Abenomics needs repression to save Japan

By Josh Rudolph, MPP ’14, Correspondent

After enduring two decades of falling wages and prices in the wake of the 1992 financial crisis, Japan’s leaders have finally decided to follow Ben Bernanke’s advice from back in 2000 and persuade the central bank to buy as many bonds as it takes to create inflation.

Unfortunately, given the enormity of the debt burden racked up by the government over the two lost decades, it may be too late for this strategy alone to successfully avoid another crisis.

Having spent spring break on the HKS trek to Japan and meeting top policymakers all the way up to Prime Minister Shinzo Abe himself, I am convinced that they are moving in the right direction, but not boldly enough.

Three Arrows of Abenomics: Monetary, Fiscal, Micro

Abe’s economic strategy includes shooting three “arrows” to boost the economy. The first arrow is doing whatever it takes to generate 2 percent inflation. The second arrow is “fiscal flexibility,” which apparently means stimulus until this summer’s upper house election and austerity afterwards. The third arrow is “microeconomic reforms,” which means making Japanese companies more competitive by slashing both barriers to entry and barriers to exit.

Given that the second and third arrows require both time and political capital, it is really just the first arrow, monetary easing, that boosted the Japanese stock market by 45 percent and weakened the Yen by 20 percent in the months following the election.

From one perspective, inflating away debts sounds great when the government debt burden is an award-winning 245 percent of GDP (the second highest in the world today is Greece at 182 percent).

There’s only one problem with this strategy: Japan’s government debt is relatively short-term, with an average life of only six years. As that debt is rolled over, investors may insist upon being compensated for the higher expected inflation in the form of higher interest rates, which could push up the portion of Japan’s budget spent on interest payments from 10 percent to about a third.

That, in turn, would require the government to sell even more bonds, which could push up interest rates further. Using new debt to pay the interest on old debt was Hyman Minsky’s definition of a Ponzi scheme.

Missing Fourth Arrow: Financial Repression

What can Japan do to avoid this debt spiral? The same thing the US and UK did when their debt loads exceeded 200 percent of GDP after World War II: use financial repression to liquidate the debt at a rate of 3-4 percent of GDP per year (30-40 percent of GDP per decade without even compounding).

This strategy, analyzed in the work of HKS professor Carmen Reinhart, involves generating inflation while instituting an arsenal of both formal regulation and informal pressure on domestic banks to cap nominal interest rates, effectively taxing savers by limiting their investment alternatives to government bonds with negative real yields.

Abenomics is a step in the right direction, but without turning up the throttle it will not be enough to avoid an even less appealing end game.

Luckily for Japan, they’ve already laid the groundwork for financial repression by doing the hard part, which is developing a large captive domestic investor base. Few people realize that the Japanese government owns the largest bank in the world, Japan Post (which is far more than a post office, holding about a quarter of all Japanese household deposits and investing three quarters of them in Japanese government bonds).

The easy part of financial repression should have been creating inflation, but the Bank of Japan is only getting around to this now. At this stage, with so much debt to liquidate, 4 percent inflation would be better than 2 percent. The government may also have to get more creative in finding new ways to induce domestic banks to hold government bonds, perhaps under the guise of liquidity requirements and prudential regulations. Some form of capital controls may even have to be reintroduced. The need to lean on more banks would be particularly elevated if Japan Post is privatized to pay for earthquake reconstruction.

No Time for Half Measures

The need to scrape the bottom of the barrel of Japanese savings comes at the worst possible moment, since the population is getting older, which lowers the country’s savings rates. The result of the savings shortage will be that Japan will have to issue more bonds to foreigners, who would charge much higher interest rates, given the glaring risk of currency debasement. Financial repression can be employed to roll over the existing debt stock to domestic savers, but it can do nothing to force foreigners to buy newly issued bonds.

Thus, the second arrow of Abenomics, fiscal flexibility, must turn towards austerity far more aggressively than has been advertised to the public. Japan must work towards closing its budget deficit, and should probably also turn its nuclear power plants back on to forestall the day when its current account turns negative.

None of this sounds appealing. But neither does a debt crisis that forces similar medicine to be swallowed all at once. Abenomics is a step in the right direction, but without turning up the throttle it will not be enough to avoid an even less appealing end game.

Josh Rudolph (MPP ’14) worked for seven years on Wall Street, most recently as a fixed income strategist. This piece was written following a Harvard Kennedy School trek to Japan in which group members met with ministers, members of parliament and the prime minister.

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