liverpool, who brought Britain’s debt to GDP ratio below 200% by the time he left office in 1827, nor his admirably stern and economically literate Chancellor of the Exchequer, Nicholas Vansittart. He is instead more like Vansittart’s successor, the feeble “Prosperity” Robinson, who specialized in florid optimistic budget speeches promising eternal prosperity and then burst into tears when the stock market crashed and banks went bust in December, 1825. Abe has no solutions for Japan’s current problems, merely short-term palliatives that make matters worse.

The end of the road for Japan must be close. You cannot run an economy for long with productivity declining at more than 2% per annum; the inefficiencies rapidly become too great and the whole machine seizes up. The only question is what form the disaster will take. The strength of the yen, when Abe wants it to weaken, suggests that the effective supply of useful money is in fact far too tight (yes I know that is not an accepted economic term, but Abe’s are not previously accepted economic policies; we are covering entirely new ground here, far away from the well-mapped road towards prosperity.)

The Bank of Japan’s bond purchases are starving the productive private economy of funding, as its holdings of Japan Government Bonds are rising faster than even the government’s swollen deficits. Bank of Japan Governor Haruhiko Kuroda’s recent promise to push rates further into negative territory will only make matters worse. Probably more important, the Bank of Japan’s share purchases, running at $27 billion per annum and making it a ‘top ten” shareholder of 90% of Japan’s public companies, are propping up the Nikkei far above its market-clearing level. As I mentioned above, the Nikkei is already down 20% over the past year; that fact, together with the Bank of Japan’s purchases, suggest that a truly major stock market crash cannot be far away.

All the signs are that the wheels are dropping off the Japanese economy, in much the same way as the signs in late 2007, after the Bear Stearns mortgage bond fund failures in August, showed that the U.S. housing finance sector was on the point of collapse. The housing finance collapse took a year to reach its final denouement, and there were several points during that year when it looked as if the bottom had been reached, but further depths were in the event plumbed. Doubtless the Japanese equivalents of John Paulsen, Goldman Sachs’ Fabulous Fab Tourre and the “heroes” of the financial crisis film “The Big Short” are currently shorting all available Japan-related markets like mad.

My bet is they will make most money by shorting the 10-year Japan Government Bond, rather than the somewhat illiquid stock market – there has to be a money-making advantage in playing in a market worth 260% of GDP. If foreign speculators are trying this, however, they had better watch themselves. A financial crash that bankrupts the Japanese middle class will probably be followed by a revival of the less merciful Tokugawa-period forms of punishment, applied to politicians and speculators alike, with justice in both cases. As Gilbert and Sullivan’s Mikado said “My object all sublime, I shall achieve in time, To make the punishment fit the crime, the punishment fit the crime. And make each prisoner pent, Unwillingly represent, A source of innocent merriment, of Innocent Merriment.” The Japanese people’s idea of innocent merriment following an economic collapse is likely to be distinctly unpleasant.

Japan is an utterly admirable society, especially to a native Briton from a similarly eccentric, fiercely independent offshore island. But the Japanese politicians of the past generation, with the exception of Koizumi, have been “slaves of some defunct economist,” in this case of Maynard Keynes himself, and they are about to run their beautiful economic Porsche into a very unforgiving wall. They will deserve all the obloquy which the Japanese people will shortly heap upon them.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)