Leading Japan economist Takatoshi Ito once described Japan’s underlying problem: “When an economy is growing, governments can afford to give a generous pension to the first generation. As long as it continues to do so, the pension can be rolled over into ever bigger amounts in a perpetual Ponzi scheme. But when growth rates decline and population growth turns negative (as is the case in Japan), the infinite Ponzi scheme ceases to work. Then the government must (among taking other actions) claw back the pensions of those already retired,” he said.
That claw back is well underway. As Japan approaches the boundaries of what monetary policy can achieve, economist Martin Schulz puts Takatoshi Ito’s remarks into broader context. Schulz is Senior Research Fellow at the Fujitsu Research Institute in Tokyo, where he works within the firm’s not-for-profit think tank.
According to Schulz, Japan was a former classical textbook case of a growing, productive economy with a positive “natural” rate of inflation. It is now in a transitional phase experimenting with new policies, trying to prop up the nation’s pension Ponzi scheme. In the future, Japan will likely rewrite textbooks for aging societies that are shrinking and in which the “natural” state is deflation.
Abenomics aimed to perpetuate Japan’s Ponzi scheme through debt monetization. It pushed down yields, lifting asset markets and investor spirits. The goal was to make possible difficult but needed structural reforms that Tokyo hoped would lift growth. With enough growth, the government’s huge national debt could be reduced to sustainable levels. In hindsight, the reforms failed to keep pace with the easing.
Monetization has since taken on a new role and meaning. Instead of acting as a growth catalyst, it has become a “tax” — a claw back of wealth from its own citizens. The “tax” goes to finance fiscal policy, helping to pay the costs of Japan’s rising healthcare and public pensions.
The taxing mechanism is simple. Through monetization, the government shifts national debt from private hands to public sector accounts. This forces yields down and replaces interest paying debt with non-interest bearing money. The interest-free debt then subsidizes pension and health care entitlements, which form the largest slice of central government spending. The “tax” (as forgone interest) is paid by an older generation of savers who had hoped to live off interest income on savings in their retirement.
“The Japanese government is up to something new,” says Schulz. “They are paying for the social security system with public debt by returning it to the government sector at the cost to current savers. It’s quite interesting.”
This and the recently introduced negative interest rate policy are new instruments the government experiments with as it grapples to contain the growing national debt. They don’t always work as planned. For example, instead of encouraging consumption, inflation, and growth, people are saving more to compensate for what they foresee as a decrease in their retirement savings.
Nevertheless, all is calm. Pensioners earning nil on their savings are satisfied as consumer prices have fallen over many years. “They’re okay with that,” says Schulz. Companies adjusted to Japan’s shrinking domestic economy by cost cutting. “They’re okay with that as well,” he says, as firms can live off existing cash flows and savings, rather than by growing sales. Even the Ministry of Finance, typically the fiscal hawk, has become eerily quiet — perhaps because it earns money by issuing extra public debt.
Another reason for the calm is that central bank monetization drags consolidation with it. “Under current Bank of Japan (BOJ) policy, the overall debt is shrinking by a tremendous amount which could never have been achieved under normal fiscal policy,” notes Schulz. Over the next two to three years the nation’s debt to GDP ratio will likely fall from over 240 percent in gross terms today down to about 100 percent in net terms, if all government holdings (including those of the BOJ) are taken into account. As a result, the government is reluctant to follow through with fiscal consolidation “because they don’t actually have to,” he says.
For the moment Japan’s economy is in low-growth equilibrium, as debt monetization allows the nation to live beyond its means. Schulz warns it can’t last. “The huge public debt never exploded because the returns on savings have been falling all the time. Zero interest rates are now becoming negative. This will not suffice in the coming years,” he predicts.
Meanwhile, the BOJ is fast approaching the limits of what it can accomplish through monetization. It already owns over 60 percent of government debt and continues to buy about 15 percent of the public debt as a percent of GDP each year. Entitlements, which consume 33 percent of government expenditures, are set to skyrocket as all baby boomers become or surpass age 75 by 2025. In around two years, off-balance sheet financing by monetization alone will not be enough to cover the rising cost of social entitlements. “We are at the boundary of what monetary policy can achieve,” says Schulz. Then the government will have to consider cutting social security benefits and raising taxes.
But Schulz wonders how much further consumption tax can rise. He guestimates that Japan’s 8 percent consumption tax, low by European standards, is almost 5 percent higher after adjusting for the nation’s high import duties and agricultural subsidies.
He gives the nation about five years time to show clear-cut plans to achieve fiscal sustainability. Thereafter he believes continued monetization would create cost-push inflation. “In the future, the BOJ will move the economy into higher inflation to take care of the remaining chunk of the outstanding public debt,” he says adding, “Let’s call it the delayed success of Abenomics.”
Under cost-push inflation, the rising cost of goods exceeds wage inflation. Schulz puts a positive spin on what is typically called “bad” inflation: “Using the traditional model, Japan would never be able to repay its public debt as the overall growth rate is not high enough. The 240 percent debt would have risen to over 300 percent in future years. But through inflation (created by monetization) the remaining debt can sit neutralized on the balance sheet of the central bank forever,” he argues.
Inflation has so far been avoided. Banks, which have been the main sellers of government bonds, have parked their proceeds at central bank accounts where it remains unspent. But as the BOJ exhausts the supply of government bond that banks hold, it will seek to buy up longer-dated instruments from private sector holders — should it continue to monetize the debt. This, Schulz says, delivers real cash to life insurers, to pension funds and into people’s pockets. They will spend it, buy more real estate assets, or invest overseas. Inflation will follow.
He also predicts further monetization will undermine the business model of private pensions by denying them the ability to earn a profit on the funds they manage. Pensions are already under pressure by the nation’s shrinking workforce and graying population. The government currently bails out corporate private pension plans by returning them to the public fold. In the future, more companies will default on their pension promises, Schulz envisions.
“The defining moment of the flip from deflation to inflation will come when the BOJ starts buying bonds not only from private sector banks, but from the wider private sector — especially from pension funds,” Schulz says.
He adds, “It’s a slow rolling process. But it’s coming! It’s coming for sure.”
Richard Solomon produces Beacon Reports, a newsletter that reveals Japan through the lens of thought leaders. He is also contributing writer to the Nikkei Asian Review and The Japan Times. He posts regular Beacon Reports at www.beaconreports.net