Guest Post: Mr. Abe's Trigger
Submitted by Gonzalo Lira,
The newly elected Japanese Prime Minister, Shinz? Abe, has caused quite a stir. The leader of the Liberal Democratic Party, which scored a landslide victory in 2012’s election, he’s promised to restart the Japanese economy, whatever it takes.
How will he do this? He “will implement bold monetary policy, flexible fiscal policy and a growth strategy that encourages private investment, and with these three policy pillars, achieve results”—according to his statement following the LDP election victory.
By “bold monetary policy”, what he means—and what he has said—is to end the independence of the Bank of Japan, and have the government dictate monetary policy directly. (You could argue whether any central bank in any of the developed economies is truly “independent”—or indeed, has ever been so. But for the sake of this discussion, let’s assume that they have been.)
The perception is, the Bank of Japan will not only print yens and buy government bonds à la Quantitative Easing of old - it is also generally thought that Mr. Abe and the incoming Japanese government fully intend to target the yen against foreign currencies, like Switzerland has been doing with the euro.
This perception is what has been driving the Nikkei 225 index higher, and driven the yen lower.
[ZH - as as an aside - the correlation between JPY and the TOPIC is the highest since 1988!! via Bloomberg]
Prime Minister Abe’s policies have yet to be fully implemented—so far, it’s all been just talk. But the markets are taking Mr. Abe at his word, convinced that he is going to set a policy very similar to what the United States and the Federal Reserve have been doing: Targetting the equities markets, and printing in order to bring the yen down, and thus make Japanese products competitive in foreign markets.
But why was this decision triggered? For going on twenty-three years, Japan’s GDP growth has been sluggish at best, it’s government amassing huge debts, all the while the yen slowly strengthening and the Nikkei index meandering—yet all of a sudden, now the Japanese government is ready to do whatever it takes to turn the Japanese economy around, which begs the question: Why now?
Simple: Japan’s balance of trade has turned decisively negative for the first time since the Oil Shock of 1980—and this has put the fear of God into the Japanese leadership. Look at the following chart:
|Click to enlarge.|
Since the Iranian Oil Shock of ‘79, Japan has consistently held a positive balance of trade—until 2011. And 2012 was a nasty shock, as the balance of trade went full-on negative. Japan had a trade deficit for the first time in 33 years.
This was Mr. Abe’s trigger.
In a very real sense, Japan could afford to have an economy in the doldrums because it was a net creditor nation. The United States and Europe might follow Keynesian claptrap that “deficits don’t matter”, be they fiscal deficits or trade deficits. But the Japanese believe that trade deficits matter.
Japan don’t seem to mind about fiscal deficits: If the government was overindebted, the Japanese people were down with it, as shown by the polls—because the Japanese people were the ones financing the Japanese government’s deficit. Consider this chart:
As can be seen, over 85% of the Japanese government’s debt is held by the Japanese. So although Japan’s fiscal debt is monumental—over 230% of GDP, dwarfing the U.S.’s figure of 110% of GDP—it has never been that much of a political issue in Japan, because it is internal. It is money the Japanese government owes the Japanese people.
But the turn to deficit in the balance of trade has the Japanese public and political establishment shitting lead bricks, to use a highly specialized, technical socio-economic term for the situation they are in.
This is why Mr. Abe’s LDP party won so decisively: The deficit in the balance of trade proved to be politically unacceptable. Mr. Abe won by promising to turn that deficit into a surplus.
Now, how can Mr. Abe do that? Well, if you want to export more than you import, a country has to produce stuff that other countries want—or make foreign imports expensive. What’s the quickest way to make a country’s goods cheap so that others buy them, while making imports that much more expensive? Easy-peasy, Japan-easy: Devalue the currency.
And that’s what Mr. Abe is proposing. Not in so many words, but he is saying that the Bank of Japan’s autonomy ought to end, and that monetary policy should be directly under the thumb of the government.
Since a fiat currency like the yen cannot be devalued by diktat, the only way for it to fall is relative to other currencies—like the dollar, the euro, or the pound sterling.
How do you get a fiat currency that is the region’s reserve currency to fall against other foreign reserve currencies? Simply by buying up foreign sovereign debt with your local currency, flooding foreign markets with your currency, and thus driving down its value against the dollar, the euro and the pound.
This is basically what the Swiss have been doing, by targetting the Swiss franc at CHF1.20 to the euro. And this is what Prime Minister Abe and his government plan on doing—of course on a much larger scale, considering how much bigger Japan is than Switzerland.
Prime Minister Abe also unveiled a massive ¥10.3 trillion (US$116 billion) stimulus package. Adjusting for the size of the GDP, this Japanese stimulus would have been equal to a $296 billion package in the United States. An impressive-enough number.
But the Abe stimulus is a sideshow—the real issue is the devaluation of the yen.
Devaluation is the only way for Japan to make its exports cheaper and its imports more expensive—and this flies directly in the face of what is going on with Japan’s historic deflationary trend, which as I explained in the previous section of this discussion, is a product of the demographic realities of Japan that are inevitable.
But this is where Mr. Abe wants to go. And the trigger for this radical—extremely radical—approach was not the sluggish GDP, nor was it the massive fiscal deficit, no: It was all triggered by the rising Japanese trade deficit.
Here is where economic realists have to tread very, very carefully, lest they be blown out of the water by something I call Cassandra’s Blindness. In the next section, I will discuss some investment ideas I think might be worthwhile, considering the new reality going on in Japan.