Japan, Abenomics, the consolidated balance sheet and nationalism

Today’s commentary

With Shinzo Abe’s radical economic policy shift now one year old, now is an appropriate time to look back and assess its effectiveness. I see results principally in the currency and asset prices and to a degree on inflation. However, it is not clear that Japan has broken out a deflationary stupor. What should we expect going forward? And what do Abe’s nationalist tendencies augur for the future? Comments below

On 20 Dec 2012, just before Japan’s move to a consolidated balance sheet approach in which central bank and central government work hand in hand, I had this to say about Japan’s problems:

“The real problem in Japan is that the Japanese have allowed zombie companies to extract wealth from the economy at the expense of better-positioned companies or at the expense of new capital formation. Basically, the Japanese have misallocated capital on a grand scale by propping up their economy artificially with deficit spending. Deficits certainly can help deleverage but they are no panacea because government cannot control how those deficits affect private sector capital allocation. And deficits will always tend to give a helping hand to the least profitable institutions even without active intervention on government’s part in picking winners and losers.”

My comments go to the idea that Japan’s real problem is political and not economic. After two decades of stop-go policymaking, the Japanese are still unwilling to make a radical overhaul of laws governing business structure or to allow large companies to fail. Just yesterday the Japan Times was reporting on the new turnaround plan by the bailout fund for Tokyo Electric Power Cp. (Tepco), the company whose nuclear facility controls went catastrophically wrong after a large earthquake in Japan in March 2011. Tepco is a company we should expect to go under, not get bailed out. But Japanese banks would be on the hook for massive losses which would crimp their capital base and ostensibly curtail credit elsewhere. So these loans are rolled over and Tepco is bailed out in order to keep credit flowing.

But then came Abenomics, which, in my view, was most different in the consolidated balance sheet approach it represented. The fig leaf of central bank independence was almost entirely removed and thus we saw the central bank and the government working hand in hand to promote growth and manage government liabilities. On Christmas Eve of last year I wrote about Abe’s threats on the issue in these terms. What I wrote then is important as a backdrop to what has unfolded since. Let me repeat it here, highlighting the crucial parts:

“Like a lot of macro analysts, I look to Japan now because they are at the forefront of the debt deflationary revolution we have entered at this end of a debt super cycle. They got to peak debt first. Japan resorted to zero rates first. And these zero rates turned into a permanent policy first – what I call “permanent zero.” Japan also was first to run massive budget deficits to ease the pain of deleveraging, rather than let the economy collapse. And the Japanese were also first to run into a lack of political policy space for their deficit policies, something we have seen in euroland, the UK and are now seeing in the US. Likewise, Japan is first in threatening to strip the central bank of its independence so that it can run an easier monetary policy. We’re not talking about political oversight a la Ron Paul to keep the central bank from printing money, just the opposite.

“So this is it. If the Bank of Japan loses its independence and the government gets to set monetary policy, we will effectively have one consolidated government balance sheet for fiscal and monetary policy. I think this will be the end stage for any nation looking to get out of the terminal debt stage. In Japan, what has happened over the least 20 years is that the private sector has started to deleverage and this has caused a big hole to open up in the government’s finances as the economy’s sectors must balance. The Japanese government has accommodated this by-in-large and the government’s debt levels have skyrocketed as a result. Meanwhile, much of the government’s largesse has gone to bailing out banks and industrial companies, even airlines, in order to save jobs. Clearly, this policy has been a socialisation of losses on a massive scale which has taken private debt and essentially converted it into public debt.

“Meanwhile the political policy space for such a policy response has waxed and waned. Eventually, deficit hawks get sick of the large deficits and look for government to retrench by raising taxes and/or cutting expenses, something I see as inevitable. And the result every time is recession, further private deleveraging and large government deficits, despite the move toward austerity. This cycle has taken Japan to well over 200% government debt to GDP, twice the levels in the UK, Ireland, Spain and the US, the four housing bubble economies with debt levels now about on par with Belgium and Italy, the only big debtors of Europe before the financial crisis.”

So where are we now? I would say we are in the period of incipient fiscal retrenchment that tips the economy into slower growth or recession. So, Abe came in guns blazing, taking Japan to a new level of monteary and fiscal ease in order to jump start the economy. The effect on stocks has been tremendous. The Nikkei is above 16,000 for the first time since 2007. Japanese hedge funds are this year’s top performers. The Yen has dropped to 105 to the US dollar, a five-year low.

In the first half of the year, Abenomics also lifted the economy on the back of deficit spending. GDP growth was about 4% on an annualized basis. And deflation lifted. In fact, the most recent numbers out in the last day show Japan’s consumer price index up 1.2% year-on-year, a five-year high, with core prices up 0.6%, a 15-year high. So the progress is there on these two fronts. And it is this progress which has led to the stop portion of stop-go, the fiscal retrenchment that is inevitable given Japan’s government debt load.

However, the 2014 budget draft is a record 95.9 trillion yen because of a $180 billion fiscal stimulus package designed to offset the hike in consumption taxes due to come online. And Japan’s Finance Minister told reporters at the unveiling of the draft budget that. Japan will issue 41.25 trillion yen in government bonds, less than the 42.9 trillion yen in the 2013 draft budget. Bonds will therefore cover only 43% the budget versus 46% last year. The primary deficit is projected to shrink to 5.2 trillion yen (about $50 billion).

Here’s the problem. For all the success in stopping deflation in Japan, we should worry that we are seeing ‘bad’ inflation i.e. imported inflation from a declining currency that does not spur consumption but reduces it via the desire to net save in the face of stagnant wages. This is occurring at the same time that a large consumption tax is being initiated. So the combination of inflation, taxes, and low wage growth are a mix that I believe restrains growth and could create another recession. Growth has already slowed markedly according to data released regarding Q3. Meanwhile, the Ministry of Finance sees the government debt hitting 227% of GDP in March. The IMF estimates Japan’s government debt will rise to 242% of GDP, a record that surpasses even the debt burden after World War 2, a number that will rise even more if the economy slows further.

The goldilocks outcome here would be a temporary dip in GDP that does not dent business confidence, which is at a six-year high. This would be followed then by improved capital spending, which had unexpectedly slowed to 0.2% in Q3. At the same time, the business spending spurred new employment and wage gains that allowed consumption to increase while Japan worked on structural issues which would ensure better longer-term growth.

I don’t see this happening, however. Multiple links in that story are dubious. Even assuming business confidence remains high, translating into actual capital spending, there is no indication that job and wage gains are forthcoming. Meanwhile the consumption tax and inflation should constrain spending in a nation that has a 50-year high in households without any savings. But above all, the third arrow of Abenomics is suspect.

Let’s remember that Shinzo Abe is a nationalist above all. His policies are more about his nationalist tendencies than they are about any radical transformation in economic thinking. The recent visit to the Yakusuni Shrine that has everyone outraged is typical of that worldview. Marc Chandler doesn’t understand why such an astute politician and intelligent man would do this – on the anniversary of his term in office, no less. But if you look at Abe as a nationalist trying to improve Japan’s lot because of his deep sense of national pride then the picture becomes clearer. It also explains the increase in military spending and the confrontation with China as well. While Abe’s nationalism doesn’t discredit his economic policies, it should make one sceptical about the durability of the transformation we are undergoing. We actually may well be seeing a conventional fiscal policy normalization in Japan that could be joined by monetary policy normalization as well. There is a split at the Bank of Japan as to whether we are seeing a slowdown that would warrant continued policy stimulus. And that suggests to me that the guns blazing phase may soon be over – well before any structural reforms have come on the table.

So what we are seeing then is a nationalist politician attempting to cement Japan’s position economically by whatever means necessary, including unconventional monetary policy and high government deficit spending. Rather than believing these moves are necessary to achieve full employment and thus boost jobs and wages once full employment is reached, we are seeing an incipient retrenchment in accommodation just as imported inflation is starting to bite. We have seen this stop-go policy play out again and again in Japan. Will this time be any different? I don’t believe so.