OECD Delusional About Japan (Again)

Yet another "stronger growth in the second half of our forecast horizon"outlook, this time by the OECD. The headlines for the latest OECD Economic Outlook highlighted the danger of slowing developing economies, and so they have notched down their 2013-2014 global growth forecasts by 0.4%. But, as one has come to expect, stronger growth awaits at the back end of their forecast horizon:  2013, 2014, 2015 annual global growth rates are forecast to be 2.7%, 2.6%, 3.9% respectively.

I do not follow the developing economies enough to comment on the global forecast, but I am not too optimistic about accelerating growth in the developed economies. The euro area is a horror show of misguided policies. In other regions, the action of increased tax payments in response to nominal growth should help keep growth stabilised near its present pace. And I  may be missing something, but the capital expenditures cycle already looks mature.

However, the OECD analysis for Japan is particularly weak.

With gross public debt surpassing 230% of GDP, a detailed and credible fiscal consolidation plan to achieve the target of a primary budget surplus by FY 2020 is a top priority to sustain confidence in Japan’s public finances. (Japan forecast summary - OECD.)

As always, they look at the gross debt, as that gives the scariest sounding number. However, it makes no economic sense to avoid consolidating government assets and liabilities. If I write myself an IOU for $1 billion, have I suddenly turned into a billionaire?  No I have not, as people will net out my assets and liabilities. In any event, there is no particular reason to care about "high" debt-to-GDP ratios.

And with the 10-year JGB trading near 0.61%, I think investors need to have less confidence in Japan's government bonds, not more. (Why be short an almost-free put option?)

The OECD analysis applauds the upcoming consumption tax hike. The level of Japan's VAT is relatively low when compared to other countries, and I think that there may be  advantages to raising it slightly. However, this would have to be combined with an income tax cut, in order to keep the effect on consumers roughly neutral. Since Japan is not cutting personal taxes, the likely result of the VAT hike in Japan is to murder the feeble recovery, which will make the debt-to-GDP ratios higher in the long term.

The theory that Japan should aim for a primary fiscal surplus by 2020 (fiscal balance excluding interest payments) is the most misguided part of their analysis. As long as the policy rate remains near zero, the aggregate interest rate on Japan's debt is well below 1%, even if the 10-year JGB returns to the top end of its long-term trading range. This means that Japan's net interest cost is only 1-2% of GDP, despite the "high" debt-to-GDP ratio. A primary surplus would imply that the government budget is roughly balanced.

It may be that large structural changes will hit Japan before 2020. However, a balanced budget would indicate that the non-government sector is no longer attempting to increase the level of government-guaranteed financial assets they hold.

An important dynamic that is often overlooked is the tendency of financial assets to be increasingly held by entities that hoard financial assets. A staple of celebrity news is the story of a pop star or athlete who rapidly ended up bankrupt as soon as their income sources dried up.  People with a "high propensity to consume" do not accumulate much in the way of financial assets (by definition).

Even demographics may not affect this tendency towards hoarding. A fairly standard approach to personal finance is to only consume enough to avoid "touching the principal", and so the assets held by retirees in aggregate could rise over time, not fall. Unless this dynamic is somehow broken, it will be almost impossible for Japan to run an aggregate fiscal surplus.

It may be the OECD is banking on a JGB collapse; higher interest rates will allow a primary surplus to coexist with an overall fiscal deficit. Although possible, I am skeptical that the Japanese will tolerate the inflation needed to generate that collapse. (NOTE: The VAT hike will generate a one-off jump in the price level, which will excite some people. I find it hard to get too bearish on bonds as the result of contractionary fiscal policy.)

(c) Brian Romanchuk 2013