Ramsey,
Thanks for guiding me to Makin's papers, which I used to read a long while ago, but I never bookmarked the site and forgot about it in the mists of time. I am excerpting below part of his 2/99 column, in case people didn't bother reading it. Seems like it could stimulate some thought/discussion about where we're going. [Robert, if he's right, not many people who are long will do very well in '99; on the other hand, if commodities strengthen, who knows, maybe "ours" will as well<g>].
The Japanese Trap
The Japanese financial crisis has deepened. The world has begun to notice the Japanese government's $700 billion sp
ending spree, undertaken while the economy and its government revenues were still weakening, that has turned Japan
into a fiscal disaster. Japan's budget deficit will exceed the expected 11 percent of GDP in 1999 because that forecast is
contingent on the usual optimism about economic performance and revenues. The Japanese are in a classic debt trap. If,
as seems unlikely, the economy begins to speed up, interest rates will rise back to levels of 3ÿ4 percent as part of a
normal recovery process and thereby choke off recovery and increase the cost of financing the national debt, which is
now close to 100 percent of GDP.
Alternatively, if the Japanese economy continues to founder as seems likely, revenue growth will slow further (especially
in Japan's deflationary environment) and push the budget deficit even higher. A simple rule of thumb for a sustainable
level of government debt—that is, to stabilize the ratio of debt to GDP—is that the economy's growth rate in nominal
terms approximate the nominal interest rate on the debt. Since
Japan's debt-financing picture is further complicated by the need to roll over a huge amount of
government borrowing conducted through its postal savings system.
Japan's nominal growth rate during the third quarter of 1998 (the latest for which data are available) was an annual rate of
minus 5.6 percent (3.2 percent year over year), those stable debt-to-GDP ratio conditions cannot be met (nominal interest
rates cannot go below zero). In fact nominal interest rates are rising and intensifying upward pressure on Japan's
debt-to-GDP ratio.
Japanese nominal interest rates have begun to climb sharply because the Japanese financial market has begun to search
for an interest rate at which investors will buy and hold Japanese government securities. The interest rate on ten-year
Japanese government bonds fell as low as 0.7 percent in October after the global market scare associated with the
Long-Term Capital Management crisis. Since then, the rates have jumped sharply to nearly 2 percent—still low, but
suggestive of an acute reevaluation of Japan's fiscal picture. Japanese investors, who now know that interest rates can
only climb, must be convinced to buy bonds. This will occur only when interest rates in Japan ascend to a point where
investors actually expect them to fall.
The level of interest rates required to create this "overshoot" and the expectation of lower interest rates is not known, but
when inflation was zero over the past decade, Japanese bonds have carried an interest rate of about 3.25 percent.
Concomitantly, however, the Japanese fiscal picture was improving. This consideration, along with the "overshoot"
dynamic, suggests that interest rates greater than 4 percent can be expected in Japan. And why not? The market-clearing
interest rate in the United States and Europe is 4ÿ5 percent.
Japan's debt-financing picture is further complicated by the need to roll over a huge amount of government borrowing
conducted through its postal savings system. In 1990, Japanese interest rates ranged between 6 and 8 percent, and
Japanese savers purchased more than 70 trillion yen of Japanese postal savings deposits carrying a coupon of
approximately 6 percent. The interest on the 70 trillion yen in postal savings deposits accumulates over the holding period
and is paid out when the deposit matures in the year 2000. The 70 trillion yen in principal plus an accumulated 50 trillion
yen in interest means that 120 trillion yen of postal savings deposits will mature in the year 2000. The Japanese
government must induce Japanese savers to roll over most of that money back into the postal savings system or directly
into Japanese government bonds. Failure to do so would be a financing disaster since 120 trillion yen is more than
one-fifth of the total stock of outstanding Japanese government bonds.
Japan's fiscal situation, along with the need to push up interest rates to levels that will satisfy Japanese savers confronted
with the Japanese government's fiscal mismanagement, comes at a particularly inopportune time. The fragile Japanese
economy hardly needs sharply higher interest rates and an attendant jump in the value of the yen, as occurred since last
summer, when the yen was at 145 compared with the current level of 110ÿ115.
As far as global financial markets are concerned, higher interest rates and a stronger yen are signaling that the Japanese
government will need to draw more heavily on the resources of Japanese savers. Higher interest rates in Japan have led to
repatriation of funds into Japan and a broad desire for liquidity, which caused the yen to strengthen to 108 yen per dollar
early in January. That yen level resulted in Japanese intervention to push the yen down to avoid too much deflationary
pressure from a strengthening currency.
Japan's need to use its large savings flow to absorb disruptive additions to government debt means that less savings will
be available to finance current account deficits of emerging market countries and the United States. Indeed, the rise in
Japanese government bond yields by more than a full percentage point in a month was accompanied by a rise in U.S.
government bond yields of twenty to thirty basis points. While the slight increase in real yields in the United States has
yet to dent the optimism in the strong sectors of the U.S. equity market, it has created problems for the less-favored
sectors. Since Japan's need to fund larger government deficits will not go away quickly, little relief can be expected in the
global deflationary financial problem from Japan.
China's Problem
In the background China presents another problem for the Fed. The Chinese maintained artificially high growth rates of
more than 7 percent during 1998, partly by lying about the numbers and partly by pressing ahead rapidly on government
infrastructure investment projects equivalent to 30 percent of GDP. The Chinese government has directed state
enterprises to continue to produce goods. Many of these are then dumped into inventory and add to incipient and actual
deflationary pressure on global markets.
The Chinese maintained artificially high growth rates of more than 7 percent during 1998, partly by
lying about the numbers and partly by pressing ahead rapidly on government infrastructure investment
projects equivalent to 30 percent of GDP.
Unfortunately, China's accelerated spending on infrastructure is guided not by any market principles, but rather by the
perception among the Chinese leadership about what projects are most urgently needed. Rapid execution of government
investment projects without any market guidance has a bad history and often leads to useless projects. Japan has forged
ahead in this area; the Chinese seem remarkably willing to follow that bad example.
China's symptoms continue to be accelerating deflation and rising unemployment. China funds its huge infrastructure
projects and government bailouts for insolvent banks and enterprises from a flow of household savings. That flow
represents about 40 percent of household income, which goes directly into the state banking system. Most Chinese do not
know that the state banks are insolvent, and the Chinese government has so far been prepared to underwrite the
insolvency.
Financial markets will be disappointed if the current euphoria is predicated on yet another Fed easing
in response to anything other than a recession in the United States.
Should any scare, such as spreading failure of China's regional government financial institutions, interrupt the flow of
household savings into Chinese banks, the country's financial structure would collapse quickly and with it the Chinese
economy. Even without such drama, the accelerating deflation and excess-capacity problems of Chinese exporters
(despite substantial increases in export rebates) are further pressuring China to devalue. The problem is the familiar one
faced by other countries with the exception that Chinese currency is not convertible so the Chinese are not subject to
normal market forces. This situation makes devaluation an expedient decision timed to coincide with the convenience of
the Chinese government, not that of nervous Western financial institutions.
Looking Ahead
The answer to the question of what is next in this new year depends on the Fed's assessment of yet another in the series
of predictable crises in financial markets as a harbinger of "systemic" risk and therefore justification for a further e asing.
There is a good chance that next time will be different and that the Fed will leave rates unchanged. The surge in the equity
markets and the surge in consumer spending above sustainable levels during the fourth quarter after the Fed's recent
easing exercise cannot have pleased the Federal Reserve. Financial markets will be disappointed if the current euphoria is
predicated on yet another Fed easing in response to anything other than a recession in the United States. And a U.S.
recession would itself be a disappointment to financial markets. |
