I recently read two papers about the bond market, one of which was the intellectual equivalent of a bathtub of vomit, while the other was a breath of fresh air – which one do you think was written by Goldman?
The Goldman paper is 40 pages long and is a masterpiece of long-worded deception.
The core logic (amply-padded with generous fluff) goes something like this:
1. We think we can model corporate cash balances.
2. We will also say a few things about household cash balances, although we make a serious error by confusing the savings rate with the actual stock of cash holdings.
3. The reason why we think we can model corporate cash balances is because they seem to follow GDP growth.
4. Therefore, as long as we have a perfectly accurate forecast of GDP growth, then we are bang on the money with the corporate cash balances.
By contrast, this is what the paper by the National Institute for Research Advancement said:
“Both the household sector and the corporate sector are holding a huge amount of excess savings, and these savings flow into the financial system in the form of bank savings, etc. However, there are insufficient borrowers and investment opportunities available for financial institutions to actively operationalize these funds. With the economy in a downturn, there are no destinations for the funds, and as a result they flow into the government bond market. Even when prices are high, there is no alternative but to buy bonds. … If there is a collapse, will it occur in the desirable form of an economic recovery, or will it result in a severe decline in the price of Japanese government bonds?”
Simple: We know some stuff. There is some other stuff we do not know.
Although they do not get into any complicated analysis, at least they stick to what is clearly known and not known, and do not venture down a mineshaft of erroneous thinking.
Back to Goldman:
They get so excited by various inter-dependent models that they come up with “Household cash holdings are also influenced by factors such as economic uncertainty, albeit to a smaller degree than the corporate position”, when it is the savings rate (the flow) that is affected meaningfully, whereas savings themselves are pretty stable (still growing but at a lower rate). In case you think that is just a typo, they come up with this chart:
Japan bond market erroneous thinking
Clearly, this is a confusion of the savings rate. The total amount of household savings is greater than GDP (doh): http://www.bloomberg.com/news/2011-09-20/japan-household-assets-rise-for-first-quarter-in-five-boj-says.html
There is no shortage of funds in the household sector. Particularly old people are bloated with cash, and are starting to spend it (this was on the front page of the Nikkei Shimbun last week) on sports, English lessons, travel, etc.
Wake up Goldman, your Bloomberg terminals are costing you over $20k a pop – use one of them!
As you can see, you could drive an Isuzu truck through the holes in this paper, much like this one:
http://www.youtube.com/watch?v=8DyFRNoqpjA
(Chorus lyrics: Drive on! Drive on! Isuzu Truck!)
I would like nothing more than to ignore their other premise: “Which is the more effective approach to fiscal consolidation: tax hikes or spending cuts?”
But this is the fiscal equivalent of asking “Which is more effective for a cancer patient: a brisk morning jog or a nice healthy carrot salad?”
The people who think that this debt is going to get repaid in a sensible manner are the same folks that would have sold you Greek debt about 10 years ago.
It is better to get the general direction right than to model your thinking into self-referential meaninglessness. Let’s look at this in the most basic way – what do we know that will happen in the future, and what can be put into a scenario analysis?
The following we know to be true for the household sector (corporate sector ignored due to GDP-sensitivity and lack of Goldmanesque sophistry on my part):
1. Debt issuance can only be maintained until the source of savings dries up
2. The working population is shrinking, and incomes are not growing. Therefore, their savings cannot grow unless they reduce spending.
3. Old people are much richer than young people and may be increasing spending.
=> This means that we are pretty close to running out of the fuel for JGBs
…unless the BoJ keeps on buying more JGBs (it currently owns about 10%, more than all foreigners)
Therefore, there are two obvious scenarios that may play out:
Current Japan bond market
One is a deflationary spiral and the other is an inflationary spiral. Although the government in Japan is particularly good at repeating mistakes, it is fairly well known that by now they have decided that they cannot get through the deflation by accepting a big depression where assets are liquidated as per the standard capitalist textbook model (they should have done it twenty years ago, but that’s a story for another time).
That is the first reason why I believe the deflationary spiral into depression is much less likely than the other scenario.
The second reason is to do with banking. If all banks and insurers in Japan are stuffed to the rafters with JGBs, and the price of JCBs falls, what do you think will happen to the banking system?
Of course, it will implode very badly. This cannot be allowed to occur. The only way to prevent this from occurring is to support the bond market.
The reason why QE will be different in this kind of scenario is that money from the private sector will actually be leaving the bond market, as opposed to entering it.
When the private sector is voluntarily net lending money to the government, it is not putting it to use for productive uses (assuming that most government spending is basically a waste of money, as illustrated by the way that TEPCO operates on the street next to mine – 14 men to dig a hole, of which 9 are standing around waving sticks to warn passers-by), and the amount of money floating around in the economy would shrink by that much if the government would not go and spend it on a bridge to nowhere or 14 guys digging a hole.
Now, in that scenario, where the private sector is taking money out of the JGB market and spending it, the opposite will occur. There will be an increase in the amount of money floating around the economy. This will give rise to inflationary pressure. Once inflation starts, the cycle will turn yet faster. Yes, I know it is hard to swallow this argument if you are one of those people who draws straight lines through things – NASDAQ earnings, Chinese growth, US corporate margins, etc. – but if you can accept that deflation has its own dynamic due to money being squirreled away, then you must accept that the opposite will reverse the dynamic. If not, dear reader, I am afraid that would make you an imbecile.
All the while, the bond market must be propped up, or otherwise the government will not be able to meet its obligations – just the interest alone could easily swamp the entire budget if bonds are allowed to fall even a little.
We know that this kind of outcome must happen at some point – the debt just cannot be repaid straight.
Another way to think about this is a wealth transfer from the rich old folks to the poor(er) young(er) folks.
The people who have the money in Japan right now are the old folks. They will need to increase their spending as they retire and spend money on things like healthcare and holidays, and you cannot save any money when you are retired.
The people who are working have much poorer prospects than their parents’ generation. There is simply no way that a shrunken workforce will be able to grow the economy while simultaneously paying a much higher rate of tax.
Therefore, who exactly is going to repay this debt?
The answer is: not the young people, at least not meaningfully – they cannot afford it, and will be even less able to do so in the future.
The debt is owned by all of these old folks, and for them it is just mountains of cash in a bank account. Those mountains of cash will be spent. When they are spent, the JCB market will either collapse or be supported by the Bank of Japan. Therefore, ultimately, the debt has to either be defaulted on (deflation), which would entail telling all of these old folks that their cash is not worth what they thought it was; or inflated away, which would keep the banking system intact, keep the government solvent, and keep all of the old folks happy (in the beginning, anyway). Which do you think is more likely?
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