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Thoughts from the Frontline

The Mother of All Painted-In Corners

May 25, 2013

Alice laughed: "There's no use trying," she said; "one can't believe impossible things."

"I daresay you haven't had much practice," said the Queen. "When I was younger, I always did it for half an hour a day. Why, sometimes I've believed as many as six impossible things before breakfast."

– Alice in Wonderland, Lewis Carroll

I wrote several years ago that Japan is a bug in search of a windshield. And in January I wrote that 2013 is the Year of the Windshield. The recent volatility in Japanese markets is breathtaking but characteristic of what one should come to expect from a country that is on the brink of fiscal and economic disaster. I don't mean to be trite, from a global perspective; Japan is not Greece: Japan is the third-largest economy in the world. Its biggest banks are on a par with those of the US. It is a global power in trade and trade finance. Its currency has reserve status. It has two of the world’s six largest corporations and 71 of the largest 500, surpassed only by the US and comfortably ahead of China, with 46. Even with the rest of Asia's big companies combined with China's, the total barely surpasses Japan's (CNN). In short, when Japan embarks on a very risky fiscal and monetary strategy, it delivers a serious impact on the rest of the world. And doubly so because global growth is now driven by Asia.

Japan has fired the first real shot in what future historians will record as the most significant global currency war since the 1930s and the first in a world dominated by true fiat money.

At the risk of glossing over details, I am going to try and summarize the problems of Japan in a single letter. First, a summary of the summary: Japan has painted itself into the mother all corners. There will be no clean or easy exit. There is going to be massive economic pain as they the Japanese try and find a way out of their problems, and sadly, the pain will not be confined to Japan. This will be the true test of the theories of neo-Keynesianism writ large. Japan is going to print and monetize and spend more than almost any observer can currently imagine. You like what Paul Krugman prescribes? You think he makes sense? You (we all!) are going to be participants in a real-world experiment on how that works out. 

(Note: This letter will print longer than usual as there are a lot of graphs.)

But first, I want to mention a very special event, that is of great relevance to this discussion, and that will be coming your way in just a couple weeks. I'm going to get together in New York with five of the most powerful investing minds in the world – Kyle Bass, Mohamed El-Erian, John Hussman, Barry Ritholtz, and David Rosenberg – and we're going to totally take apart the New Normal environment in which we all find ourselves and then rethink and rebuild it in a way that will help you not only survive it but profit from it. Investing In the New Normal will feature a full hour of our unfiltered conversation and uncensored analysis. It will come to a computer screen near you on Tuesday, June 11, and you will want to be there! The event is free, and you can register here. Seriously, a full hour with those five guys. How cool is that? I will make sure you get a few powerful take-aways that will impact your thinking and your investing. And now, let’s take a look at that hard windshield and that big bug.

The Mother of All Painted-In Corners

In no particular order, let’s look at some facets of the daunting task facing Prime Minister Abe and the country of Japan.

After the collapse of what might still be the largest economic bubble in history, in 1989, Japan is still mired in a 24-year non-recovery. Nominal GDP in 2011 was almost exactly what it was 20 years earlier, in 1991 ( You can…

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Jim Summers

May 27, 2013, 5:23 a.m.

Why is there a constant emphasis on how Krugman’s suggestions are bad?  Over and over again, since before this crisis got started, I have been hearing there are no good solutions to the crisis.  So of course Krugman’s solutions are bad; austerity is also bad, and anything Mauldin or his friends suggests is bad too.

When there are no good solutions, it is a strawman argument to point out that any particular solution is bad.  Rather than simply repeating the strawman argument that Krugman’s suggestions are bad, maybe you could spend more time comparing his solution to alternate bad suggestions, and perhaps say which is worse.

Also, perhaps we should remember that the government isn’t alone in making bad decisions.  Private banks made bad loans, the rating agencies awarded bad ratings and private insurance companies made promises they couldn’t keep.  The government was forced into a bad decision to bail out the private sector, which is the major blame for recent increases in government debt.  Financial companies, in the absence of regulation and enforced reserve ratios, created a lot of fiat debt, that governments turned into fiat currency.  Let’s not ignore the bad decisions in the private sector, which made the choices of the government much worse than they could have been.

Tom Warner

May 26, 2013, 5:48 p.m.

I appreciate the way you take a strong position while at the same time admit that we’re in uncharted territory and nobody can know how this will play out.

I see things somewhat differently. What really matters for well being is GDP/capita and Japan is not doing unusually poorly. Japan has been reducing investments in capacity that caters to domestic demand while maintaining high investment in R&D, export-oriented production and FDI, which is what they need to do. Japan has not been falling apart or even falling behind.

Deflation is not by itself the huge problem that many have made it out to be. What matters is the real interest rate. A 1% deflation rate and zero interest on demand deposits equals a 1% real interest rate on demand deposits, same as a 2% inflation rate and 3% interest rate on demand deposits. That’s actually fairly normal. What deflation does is prevent the central bank from engineering negative real interest rates. It has become the fashion lately to believe that negative real interest rates are good, and thus, deflation is bad. Some people also cite the scare-story of depression-era deflation when prices were dropping so quickly that consumption was discouraged. Japan does not have that kind of deflation. Its deflation is largely driven by technology advancement.

But shrinking population also requires adjustments to fiscal policy, which Japan has been resisting for far too long. As always with debt, it’s the real interest rate that matters. Despite the Japanese government’s low nominal borrowing costs, its real borrowing costs are relatively high. Japan has been able to fund those deficits with trade surpluses, now gone, and income from foreign investments, which continues to be strong. But there has been an increasing crowding out effect, working largely through FDI income coming home to buy JGBs and driving up the yen, decreasing competitiveness.

Getting a clear picture of Japan’s debt problem is very complicated. Much of the gross debt is owned by the government, so there is no interest really paid, except by one arm of the government to another arm of the government. The government owns other domestic financial assets that it earns income from, and the central bank owns lots of FX assets, mainly Treasurys.

One way of looking at what Japan is doing is that it is sidestepping new borrowing without reducing its fiscal deficit. The government borrows from the central bank, paying effectively no interest, as the central bank refunds its interest income to the government. Rising interest rates would still be a problem because of all the JGBs held outside the government, but the new issuance is in terms of interest cost-free. The central bank’s funding of the fiscal defict also frees up that FDI income to do other things, mainly abroad, which explains the drop in the yen.

Another way of looking at what Japan is doing is that it’s trying to inflate away its debts. Certainly there is some hope but I don’t see huge confidence even from the policy makers. The central bank is talking about achieving 2% inflation in two years helped by a big increase in sales tax, which comes to practically no underlying inflation. My suspicion is the consumption tax increase won’t happen, or will be offset by other stimulus as soon as the fiscal drag bites.

As for Romer, Krugman and the many other Keynesians who are strongly supporting Abe’s policy, they don’t seem to realize how far they have left Keynes behind them. Keynes favored counter-cyclical stimulus. The argument that the United States remains in a cyclical lull and requires counter-cyclical stimulus four years after the recession bottomed is dubious enough, but at least there’s room for debate. The US does still have high unemployment and it’s easy to believe that it’s a cyclical issue. There’s no way to argue that Japan’s low demand is cyclical. Japan has low unemployment and its demand shrinkage is driven by population shrinkage. By promoting massive counter-cyclical stimulus against patently structural problems, today’s Keynesians are making a leap of faith in a direction that Keynes never pointed them toward.


May 26, 2013, 10 a.m.

Glossing over details ? I think is more like messing over.

“If you run a trade deficit and a fiscal deficit, either private savings has to make up the difference, or the central
bank has to print massive amounts of money. That is an accounting identity”

Wrong! The accounting identity you refer is: Domestic Private Sector Financial Balance + Fiscal Balance + Foreign Financial Balance = 0.


Financial Balance = Earnings - Spending = Savings (deficit) and Foreign Financial Balance = Foreign Savings (deficit) = - Current Account. The parenthesis denoting a negative number.

So, putting in another way: Domestic Private savings (deficit) + Government Savings (deficit) - Current
Account = 0. And that means: Fiscal deficits is either financed by the private sector or by the foreign sector or by some combination of the two.

So Obviously trade deficits, in Japan or any other country, is not only compatible with but spurred by fiscal deficits, lest the private sector be burdened too much.

Thus the private savings don’t have to make up the difference alone. The Foreign sector can help and will if the Abe plan is perceived as feasible, in this regard and in special the huge foreign currency reserves Japan detains serving as short-medium term buffer.

Another point: Regarding GDP growth vs. Productivity and population growth.

Well, that depends on the slack of the economy. These restriction only applies fully to GDP potential. If capacity utilization has space to grow in labor employment you could have GDP growth without population or Productivity growth. If the slack is in capital effectively employed you could have high productivity growth in a short/medium term. Granted this relativity freedom of constraints and scope to growth is only for a while. But it rises the GDP level. And the GDP level is very important.

The situation in Japan admitted difficult but complex, is not this landslide foregone conclusion of quasi collapse.

Hey Mauldin, maybe you need a Chardonnay and a Cigar once in a while.

John Usher 37833

May 25, 2013, 3:51 p.m.

Wow. This will take re-reading a few times to sink in.

Russ Abbott

May 25, 2013, 10:58 a.m.

John,  You said we are about to conduct a Krugman/Keynesian experiment.  And I gather that you think it will work out to our detriment. 

It’s only fair, then for you to say what you think that experiment is, when you think we will know the results, and what you predict those results will be. Otherwise, you are taking potshots at respected economists without committing yourself to a prediction.  And that’s dishonest.