Protecting Yourself From Japanese Insanity

by James Gruber on April 6, 2013

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{ 6 comments… read them below or add one }

Jon April 15, 2013 at 1:06 am

James,

Thank you for that clarification. So, let me just try to summarize/restate the possible outcomes and see if I understand you correctly. Right now, Japan is printing mass quantities of money in an effort to inflate their currency to at least partially alleviate their debt. They have historically been dealing with a deflationary environment (and still are currently (?)) which is at least partly due to a receding economy and aging population.

Okay, so the goal of the Japanese right now is 2% inflation, which I presume will help increase or at least maintain their export levels, and perhaps nominally increase GDP, thus making repayment of older, fixed debt easier. However, it will also lead, most likely, to rising interest rates, which could make repayment of future debt virtually impossible if Japan ever reaches a point where the average interest rate on all of their outstanding debt reaches 2.8%. Is that correct so far?

So, scenario 1 would be that they are successful in reaching their inflation target, which means interest rates rise, which will eventually lead to the percentage of Japan’s revenue being eaten up by interest repayment on the debt as it could rise up to as much as 100% or more of current revenues, if some austerity measures are not taken to reduce the overall debt level before that happens. If austerity measures are not taken, as has been the custom, then the bond market will put less and less trust in the Japanese government until the point that their confidence “breaks” and interest rates spike upward. Once that happens, Japan’s only options, it would seem, would be to enter hyperinflation in order to offset the debt, or some level of default on their outstanding debt, which I presume would lead to a world-wide financial/credit crisis. If they choose the former, their residents will be hammered financially on the cost of all imported goods, but their exporters may benefit, as long as currency volatility is not so unstable that it prevents trade from happening with other countries. If trade is not permanently damaged, then the inflation would also inflate nominal GDP, and hence nominal government revenue, which could help them unwind some of their debt, but at great cost to their people, and probably to the entire global economy. If they choose the latter, we will face an even larger version of what we just came through in 2008/09.

Under scenario 2, they fail to reach their inflationary target because existing deflationary pressures (primarily in the form of weakening demand for Japanese goods(?)) are too much to overcome. In this case, rising nominal interest rates on new debt would not be the problem, but the real interest cost on existing debt as the Yen gets stronger relative to other currencies, thus leading to reduced nominal revenues for the government and hence increased real interest expenses on their existing debt. Thus, the debt repayment as a percentage of government revenues would again rise, once again putting pressure on the bond markets, etc. So then, it seems like their choices are, once again, to either intentially enter hyper-inflation, or to default (perhaps selectively) on their debt.

Am I on track, so far? Please correct where I have misunderstood. If what I have said is the case, and checkmate seems inevitable for Japan, then, honestly, I think I see why they are choosing the inflation route as opposed to doing nothing, or outright austerity. Either of those two choices will lead to deflation, which will truly give them no real window in which to make any attempt at avoiding default. Under the moderate inflation scenario, they can hopefully increase nominal GDP enough to pay down some debt before the average interest rate on their outstanding debt becomes untenable (still unlikely, but at least it provides some measureable window in which they can hope for a fix).

All of this, if it comes true, is very sobering stuff, not only for the Japanese but, really, for the entire world. There are so many moving pieces to the global financial system that it is impossible for me to wrap my head around what the global implications will be of a Japanese default, which seems like the ultimate end game. Perhaps, with such a large percentage of Japanese debt being held domestically, it will mean a less severe blow to the international community, but it will be devastating for Japan. Still, being the world’s third largest economy, I would think that even a default on the 9% of their debt held by foreigners could deal a greater blow than did the collapse of Lehman Bros.

Out of curiosity, I Googled Japanese total government revenues. According to http://stats.oecd.org/Index.aspx?QueryId=21677, from 1971 to 1991, Japan’s annual tax revenue increased from 16T Yen to 135T Yen. But, 20 years later, in 2010, revenue decreased to 132T Yen, annually. I have never really studied the cause of Japan’s deflationary tail spin, but I am curious how much of a role their aging population plays into the picture.

I do have a couple of questions regarding all of this. First of all, do you think that a default of Japanese debt, at some level, is unavoidable? Second, do you think that the net effect of a default (particularly in Japan where 91% of debt is domestically owned) would be inflationary or deflationary to the Yen and why? Third, how severe do you think the international fallout will be from these various endgame scenarios? Particularly, what do you think the net effect will be on demand for other forms of sovereign debt from other countries like the U.S.? Lastly, do you foresee the same endgame scenarios being relevant to the U.S. and U.K, or are their circumstances different enough that you expect a different endgame with them?

Thank you for your insights. I really enjoyed reading your article and comments.

James Gruber April 14, 2013 at 10:01 pm

Hi Jon,

A couple of very good questions. Japan has the highest government debt to GDP in the world, estimated at around 230% currently, heading to 245% this year. With debt this high and interest expenses of the debt being 25% of government revenue, that debt needs to be cut. There are two options. Either you reduce government spending and risk a painful economic contraction. Or you print money to reduce the value of that debt in yen terms. The new Japanese government has chosen the latter in a big way.

If the government is successful in producing its targeted 2% inflation, it means the yen will fall further and interest rates will rise. Once rates start rising, that’s when the bond market could break, along with the yen. Because the debt servicing costs will spiral out of control. Remember that if rates rise to just 2.8%, interest costs on debt will match government revenues. The bond market will break will before that point though.

And if the government is unsuccessful with producing inflation, it will print and print and print. It has no other option other than austerity, which it won’t do. That means a much lower yen and the bond market will crack sooner rather than later.

Under either scenario, you’re likely to have serious consequences, with deflation quickly flipping into incipient hyperinflation.

In sum, I don’t see a binary outcome from this. What I attempted to explain in the article, perhaps not totally clearly, is that deflation turning into hyperinflation can happen very quickly. That’s what I see happening here; I don’t see another way out.

By the way, the Japanese bond market behaviour of the past week should be of concern. Massive volatility, with partial signs of a market breaking down. Something to keep an eye on as events could move rapidly, at some point.

As for other countries and currencies, you have different situations, but most have a common theme: way too much debt and governments are primarily choosing to print money to inflate the debt away. That means you likely to see lower currencies in the money printers of scale such as the US, UK and Japan.

Japan is much worse than any other country. But if these other countries fail to boost GDP sufficiently, debts will continue to compound, and the issues that Japan faces today, will be issues for others down the track.

The thing to watch out for is rising bond yields in these markets. When bond markets start to break, ie the bond vigilantes come in, that’s when things will get serious.

I hope that’s addressed some of your issues.

Jon April 13, 2013 at 7:37 am

James,

In this article you state that you have gone on record saying that the Yen is likely to depreciate significantly from here. However, in your article, “Sayonara to the Yen” you suggest that hyperinflation is in order. If I understand correctly, the end result could be binary, and go one way or the other, correct? With such uncertainty, I was wondering if you could give the earliest signals that we should look for that would confirm which path the markets are heading. And, would these same signs also apply to future scenarios with the US Dollar, or other currencies, as well?

Michael Heyward April 9, 2013 at 12:19 am

Good morning James:
Excellent article. I have been a follower of Harry Browne for many years, and have profited handsomely from following his investment principles. The performance of the Permanent Portfolio has been outstanding, to be sure, and has profited handsomely from the 30 year bull market in bonds, which may not be nearly so helpful as we go foward. May I suggest that his first book, How You Can Profit from the Coming Devaluation, written in 1970, predicted with uncanny accuracy, the devaluation of the dollar eigheen months later when Nixon closed the gold window. Harry, in that first book, provided a profoundly simple explanation of the dangers in the fractional banking system, and the reasons why gold and silver should (as the “real” money) should be part of every portfolio. Many of today’s advocates of gold ownership don’t really understand its long term utility. Your article was well balanced in terms of possible outcomes of today’s worldwide financial promiscuity. Noone can predict what the “endgame” will look like, but likely it will not be pretty.Each of us has an individual challenge to stay flexible, and react as events unfold.
Best,
Michael Heyward

James Gruber April 8, 2013 at 3:02 pm

Hi Nate,

Thanks for the question. Commercial real estate, like most real estate segments, performs best during periods of inflation. It acts somewhat like a bond, as you say. But it would suffer under hyperinflation as you wouldn’t be able to sell it for anything worthwhile and could possibly wind up trading it for something that normally has little value. Under deflation, commercial real estate would suffer in a similar way, as you’d be unable to liquidate it if you wanted too.

In sum, commercial real estate does best during inflation, and will hold up ok during recession. But under my extreme scenarios, it will underperform some of the other alternatives mentioned in the article as it’s an illiquid asset.

Nate April 8, 2013 at 1:28 pm

Thanks for this article. It is interesting to analyze how all this creation of money will play out.

I have a question, you talk about stocks, bonds and precious metals in your 4 possibilities. Can you comment on where commercial real estate fits in this? (my understanding is that historically CRE has been a hedge against inflation – like precious metals, but that it pays a return like bonds). Do you have any analysis on this?

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