Saturday, April 3, 2010

The curious case of Japan

According to the deficit terrorists, Japan should be going down the drain.

After a Republican administration where "deficits don't matter", as Dick Cheney put it, we are back in familiar territory with a Democratic administration hounded by the deficit terrorists for "profligate" spending and a "burgeoning" public debt that is "unsustainable", "out of control", with debt clocks counting down (or up) and warnings of armagaddon. Which is it, and why all the drama?

The drama, as one can imagine, is almost entirely political. But before we get to that, one needs to understand the substance of national debt. In this analysis I am following the Modern monetary theory school of William Mitchell et al., whose blog rewards close study. This perspective was also recently put very well by James K. Galbraith.

In the modern state system, nations issue fiat currency that has no intrinsic value- it isn't based on gold, conch shells, or anything else. Its value derives from the state's power to coerce all citizens to settle their taxes to and payments from the government with this symbolic tender, and the promise that the government will maintain that tender at stable value through its monetary policy actions. It also floats vs the currencies of other countries, adjusting relative value continuously in response to trade balances and related currency trading.

Other systems, where nations have pegged their currency to some external value, are not uncommon (the Euro nations have notional sovereignty individually while not having sovereign currencies, and China has effectively pegged its currency to the dollar). But they have an entirely different set of problems, are not the focus of this theory, and are not relevant to the US monetary system. Gold, thankfully, is no longer used anywhere as a currency base.

So the government creates currency and spends it, transferring it to the private economy, and then demands some of it back as taxes. The government is free to produce as much currency as it likes, but if it goes on a bender, (as in Zimbabwe), then its people find that their currency has become worthless, since an excess of paper notes are chasing a limited number of real goods. Note that the Zimbabwe situation is due both to excess currency production, and also to a death-spiral decline of real goods production.

The next step of a currency-issuing government is to allow banking to take place. Banks take deposits of currency in return for promises of interest payments and safekeeping, and likewise extend loans for (higher) interest in return for promises of repayment. This system has the ability to create money as well, in the form of loans which the bank credits as deposits to the account of the debtor. There is no intrinsic need to have deposit money on hand to cover the loan created, and indeed according to MMT, there isn't really even a fractional necessity for some reserve amount to support lending- a point that Ben Bernanke has recently underlined by suggesting that the US scrap fractional reserve requirements entirely for banks. "The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system."

Allowing banking is quite dangerous, since this money created by banks (called endogenous, as balanced debt and asset accounts in the private economy) and can implode in crises like we have recently experienced. Banks call in and extinguish loans, refrain from making new loans, and debtors walk away from their remaining balances, which are then written off. This is in addition to the market-based paper wealth lost in such a crisis, also in large amounts. The government tries to control this money by regulation, like centrally controlled interest rates, capital requirements, and sound lending practices. We learned recently what can happen when these controls go by the board.

Part of the mechanism by which the government controls interest rates and inflation are Treasury bills, notes, and bonds, created to exchange money out of the private system in return for more ornately printed pieces of paper which function as longer-term money, with maturities set from one month to thirty years.

If the government offers a bond at a selected interest rate, and finds buyers, this sets the national interest rate at that maturity level, since private bankers, with their higher risk and need for a spread, would never offer loans for lower interest, nor deposits for much higher interest. They get their liquid money from this bond system and related instruments, after all. The government can (print up) and buy and sell massive amounts of such bonds in its market operations in order to achieve the interest rate structure it desires.

The key question is- why is money available to buy these bonds? Isn't everyone busy buying and selling real goods, and also squeezing their last farthing to pay taxes? No- some people restrict their consumption in order to save for the future. Much of this saving constitutes the private debt/asset balances of investment and bank operations, and as such keeps churning around the private economy. But if the government offers a perfectly safe way to save and pays a modest level of interest as well, why not take advantage of it?

This saving is foregone consumption for the private sector as a whole, and the government gathers up this net saving as its inflow of bonds, amounting to the national debt, denominated in its own currency, which means that it can pay any interest required by again printing money as needed. All this foregone consumption doesn't contribute to inflation, which is a function of consumption, so neither does the bond and debt position of the government.

What we have here, then, is a grand cycle of money creation and storage, where money issued by the government is collected back from the private sector in taxes and bonds, then spent again (or burned, or stored on an electronic account) by the government, as it deems best to keep the value of the currency stable. If government spends too much without collecting commensurate amounts of money back in taxes or bonds, (or seeing it disappear into the hands of foreigners by way of the balances of trade), inflation results. Conversely, if it collects too much, or issues too little, then deflation results, barring the effects of private money creation.

You can see from all this that the absolute level of government debt is immaterial. It is the flows that are important, and these flows tend to be self-correcting as the system evolves, with excess spending and public debt in low points of the business cycle where private savings flee to the safety of government bonds just as the government has greater spending needs for unemployment and other cyclical costs, (or more hopefully, for anticyclical fiscal intervention), and conversely at high times of the business cycle, high appetite for private investment risk (rather than government bonds) and lower government spending.

When well managed, these flows keep the currency value stable even as they counteract problems that private economy creates through the business cycle, and also provide a savings vehicle that institutions and citizens take advantage of (now that, through the wonder of capitalism, they typically have no pensions and may still be thinking about retirement). Low inflation can be as compatible with high debt as with low debt, since the absolute amount of debt has no direct effect on inflation. Nor does it have effects on anything else, other than an obligation for the government to, minimally, keep printing the money required to service the debt and to redeem it or roll it over, as it desires for its macroeconomic policy settings.

At last, we now get to Japan, whose population of champion savers has generated a government debt of 200% of GDP, the second highest in the world (second to Zimbabwe, indeed). That is 2.5 times the level of ours, which stands at 80% of GDP. With all the hue and cry about our public debt, you would think that Japan is a bananna republic, already twirling down the proverbial drain. The ratings agencies think so, having downgraded Japan's soverign debt a few times.

But they don't know anything. (Big surprise!) Japan can keep on printing whatever money is needed to cover the interest as well as further fiscal stimulus, since it has been facing deflation, not inflation, for nearly twenty years. The meaning of this is that Japan, as a currency system, has been underconsuming for many years, preferring to save vast amounts of money in their state-run postal / banking system: the money that the people owe to themselves. Additionally, Japan's large export surpluses mean that, unlike the US, Japan is not devoting any of its public money creation or fiscal spending to the accumulation of foreign Yen balances. So the system stands out as unusual, but also quite innocuous- a stable and prosperous nation which happens to have a super-high amount of debt (i.e. savings) owed to itself in a great big government piggy bank.

What does the future hold? Could everyone in Japan take a year off of work and consume out of savings? That wouldn't work, since there would then be nothing produced and nothing to buy. Inflation would quickly result. But a little of that would't hurt, since deflation has been ongoing for over a decade.

Savings rates are declining in Japan, and its pension funds have become net sellers of government bonds. This means that the government will find it more difficult to sell bonds at its chosen interest rate of near zero. This won't be a problem in the least. Japan does not need to sell bonds to "finance" its public spending (nor does any fiat currency-issuing government). They can just print it. Indeed, perhaps at that point, without mitigating bond sales, their fiscal stimulus will finally have the positive effect of reversing the deflation that has been dogging the economy so long.

The debt will decline as the demographic transition works out, and the real claims this debt represents will be drawn as consumption, returning Japan to a more normal state of economic affairs, perhaps even importing more goods from the US, and devoting more of its saving to business investment after a long period of investment decline. Japan's public debt may well remain relatively high, however- a healthy safety blanket for a security-minded, saving-oriented culture.

Incidentally, why all the political posturing on public debt here in the US? Some fears are honest, but inapplicable. Others are purely opportunistic. Debt denominated in a currency you don't administer is indeed highly dangerous, as Greece found out this year. They are in the same situation as any household- having to balance income with outgo, and make up the difference with temporary borrowing on the private bond markets. No printing Euros for them! Debt to others is risky indeed. But public debt in our own currency is not, even if that currency is lying in Chinese bank vaults (whose spending would cause devaluation of the dollar vs the RMB, exactly what China so staunchly resists).

One might also compare all this for a moment to private debt, like sub-prime mortgages or over-leveraged credit default swaps. Such debts are unstable, since they are not backed by a fiat currency- issuing government, (supposedly, at least). Such a government may make an error in its inflation settings, but has no reason to ever default on its own-currency debt. Private debts are subject to loss of confidence of repayment or outright default, such as in the Lehman situation, when the ability to make payments is interrupted, if only temporarily in a great game of musical credit chairs. Such catastrophic loss of confidence is impossible for public debt in financial terms. Only in political terms, through revolution or other complete breakdown, could such confidence be put in question.

Much confusion arises since the word "debt" is used, and the analogy of government debt to household debt is so very tempting. But they are not the same at all, and shouldn't be confused. Public debt could just as well be called public savings, (much like the chimerical Social Security trust fund), though either way it only represents redistributed claims on future real production, not actual saved-up production or loss.

So Dick Cheney was right. Debt doesn't matter, other than how the Treasury and central bank handle its flows in their pursuit of stable monetary value. Real macro-economists worry about inflation and unemployment, not public debt.

However, much of the confusion and vitriol is not honest at all, but part of a longstanding conservative agenda to hobble government, to prevent policy action by Democrats, to keep the private sector in the driver's seat of (volatile) money creation, and, most perniciously, to prevent the use of fiscal tools to improve the position of labor.

The original mandate of the Federal Reserve was to keep the money stable and to maintain full employment. Conservative ideology has chipped away at the latter bit by bit, until today that part of the Fed's mandate is all but forgotten, in favor of the first. High unemployment (as much as low inflation) is in capital's interest, decreasing labor costs in a hyper-competitive labor market. Proper use of Keynesian policy with fiscal support at ebbs of the business cycle can keep employment high with minimal impact on inflation, however, as it did in the 50's and 60's.

Certainly in this cycle, the amount of fiscal stimulus in the US has been insufficient, and been inefficiently applied. Unemployment remains shockingly high. Debt terrorism is explicitly dedicated to preventing any more stimulus from being created, even as we still face more deflation than inflation pressure, and more importantly, devastating unemployment. From a macroeconomic perspective, this makes no sense, since we have such glaring infrastructure and other needs (green energy) which could be so productively matched with unemployed labor. But no! Nothing further should be done- we must await the spiritual stirrings of our bankers who, doing God's work, may, in the fullness of time, once again deign to lend to worthy capitalist projects.

  • Some more data on Japan, with a conventionally alarmist view of debt.
  • Excellent counterpoint.
  • Some more details on the Fed... accountability might be better than independence.
  • Newsletter of Fed data, with graph showing the direct relation of private saving with government debt (I believe BOCA refers to the leakage due to trade deficits, to be added to private saving).

  • Debt terrorism, cont... not that a smaller union among a few northern European nations wouldn't make more sense than the broad euro zone, but that there is any "possibility of a catastrophic plunge in faith in the dollar" from "which global investors could flee".
  • Legalize it (the poppies) ...
  • Then replace the Afghan government.
  • And then my wife said: "What's an atheist at his funeral? .. All dressed up, and nowhere to go."
  • Manipulation of morality in the brain.
  • Goodbye to coal.
  • Bill Mitchell quote of the week:
"It is now forgotten but the ECB also took advantage of hundreds of billions of US dollars provided by the Federal Reserve via swap lines which helped prevent an entire collapse of the European banking system.
Further, the only sustained fiscal response to the crisis by the EMU has been to pressure member governments to employ pro-cyclical policies to get back within the “rules” even though the rise in the budget deficits was driven significantly by the automatic stabilisers. Pro-cyclical fiscal policy is the exemplar of bad policy practice and defies the concept of sustainable fiscal intervention."

1 comment:

  1. The is one debt (deficit) we need to take care of on a consistent basis that will significantly redefine the frame of reference for the whole discussion is the following:

    "Owe no one anything, except to love one another; for he who loves his neighbor has fulfilled the law." (Romans 1.8)

    If we would endeavor with all personal and communal responsibility to struggle consistently to this end we would find ourselves thinking and acting differently toward the issues of economic policy and a bunch of other things as well.