Tag Archives: Japan

Noah Smith argues (quite convincingly) that Japan can benefit from public default:

  1. Default doesn’t have to be costly in the long-run.
  2. It would clear the rot in Japan’s ‘ancien regime’.
  3. Creative destruction would ensue.

Point (1) has a lot of empirical support. An IMF paper I’ve linked to before from Eduardo Borensztein and Ugo Panizza suggests that ”

the economic costs are generally significant but short-lived, and sometimes do not operate through conventional channels.” Argentina is a great example to this point, and so are other South American countries like Paraguay and Uraguay. I was comfortable using this in defense of Greek default, where heroin addiction and prostitution are at an all-time high because of unemployment. I feel less empathy for the highly-employed Japanese, and hence my gut conservative suspicion of borrowers kicks in. But idiotic gut feelings should not guide policy, there are other reasons to tread carefully.

Successful defaulter countries can be described thusly:

  • Poor (low GDP)
  • Developing (high post-default growth or in strong convergence club)
  • Forced, without choice, to default (high cost of capital)

Incidentally, this defines countries like Pakistan, Russia, and the Domincan Republic; not Japan. As I discussed in this (surprisingly) hawkish post, the reason for default or inflation plays a key role in market reaction. Ken Rogoff rightly suggested that America should embrace “4-6% inflation” – which I’m all for – but said this is “the time when central banks  should expend some credibility to take the edge off public and private debts”.

America’s debt is very stable and safe, and if the government with Ben Bernanke’s support inflated that value only to bring it down we tell the world that “we default on debt we can repay”. (Read the whole post if you want to jump on me, because I think there are many other fantastic reasons to inflate – but the market should know that). The central bank’s credibility would be in international ruin if the market perceived Rogoffian default as reason thereof.

And Noah’s proposal for Japan is born of the same ilk. Japan’s debt might become unsustainable, but dirt cheap cost of capital implies that the market does not feel default is imminent. This is in strong contrast to the feedback loops which compelled successful countries to default. There would be long-run reputational cost to this action and, as it turns out, Borensztein and Panizza find the same thing:

A different possibility is that policymakers postpone default to ensure that there is broad market consensus that the decision is unavoidable and not strategic. This would be in line with the model in Grossman and Van Huyck (1988) whereby “strategic” defaults are very costly in terms of reputation—and that is why they are never observed in practice—while “unavoidable” defaults carry limited reputation loss in the markets. Hence, choosing the lesser of the two evils, policymakers would postpone the inevitable default decision in order to avoid a higher reputational cost, even at a higher economic cost during the delay.

What if Japan defaults when markets think it can handle debt service (i.e. when cost of capital is very low). The question here is between “austerity-induced stagnation” and default. This is a very tricky question for developed countries, and the results would be interesting. I don’t think Japan will ever be on the brink of {choose | stagnation, default, hyperinflation} but, if it is, unlike poor countries I am unconvinced that austerity cannot be a possibility.

Would fiscal consolidation hurt growth? Yes. But would the Japanese standard of living remain far above most of the world and other defaulters? Absolutely, especially if its implemented carefully with high taxes on the rich. The biggest risk would be an era of labor protectionism from international competition, but that’s a cost Japan (and the world, indeed) must bear. On this point, I’m also very doubtful of Noah’s optimistic Schumpeterian take on removing the “rot”. Is a default like a good, cold douche? Yes, if banks are able to extend credit to small businesses, again. Why are we so confident that a defaulter Japan (especially one that isn’t believed by the market to be on the brink of default) will have that luxury? Especially when even the most accommodating IMF paper on default acknowledges deep, short-run costs. And we know that short-run brutality carries well into the long-run…

Again, I doubt Japan will be in this dire position – I’m more confident about Abenomics than Noah – but if it is, I cannot support default on the basis of “other countries did it well”. I am a strong proponent of general debt forgiveness, like any leftist, but Japan is no Pakistan or Argentina. It’s a rich country with a history of innovation and remarkable recovery; not a post-communist wreck or terrorist stronghold. We should act like it.

In a 1963 paper Robert Mundell first argued that higher inflation had real effects. He challenged the classical dichotomy by suggesting that nominal interest rates would rise less than proportionally with inflation, because higher price levels would induce a fall in money demand, thereby increasing velocity and capital formation which, in turn, would bring real rates down. The most interesting part of my argument comes from a model designed by Eric Kam in 2000, which I’ll get to.

And as Japan emerges from a liquidity trap, the Mundell-Tobin effect (named, too, for James Tobin submitting a similar mechanism) should anchor our intellectual framework. I don’t see any of the best bloggers (I may be wrong but see the self-deprecation there via Google) arguing along these lines, though Krugman offers a more sophisticated explanation of the same thing through his 1998 model, this can only strengthen our priors.

Paul Krugman, Noah Smith, Brad DeLong, and Nick Rowe have each replied to a confused suggestion from Richard Koo about monetary stimulus. Smith, as Krugman points out, was restricting his analysis on purely nominal scope and notes that DeLong captures the risk better, so here’s DeLong:

But if Abenonomics turns that medium-run from a Keynesian unemployment régime in which r &ltl g to a classical full-employment régime in which r > g, Japan might suddenly switch to a fiscal-dominance high-inflation régime in which today’s real value of JGB is an unsustainable burden..

Moreover, to the extent Abenomics succeeds in boosting the economy’s risk tolerance, the wedge between the private and public real interest rates will fall. Thus Paul might be completely correct in his belief that Abenomics will lower the real interest rate–but which real interest rate? The real interest rate it lowers might be the private rate, and that could be accompanied by a collapse in spreads that would raise the JGB interest rate and make the debt unsustainable.

I’ll address the latter concern first. Let’s consider the premise “to the extent Abenomics succeeds in boosting the economy’s risk tolerance”. If the whole scare is about Japan’s ridiculously-high debt burden, and we’re talking about the cost of servicing that debt, as far as investors are concerned isn’t Japan’s solvency a “risk”. I don’t think it is, I certainly don’t see a sovereign default from Japan, but that’s the presumed premise DeLong sets out to answer. So with that clause, the question becomes self-defeating, as increased risk tolerance would convince investors to lend Japan more money. Note the implicit assumption I’m making here is that it’s possible for a sovereign currency to default. I make this because there are many cases where restructuring (“default”) would be preferable to hyperinflation.

Even ignoring the above caveat, the fall in interest rate spreads can come from both private and public yields falling, with the former falling more rapidly. A lot of things “might be”, and do we have any reason to believe it “might be” that inflation does nothing to real public yields?

Well, as it turns out, we have good reason beyond Krugman’s model suggesting that inflation increases only nominal yields:

  • Mundell-Tobin argue that the opportunity cost of holding money increases with inflation, resulting in capital creation and decreased real rates. This is a simple explanation as any, but would be rejected as its a “descriptive” (read: non-DSGE) model.
  • So comes along Eric Kam arguing that: The Mundell-Tobin effect, which describes the causality underlying monetary non-superneutrality, has previously been demonstrated only in descriptive, non-optimizing models (Begg 1980) or representative agent models based on unpalatable assumptions (Uzawa 1968). This paper provides a restatement of the Mundell-Tobin effect in an optimizing model where the rate of time preference is an increasing function of real financial assets. The critical outcome is that monetary superneutrality is not the inevitable result of optimizing agent models. Rather, it results from the assumption of exogenous time preference. Endogenous time preference generates monetary non-superneutrality, where the real interest rate is a decreasing function of monetary growth and can be targeted as a policy tool by the central monetary authority.

[Caution, be-warned that we can probably create a DSGE for anything under the sun, but I will go through the caveats here as well] Note that he’s not making any (further) remarkable constraints to prove his point, just relaxing a previous assumption that time preference is exogenous. A previous paper (Uzawa, 1968) followed a similar procedure, but made the strong, questionable, and unintuitive assumption that the “rate of time preference is an increasing function of instantaneous utility and consumption” which implies that savings are a positive function on wealth, which contradicts the Mundell-Tobin logic.

Kam, rather, endogenizes time preference as a positive function on real financial balances (capital + real balances). He shows non-neutrality with the more intuitive idea that savings are a negative function on wealth. (So unanticipated inflation would result in higher steady-state levels of capital).

Look, in the long-run even Keynesians like Krugman believe in money neutrality. By then, however, inflation should have sufficiently eroded Japan’s debt burden. DeLong’s worry about superneutrality in the medium-term, where debt levels are still elevated, seems unlikely even without purely Keynesian conditions. That is, no further assumptions other than an endogenous time preference are required to move from neutrality to non-neutrality. DSGEs are fishy creatures, but here’s why this confirms my prior vis-a-vis Abenomics:

  1. Lets say superneutrality is certain under exogenous time preference (like Samuelson’s discounted utility).
  2. Non-superneutrality is possible under endogenous time preference. Personally, I find a god-set discount rate/time preference rather crazy. You can assign a Bayesian prior to both possibilities in this scenario. But note, the models which support neutrality make many more assumptions.

Now we need a Bayesian prior for (1) vs. (2). My p for (1) is low for the following reasons:

  • It just seems darned crazy.
  • Gary Becker and Casey Mulligan (1997) – ungated here – quite convincingly discuss how “wealth, mortality, addictions, uncertainty, and other variables affect the degree of time preference”.

I’d add a few other points to DeLong’s comment – “the real interest rate it lowers might be the private rate, and that could be accompanied by a collapse in spreads that would raise the JGB interest rate and make the debt unsustainable” – if the idea of falling real yields is not plausible. A fall in private cost of capital should be associated with a significant increase in wages, capital incomes, and at least profits. This by itself increases more revenue, but likely a greater portion of the earned income will fall in the higher tax brackets, suggesting a more sustainable debt. Of course my belief is that both private and public debt will be eroded quicker, but even if that’s too strong an assumption, there’s no reason to believe that falling spreads per se are a bad thing for government debt so long as it maintains tax authority.

However, the Mundell-Tobin and similar effects derive from a one-time increase in anticipated inflation. It’s not even to be seen that Japan will achieve 2%, and that’s a problem of “too little” Abenomics. On the other hand, if Japan achieves 2%, and tries to erode even more debt by moving to 4% it will loose credibility. Therefore, Japan should – as soon as possible – commit to either a 6% nominal growth target or 4% inflation target.

This is preferable because it increases the oomph of the initial boost, but primarily it extends the duration of the short run where monetary base is expanding and inflation expectations are rising. A longer short-run, we minimizes DeLong’s tail risks of a debt-saddled long-run, even if you reject all the above logic to the contrary.

DeLong concludes:

Do I think that these are worries that should keep Japan from undertaking Abenomics? I say: Clearly and definitely not. Do I think that these are things that we should worry about and keep a weather eye out as we watch for them? I say: Clearly and definitely yes. Do I think these are things that might actually happen? I say: maybe.

 I agree with all of it except the last word. I’d say, “doubtful”.