Remember back last year when the predictions were coming in daily that Japan was heading for insolvency and the thirst for Japanese government bonds would soon disappear as the public debt to GDP ratio headed towards 200 per cent? Remember the likes of David Einhorn – see my earlier blog – On writing fiction – who was predicting that Japan was about to collapse – having probably gone past the point of no return. This has been a common theme wheeled out by the deficit terrorists intent on bullying governments into cutting net spending in the name of fiscal responsibility. Well once again the empirical world is moving against the deficit terrorists as it does with every macroeconomic data release that comes out each day. I haven’t seen one piece of evidence that supports their view that austerity will improve things. I see daily evidence to support the position represented by Modern Monetary Theory (MMT). Anyway, there was more evidence overnight that I thought should be mentioned and relates to the idea that “the government is the last borrower left standing”.
Einhorn gave a speech to the Value Investing Conference on October 19, 2009. I note he is a keynote again this year so the organisers obviously haven’t been keeping track of events to realise that this guy’s predictions have been way off the mark.
Einhorn’s speech was entitled – Liquor before Beer … In the Clear – and he began by outlining what he thought were the “macro risks we face” in the investment context.
He rehearses all the known arguments of the deficit terrorists – inflation, debt-default etc. Then he gets to Japan and says:
Japan appears even more vulnerable, because it is even more indebted and its poor demographics are a decade ahead of ours. Japan may already be past the point of no return. When a country cannot reduce its ratio of debt to GDP over any time horizon, it means it can only refinance, but can never repay its debts. Japan has about 190% debt-to-GDP financed at an average cost of less than 2%. Even with the benefit of cheap financing the Japanese deficit is expected to be 10% of GDP this year. At some point, as American homeowners with teaser interest rates have learned, when the market refuses to refinance at cheap rates, problems quickly emerge. Imagine the fiscal impact of the market resetting Japanese borrowing costs to 5%.
Over the last few years, Japanese savers have been willing to finance their government deficit. However, with Japan’s population aging, it’s likely that the domestic savers will begin using those savings to fund their retirements. The newly elected DPJ party that favors domestic consumption might speed up this development. Should the market re-price Japanese credit risk, it is hard to see how Japan could avoid a government default or hyperinflationary currency death spiral.
Greenlight – Einhorn’s investment company – is known to have bought long-dated options on much higher interest rates in Japan which if rates rise significantly over the next four odd years will give it large profits. The counterparty was the major banks and I expect them to make the money.
When people are talking big like this we need to look at the data.
The first graph shows the national debt to GDP ratio since early 1990 to March quarter 2010 (left-panel) and the 10-year Japanese government bond yield since December 1998 (there was a break in the official series in November 1998). You can get Bank of Japan data for 10 year government bond yields back to October 1985. The choice of sample is immaterial.
So I wouldn’t be betting against rates rising anytime soon in Japan.
And what about the relationship between the debt ratio and the bond yields? The following graph plots the volume of outstanding national government debt (100 millions) (horizontal axis) against the 10-year JGB yield. The black line is a linear regression (sloping down!).
Short-term rates have also been very low in Japan for a very long time. This graph is from the Bank of Japan database and the red line is the overnight call rate and the blue line is the basic discount rate. The grey bars are official (GDP) recessions.
The conclusion is obvious. The BOJ controls short-term rates and has kept them at around zero for years. I could have plotted inflation rates which would have shown low and stable inflation for many years bordering on a deflationary problem arising from deficient economic activity.
Anyway, I will close my blog down immediately and apologise profusely for being a dingbat if JGB yields skyrocket in the next five years.
I also wonder how the Einhorn’s take in the regular news on the latest JGB auction results.
The Japanese JiJi financial news service carried an item overnight that caught my attention this morning and was the source of a few E-mails (thanks Marshall!):
Tokyo, Aug. 4 (Jiji Press)–Japanese government bonds rose sharply in Tokyo Wednesday amid growing uncertainties about the U.S. economy, with the yield on the benchmark 10-year issue slipping through the one pct threshold for the first time in seven years. In late interdealer cash trading, the yield on the latest 309th 10-year JGB with a 1.1 pct coupon stood at 0.995 pct, a level unseen since early August in 2003 and down from 1.020 pct late Tuesday.
So the demand for JGB rose for this issue as the total stock of bonds (absolutely and relative to GDP) continued to rise.
A bit later Nikkei reported that Long-Term Rates Climb Back Above 1%. Heavens I thought – bond yields are nearly going through the roof!
TOKYO (Nikkei)–The benchmark 10-year government bond yield rose to 1.015% Thursday morning as eased worries over the U.S. economic slowdown prompted investors to sell the safe-haven asset.
On Wednesday, the bond yield fell below the 1% line for the first time in about seven years, hitting 0.995%.
Read carefully: this is saying that financial market investors got less nervous and decided a bit more risk was tolerable so they sold the “safe-haven asset” (the Japanese government debt) and rates rose just a tad.
No Einhorn scenario is likely yet. When? Answer: never!
So why do the commentators and the insiders like Einhorn get it so wrong?
First, they don’t fully understand how the macroeconomy works. Most of their knowledge would come from either mainstream macroeconomics course at universities which worthless (actually damaging) or around lunch tables sipping cups of tea sharing “knowledge” with similarly blighted individuals.
Second, they therefore do not understand the nature of the problem at present. They think the problem is the “size” of the public deficits and the growing ratio of public debt to GDP but a considered reflection leads one to conclude these are not problems at all. The movements in these aggregates tells us about other problems – pertaining to the real economy – but in and of themselves they present no issue that is worth a moment’s thought.
The problem for the public debate though – in terms of moving it in a direction that will address the actual underlying issues such as weak aggregate demand and persistently high unemployment and rising long-term unemployment – is that these commentators are stuck in mindless obsessive warp about these financial ratios. They cannot see beyond them and they cannot see how meaningless their daily obsessions are.
Which brings me to the hearings that were conducted last week by the US Committee on Financial Services, which is a committee of the US House of Representatives.
On July 22, 2010, Richard Koo appeared before the Committee and presented his testimony – How to Avoid a Third Depression. I have previously considered Koo’s ideas in this blog – Balance sheet recessions and democracy.
Essentially, his views have resonance with the main perspectives offered by MMT although he does get some things wrong.
His recent testimony is one of the better commentaries on the current economic problems but probably fell on deaf (or dumb) ears at the hearing.
Koo told the hearing that there are recessions and then there are depressions. The correct policy response must differentiate correctly between these two economic episodes. He said:
The key difference between an ordinary recession and those that can lead to a depression is that in the latter, a large portion of the private sector is actually minimizing debt instead of maximizing profits following the bursting of a nation-wide asset price bubble. When a debt-financed bubble bursts, asset prices collapse while liabilities remain, leaving millions of private sector balance sheets underwater. In order to regain their financial health and credit ratings, households and businesses in the private sector are forced to repair their balance sheets by increasing savings or paying down debt, thus reducing aggregate demand.
So while the ultimate problem remains a deficiency of aggregate demand (total spending) the balance sheet dynamics in the private sector are also important to understand.
When we talk about deficient aggregate demand we are considering spending in relation to the capacity of the economy to produce real goods and services. This can also be viewed of as the capacity to employ workers at current productivity rates. So deficiency is a shortfall in spending which provokes firms to reduce output (so that they do not accumulate unsold inventories) and lay off workers.
All recessions have this dynamic. Private spending falls perhaps because firms feel negative about the future growth in sales. Perhaps the fall in private spending originates as reduced consumption. Either way, overall aggregate demand falls.
The normal inventory-cycle view of what happens next notes that output and employment are functions of aggregate spending. Firms form expectations of future aggregate demand and produce accordingly. They are uncertain about the actual demand that will be realised as the output emerges from the production process.
The first signal firms get that household consumption is falling is in the unintended build-up of inventories. That signals to firms that they were overly optimistic about the level of demand in that particular period.
Once this realisation becomes consolidated, that is, firms generally realise they have over-produced, output starts to fall. Firms lay-off workers and the loss of income starts to multiply as those workers reduce their spending elsewhere.
At that point, the economy is heading for a recession.
So the only way to avoid these spiralling employment losses would be for an exogenous intervention to occur. This could come from an expanding public deficit or an expansion in net exports. It is possible that at the same time that the households and firms are reducing their consumption net exports boom. A net exports boom adds to aggregate demand (the spending injection via exports is greater than the spending leakage via imports).
So it is possible that the public budget balance could actually go towards surplus and the private domestic sector increase its saving ratio if net exports were strong enough.
However, what Koo calls the depression-route is also associated with huge levels of private indebtedness that has to be cleared before private spending growth can occur. The balance sheet urgency complicates the recovery process and make the policy intervention even more critical because private saving has to be supported to allow the balance sheet corrections to occur.
Koo notes that in these circumstances (private debt minimisation) monetary policy becomes ineffective:
… because people with negative equity are not interested in increasing borrowing at any interest rate. Nor will there be many lenders for those with impaired balance sheets, especially when the lenders themselves have balance sheet problems.
From a MMT perspective, monetary policy has dubious effectiveness anyway because it is highly dependent on the reactions of creditors (facing low incomes) and debtors (facing higher incomes). The timing and magnitude of these spending reactions are unclear. Further, monetary policy is a blunt instrument and cannot be targetted at all.
But Koo’s insight remains interesting and relates to what Keynesian economists have called a “liquidity trap” – where all people form the view that interest rates can only rise and so hold their speculative wealth balances as cash rather than bonds (because they fear the bond prices will fall). At that point credit creation stalls and interest rate manipulation is futile.
But Koo’s point should also be extended to note that the claims by central bankers and others that their quantitative easing policies would expand credit were always misleading if not plain wrong. Please read my blog – Quantitative easing 101 – for more discussion on this point.
You might also like to review the blogs – Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion of the way in which monetary policy changes in recent years have been seriously misunderstood by commentators (for example, Einhorn and his ilk).
Koo then draws out the implications of this situation:
… when the private sector de-leverages in spite of zero interest rates, the economy enters a deflationary spiral because, in the absence of people borrowing and spending money, the economy continuously loses demand equal to the sum of savings and net debt repayments. This process will continue until either private sector balance sheets are repaired, or the private sector has become too poor (=depression) to save any money.
He is assuming no government response other than via automatic stabilisers and no change in the external position of the economy. You will note that the austerity proponents, in part, claim that the withdrawal of public spending will be partially or more than partially offset by improving net export positions as competitive gains arise from cutting domestic wages and prices.
There is very little chance of that happening on a global scale with all nations being bullied into austerity. The single-country/single episode examples they wheel out to “prove” that austerity has worked in the past are not only flawed in themselves but ignore the implications of all nations doing the same thing at the same time.
Please read my blog – Fiscal austerity – the newest fallacy of composition – for more discussion on this point.
But his point is sound. The problem we have been facing for several years now (about three) is that the credit binge that preceded this crisis has left a lot of private consumers and investors in diabolical straits with too much nominal debt and declining values of the assets the debt backed.
The need to remedy this problem led to a widespread withdrawal of private spending as the pessimism of future growth spread and the expenditure multipliers reverberated this pessimism across the world economies. Please read my blog – Spending multipliers – for more discussion on this point.
So what started as a financial problem spread into the real economy via the negative spending reactions and the multiplier mechanism. The latter always drives recession whereas the former instigation is not always present.
Koo gives an easy example to understand this process:
To see this, consider a world where a household has an income of $1,000 and a saving rate of 10 percent. This household would then spend $900 and save $100. In the usual or textbook world, the saved $100 will be taken up by the financial sector and lent to a borrower who can best use the money. When that borrower spends the $100, the aggregate expenditure totals $1,000 ($900 plus $100) against the original income of $1,000, and the economy moves on. When demand for the saved $100 is insufficient, interest rates are lowered, which usually prompts some borrowers to take up the remaining sum. When the demand is too large, interest rates are raised, which prompts some borrowers to drop out.
In the world where the private sector is minimizing debt, however, there will be no borrowers for the saved $100 even with zero interest rates, leaving the economy with only $900 of expenditure. That $900 is someone’s income, and if that person saves 10 percent, only $810 will be spent. But since repairing balance sheets after the bursting of a major bubble typically takes many years (it took 15 years in Japan), the saved $90 will go unborrowed again, and the economy will shrink to $810, and to $730, and so on.
While I am not really enamoured by this representation of the banking system, the dynamic is accurate. The shrinkage in spending is the multiplier in action.
Koo then argues that “Japan faced the same challenge following the bursting of its bubble in 1990, when it lost wealth equivalent to three years worth of GDP on shares and real estate alone (the U.S. lost wealth equivalent to one year’s worth of 1929 GDP during the Depression)”. He reported that “net debt repayment in the corporate sector shot up to more than 6 percent of GDP a year … on top of household savings of over 4 percent of GDP, all with interest rates at zero percent. In other words, Japan could have lost 10 percent of GDP every year, just as the US did during the Great Depression”.
He says that:
Japan managed to avoid the depression, however, because the government borrowed and spent the aforementioned $100 every year, thereby keeping the economy’s expenditure at $1,000 ($900 household spending plus $100 government spending). In spite of nationwide commercial real estate prices falling 87 percent from their peak, Japan managed to keep its GDP above the bubble peak throughout the post-1990 era … Its unemployment rate never went beyond 5.5 percent, either. Private sector balance sheets were also repaired by 2005.
While we talk a lot about the lost decade in Japan the reality is that the government fiscal intervention which was very signficant in relative terms stopped that decade from being a total disaster. The private sector made huge losses but the damage was contained and the fiscal intervention created the conditions whereby the healing was quicker.
The fiscal intervention allowed (“financed”) the increased private saving desires by maintaining demand and hence GDP growth at much higher levels than if the government had not changed policy tack in favour of expansion.
The MMT quibble would be that the characterisation of the government borrowing to spend is erroneous. What happened was that the government spend and then borrowed back some but not all of the bank reserves that the spending ultimately generated. By leaving some excess liquidity in the banking system (that is, borrowing less than the reserves created by the on-going fiscal intervention), the Bank of Japan was able to hold short-term rates at zero (as shown in the graph above).
There was also an private appetite for buying the bonds because they are riskless and offered a yield slightly above the zero on offer from cash holdings.
Koo says that:
Because the private sector was deleveraging, the government’s fiscal actions did not lead to crowding out, inflation, or skyrocketing interest rates.
Again, MMT would not express the situation in this way. The private sector may not have been deleveraging but still wanting to save and the fiscal intervention would not have caused any inflation.
The lack of any inflationary pressure relates to the relative state of nominal aggregate demand growth and the real capacity of the economy (supply-side) to absorb that spending via real output growth. When the non-government sector is increasing its saving rate (and aggregate demand growth falls) then fiscal policy has to fill the gap for output growth to remain stable.
If it “over-fills” the gap and thus runs nominal spending growth above the capacity of the real economy to absorb it then inflation will result. It has nothing to do, per se with the deleveraging of the private sector. The deleveraging is, however, motivated by the increased desire to save which is the ultimate culprit.
Further, there is no financial crowding out issue involved in government issuing debt.
It is clear that at any point in time, there are finite real resources available for production. New resources can be discovered, produced and the old stock spread better via education and productivity growth. The aim of production is to use these real resources to produce goods and services that people want either via private or public provision.
So by definition any sectoral claim (via spending) on the real resources reduces the availability for other users. There is always an opportunity cost involved in real terms when one component of spending increases relative to another.
However, the notion of opportunity cost relies on the assumption that all available resources are fully utilised.
Unless you subscribe to the extreme end of mainstream economics which espouses concepts such as 100 per cent crowding out via financial markets and/or Ricardian equivalence consumption effects, you will conclude that rising net public spending as percentage of GDP will add to aggregate demand and as long as the economy can produce more real goods and services in response, this increase in public demand will be met with increased public access to real goods and services.
If the economy is already at full capacity, then a rising public share of GDP must squeeze real usage by the non-government sector which might also drive inflation as the economy tries to siphon of the incompatible nominal demands on final real output.
However, the question is focusing on the concept of financial crowding out which is a centrepiece of mainstream macroeconomics textbooks. This concept has nothing to do with “real crowding out” of the type noted in the opening paragraphs.
The financial crowding out assertion is a central plank in the mainstream economics attack on government fiscal intervention. At the heart of this conception is the theory of loanable funds, which is a aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking.
The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.
At the heart of this erroneous hypothesis is a flawed viewed of financial markets. The so-called loanable funds market is constructed by the mainstream economists as serving to mediate saving and investment via interest rate variations.
This is pre-Keynesian thinking and was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times. If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving. So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded. The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.
So saving (supply of funds) is conceived of as a positive function of the real interest rate because rising rates increase the opportunity cost of current consumption and thus encourage saving. Investment (demand for funds) declines with the interest rate because the costs of funds to invest in (houses, factories, equipment etc) rises.
Changes in the interest rate thus create continuous equilibrium such that aggregate demand always equals aggregate supply and the composition of final demand (between consumption and investment) changes as interest rates adjust.
According to this theory, if there is a rising budget deficit then there is increased demand is placed on the scarce savings (via the alleged need to borrow by the government) and this pushes interest rates to “clear” the loanable funds market. This chokes off investment spending.
So allegedly, when the government borrows to “finance” its budget deficit, it crowds out private borrowers who are trying to finance investment.
The mainstream economists conceive of this as the government reducing national saving (by running a budget deficit) and pushing up interest rates which damage private investment.
The analysis relies on layers of myths which have permeated the public space to become almost self-evident truths. This trilogy of blogs will help you understand this if you are new to my blog – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3.
The basic flaws in the mainstream story are that governments just borrow back the net financial assets that they create when they spend. Its a wash! It is true that the private sector might wish to spread these financial assets across different portfolios. But then the implication is that the private spending component of total demand will rise and there will be a reduced need for net public spending.
Further, they assume that savings are finite and the government spending is financially constrained which means it has to seek “funding” in order to progress their fiscal plans. But government spending by stimulating income also stimulates saving.
Additionally, credit-worthy private borrowers can usually access credit from the banking system. Banks lend independent of their reserve position so government debt issuance does not impede this liquidity creation.
Finally, Koo knows full well that the Bank of Japan controls short-term interest rates and can, if it wants to, control longer maturity rates. There was never a question that rates would skyrocket!
An interesting part of his testimony came when he compared private savings during the last two years and shows how they “have exceeded increases in government borrowings, which suggest that governments are not doing enough”. He offers this Table (his Exhibit 6) to demonstrate this point (you can read his notes to the Table in the testimony).
From this he concludes that:
Yet policymakers in many of these countries, spooked by what happened to Greece, have made strong pushes to cut budget deficits as quickly as possible. Unfortunately, the proponents of fiscal consolidation are only looking at increases in the deficit … while ignoring an even bigger increase in private sector savings … Removing government support in the midst of private sector deleveraging will repeat the Japanese mistake of premature fiscal consolidation in 1997 and 2001, which in both cases triggered a deflationary spiral and increased the deficit … In fact, Japan would have come out of its balance sheet recession much faster and at a significantly lower cost … if it did not implement austerity measures on those two occasions. The U.S. made the same mistake of premature fiscal consolidation in 1937, with equally devastating results.
This is a powerful statement and has been lost in the policy debate. When you have a collapse in private spending then public spending has to increase both in absolute terms and as a proportion of GDP to make up for that if you want output growth and incomes to be stable.
You might hate government spending so much that you are prepared to tolerate the mass unemployment and massive wealth losses that would accompany a zero discretionary fiscal response. But you should admit that bias rather than lying and trying to persuade the public that private spending will suddenly re – emerge from its slump and start driving output again.
It will not usually do this and when there is balance sheet correction going on it will definitely not do that. The fact is that the fiscal intervention has been too modest by a long way and that is why the US has 10 per cent odd unemployment and Europe is in a deep crisis.
The generational costs of not intervening with fiscal policy are also huge. When you lose your home because you can no longer pay the mortgate after losing your job, the wealth impact is huge and long – lasting.
The only point that Koo assumes in his analysis above is that the external situation doesn’t fill the gap (net exports improving). That is a very reasonable assumption given the widespread malaise in domestic economies but should be made explicit.
Koo also notes that:
There is actually no reason why a government should face financing problems during a balance sheet recession. This is because the amount of money it must borrow and spend in order to avert a deflationary spiral is exactly equal to the un – invested savings in the private sector (the $100 mentioned above) that is sitting somewhere in the financial system. With very few viable borrowers left in the private sector, fund managers in financial institutions should be more than happy to lend to the government, the last borrower standing.
Although talk of “bond market vigilantes” is often invoked by deficit hawks pushing for fiscal consolidation, the fact that the 10-year bond yield in the U.S. today is only 3 percent – an unthinkably low yield given a fiscal deficit of over ten percent of GDP – suggests that bond market participants are aware of the nature of balance sheet recessions.
I liked the “last borrower standing” terminology (and stole it for my title today). But overall MMT would not present the situation in this way.
A sovereign government will never face a “financing” problem because ultimately it can dispense with all the neo-liberal flim-flam that gives the impression that it is issuing debt to spend and keep spending regardless.
Further, it just borrows what it spends anyway. It does not need “prior” saving to draw upon. The spending creates the funds that are drained via the debt-issuance.
But the point Koo makes is important in the sense that credit markets are so weak and bond yields though very low are better than nothing for those holding cash.
Finally, I liked Koo’s conclusion:
Although anyone can push for fiscal consolidation by advocating higher taxes and lower spending, whether such efforts actually succeed in reducing the budget deficit is another matter entirely. When the private sector is both willing and able to borrow money, fiscal consolidation efforts by the government will result in a smaller deficit and higher growth as resources are released to the more efficient private sector. But once every several decades, when the financial health of the private sector is impaired and in need of treatment, a premature withdrawal of that treatment will both increase the deficit and weaken the economy …
Yes, and I would be calling for notable deficit terrorists to sign contracts that they will give up their incomes and wealth when their predictions about austerity fail to materialise and economies head the way that Koo is describing here.
The fact is that there is a current need for even greater fiscal stimulus in every country I can think off. There is no problem with increasing budget deficits as a percent of GDP or increasing the debt ratio. I would not issue any more debt but it doesn’t matter if the government does.
There is no solvency issue at stake for sovereign governments.
There is no risk of inflation at present.
There are greatest gains to be made in reducing unemployment
Policy design would be much better if there was an understanding of what the problems were. That understanding is missing at present and the actions of the deficit terrorists work to further obscure the message from the public.
That is enough for today!