The Bear’s Lair: The Weimarization of Japan

The Bank of Japan has indicated that it will buy Japan Government bonds in an indefinite amount at a yield of 0.25% — thus refusing to share in the belated tightening policies of other central banks. That is a policy worthy of Rudolf von Havenstein, President of the Reichsbank in the years leading up to the Weimar Republic hyperinflation of 1923. Beyond monetary policy, there are other Weimar signs about Japan also – trouble appears to be ahead.

The Bank of Japan’s quantitative easing programs have been truly heroic in scale, with numbers von Havenstein would have recognized – 507 trillion yen ($4.2 trillion) of Japan Government Bonds were on the central bank’s balance sheet in late March 2022, about 80% of Japan’s GDP. In addition, the Bank of Japan has bought shares worth about 70 trillion yen ($600 billion). That makes it the largest single shareholder in the Tokyo market, larger than the state pension scheme and owning about 10% of the 730 trillion yen market capitalization of Japanese equities.

Meanwhile inflation is beginning to take off, though only by comparison with past years – February 2022 prices were 0.9% above those in February 2021, but the month’s inflation ran at a 4.8% annual rate, suggesting acceleration is just around the corner. The Fed’s “funny money” policies have led to inflation that is currently quickening from a trot to a canter; there is no reason to believe that the Bank of Japan’s 25-year detour from reality will not end the same way. The Bank of Japan’s zero-interest-rate policy was after all suggested to them in 1998 by none other than Ben Bernanke, the von Havenstein of our age.

First, a little history. Rudolf von Havenstein (1857-1923) was a government-trained lawyer without business or economic experience, who was appointed President of the Reichsbank as early as 1908, a post which he held for the next 15 years through a world war and several wrenching changes in government. Presumably, having held his post in the years of peace before the war, he was thought by the socialist post-war governments of the Weimar Republic to give reassurance to foreign bankers that Germany’s Reichsmark was in good hands. Little did they know!

Germany’s Kaiser Wilhelm II and the Reichstag decided to fund World War I entirely by borrowing, without imposing the harsh tax increases that were necessary. (Britain too funded a higher percentage of the war by borrowing than in the Napoleonic Wars or World War II – politicians of that generation were very self-indulgent.) Germany believed that if it won the war it could pay for it by imposing reparations on the Allies, a folly similar to the 1919 Treaty of Versailles imposing excessive reparations on Germany. The Reichsmark had already halved in value against the dollar by the end of the war, indicating that a serious inflation problem lay ahead.

By the end of 1919, with the Allies imposing reparations, the value of the Reichsmark had collapsed to one tenth of its pre-war level. From the first reparations payment in June 1921, von Havenstein followed the strategy of printing vast quantities of marks, then exchanging them for foreign currency to make reparations payments, essentially printing money to meet an ever-spiraling demand. The result was 17-fold inflation between June and December 1922, whirling further into insanity in 1923. Only after von Havenstein’s death on November 20, 1923 was it possible to cease this absurdly destructive policy, by which time a loaf of bread cost 200 billion marks and 50 trillion-mark notes were circulating.

Japan has in recent decades followed a similar route, fortunately without the war. In 1990, the country’s debt was modest and interest rates were substantially higher than inflation. Thus, the asset price inflation of the 1980s was only partially due to lax monetary policy. However, during the 1980s many Japanese companies had entered into speculative “tokkin” financial deals, assuming that the stock and real estate markets would always continue rising. During the 1990s, Japan ran budget deficits, while its banking system attempted to prop up companies that were no longer viable, usually because of disasters in their “tokkin” gambling.

Then after a financial crash in 1998, Japan began to run large budget deficits, while forcing interest rates down to zero – the Bernanke/von Havenstein approach. There was a modest return towards sanity under prime minister Junichiro Koizumi (2001-06) but the financial crisis of 2008 intensified Japan’s unsound policy mix. As a result, Japan now has public debt of about 270% of GDP, higher than any country has ever paid down successfully.

As Britain demonstrated after 1815 and again after 1945, there are two ways of paying down debt at these levels (in both cases, Britain’s debt to GDP ratio was about 250%, a little lower than Japan’s today). One is the most rigid austerity, combined with a monetary anchor – the Gold Standard – that gives investors the utmost confidence that the country will repay its debts. That is the alternative chosen by Lord Liverpool in 1819, and it worked.

The other is to lower interest rates and allow inflation to take off, keeping interest rates below the rate of inflation. Provided the government runs close to a balanced budget, that pays off the debt by inflating it away, at the expense of the country’s unfortunate savers, such as my Great-Aunt Nan, whose savings were reduced to about 3% of their initial value in real terms between 1947 and her death in 1974. That is the alternative chosen by Clement Attlee’s government and its successors, initially at the instigation of the Winchester-educated chancellor of the exchequer Hugh Dalton who, socialist or not, would have regarded the small businesswoman Great-Aunt Nan with the utmost Wykehamist class snobbery.

It is pretty clear that Japan will not follow Lord Liverpool’s path. It will not even follow that of Attlee and the wretched Dalton, since its budget deficit in the year to March 2023 is scheduled to run at least 6% of GDP, even with interest rates close to zero. Its debt to GDP ratio will thus rise rather than fall, unless it adopts von Havenstein’s solution to excess debt of allowing inflation to take off uncontrollably (Germany’s debt by 1924 was confined to its reparation payments; domestic debt, even the gigantic amount incurred for World War I, had been wiped out by inflation.)

As with Germany in 1919, the first sign of the von Havenstein solution to excessive debt will come in the exchange rate. Today the yen stands at 123 to the dollar; at 125.6 it will be lower than at any time since the 1998 financial crisis, when it hit 147 briefly. The market expects the Bank of Japan to step in with intervention, but why should it? — Japan’s government debt problem will not be solved any other way. As the yen sinks, inflationary pressures on the Japanese economy will rise, as they did in Germany in 1919-20 – and the ghost of von Havenstein will smile knowingly.

Just as Weimar Germany broke free socially from the shackles of its stolid pre-war society, with jazz, homosexuality, foreigners and decadence making Weimar Berlin an artistic Mecca, regarded as Gomorrah by its more conservative countrymen, so Japan too appears to be breaking free from its traditional society with much higher immigration and social media exercising their usual corroding effect on politics and morals. The parallels to Weimar Germany are ubiquitous, but the financial one, given the policies followed in the last two decades, appears most compelling of all.

Let us hope the Weimarization does not destroy the middle class, as it did in 1920s Germany. That way, madness and global war lies.

(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.)