Saturday, November 1, 2014
Impending Shortage of JGB Fools
As a central bank drives up bond prices investors can make money holding bonds, even at low interest rates. However, at some point the prices get so high and interest rates so low that you really need a greater fool to buy them. Currently the interest on 10 year JGBs is less than 0.5% per year. The Yen was down more than 3% for part of the day yesterday and closed down 2.7%. It takes 6 years of interest at 0.5% to make up for a 3% loss in the currency. However, there will be many more losses over the next 6 years, so investors will never catch up. At this time there is no greater fool than someone holding 10 year JGBs, except someone holding 30 year JGBs. There will soon be an acute shortage of these JGB fools.
The normal method to get more people to hold bonds in a currency is for the central bank to let interest rates go up. This past week Russia let interest rates go up to try to make holding their bonds more attractive to the market.
However, Japan is in such a bad situation that this normal method will not work. The government is spending about twice what they get in taxes, a problem almost impossible to fix. The yearly taxes were 47 trillion Yen and the central bank is now monetizing at a rate of 80 trillion per year. The total Japanese government debt is over 1 quadrillion yen (1000 trillion yen). Money printing is much more than taxes and more than the deficit. The central bank is effectively funding the deficit and about that much again buying up bonds from the rest of the market, which on net is reducing bond holdings. Even the pension funds are now getting out of JGBs. The Japanese government debt is so high that if interest rates go up to about 4.7%, just paying the interest on the debt will use up all the money collected from taxes. Rates in Japan were this high in 1991. If people don't want to buy JGBs now, they won't want to buy them when all of government taxes just cover the interest on the debt. This is not an attractive situation to bond holders. Half this rate would mean half of taxes just to pay interest, twice this rate would mean interest twice taxes. Neither of these is attractive to bond investors either. The normal method of raising interest rates to improve demand for bonds will not work for JGBs. There is no interest rate that increases demand so the central bank is not forced to monetize even more than the total deficit at this point. This is a big problem, the central bank is effectively forced to print money with no way out.
When the central bank of Japan announced the increased rate of monetization they claimed it was because they are worried that lower oil prices are pushing Japan toward deflation, so they want to push harder toward inflation. I think the real reason is nobody else is buying JGBs and people are selling, so the central bank needs to buy even faster. Also, when they announced the first huge printing it was to double the money supply in 2 years. This had the implication that they would stop. Now they are saying they are printing at a rate of 80 trillion yen per year, which does not imply any ending.
At this point the Japanese Central Bank is really funding Japan's government deficit, with no way to stop. I think the market is starting to realize this and that is why people are starting to flee JGBs. Soon, if not already, there will be a death spiral where the more the central bank monetizes, the less people want to hold JGBs and the less people hold JGBs the more the central bank is forced to monetize. The only alternative is for the central bank to let the government fail, which never happens. This death spiral has many characteristics in common with positive feedback loops in nature, which tend to end in destruction. In this positive feedback loop, which also include higher velocity of money and loss of confidence, the end is the destruction of the currency.
Keynesians live in fear of a deflationary spiral, which in practice almost never happens and when it does is usually slight. They are now acting like anything less than 2% inflation is deflation, just so they have some real world examples to panic about. However, they can't seem to imagine or understand a high inflation death spiral, which happens rather often to fiat money and is a much greater danger. They need to study up on the theory of hyperinflation death spirals.
Mark my words, there will soon be a horrible shortage of JGB fools.
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Thanks for your feedback, which I agree with.
ReplyDeleteI still have a question however : official at the BOJ must know this, right ?
So, they must know this which is basic.
What if the BOJ buys all government bond... Therefore creating an infinite loop.
I mean : the BOJ buys 100% of all government deficit.
Of course, everyone wil be fleeing JGBs.
Not a problem, they'll be buying.
Who/what will say stop (in this case) ?
Thanks for your feedback.
Gilles
They can and I expect will be buying all JGBs. Nobody will stop them. But the Yen will crash and eventually become worthless.
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ReplyDeleteI think you are correct. If you are selling oil to Japan you will be able to buy more and more real stuff as the Yen crashes. Tourist have a great time visiting countries with hyperinflation as everything seems so cheap to them in terms of their home currency. It is bad for the workers in the country getting hyperinflation.
DeleteIt seems to me that Japan has just offered to pay more for imports. As a resource poor country, they are basically a value added supplier. They add labor to products and then resell.
ReplyDeleteIf they pay more for imports, they will need to work HARDER to be able to sell cars or any product at the original (pre-devaluation) prices. That should not be good for their workers nor their retired population living on saved money.
This analysis seems very out-of-step with the thinking of the JCB. I must be missing something important.
I think the truth is they need to print money and buy bonds so the government can keep in operation. The claim that they are trying to stimulate exports amounts to a cover story. I think you are right, it is not really a good story. And over the previous history it has not been working as advertised.
DeleteWhat are the implications of a Japanese hyperinflation on the rest of the world? I am guessing it will be vastly different from the hyperinflation episodes we saw in largely insulated economies (like Hungary in the past or Russia in the 90s) or third-tier economies like Argentina or very small economies like Zimbabwe. Japan is an industrial economy and the Yen is one of the most prominent currencies in the world, unlike the Ruble or the Peso or the Zim dollar.
ReplyDeleteThere are other currencies that use the Yen as a reserve currency. So if the Yen crashes their backing is not as good and they will probably go down some.
DeleteThere is a widely believed myth that advanced Western democracies are too smart to get hyperinflation. To some extent this belief helps protect countries from getting hyperinflation. People don't rush out of the bonds of advanced western democracies because they don't believe there is risk of currency failure. After Japan shows the myth is not true then people won't feel so secure about the other advanced western democracies. At first there might be a "flight to quality" where people rush from Yen to dollar, but eventually the dollar probably goes too.
It will certainly have much more impact on the rest of the world than previous cases of hyperinflation.
The M2 money supply in Japan is 877 trillion Yen. So 80 trillion per year is about 9% of M2.
ReplyDeletehttp://www.tradingeconomics.com/japan/money-supply-m2
Vincent - I agree with you mostly but one mistake, I think, you make is assuming that, when rates rise, Japan government will pay higher interest on all debt ....they will do so only on new debt since the coupon is fixed.
ReplyDeleteYes, I do understand that, I just don't go into that much detail. In practice there is a huge amount of short term debt these days, so new interest rates quickly have an impact.
DeleteIf the Japanese actually destroy the yen, Japanese business and consumers will switch over to a better currency, probably the US$.
ReplyDeleteYen savers will be wiped out, but Japanese exporters will just price their goods in dollars, write dollar-bonds and spend dollars for raw materials.
Ironically, this would be very good for the dollar--maybe too good.
As long as there is a fairly stable reserve currency such as the US$, which can be fairly easily substituted in a world that does not restrict currency flows, there is a backstop to all manner of global central bank shenanigans.
But if the dollar goes the way of the yen, all bets are off.
Starting from scratch, it will take a d___ long time to re-establish faith in fiat currency. In the mean time, the best currencies may be canned food, bottled water and ammo.
No wonder there is so much fascination with the Zombie Apocalypse.
I also wonder about bitcoin. Because capital controls don't work on it, it is a very nice thing to hold if your country is having an economic collapse or hyperinflation. You could leave and take your bitcoins with you. In Venezuela and Argentina there has only been a little interest in Bitcoin, I am a bit surprised it has not become much more popular. Argentina has frozen bank accounts and forced dollar to peso conversions at bad rates, greatly limited how much you could take out, etc. I would think people there would rather put their money into bitcoin than into the bank. Taking bitcoin across a border is easy, they can be in your cellphone. Taking gold across a border risks confiscation or theft.
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