Today’s blog is short. I returned home today to a mountain of things to do and missing luggage. In this day of computer networks and claimed security I fail to see how airlines cannot match every person who has a seat with a bag in the hold. They claim they take bags off when there is a no show so why do they lose bags? Anyway, all my papers from last week’s meetings are in the bag and my favourite coat so I am hoping it turns up. On the blog front, several readers have written to me in the last few days asking me about the rising risk of sovereign defaults that financial markets are apparently “pricing in”. In particular, so-called influential traders are now claiming that the US and Japan are approaching situations reminiscent of “countries on the verge of a sovereign debt default”. Sounds dire. We better investigate – but only for a short bit because I am tired from my journeys.
Bloomberg journalist William Pesek is claiming – Japan faces debt tsunami. In a sorry piece of journalism he seems content to repeat the over-the-top (OTT) ravings of Carl Weinberg (High Frequency Economics) who is quoted as saying that:
A catastrophic breakdown of Japan’s public-sector finances will be the biggest story ever to hit the world economy in our times, eclipsing the current financial crisis …
Weinberg also is reported as accusing the “ratings companies of ‘criminal negligence’ for not lowering Japan’s debt to below investment grade”. It is hard to deal with this sort of comment.
As I have noted previously, Japanese government debt has been regularly downgraded by the in-grate rating agencies.
Rating sovereign debt according to default risk is nonsensical. The default risk on yen-denominated sovereign debt is nil given that the yen is a floating exchange rate and issued by the Japanese government under monopoly conditions.
Why is there no solvency risk? First, when a government bond becomes due for repayment, the sovereign government simply credits the bank account of the holder with the principle and interest and cancel the accounting record of that debt instrument. The banking reserves would rise by that amount and the wealth of the private investor would change in mix from bond to bank deposit.
Second, the massive fiscal deficits that the Japanese Government has run since the 1990s just work in the same way – adding reserves on a daily basis to the banking system (as people spend the yen and deposit them back into bank accounts etc). The bond issues are designed to give the private sector an interest-bearing financial asset to replace the non-interest earning bank reserves. The Bank of Japan has kept the interest rate at virtually zero for years now by leaving excess reserves in the banking system (not draining the deficit impacts on reserves fully with debt issuance). The excess reserves forces the interbank market to compete the rate down to zero.
Third, what if the Japanese Government decided it didn’t want to issue any more debt but still ran the deficits? The net spending would still occur – day by day – and provide stimulus to the economy. But the liquidity effects would just remain in the excess banking reserves and force the private sector to hold the new net financial assets pouring in each day via the deficits in the form of reserves rather than interest-bearing bonds.
The other angle on this that is often overlooked is that the bond holdings of the private sector also constitute an income source – that is, the government interest payments on its outstanding debt constitute another avenue for stimulus. So when the Government retires debt it reduces private incomes.
Pesek acknowledges this:
Until now, Japan has been remarkable at controlling its bond market … More than 90 per cent of government bonds are held domestically, removing the risk of capital flight out of yen assets. They are the core financial holding of banks, investors, insurers, pension funds, public entities and individuals.
The Japanese Government knows that its debt is seen as a safe haven during volatile economic times and realises that the steady and predictable income flow derived by the private sector holding the public debt is a source of security and a positive influence on growth.
Pesek also quotes US hedge-fund manager David Einhorn extensively. The latter was a guest speaker at a major investment conference recently and his full speech is available HERE.
Einhorn ridiculed claims that the US “made a great mistake by withdrawing stimulus in 1937” and said:
Just to review, in 1934 GDP grew 17.0%, in 1935 it grew another 11.1%, and in 1936 it grew another 14.3%. Over the period unemployment fell by 30%. That is three years of progress.
We could dispute these figures (they are wrong) but the point he is attempting to make contains a more important flaw and I am short of time today.
An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fall out. Our choice may be either to maintain large annual deficits until our creditors refuse to finance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline.
Which clearly misses the point of the deficits in the first place. There is nothing artificial about growth and job creation. We might dispute the composition of the growth and the type of jobs and consider the distribution of spending could have been better but the dollars spent are real (irrespective of where the spending is coming from) and the output response is not fictional.
The reason the US economy double-dipped in 1938 was that private saving had begun to recover from the 1932 and 1933 negative rates. At that time, US households were running down saving to maintain living standards as unemployment rose. The point is that if the stimulus is removed before the private sector recovery is evident then, of-course, the spending gap will widen and you will get “significant economic fallout”.
So the only choice is to maintain the deficit or adopt “fiscal discipline” which equates with falling GDP and rising unemployment and further dents in confidence. Somehow, that is not my interpretation of discipline.
Also Einhorn doesn’t hesitate to introduce the “refusal-of-bond-markets-to-finance” problem. This sounds like some evil threat in Batman or Get Smart to me because it certainly doesn’t bear any relation with the datasets that I have seen over many years.
Einhorn then agrees with right-wing American Enterprise Institute for Public Policy Research which said that:
… by all relevant debt indicators, the U.S. fiscal scenario will soon approximate the economic scenario for countries on the verge of a sovereign debt default.
It hinges of what are “relevant” debt indicators. From a perspective of modern monetary theory (MMT), the sort of indicators used by the mainstream economists (including the AEI) are not relevant. Clearly, there is no risk of sovereign debt default in the US unless for perverse political reasons the US government chose this course of action. So if there is no risk … then the indicators that the conservatives wheel out must be signalling circumstances other than default.
Inflation? Not likely at present with continued deflation being the issue.
Rising interest rates? The Bank of Japan is keeping short rates at zero (and it has demonstrated that it can do this indefinitely). Further, as we have learned in the past, by keeping short-term interest rates at zero, the longer maturity rates are also lower than they would otherwise be. And with deflation an on-going issue the yield curve spread between longer-rates and short-rates are likely to remain narrow.
It is clear that Japan’s deficits will continue to rise until its export markets are stronger given the huge leakage that occurs from the income-expenditure stream as a consequence of the high domestic saving ratio.
But with the massive deficits and accompanying bond sales the long-term bond yields are still very low compared to say the US or Australia. There is always a strong demand for the government paper in Japan. It is clear from current financial market news in Japan that the four large life insurance companies are queuing up to buy the debt.
Pesek suggests this is driven by their desire to “to head off a jump in yields” (that is, keep demand strong and yields low). Who knows their motivation. But throughout the so-called lost decade there was always a very strong (unwavering) demand for government bonds in Japan.
What does Einhorn know that we have never observed that would render that demand non-existent or even weak (such that yields rose)? I think nothing.
Further if things got that dire and no-one wanted the debt then the Government (presumably – I must check on this) could just modify its debt-issuance policy and allow the deficits to sit in the banking system as increasing reserves. As long as the domestic saving ratio is high and net exports weak, the deficits will continue to support aggregate spending and output without being inflationary.
As an aside, several readers have asked me about this for Australia. They want to know whether demand for Australian government paper is declining. I will write a dedicated blog on recent trends in the Australian bond market soon. The short answer is that demand remains very strong and yields are well below the coupon rates for the issues.
Time for sleep.