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Thoughts from the Frontline

Central Bankers Gone Wild

June 1, 2013

When Jonathan Tepper and I wrote Endgame some two years ago, the focus was on Europe, but we clearly detailed how Japan would be the true source of global volatility and instability in just a few years. “A Bug in Search of a Windshield” was the title of the chapter on Japan. This year, I wrote in my forecast issue that 2013 would be “The Year of the Windshield.” For the last two weeks we have focused on the problems facing Japan, and such is the importance of Japan to the world economy that this week we will once again turn to the Land of the Rising Sun. I will try to summarize the situation facing the Japanese. This is critical to understand, because they are determined to share their problems with the world, and we will have no choice but to deal with them. Japan is going to affect your economy and your investments, no matter where you live; Japan is that important.

In bullet-point fashion, let’s summarize the dilemma that faces Abe-san, Kuroda-san, and the other leaders of Japan.

  1. Japan is saddled with a yawning fiscal deficit that, if it were closed too quickly, would plunge the country into immediate and deep recession. The yen would strengthen, and Japan's exports would once again be damaged. Such is the paradoxical outcome if you suddenly decide to live within your means when you have been on a spending binge. The Japanese deficit is close to 10% of GDP. For my US readers, think about what would happen next year if the government cut $1.6 trillion from our budget.

    Japan has a GDP that is now close to 500 trillion yen (give or take a few tens of trillions). Their most recent budget calls for Y92.6 trillion in spending, almost evenly divided between Y43.1 trillion financed from tax revenues and Y42.9 trillion from the issuance of new bonds, adding to Japan's massive public-sector debt that already totals nearly Y1 quadrillion. Say that with a straight face: 1 quadrillion. And this massive debt is not a recent phenomenon: it has been accumulating for many years.

    Tax revenues have been going down for decades, as the country has been mired in no-growth deflation for 24 years. Revenues are now down to where they were in 1985. By way of comparison, US tax revenues in 1985 were $734 billion (or $1,174 billion in constant 2005 dollars). Last year, US revenues were $2,450 – that is, more than double the 1985 total. (

    The following chart is courtesy of my friend and Japan expert Kyle Bass at Hayman Capital Management. If this were a stock, would you be a buyer?

  1. Japanese ten-year interest rates exploded from just above 30 basis points to over 1% at one point in the past month. The Bank of Japan (BOJ) intervened, but rates closed today at 0.85%. Note that they are still down from the 1.3% where they stood two years ago.
  1. It costs the Japanese government 24% of its revenues just to pay the interest on its debt at current rates. According to my friend Grant Williams (author of Things That Make You Go Hmmm...), if rates rise to just 2.2%, then it will take 80% of revenues to pay the interest. Even at the low current rates, the explosion in Japanese debt has meant that interest rate expense has risen from Y7 trillion to over Y10 trillion. Note in the chart below (also from Kyle) that the Japanese government is now issuing more in bonds than it pays in interest. Somewhere, Charles Ponzi is smiling.

Just for fun, here is a picture of Mr. Ponzi writing a check (courtesy of Geert Noels).

  1. For 20-plus years, Japanese nominal GDP has barely risen. If your nominal GDP stagnates and you are running large deficits every year, then your debt-to-GDP ratio rises. For Japan, the ration will be a staggering, never-before-seen 245% this year.  

  2. The only way you can lower the rate of debt-to-GDP expansion – and perhaps convince investors to continue to buy your bonds – is to increase your nominal GDP while slowly lowering your deficit over time until the increase in your debt is less than the nominal growth of your economy.
  1. After years of running trade surpluses, Japan is now running a trade deficit. Basic economic accounting tells us that for Japan to get to its goal of sustainability, it absolutely must have a trade surplus. And as deep a hole as Japan is in, it needs seriously large trade surpluses. Like back in the good old days of only a few years ago. Not to mention that the country's current account surplus is down by over half from its peak in 2007 and back to where it was 20 years ago. The trend is ugly.

  1. There are only two ways to get nominal growth. You can get real growth or you can create inflation. There are not many things that you can get Hayek and Keynes and every other economist to agree on, but this one thing is the universal answer to your fiscal problems: Growth, with a capital G. That is the remedy put forth by every economist and every politician : “We need to grow our way out of the crisis.” But there are two problems as Japan tries to get to growth.  

Problem #1: Your nation is aging, and internal consumer spending is not going to be a source of real growth. You have to talk like that can happen, but you know it is just not all that realistic. You have been trying for 20 years to get your country to spend, and people are just not up to it. What you really need is for your export base to get with the program and massively increase its sales to the rest of the world. In fact, that is your only real option. And one of the easiest ways to do that is to drive down the value of your currency, especially against the currencies of competitor nations. That boost in exports can help relieve your chronic excess productive capacity and maybe, possibly, hopefully, engender a labor shortage and drive up the cost of labor, which will help stimulate inflation.

Problem #2: You are mired in deflation and have been for 20 years. Since there is no natural source of inflation in Japan – a nation of savers and an increasingly elderly population –you have to create inflation by increasing the prices of your imports. And the way to increase those prices is to drive down the value of your currency, especially against the dollar and the euro.

Hmmm, we see a possible strategy emerging here.

  1. But if you set out to decrease the value of your currency, you violate all sorts of central banker and G7 codes and rules. Given the scale at which you need to operate, you would start a currency war, and no major central bank could possibly be associated with something so distasteful. That is a touchy problem, but fortunately for you there is a solution: you can engage in quantitative easing in order to stimulate your economy. That is certainly within the rules, as the central banks of every other major member of the club (the Fed, ECB, and Bank of England) have been doing it for years.<

    How can anyone object to a policy that simply targets inflation? The fact that such a pursuit happens to drive down the value of your currency is merely a by-product of the necessary pursuit of mild, 2% inflation, which is the only way for your country to get out of its slump. The other big players all have 2% inflation targets; you are just aligning Japan's course with their own stated policies. And besides, even with the huge size of your announced quantitative easing, you can point out that you are way behind the growth of the monetary base of the Fed, the ECB, and the BoE.

  2. That brings us to a major dilemma, which Kyle Bass calls the Rational Investor Paradox. If you are an investor or fiduciary in Japan and you now believe the Bank of Japan is quite serious about creating inflation, do you continue to hold Japanese government bonds (JGBs)? Any serious analyst would assume that interest rates will climb to at least the rate of inflation, assuming you believe that Japan can create inflation. And especially if they pursue a policy that is going to lower the purchasing power of the yen, why would you, a rational investor, want to hold long-term Japanese bonds? Why wouldn't you sell as soon as Kuroda announced the “shock and awe” policy? (It certainly left me in shock and awe! And intellectually, I knew it had to be coming!) And that is exactly what happened the day after Kuroda announced his policy. The BoJ had to step in a few days later and start buying bonds in significant quantities to hold the rate down.

  3. Your problem is compounded by the fact that the natural buyers of your bonds for the last 20 years have been the retirement plans of your workers. But your country is rapidly getting older, and now those pension plans and individual savers are starting to cash in those bonds in order to meet pension obligations and to live in retirement. Your major pension plans are now sellers (on net) of JGBs. Mrs. Watanabe is not going to be a buyer of bonds in retirement. She will want to sell in order to buy rice and help out her grandkids. She will need to pay for rising energy and healthcare expenses and other basic needs. In short, you are rapidly running out of buyers “at the margin,” which is where markets are made.

  4. Now, to the crux of the problem. You cannot allow interest rates to rise much more than they already have. That way lies fiscal disaster. Yet the buyers of Japanese bonds are starting to get nervous and to leave the market, which is a rational consequence of your drive for inflation, which you absolutely must have if Abenomics is to have a snowball’s chance in Hades of working. That means there is only one real source of bond buying power left: The Bank of Japan.

    The Bank of Japan is on its way to becoming the market for Japanese bonds. It is eventually going to have to “hit the bid” on every bond that is issued by the government, because if the current policy is maintained it will drive all buyers from the market, leaving just sellers. The pension systems will not necessarily exit their JGBs, but they will let them roll off as they need to raise cash to meet their pension obligations. International buying of your bonds will also slow to a trickle.

    The Bank of Japan is going to have to print – sorry, Kuroda-san, I mean pursue quantitative easing – to a far greater extent than it has announced in order to keep up with the demands that will be heaped upon it. We are talking about numbers that will stagger the imagination. This will be bigger than Carl Sagan’s "billions and billions." It will not be long before the word quadrillion starts to be used more frequently. Kyle Bass remarked during the webinar that he, Jon Sundt, and I just recorded that if you started counting and called out one number every second, it would take 33 million years to get to a quadrillion. A quadrillion is a thousand trillion, or a million billion or a billion million. We humans simply have no way to grasp the enormity of such a number. Nor can we understand the implications when such fantastic numbers must be applied to the world’s money supply.

Exporting Deflation

  1. In summary, along with increasing your exports of cars, flat-panel screens, robots, and machine tools, you are going to try and export the one thing you have in abundance that the world does not want: deflation.

This is a nightmare scenario for central bankers worldwide. If there is a mandate, a central theme in the Handbook for Central Bankers, it is that deflation must always and…

Discuss This


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Sep. 26, 2013, 11:45 p.m.

Phrases like “bank bailout” and “too big to fail” have left a bitter taste in the mouths of customers. The outcomes are easy to see in recent consumer confidence polls, suggests Bankrate. “Do you trust your bank?” posed a recent financial institution sentiment polls by consulting firm BAI & Finacle. Not astonishingly, recession-stung customers responded largely in the negative. Not only that, but the survey confirms that bankers’ assessment of customer confidence is entirely out of whack. I read this here: Consumers trust banks a great deal less than bankers think they do

Andy Toop

June 3, 2013, 12:46 a.m.

DC, NYC, France, Cyprus, and Vegas…

Who’d have thought that on that trip, Vegas would be the place with the least riding on a roll of the dice!

Hang emhi

June 2, 2013, 7:05 a.m.

One person’s/entities debt is another’s savings.  So high gov debt causes high savings and vice versa.  Understanding that you see that this article talks out of both sides of its mouth saying “problem of deflation due to elderly saving” and later that these savers won’t be buying bonds because now they have to spend.  Mauldin sees this as a problem of no one buying Japanese gov debt rather than there being less need for Japanese gov debt.  It is clever to talk about how long it would take to count to a quadrillion so that people are so scared they don’t see the glaring mistakes in the rest of the analysis

June 2, 2013, 3:25 a.m.

An excellent summary. In Endgame the Japanese chapter makes reference to Japan’s substantial foreign exchange reserves in only one brief sentence.
I would like to know how these signicant reserves may influence the outcome. Surely they at least buy some time?

Warren Stephens

June 2, 2013, 2:42 a.m.

“There are only two ways to get nominal growth”. 

Let’s review the economists GDP “identity” for “nominal” GDP:

With consumption (C), real investment (I), government spending (G), and exports (X), less imports (M).

Y = C + I + G + X – M

with T for Taxes, and rearranged:

I = (Y - C - T) + (T - G) + (M - X)

So, Gross Investment = Private Savings + Government Savings + Foreign Savings

But after introducing “nominal” Printed Money or “P”:

I = (Y - C - T) + (P + T - G) + (M - X)

Here, P looks the same as increased Taxes, but with the private sector not having to pay them.


I = (Y - C - T) + (T - G) + (P + M - X)

Here, P looks the same as Foreign Savings, but with foreigners not having to really invest.


I = (Y + P - C - T) + (T - G) + (M - X)

Here, P looks the same as an increase in private savings, but without the private sector having to cut consumption.

“Nominal growth” is something only economists and governments desire.

Marshall Gittler

June 1, 2013, 10:52 p.m.

Grant’s figure of 24% of revenues to pay the interest on Japan’s debt is wrong. That is the total debt servicing cost, which includes roll-over of maturing bonds. The interest payments are Y9.9tn or 10.7% of total revenues, not far off from the US. See “Highlights of the Budget for 2013” slide #6 at The Y9.9tn is actually less than in 2001, as interest rates have continued to decline, which is why Japan hasn’t blown up yet (see graph #6 in “Japan’s Fiscal Condition,” )

However…the “total revenues” figures includes bond issues, so it’s sort of double counting, no? Interest payments as a % of tax revenues are the crucial figure to me. Interest payments are 23% of tax revenues, which is indeed quite high.

I don’t see how Grant calculates that if rates rise to 2.2% it will take 80% of revenues to pay the interest. Finance Minister Aso was reported as saying that every 10 bps increase in rates adds Y100bn to the interest bill. Assuming rates are 0.5%, a rise in rates to 2.2% would be a rise of 170 bps, which would add Y1.7tn to the interest bill, bringing it to Y11.6tn. That’s 12.5% of total revenues or 26.9% of tax revenues. On the other hand, the 10 bps = Y100bn calculation seems a little too neat for reality. I would like to see a worked calculation for this.

Gordon Davis Jr

June 1, 2013, 8:48 p.m.

It would appear that these are historic times.  Assuming a “currency war” is inevitable, we will soon be immersed in a world wide trial of modern monetary theory.  Of course we won’t call it that but even now it becomes clear that central bank unwinding is more or less a fantasy.  Central bank “easing” around the world has become a very thin veil over what is nothing more than the printing and thereby debasing of fiat currencies.  Hard to see how this ends well.

June 1, 2013, 7:59 p.m.

Dear John, do you remember that completely stupid idea of mine of an universal debt pardon in order to get out of this mess? Well, to me it looks increasingly as the only alternative left. I know you don’t agree. We will talk again about this stupid idea in another year or so…

Nick Jacobs

June 1, 2013, 7:42 p.m.

“But if you set out to decrease the value of your currency, you violate all sorts of central banker and G7 codes and rules.”

And the penalty for violating these rules is ... what?

Paul Speer

June 1, 2013, 5:42 p.m.


There is also the prospect of Japan having to amend the constitution and fund rearming to face the PRC claims in the Ryukyu chain.

I have always been a fan of matching term of assets to the life of liabilities, and to specifically note the funding of assets with the series of liabilities being offered.

It is time to consider the use of Consols as a partial solution to the Japanese problem.


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