English: Portrait of Milton Friedman (Photo credit: Wikipedia)
The Japanese are rapidly coming to their own Endgame, the end of their ability to borrow money at interest rates that are economically rational. If interest rates on Japanese bonds rise to a mere 2.2%, 80% of tax revenues will go just to pay the interest on their debt. At a 245% debt-to-GDP ratio, they are in desperate straits, and they know it. And desperate times call for desperate measures.
To get to where they want to go, to grow their way out of their deflationary problem, the Japanese need both inflation and real growth. Real growth can come from massively increased exports, and inflation can even come from an increase in export prices. Both results can be obtained by weakening the yen. As I have shown, they need to devalue the yen by 15-20% a year for many years in order to break through to the other side.
That should be easy, at least in theory. Inflation, Milton Friedman famously said, is “always and everywhere a monetary phenomenon.” If you want to create inflation and devalue your currency, just print more money. A second shift in the print shop is in order, and if that doesn’t produce the desired results a third shift can be arranged, and then you can run full tilt on weekends. And soon maybe it will be time to build another print shop.
But that is the theory. In practice it may be harder for Japan to grow and generate inflation than it might be for other major nations. Today we’ll focus on Japanese demographics. . The forces of deflation will not go gently into that good night.
The Demographics of Doom
Creating inflation is the goal, but Prime Minister Abe and Bank of Japan Governor Kuroda face a very difficult task. Unlike in Zimbabwe, Argentina, and a host of other countries with defunct fiat currencies, in Japan it is not simply a matter of racking up untenable amounts of debt and then printing tons of money. If it were that simple, inflation would be rampant in Japan, for the Japanese have borrowed more than any country in modern history (relative to their size). And while their efforts to create inflation have been futile, it is not for lack of trying: the Japanese have been actively pursuing quantitative easing for many years. Carl Weinberg of High Frequency Economics, writing in the Globe and Mail, gives us a very succinct summary of the Japanese dilemma:
The National Institute of Population and Social Security Research projects that Japan’s working-age population will decline over the next 17 years, to 67.7 million people by 2030 from 81.7 million in 2010. We select 2030 as the endpoint of today’s discussion because almost all the people who will be in the working-age population by 2030, 17 years from now, have been born already. Immigration and emigration are trivial. The 17-per-cent decline in the working-age population is a certainty, not a forecast. It averages out to a decline of 0.9 per cent a year. In addition, these official projections show a rise in the population aged over 64 to 36.9 million in 2030 from 29.5 million in 2010. If the labour-force participation rate stays constant, we estimate the number of people seeking work in the economy will fall to 56.5 million by 2030 from 65.5 million today and 66 million in 2010.
What happens when a nation’s population declines and the proportion of working-age people decreases? In the first, simplest, level of analysis, the production potential of the economy declines: Fewer workers can produce fewer goods. This does not mean GDP must decline; productivity gains could offset a decline in the labour force. Also, an increase in the labour-force participation rate could mute the effect of a declining working-age population. However, even if the labour force participation rate were to rise to 100 per cent by 2030 from 81 per cent today (which it cannot, because some people have to care for the old and the young, and some are disabled or lack adequate skills or education), there would be fewer workers available in 2030 than there are today.
With fewer people working, the burden of servicing the public-sector debt will be higher for each individual worker. We project that the debt-to-GDP ratio and the debt-per-worker ratio will grow unabated over the next 17 years and beyond. Also, the rise of the ratio of retired workers to 32 per cent of the population from 23 per cent means that people who are still working in 2030 will have to give up a rising share of their income to support retirees. The disposable income of the declining number of workers will fall faster than the decline of production and employment. Overall demand of workers will decrease – with their disposable income – faster than output for the next 17 years at least. Demand will also fall as new retirees spend less than in their earning years.
Based on demographic factors alone, the decline of aggregate demand between now and 2030 will exceed the decline of output, creating persistent and widening excess capacity in the economy. Prices must fall in an economy where slack is steadily increasing. In addition, advancing technology will likely increase output per worker in the future. With overall demand and output falling, productivity gains will lower labour costs and add to downward pressure on prices. Disinflation and deflation are the companions of demographic decline.
Andrew Cates, an economist for UBS, based in Singapore, published a penetrating study on the relationship between inflation and demographics this week. He notes that countries with older populations tend to have lower inflation. That is not what the textbooks suggest, but it’s what the data reveals:
Since ageing demographics will now start to feature more prominently in the outlook for many major developed and developing countries this is clearly of some significance for how inflation might evolve from here. By extension it could be of greater significance for monetary policy settings and the broader outlook for global growth and financial markets as well.
Let’s first look at the evidence. In the chart below we show average inflation levels over the last 5 years plotted against the 5-year change in the dependency ratio. The latter is the ratio of the very old and the very young to the population of working age. A shift down in that ratio implies that the population in a given country is getting younger (and vice versa). The chart therefore shows that those countries that have been getting older in recent years have typically faced very low inflation rates and, in the case of Japan, deflation. In the meantime those countries that have been getting younger in recent years, such as India, Turkey, Indonesia and Brazil, have faced relatively high inflation rates.
Abe has proposed an economic reform package comprising “three arrows”: aggressive monetary easing, labor and other structural reforms (which will be politically very difficult to achieve) intended to induce private-sector growth-promoting investment, and a flexible fiscal policy (whatever that means – I guess, since it’s “flexible,” it means whatever he decides it means). He gave a speech this week on those reforms, and the market promptly threw up. The “reforms” he touted were more of the same old same old. At dinner on Wednesday night, Art Cashin modified the opening line from the old Longfellow poem: “I shot an arrow into the air… and it landed in my foot.”
Not that I think Abe had much choice. He has a critical election next month. Touting a policy that allows employers a freer hand in firing workers is not likely to win over many voters, but he must get serious about reform if he is to have any hope of limiting the disaster he faces.
Banzai! Banzai! Banzai!
The Japanese are charging the deflationary battle lines, crying “Banzai!” This attack is all or nothing. I think the Japanese are offering us investors their flank. This week’s action in the markets showed us that this battle will not be one-sided. It will often get ugly. But I want to keep reiterating what I have been saying for a long time: shorting the Japanese government is the trade of the decade. That is the largest position in my personal portfolio, and it is going to get larger, as I intend to fully swap the mortgage I just took out this week into yen. As I said to Tom Keene this morning, it is my intention (more accurately styled as hope) to let Abe-san and Kuroda-san pay for a large chunk of my new apartment through their policy of destroying the yen. I have to admit to feeling good when the yen backs up like it has this week, since that gives me a chance to get my trade on at a better entry.