The Duke of Wellington on the best way to start a Japanese debt crisis

I happened to read Michael Schuman's article in Time. The title is "Will Japan's Next Prime Minister Start a Debt Crisis?" .

My immediate reaction: I hope so. Because the only thing that can save Japan is a debt crisis. It's a pity Japan didn't have a debt crisis 20 years ago, but better late than never. And the longer Japan waits before having a debt crisis, the harder it will be to control. And it will have a debt crisis eventually. But can he do it? And what would be the best way to start a debt crisis?

When people don't want to hold your debt, or your money, they will spend it, which is exactly what Japan needs. But (as I said in this old post) too much of a good thing is a bad thing, because you end up with too much inflation, rather than just an end to deflation and recession. So if you get too big a debt crisis you have to offer much higher interest rates to persuade people to buy new debt to rollover the old debt. And you have to increase taxes or cut spending so they know they will eventually get repaid.

It's a lot easier to control a debt crisis when debt is 25% of GDP than when it's 250% of GDP. If you need to raise interest rates 1% to control a debt crisis, that's an extra 0.25% of GDP in taxes in the first case, and an extra 2.5% of GDP in taxes in the second case. If you need to raise interest rates 4% to control a debt crisis, that's an extra 1% of GDP in taxes in the first case, and an extra 10%% of GDP in taxes in the second case.

It won't be as scary as those numbers make it look. The debt crisis will be partly self-solving, because the economic recovery that comes with it will increase tax revenues, and because the government will be able to stop spending on things that weren't really needed except to create demand. And long run growth will mean the denominator in the debt/GDP figure will be rising. Britain had debt/GDP ratios that high in the past two centuries, and survived. But the fact that it doesn't look that scary yet is precisely the problem.

I can think of two ways for Japan to start a debt crisis.

The first is monetary policy. Something like a level path target for nominal GDP would make real assets and goods more attractive relative to nominal bonds and money, so people would want to sell bonds and money to buy real goods.

The second is fiscal policy. Keep on increasing the debt/GDP ratio until it gets high enough to frighten the bondholders so they don't want to hold any more.

There's one big problem with that second strategy: unless Japan's bondholders scare easily, and they don't seem to, a debt/GDP ratio big enough to frighten the Japanese bondholders would be frightening.

As the Duke of Wellington once said: "I don't know what effect these men will have upon the enemy, but by God, they frighten me."

Comments

[Ritwikbut]

Good stuff, Nick!

[Collin]

It seems the main reason Japan does not have a debt crisis is because the population does not want a debt crisis. With so much of the debt held within the country that means the bondholders would have to take their money away from the Japanese government and invest in other countries.

Frankly, I am surprised Rs simply compare the US current debt situation to Greece. It seems the US is having its cultural version of Turning Japanese.

[Phil Koop]

So, do you believe that the present power of a CB's monetary policy can be vitiated by past fiscal policy? Do you think that Japan is past this point?

How would you respond to Noah Smith's post yesterday? Would you say that the Fed is indeed omnipotent ... except when the debt is too big? How can we know when the debt is too big? Before the Fed finds out the hard way, I mean.

[Nick Rowe]

Thanks Ritwik!

Collin: Yep, Greece is very different from Japan and the US, because Greece borrows in a currency it can't itself print.

Phil: I put a couple of comments on Noah's blog post as my response.

A big debt/GDP ratio does not prevent monetary policy working. But the bigger the debt/GDP gets, the more scared I get of recovery. I can't think of a good metaphor.

[Frank Restly]

Simple answer to reducing debt:

Convert debt to equity. Corporations have been doing it for a long time.

[Nick Rowe]

Frank: targeting NGDP comes to much the same thing. Not exactly, but it's a reasonable analogy.

[Andrew F]

Nick, maybe it's like an avalanche.

There are two ways to deal with a threatening snow pack. Keep adding snow until it gives way, or trigger it earlier rather than later (generally using explosives). The latter method has the benefit of being done in a somewhat controlled way, and before the consequences get too bad. Some things in the path of the avalanche may get flattened, but if everyone is warned ahead of time it's better than getting surprised later.

I've always wondered why Japan has responded to its long depression the way it has. They have done half-hearted QE, but not kept on ratcheting up the dial when inflation failed to pick up. Is it just lack of political will to print enough Yen (or threatening to do so) to induce inflation?

[Frank Restly]

Nick

"Targeting NGDP comes to much the same thing. Not exactly, but it's a reasonable analogy."

By targeting nominal GDP, I presume you to mean that the government would sell an equity like liability whose return on investment is positively correlated with nominal GDP ( pro-cyclical fiscal policy ). In my mind government equity should have a return on investment that is positively correlated with the output gap ( counter-cyclical fiscal policy ).

My reasoning is that pro-cyclical fiscal policy tends to exacerbate boom - bust cycles.

[Bob Murphy]

Nick, I'm having trouble reconciling this with your critique of Krugman on the bond vigilante stuff. A naive reader would have thought you believed his post saying bond vigilantes would help, was borderline dangerous. And yet, a naive reader would also think you were here saying Japan should welcome a debt crisis.

[Nick Rowe]

Bob: it wasn't really a critique of Krugman. More of a qualification and extension.

I really wish I could find the right metaphor. Andrew's "avalanche" helps a bit, but it's not quite right, because....we are short of snow down here in the valley.

Japan should welcome a debt crisis. Just not too big a crisis.

[Bob Murphy]

Nick, OK, let me try it this way: Should the US welcome a debt crisis too?

[Nick Rowe]

Bob: yes. Not too big a one. Just like Japan.

[Bob Murphy]

Sorry Nick, you leave me no choice.

[dlr]

Metaphor: Trying to ignite a propane grill. First few tries, you cook burgers. After too many tries with the tank flowing, gas accumulates, and you might spark a conflagration that cooks your burgers but also your deck.

[RebelEconomist]

....the answer is, trash money. Now, what's the question?

Japan's government debt is 90odd percent domestically owned. A debt crisis is going to create as many problems for Japan as it solves. If the government feels that its debt cannot be paid, the right thing to do would be to tax wealth in a targeted fashion rather than just debasing the yen and imposing losses indiscriminately on all holders of nominal yen claims. The main reason why Japanese hold so much in liquid assets is that they understand that they face an uncertain future, partly because of the continued overhang from the bubble (eg Olympus) and partly because they know that the fiscal situation is unsustainable. Instead of trying to coerce them to get rid of their money out of desperation, it would be so much better to give them a positive reason to spend it, by dispelling the causes of their apprehension, such as by tackling Japan's structural problems (eg by introducing rigorous and transparent accounting) and starting to improve Japan's fiscal situation by raising taxes (like the 5 to 10% increase in consumption tax that Abe supported in return for getting a general election).

In the last couple of weeks or so, with Mark Carney, Abe and talk of negative euro rates, I think I begin to understand what it must have been like to watch the impending disaster of the First World War, or the Jewish Holocaust - it seems like the world is going mad. I am particularly disappointed to see such inflationism supported by you, Nick, who must have witnessed the futility of inflation in the UK in the 1970s. A conservative like Wellington would have you horsewhipped!

[Ritwik]

Nick, Bob

Bi-modal distributions, multiple equilibria, over-shooting models, corridors of stability etc. can all provide the theoretical justification for a view that reconciles fear about debt crises alongwith rooting for a debt crisis.

Here's my real rates framework on public debt. The central bank can backstop any sovereign bond auction/market, i.e. it can fix any nominal interest rate on the yield curve that it wants, at leats temporarily. Further, for any given fiscal stance, the central bank can prevent high and accelerating inflation by raising real rates enough to crush private demand. Unfortunately, doing so also increases the borrowing cost of the government.

Thus, the fiscal-financial-monetary policy of the government comes down to ensuring that it indulges in just the right amount of penny-pinching of risk-averse savers. Now, for any given amount of penny-pinching, i.e. for any given value of g-r>0, the deficit that it can run varies positively with the equilibrium debt/GDP. The real question is, what debt/GDP is sustainable? This may have at least two answres, say a 'high' one and a 'low' one, which are both consistent with long run macroeconomic balance and investor portfolio choice. In situations of elevated risk premium, the high debt/GDP equilibrium is more desirable, but it is also more sensitive to any changes in the real rates that the CB may be forced to undertake in case of rising inflation. Therefore, we should welcome a bust of the bond bubble, but ensure that it doesn't kill us, only leaves us less mitigated.

[jb]

Sir
I catch your drift, but trading floors are littered with the bodies of people who "went short" of Japanese Government Bonds..

[Nick Rowe]

Ritwik: Yep, that's sort of how I think about it too.

Bob and Rebel: suppose that the only asset that people wanted to hold, and the only good people wanted to buy, was government bonds. And if the interest rate on those bonds fell to 0%, they would hold money instead. Call that a bond/money bubble, if you like. That would cause recession and deflation. We don't want that. We want to burst that bubble. We want a bond crisis, if you like. We want people to stop liking bonds so much.

Don't get hung up on names. See through the names.

dlr: yep. Something like that. With the addition that it is going to explode spontaneously sometime, when too much gas accumulates.

[Nick Rowe]

jb: yep. Was it Keynes who said something like "the market can stay irrational longer than you can stay solvent?"

Plus, there's something fundamentally different about a government bond bubble. Hmmm. must do a post on this.

[RebelEconomist]

"..suppose that the only asset that people wanted to hold, and the only good people wanted to buy, was government bonds. And if the interest rate on those bonds fell to 0%, they would hold money instead.....That would cause recession and deflation"

I take your point that hoarding the medium of exchange can generate a contractionary force, Nick, but the Japanese authorities have certainly gone a long way to supplying as much of that medium of exchange as people might want and kept trying for many years. But this is what drives me mad about this debate. Monetary policy is just one possible aspect of Japan's problem. Why are people holding so much money, and can that issue be fixed? Maybe wages are sticky, but why, and can that issue be mitigated. And so on. But the politicians and financial industry commentators have successfully shifted the burden of stimulating real economic activity to the central bankers, despite the best efforts of central bankers like Shirakawa, and for some reason, few academics and financial journalists are questioning that presumption. Instead of steadily more depraved monetary easing, its time to review the problem and ask whether other solutions might be more effective.

Don't get hung up on monetary solutions. See through to the objective, which is to make the economy run better.

[jt]

Japan has a significant net foreign investment position. When the crisis hits and the Yen devalues, who cares? The J government has been trying to devalue if for 30 years and have been encouraging their corporations and citizens to invest the trade deficit overseas. As the Yen devalues these assets will be repatriated; if not voluntarily, by government taxes as needed. I don't see a crisis until their net worth to debt becomes precarious, not just their federal debt to GDP. Japanese production is still very in demand, esp. in numerous niche areas, just like the German Mittelstand. Remember the Kobe earth quake and how it impacted areas like integrated circuit manufacturing around the world?

[Steve Roth]

@Nick:

I'm kind of liking this metaphor, of the economy as an airplane:

https://sites.google.com/a/dominican.edu/econo-physics/Home

Japan is "behind the power curve" -- essentially hanging on its prop (monetary easing), just shy of a stall. (Ditto the U.S.?) The only way to get out of the trap is to drop the nose (not sure what the economic equivalent of elevators would be...), which results in a big elevation loss before airspeed comes back.

This metaphor works for me partly because it puts across the counter-intuitiveness of controlling an airplane/economy: in normal flight to control elevation you use the throttle (government spending?), and to control airspeed you bring the nose up and down (taxation?) -- exactly opposite of what most people would think.

The plane only has so much throttle. Not true of the economy. ??

[Steve Roth]

Note the usage: "the flight of an economy through an atmosphere of transactions." Very interesting. The density of the atmosphere is a key factor in flight. Not sure what the economic equivalent would be.