Is foresight knowledge? Nobel prize winner Gabriel Garcia Marquez commences his classic novella “Chronicle of a Death Foretold” with a scene of mourning for the central character Santiago Nasar. The author then takes us back in time to chronicle the events that led up to Nasar’s demise. As the day in question unfolds, one discovers that almost the entire occupants of the town where Nasar lived knew of the plot to kill him. Nonetheless, no-one forewarns Nasar: some don’t believe the murderers will carry out their threat, many are distracted by the imminent arrival of a Bishop to their island backwater, a few encourage the perpetrators of the crime, and yet others try to warn Nasar but cannot find him.
Throughout all this, the reader realises the inevitability of the final outcome, but at the same time feels frustrated over the innumerable missed opportunities to prevent the death. Coming as I do from the west country of England, I feel the oppressive fatalism of Thomas Hardy. We understand that what we do is wrong, but we are fated to do it anyway.
Looking at Japan’s burgeoning public debt, I feel that I am peering down on Garcia Marquez’s fictional town. Everyone knows that public sector liabilities are ballooning, but there is no common purpose over what to do. Indeed, most are too occupied with the distractions of popular culture to pay the debt much heed, while some argue that the debt is harmless since the country has remained prosperous though the years over which it has accumulated. A few utter Cassandra-like warnings, but the fact that disaster never strikes blunts the message. (Of course, the accusation of being a Cassandra is a strange smear: it ignores the fact that Cassandra was eventually proved right; her true curse was that no-one believed her.)
In my last post, I argued that the next three years will prove pivotal for Japan as the baby boom generation switch to becoming dissavers, so choking off the ultimate source of demand for all those Japanese government bonds. The chart below is taken from a recent IMF report on Japan’s fiscal imbalances and shows the long-term slump in household savings. The blip up in 2009 was a knee jerk reaction to the credit crisis, but in 2010 and 2011 the savings rate dipped again.
Moreover, things are going to get far, far worse. The next chart was originally from a 2007 article in The Economist on Japan’s ageing population, but given the glacial change in demographic changes it is still a perfectly valid indicator of what Japan will look like in the year 2050. I like the chart because it not only shows the changing age structure of the country but also captures the fact that the total population is now also on a long-term downward trend.
I still feel that there is little sensible analysis of what this stunning chart actual foretells. Indeed, the implications of this incredible population ageing and contraction are hardly touched upon in the IMF report I linked to above. The closest I have seen to a sensible analysis of this demographic earthquake is from the perceptive economist and commentator Edward Hugh in a recent blog post here.
If Japan is going to see a decline in working population over the next several decades (and possibly much longer, since so long as fertility remains below replacement rate each generation will be smaller than the previous one) and if this lies at the heart of the problem, then it means the problem is a deep structural one which won’t be resolved by any kind of “kick start”, however large. It isn’t a question of a planet which has slipped off its orbit, and just needs a nudge to get it back on, it is a planet which has veered off onto a whole new trajectory, which leads who knows where. As I say, this situation was never contemplated by the founders of neoclassical theory, and yet, having started in Japan, the phenomenon is now extending itself steadily across all developed economies in one measure or another.
The quote is partially a response to Paul Krugman’s writings on Japan’s lost decades of economic growth. In particular, Krugman’s idea that Japan could be bashed back onto a growth trajectory through a combination of hyper aggressive monetary and fiscal policy. To me, Hugh is touching on many of the issues that I deal with on this blog; that is, that neither Keynesianism nor the Austrian style of austerity economics are solutions for deep underlying structural weaknesses that have been developing within most advanced economies. Here is Hugh again:
I think that Krugman’s work at the time was truly innovative. He identified a problem, a country with an ageing and declining workforce, and he looked for a solution to that problem. This put him head and shoulders above the majority of his contempories. But he stopped short of digging deeper, and allowed his spade to be turned too soon. He could see that the problem was one of demand deficiency due to the changing balance between saving and borrowing, but he didn’t follow this through and see that the problem was not simply temporary (even if decades long) but more or less permanent, and he didn’t see that this demand deficiency results in export dependency (leveraging the global rather than the local economy in the search for customers), and that the only consequence of having permanent fiscal injections would be not to give stimulus, but rather an accumulation of debt that will be increasingly harder for those smaller and poorer (deflation) workforces to pay down in the future.
In addition to the head winds provided by ageing populations, I would also throw into the pot the increasing drags on growth that will manifest themselves over the coming years from resource constraints (one of which is peak oil), the tendency of modern technology to concentrate wealth and render parts of the population unemployable, overall diminishing returns to technology in general and climate change. But for the purpose of this post, let’s just restrict ourselves to demographics.
For me, Japan’s predicament lies in the fact that the inverting age pyramid is turning traditional interest rate theory upside down. Under neoclassical economic theory, real interest rates (adjusting for inflation) are premised on the time preference of individuals. In other words, individuals will, other things being equal, prefer to consume something now rather than wait to consume something in the future. An interest rate is thus the price paid to bribe people to defer consumption. But look at the demographic charts above. We can see that as we move between the second and third age structures, a large percentage of the population become retirees with no earned income. Critically, for this cohort the key consideration is to lock in future consumption—such as medical services and nursing care—in their old age. You don’t need to bribe these upcoming seniors to stop spending with an interest payment; indeed, if you could guarantee them future security, they would probably pay you! That is why the Japanese government found a receptive market for its paper issuance throughout the 90s and 00s (via the banks and post office) at minimal interest rates.
Meanwhile, tectonic movements have been taking place within the corporate sector as well. An ageing and shrinking population means that effective demand within the economy will be in long-term decline. And on the supply side, the pool of available workers will also be diminishing. To date the growth in productivity (albeit declining) has been enough to compensate for these drags on growth but things are about to change as the following two charts from a recent speech on Japan’s demographics by Masaaki Shirakawa, the Governor of the Bank of Japan (BOJ), show:
Shrinking employment will ultimately swamp gains in productivity. Moreover, in a no growth world, firms will continue to deleverage, and banks will reinvest the paid back loans back into Japanese government bonds—indeed, Japanese banks resemble government bond mutual funds these days rather than traditional intermediaries of funds between households and corporations. But eventually in a no, or negative, growth world these net savings from the corporate sector will decline rapidly as well.
So how does the end game play out? In my opinion it will be when households realise that their attempts to save in order to fund future consumption have been in vain. The post office savings, bank deposits and life insurance policies in the chart below (also taken from the BOJ presentation referred to above) have generally ended up in Japanese government bonds as their final destination. The government, in turn, has predominantly used these funds to make social welfare payments. The funds haven’t ended up is in either private or public investment goods that can underpin future growth (see my last post for the extraordinary collapse in non-social security expenditures in Japan to the extent that the country is now at the bottom of the OECD league table on this particular metric).
Further, when households become net dissavers over the next few years and corporations become much smaller savers, the only way the government will be able to balance its books is by monetizing its debt via money printing by the BOJ. In short, the BOJ will become the bond purchaser of last resort.
Unfortunately, the printing of money will not provide the services the elderly need. The demographics are quite simple. If now there are two nurses for every two elderly people who require a nurse, in the future there will be one nurse for four elderly people who require the services of that one nurse. Each of those four elderly people will believe that through judicious saving over the years they will have created a nest egg to call on nursing services as and when needed. But the money they put into the bank has gone into government bonds. When the money is taken out the bank (and thus out the bonds) ultimate payment will come by way of the BOJ’s printing press (the government has no alternative except to default). But the nurse can’t replicate herself. Thus, when faced with four claims for her services, the market will dictate a fourfold increase in her price to balance supply and demand. This point is worth restating: there is no type of fiscal or monetary policy that can rebalance Japan’s demographics!
My belief is that when Japan’s elderly public wake up to the fact that their attempt to lock in future consumption has been completely in vain the ramifications will be massive. The hunt by individuals will be on to find an alternative asset to bonds that can provide some future security. That probably means trying to tap into future consumption by investing in countries with a more balanced demographic structure or storing future purchasing power in a hard asset like land or gold that the government can’t debase. Personally, I think the system could suddenly tip (just as the sub-prime housing market did), and the BOJ could be faced with the daunting prospect of having to take ownership of most of the government bond market as households flee abroad or into hard assets. The potential for cascading feedbacks in a modern complex economy like that of Japan are huge. Greece also shows that once a populace finds its assumptions over future prosperity have been proved wrong, it may then go on to to question the political institutions that have delivered this state of affairs.
To date, Japan has managed its growth descent remarkably well (although if you read the blog Spike Japan you will realize that the outer prefectures are experiencing considerable pain—pain that is not visible in Tokyo). I personally believe that Japan—as the poster child for a post-growth economy—faces far greater challenges over the next few years. Whether the country continues on it current path of gradual descent with dignity or displays a far more accelerated economic, social and political deterioration is still to be seen. As other advanced nations struggle to cope with a post growth world, Japan’s ability (or not) to avoid an uncontrolled collapse will provide lessons for us all. At this stage, I am not foretelling a death, but certainly some severe distress.