Abenomics: now would be a good time to panic

by George Hatjoullis

Despite all that has been attempted by Abe, the Japan economy refuses to stage a sustained recovery. The problem is, as readers of this blog will by now have grasped, the impossibility of achieving his goals without resorting to monetary financing. The goals were to return inflation expectations to 2%, generate sustained positive real GDP growth and return the fiscal position to a sustainable debt path. After 20 odd years of negative inflation expectations and a debt-to-GDP ratio of 245%, this was never going to be possible. If a sustainable debt position is 80% of GDP it is impossible to find any credible combination of growth and primary surpluses that will reach this sustainable level. A primary surplus is government income (mainly tax revenue) minus government expenditure, excluding interest on outstanding debt. The mere fact of running a surplus depresses GDP (the austerity so much talked about).

If Japan were a private individual or company it would long since have defaulted. It would have gone into bankruptcy. Nominal default, for a sovereign nation, is not normally necessary. Nominal default is just direct repudiation of the debts. A refusal to pay. Nation states can normally achieve a sneaky default via inflation. By pursuing high inflation policies they reduce the real value of the debt and generate more tax revenue (normally positively correlated with inflation). Japan has spectacularly failed to achieve a sneaky inflation default through conventional means. It has one option left; monetary financing.

Monetary financing has been explained so many times on this blog that it should not be necessary to explain again but let us a try a very simple and somewhat simplistic explanation. The Bank of Japan prints trillions of Yen notes and gives them to the Finance Ministry. The latter then drive over to the BoJ and buy back the government debt held by the BoJ. The debt to GDP ratio is reduced at a stroke and the notes are back with the BoJ. What has changed? The notes originally printed to buy the debt are still in circulation but there is no corresponding debt liability set against these notes. if the BoJ wants to withdraw these original notes from circulation it has no debt to sell through open market operations in order to get the notes back. There is a permanent increase in the stock of notes in circulation.

It is the same as the BoJ giving  the Ministry of Finance truck loads of yen notes and telling them to spend it. It is a net injection of spending power into the economy without generating a government debt liability. So long as there is plenty of spare capacity the impact of this currency debasement (for that is what it is) will simply be to get economic activity up. Prices may not shift at all. The external account may deteriorate as some of the Yen gets spent on imports and this may encourage the Yen to depreciate further. Indeed if the policy is run long enough, and given plenty of publicity, inflation expectations should rise, maybe even to 2%.

Let us now assume inflation expectations pick up and the BoJ wishes to stop expectations rising further. It may be sufficient to simply stop giving the government money to spend. If not the, the BoJ can start by using conventional means to stop banks extending credit, raising interest to discourage credit growth etc. Let us assume this proves to not be enough. The government can also act by running primary surpluses. Indeed at this point government revenue would have picked up nicely so running surpluses will not necessarily involve cutting government spending, but this too is an option. There are plenty of policy tools to cap inflation expectations generated by a brief period of monetary financing.

Monetary financing reduces the debt to GDP ratio, and ignites the economy and inflation expectations. The risk lies in continuing the policy for too long rather than in the lack of the means to stop and control the re-ignited inflation expectations. Given the impossibility of the present Abenomics strategy I suggest, yet again, that monetary financing is a legitimate policy solution and the only one that Japan has left to it.