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Saturday, April 16, 2016

Olivier Blanchard Joins The "Japan Is Doomed!" Crowd

Olivier Blanchard (ex-Chief Economist of the IMF) has been quoted arguing that the Japanese face serious macro risks; in reality, probably the biggest economic risk Japan faces is listening to New Keynesian economists. Ambrose Evans-Pritchard, of the Telegraph, summarised Blanchard's comments at a meeting at Lake Como as "Olivier Blanchard eyes ugly 'end game' for Japan on debt spiral." Although the article only provides a few quotes, the logic is quite weak.

Since we do not have a long form paper to analyse, we have to keep in mind the possibility that Evans-Pritchard has misquoted Blanchard. Therefore, I believe it would be a mistake to get to exercised about these comments. That said, it seems that common sense is still not breaking out amongst Western economists.

Fiscal Dominance

Evans-Pritchard quotes Blanchard as follows:
One day the BoJ may well get a call from the finance ministry saying please think about us – it is a life or death question - and keep rates at zero for a bit longer. [...]
The risk of fiscal dominance, leading eventually to high inflation, is definitely present.   I would not be surprised if this were to happen sometime in the next five to ten years. 
Chart: Japanese Price Level

If we take the notion of "revealed preference" seriously, we have to conclude that Japanese policymakers want to achieve a target of price level stability. As the chart above shows, if that is the case, they have achieved their objective. The price level (as measured by a non-standard CPI index, but which has a longer history than the headline CPI) has been in a band 5% since the early 1990s. This probably represents finer control of the price level than was achieved during the Gold Standard era by most countries (although the long-term average price level was stable in the Gold Standard, there was considerable variation around the average),

New Keynesians (such as Blanchard) pushed the notion that a stable, low level of inflation (e.g., 2%) as being an optimal state of affairs. Considering that the era in which that objective was achieved in the U.S. (and other countries) also happens coincide with "Secular Stagnation," that theory looks to have been worthless.

Price level stability is extremely attractive from the point of view of political economy.  There have been any number of dubious economic theories and policy frameworks advanced which are designed to tame the scourge of inflation. This has proved to be fairly costly, as shown by the experience during the Great Depression (the Gold Standard) and the euro area periphery (the "Euro Standard"). Therefore, if you avoid inflation, it undercuts the drive to impose such a policy straitjacket.

One could say that the Japanese economy has been hardly dynamic in recent decades. However, it seems highly implausible that an export-driven nation with a declining working age population is going to post spectacular growth numbers in an environment where China is flooding practically every goods market with overcapacity.

Therefore, Blanchard's remarks are a bit silly. Japan has achieved price level stability, and nothing has changed.

If the Japanese do start to experience positive inflation, the implication would be that nominal GDP would grow. This will create a natural fiscal tightening (due to automatic stabilisers working on nominal income), the debt/GDP ratio will drop due to the growth of the denominator. This growth effect was seen in the United States, as shown below (and discussed in "Higher Bond Yields Means ... Lower Bond Yields?").
Chart: U.S. Debt-To-GDP Ratio And Bond Yields (BondEconomics.com)

We cannot generate as useful a chart for Japan, since there was no issuance of long-dated bonds until after the high inflation period of the 1970s. The article "Higher Debt-To-GDP Ratios And Lower Bond Yields: Japanese Experience" discusses the more limited Japanese data set.

Furthermore, raising interest rates to respond to higher inflation rates is right out of the New Keynesian playbook. When bond yields in the United States did not rise during the 2000s in response to Fed rate hikes, it caused widespread hand-wringing amongst New Keynsians ("the Conundrum"). (As I discuss in my upcoming report Interest Rate Cycles, this should not have been a surprise.) In other words, rising bond yields is exactly what is expected to happen during a tightening cycle, so why make a big deal about it?

Those Darned Retirees And Hedge Funds

Returning to what Blanchard said.
To our surprise, Japanese retirees have been willing to hold government debt at zero rates, but the marginal investor will soon not be a Japanese retiree, [...]
If and when US hedge funds become the marginal [buyer of[ Japanese debt, they are going to ask for a substantial spread, 
Anyone who thinks that hedge funds have the balance sheet capacity to "fund" a G7 nation does not understand how financial markets are organised. There has been a parade of hedge funds shorting the JGB market (directly or indirectly) for decades, and the negative yields on JGB's tells you how well those trades worked out. To what extent hedge funds matter in developed country fixed income, they determine pricing for relative value trades. (Until their lack of balance sheet capacity causes them to blow up, as we saw in practically every fixed income market in 2008.)

Why have retirees been buying Japanese bonds? Simply, they are rich. Asking when "retirees" will stop buying government bonds makesas much sense as asking when "rich people" will stop buying government bonds. Given that the European Left has been complaining about the rentier class and their bond-buying for centuries (Thomas Piketty being the latest high profile example), this state of affairs is unlikely to change any time soon.

Talking about "marginal buyers" is just an attempt to fool people with economic jargon. The buyers that determine the level of bond yields are Japanese banks and Japanese institutional investors, Those investors are always balancing the attractiveness of JGB's versus yen risk assets and foreign currency assets. Since those institutional investors have yen-denominated liabilities, there is no chance that they will abandon the yen interest rate market.

Finally, given the huge overhang of Japanese holdings of foreign currency debt (including Japanese official reserves), it will be a long time before non-Japanese investors will dominate the valuation of the yen.

Concluding Remarks

The most interesting part of this subject is the following -- what is it about Japan that compels western economists to make up scare stories? How many decades will it take before people can figure out that a debt-to-GDP ratio over 100% is perfectly sustainable in a floating currency regime?

(c) Brian Romanchuk 2015

5 comments:

  1. OB's been on this for a while. His comments about Abenomics said it all: "I'm in favor of 2 of the 3 arrows".

    He's normally very sensible about fiscal policy in general (and inflation too: he's actually not that crazy about the 2% target...); but he believes in the bond vigilantes. Get him to give that up and he'd be a strong voice of reason (though I think he does quite well, but his comments on Japan are surprising to say the least).

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    1. The ris in situations like this is that his comments made more sense in context. The media loves these scare stories, and will run with them.

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  2. "If and when US hedge funds become the marginal [buyer of[ Japanese debt, they are going to ask for a substantial spread, "

    They can ask all they want. They are not going to get it, so won't buy the JGB.

    What OB fails to do then is follow that through to its natural conclusion. What else are they going to do with their Yen (assuming they have any)?

    I find it astonishing that they cannot see that it is the retirees/rich people buying JGB that is *causing* the amount of JGB. It's almost like they can't work out that increased spending of retirees causes taxation which would obviate the need for so many JGBs and so much government action to fill in the paradox of thrift.

    The rigid viewpoint is remarkable.

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  3. Brian: do you have a link for the Blanchard paper / speech or whatever it was? I couldn't see one above.

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    1. I could not find one. Based on the context, he was giving comments at a round table discussion, and not speaking from a prepared speech. The meeting he was at had a web site; I looked very quickly, and did not spot a transcript. This is why I was cautious about attributing particular views to him; he could have been misinterpreted.

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