Mittwoch, September 02, 2009

Keynes, Debt, Politicians, Japan and the US...

Permit me, if you will, a small "Gedankenexperiment", i.e. thinking something through...

Generally speaking, lots of folks "know" what Keynes' economic policy was all about: governments should invest counter-cyclical in order to alleviate the negative effects of economic downswings on employment. Governments should go into debt in order to avoid the worst of a cyclical downturn, and the disciples of Keynes believe that there is a positive multiplier in his policies (i.e. you get more than it costs).

They tend, however, to forget that Keynes also intended for governments to draw down their debt in the good times.

But what did Keynes actually discuss?

According to Keynes, recessions - and depressions - were caused by overcapacities, i.e. supply in excess to demand, reducing investment and slowing the economy down to a an equilibrium at a lower capacity level as the excess capacity is taken off-line. This draw-down of capacity comes with a reduction in employment as well, further slowing the economy. In order to work against the drop in employment, government should choose - preferably wisely, but we are talking about governments - investment objects that have general utility and which should provide infrastructure for further economic growth. Employment is hence shifted from previous occupations within those factories. warehouses and shops that are excess to needs to government work to avoid unemployment.

When growth does resume, from a lower level, then two things must happen for Keynes: first, the government investments must be completed and the workers freed in order to go to factories, warehouses and shops that need additional workers, and the government must then reduce the debt that it took on in order to finance the investments.

It's a nice theory, and in theory it should work.

The reality is rather different.

As we now know, empirically, government debt is a never-ending thing. While there are those who argue - with some success - that this is in and of itself not a bad thing, the question then becomes one of how much debt is permitted. That is our current problem: at the end of the day, it is the politicians who decide what that level is and not economists. Hence "permitted" debt becomes a function of the political process and is hence permanently corrupted.

This is compounded by the temporal effects of debt: when politicians increase spending, they get an immediate benefit, but any costs are, largely, deferred to a much later point in time. Given that time horizons for politicians are between 2 and 6 years (at least in the US, this varies elsewhere) due to their need (and indeed compulsion) to be re-elected and that the time horizon for debt repayment is significantly longer (at least 10 years for long-term government bonds), politicians have a positive incentive, ceteris paribus, to be prolific with government spending.

And indeed they are.

Now, what does this have to do with Japan and the US?

Simple: both governments are heavily indebted, both in nominal terms and in terms of sustainability (i.e. percentage of GDP, or how difficult it is going to be to repay the debt out of the government's cash flow).

In Japan, the debt has reached dimensions that should, if you pardon the vernacular, have economists shitting Twinkies (for my non-English language readers, that means seriously scared). While US debt isn't anywhere near the percentage of GDP that Japanese debt has reached, it has become, in terms of the sheer volume of debt, also rather frightening.

How do the Japanese manage their debt?

First of all, let's remember how governments are financed. They raise taxes and apply duties and fees for government work, and when that is not adequate (and it rarely, if ever, is) then issue debt in the form of government bonds. These have to find buyers, and are hence interest rates - which the central bank sets - tend to reflect demand for such bonds as "safe havens", i.e. investment instruments that fundamentally bear no risk (and indeed serve as benchmarks). As bonds, there can be a discount from the face value that is implicitly calculated as an effective interest rate, and given the relative scarcity of bonds, they can also sell for more than their face value if demand for safe haven investments picks up. Buyers are both domestic and international.

Japanese government bonds are largely held by domestic purchasers, notably the Post Bank there, and these investors are apparently happy to have virtually no interest paid, given Japanese deflation. This fact has allowed the Japanese government to go into debt so massively.

But the Japanese have problem coming up: domestic savings are slowly but surely drying up as the Japanese population ages and starts to consume their savings. The Japanese economy has been badly hit by the world-wide recession and Japanese consumers are pretty much at their limits, which is reflected in a significant drop in the savings rate.

Hence their debt - and do remember that debt is not monolithic, but is rather constantly being serviced (i.e. retired and issued). Changes in interest rates have hence an immediate effect, one that is small at first but rapidly accelerates over time. Since governments pay interest rates out of current cash flow, the ultimate size of government debt can be determined by the ability of the government to finance this debt.

Of course, with interest rates being very close to zero in Japan, this means that the government has handily managed the staggering amounts of debt it has generated: this also means, however, that the Japanese government cannot afford to change this.

If, however, they run out of domestic savings, they will have to attract foreign capital. While interest rates are, internationally, extremely low, even in real terms, there is very little or even no incentive for foreigners to invest in Japanese government bonds (exception being fund managers and the like whose business concept includes such investments).

Hence Japan is facing the challenge of financing the debt whilst also offering attractive investment instruments at the same time when interest rates are virtually zero. This can only be done by providing a heavy discount on Japanese government bonds, which, however, sends the signal that such an investment is a high-risk investment, which government bonds aren't supposed to be.

Hence there will be massive pressure for the Japanese central bank to raise interest rates. The moment they do so, however, Japanese government debt becomes impossible to finance. In other words, they are in a lose-lose situation.

How do they get out of this?

There are only three alternatives (if you know of more, let me know!): inflation, repudiation of debt or exchange rate devaluation.

Inflation makes it easier to pay off past debts by making them less worth. However, inflation is not an option for Japan, given the liquidity trap of interest rates being effectively zero. Hence the option of reducing interest rates to increase inflation is off the table.

Repudiation of debt - defaulting, refusing to honor the bonds - would be tantamount to declaring national bankruptcy. Not attractive, to put it mildly.

By devaluing the yen, the Japanese could then deal with both deflation and with underused capacities, as their exports would boom and imports would become very expensive (hence bringing needed import inflation to combat deflation). Devaluing the yen would also alleviate the need to finance the debt, since a booming Japanese economy would generate revenues to put off the final day of reckoning.

But that is the key phrase: the final day of reckoning.

Fundamentally, Japan has taken on unsustainable levels of debt. Just like a private person or company that has fully spent its cash flow to finance either an investment or a lavish life style, this means that there is no leeway, no playing room, no reserves left. It can postpone a final reckoning, but fundamentally that person or company is effectively insolvent the moment personal finances or business plans no longer function.

In other words, Japanese debt is an extremely high risk area, despite extremely low interest rates.

What is the connection to the US?

Well, the US doesn't have the same kind of debt that Japan does - duh - but in principal the situation is the same: the government has acquired too much debt for it to be properly serviced. With interest rates close to zero, the debt can be currently financed off the cash flow, but the moment that interest rates rise, the debt will choke government spending.

Now, politicians being what they are, especially those of the Democratic variety who never saw a social program that they didn't love, this means that they will lose their ability to spend money.

While fundamentally a good idea, what it really means is that politicians will at least try to find a way of postponing the final day of reckoning until they leave politics. No one wants to be the naysayer, the one who has to clean up after 40 years of partying.

But that bill will come due when the ability of the government to finance the debt is diminished to the point where the debt service becomes so large that it starts to push down discretionary spending.

What I am trying to say here is that the party is over. The spending plans of the Obama Administration will be the straw that broke the proverbial camel's back.

And the only choice is one of the lesser evils: inflation, debt repudiation or devaluation.

The latter is vastly more attractive to the US that to Japan, given that so much US government debt is held by overseas investors.

Regardless, I think this lays out the problem of government debt, the effect that dead economists have on current economic policy (and how even the best thinking can be perverted), the fundamental problem of politicians being allowed to spend like there's no tomorrow and which countries are a real mess.

It's not something I have an answer to, really, since my solution would be killed by the politicians: it involves reducing government debt to sustainable levels permanently by instituting maximum limits on debt with exceptions requiring the approval of both Congress and the President after public debate and with 75% majorities in both the House and the Senate.

But I can warn that the next crisis will be one of debt, either indirectly via devaluation of currencies and/or sharp increases in inflation, or explicitly via repudiation of debt.

Regardless of how the crisis will appear: it is the fault of governments and politicians who believe (incorrectly) in the words of long-dead economists and act accordingly while avoiding the hard choices.

The hard choice we will be facing will mean that everyone will lose. Social spending is out of control, the government has become too large, and the belief of a good proportion of the US electorate that the Government is there to make social changes and to do good has brought unmitigated financial disaster.

I hate to sound like Cassandra, but consider this: she was always right.

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