Dylan Grice loves debunking popular delusions. Perhaps that is why he has picked precisely that phrase as the title of his periodic research piece at SocGen. In his latest piece Dylan asks a question so simple and profound that it should immediately force all Keynesians to provide a definitive answer, or else they should all be fired for being nothing else than card-carrying shamans of the world's most destructive religion (and if you thought the Catholic Inquisition was bad, you obviously have never been drawn and quartered by four of Bernanke's most vicious and bloodthirsty printers). Here it is: "For all I know, Keynesians might be even right in thinking policy makers can fiscally jolt economies back to life, allowing them to recover back to their ‘default mode.’ But their assumption is that ‘default mode’ is positive growth. But what if it isn’t? What if the ‘default mode’ is falling output because the population is declining? Japan might just have spent the best part of twenty years trying to fiscally stimulate its way out of a demographic compression. If this is correct, and population decline has blown the hole in Japan’s government balance sheet there’s still plenty of damage in store because the demographic compression isn’t over yet." Zero Hedge has long contended that Economists dwell so high up in their ivory towers of (flawed) theoretical construction, that they always ignore the simplest things that have the most profound systemic impact... such as demographics. Consider the creation of the Social Security Trust Fund, which would have been perfectly solvent in perpetuity... If only people died quietly as they were expected to do so in 1930s, some time in their mid- to late-60s. Now it is insolvent. Keynesianism, as an economic theory itself, is an anachronistic artifact of another time. As such, Dylan's question is arguably the most critical one that Krugman, Koo, and even the Kretins (sic) from the Fed should answer before they propose any additional and infinitely more destructive theories, and conduct any more failed experiments on a world population of roughly 7 billion people.
From Dylan, on how anecdotal evidence is always wrong, appropriately starting with that most misunderstood topic - the Weimar hyperinflation:
Anecdotal evidence can be a dangerous thing. In 1919 in the aftermath of the First World War, for example, the situation in Germany was about as dire as it’s possible to imagine. Humiliated by the Allies, embittered by the realisation that their leaders had betrayed them, and stunned by the toppling of their Kaiser during the November 1918 Revolution, the streets were seething with violence and anger.
There was no government to speak of as the political anarchy unleashed by the Revolution remained out of control and unchecked. The economy’s productive capacity was shattered too. Since it had been entirely mobilised for war by Hindenburg in 1916, the War’s abrupt end caused sudden and painful unemployment. And that was before the demobilisation of six million traumatised troops from the trenches. Having gambled decades of accumulated national wealth on war, and lost, there was simply no money to pay for the reconstruction of the economy and of peoples’ lives, other than from the printing presses ...
With the benefit of today’s hindsight we know that the Weimar Republic the Revolution bore was stillborn. The economic policies aimed at buying peace with increasingly intimidating political factions succeeded only in causing hyperinflation. The pact with a group of demobilized nationalist troops aimed at preventing communists from hijacking the Revolution (as the Bolsheviks had recently done in Russia) would inadvertently seed the military might which would one day propel Hitler to power and the world back to war.
But in February of 1919 such a bleak future was merely one scenario, and a distant one at that. The true condition of Revolutionary Germany was unknown so the British government sent two officers to Berlin find out. At the Adlon Hotel where they were staying they saw “no sign of want of anything” and noted the hotel’s restaurant was putting on meals “which would have done justice to the Ritz.” A plump lady feeding her dog expensive biscuits at the table made an impression on the two agents. But the explanation as to why there were so few cats and dogs in Berlin (they’d been eaten and their skins used for leather) did not. Indeed any claims by locals of shortages, hunger or starvation was treated as “hearsay” since “there was no evidence, whatsoever, of scarcity or want in the outward impressions we got.” On the contrary, the “mania for dancing” was observed as was the “huge crowd of middle class men and women” in the local bars “… waltzing and foxtrotting and drinking expensive wines.” (see “The Great Disorder” by Gerald Feldman, Ch 3)
The officers came to the calamitously incorrect conclusion that fears over the stability of Germany were exaggerated and partly due to this anecdotal ‘evidence’ Britain would soon back French demands for reparations which were so burdensome, historians now consider them the “continuation of war by other means.” (See Sally Marks “Central European History” page 338) Less than twenty years later the world would be at war again. So much for anecdotes …
So how does anecdotal evidence apply to today, especially run through the infinitely distorted prismatic farce that is the stock market?
Well for starters, it’s very dangerous to use what the market is saying as any sort of definitive truth. A few years ago the market was saying Greece sovereign credit was basically as sound as Germany’s, and that lending 125% of a home’s value to sub-prime borrowers was perfectly sensible.
Fast forward 80 years - would a preemptive visit to Tokyo indicate that, just like in Weimar Germany, things were at rock bottom? Not at all.
A visit to the glitzy districts of Tokyo won’t show that the so-called precariat – the “precarious proletariat” without job security or social security entitlement – has mushroomed to 20 million or 34% of the labour force; that suicide is now the leading cause of death among young men aged 20-44; or that 56% of 15-34 year olds need outside supplements to their salaries to cover mere living expenses. Neither will it show that young men aren’t the only ones who need help to pay for the basics: the Japanese government itself no longer manages to cover its bare necessities with revenues and must borrow just to cover debt service, social security and education (see chart below).
And when discussing the collapse in tax revenues, no piece on popular delusions would be complete without the customary smack down of the Keynesian priests who only know one response - spend, spend, spend: "The best way to revive growth is one of the favourite topics of economists everywhere: “almighty fiscal stimulus” says Richard Koo; “raise inflation expectations” says Paul Krugman; “who cares?” say the rest of them, “just break this entrenched deflationary psychology which discourages private sector spending, and encourages excess saving.” Fix that macroeconomic malfunction and you’ll fix everything else, they say."
Here Dylen makes a startling observation: namely that even with a declining economy, GDP per worker has actually grown and outpaced that of the US:
The following chart (left panel) shows how sluggish Japanese GDP growth has been since the bubble burst … but how confident are we that our economists have diagnosed the cause of the malfunction correctly? The chart on the right shows that the growth in Japanese real GDP per worker has outpaced that of the US over the last five and ten years. If things are so bad in Japan, how come each worker has grown output more than his/her American counterpart?
Maybe Japan’s macroeconomic malfunction has actually been a demographic compression, and maybe no particular policy – fiscal or monetary, conventional or unconventional – will ‘normalise’ Japan because Japan is actually already behaving perfectly normally. Maybe Japan is what economies which demographically peak look like.
And here we get to the most critical argument that if validated, would refute all of Keynesianism clinically and efficiently.
For all I know, Keynesians might be even right in thinking policy makers can fiscally jolt economies back to life, allowing them to recover back to their ‘default mode.’ But their assumption is that ‘default mode’ is positive growth. But what if it isn’t? What if the ‘default mode’ is falling output because the population is declining? Japan might just have spent the best part of twenty years trying to fiscally stimulate its way out of a demographic compression. If this is correct, and population decline has blown the hole in Japan’s government balance sheet there’s still plenty of damage in store because the demographic compression isn’t over yet.
Continuing with the demographic shift, specifically an aspect of it which has been undressed extensively previously, is the impact of the aging population on the savings rate.
It isn’t just government revenues which are hit by demographic decline. The government’s ability to fund itself will also be effected since government deficits are funded by Japanese household savings and as households retire they spend their savings. The below chart (left panel) shows savings ratios (actually, “surplus” ratios) as a share of disposable income for various age cohorts and shows that old workers save a lower share of their disposable income than average, while retirees have negative savings ratios. As the population continues to age (right panel) the savings ratio will be increasingly pulled down, leaving less available capital to lend to the government.
Of course, the other impact is that as the bulk of JGB purchases are funded internally, there will be a time when there is simply not enough money to fund the government's spending. Which brings us back to the original point, and attempting to determine if the seeds of the Weimar bankruptcy case study can be seen (granted, deep below the surface), in the Japan of today. Dylan attempts to answer the key question for Japan - when will the country go "broke."
But when will that ‘some point’ be? When will the government no longer be able to fund itself at economic rates (even at 1% yields, debt service is expected to come in at around 43% of revenues by 2010!). I wish I knew, but I don’t see how you can. Most investors I speak to think that even if there is a problem it won’t blow up for some time …. but doesn’t that imply they know when (i.e. a while from now) and how does anyone know that?
We know the single biggest holder of JGBs, the GPIF is selling them. They’ve been very open about it, but you can see it in the Flow of Funds data too (top chart left panel). The reason they’re selling them is that they have to pay for the growing number retirees, a trend we know will continue from here. And we know from Reinhart and Rogoff that one of the early warning signals of government funding pressure is a narrowing of the debt maturity. The vehicle of choice for the Japanese government has been bills, not JGBs (top chart right panel).
There is also another signal to keep track of. One that has recently broken down in correlation with the deflationary trend gripping the country:
A bankrupt government implies default via inflation, which isn’t what people think when they think of Japan, but who expected such deflation 20 years ago? But the problems should first show up in the JGB market. A potential ‘grey swan’ with unforecastable timing argues for insurance, but there’s no point buying insurance unless it’s cheap. The chart below shows ATM swaptions on the 10y yield 10y forward. They’ve spiked recently because of Ozawa’s manoeuvres but at 60bps still seem reasonable to me.
Of course, those who wish to benefit from a Japanese bankruptcy in fiat terms may end up being disappointed - the second (or third, although China's endless lying about its economy probably means that Japan will be #2 for decades in unadjusted terms) economy going under would drag all of the developed world, not to mention all US banks, and financial instruments. And yes, the only recourse would be more money printing everywhere.
The bottom line is that in the supremest of ironies, perhaps Japan will be the first to teach the rest of the world what a developed country bankruptcy via hyperinflation would look like. Just like nobody anticipated the Weimar chain of events in 1919, it took just 2 years for the unthinkable to become accepted. 20 years of deflation has made the topic of Japanese hyperinflation the stuff of stand up comedy. Which is precisely why with so many people on the same side of the bandwagon, they will be wrong.