Veneroso Associates. Global Economy Where Will The Debt Confiscating Inflation Occur? Japan, Not Europe And The U.S. Frank Veneroso.

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1 Veneroso Associates Global Economy Where Will The Debt Confiscating Inflation Occur? Japan, Not Europe And The U.S. Frank Veneroso August 17, 2011 What follows is about the inevitability of the depreciation of the yen. Right now the BOJ is under pressure to intervene to get the yen down. They will probably do so, and they will probably succeed. This is a short term scenario. It is not the long term scenario that will lead to the inevitable depreciation of the yen. On that latter scenario, I do not know when it will really take hold. Executive Summary 1. Recently the yen has been very strong. We are told that it has become the safe haven currency. I believe this kind of talk will go down in financial history as one of the Great Stupidities. 2. It is obvious to everyone that Japan is basically on an explosive sovereign debt path unlike any other country in the world, except perhaps Greece. 3. In today s casino market of the absurd it is a consensus view that the U.S. and its Fed under Helicopter Ben Bernanke will surely have a debt confiscating inflation. In buying the sky high yen the casino market seems to think it won t happen in Japan. 4. The one guy who keeps reminding us that Japan is on the verge of such an inflation is BOJ governor Shirakawa. 5. All you have to do is look at the money to GDP ratio in Japan and in the rest of the first world and it becomes obvious why he is so concerned. 6. Though the U.S. M2 to GDP ratio rose into the mid-2000 s cyclical peak of 60%, it is more or less unchanged since then and it is in line with much of the post war historical experience. 1

2 7. Japan stands in striking contrast. Its M2 to GDP ratio at 100% was in line with most first world countries twenty years ago. It is now above 170%. No first world country can compare. 8. The Japanese people hold such vast money balances relative to income only because they have trust in the BOJ s commitment to deflation. With deflation they earn a positive return on their zero nominal return money balances. If they thought deflation would end they would not want to hold such large real money balances. 9. Because the chronic large Japanese fiscal deficit ensures further growth in nominal debt and money, they can flee these excess money balances only by bidding up the prices of assets and goods and services. The consequent increase in monetary velocity will generate a high inflation that will feed back into inflation expectations and money demand and set off feedback loop dynamics. This is why Shirakawa says that the inflation threat he faces will be uncontrollable. 10. This flight from real money balances is inevitable in the case of Japan. 11. The current combination of high fiscal deficits and stagnant nominal GDP has Japan on an explosive debt path. Continued increases in the already sky high money to GDP ratio is the monetary counter party to this rising path of debt to GDP. Japan s monetary overhang will get bigger and bigger. The trust of the Japanese people in the ability of the BOJ to deliver deflation will get evermore untenable. 12. The cake is baked: Japan s monetary overhang has passed the point where an inevitable debt confiscating inflation could be avoided. Nothing like this can be said of the U.S. 13. There is nothing in the U.S. data to suggest unwanted real money balances which the public may someday want to flee, not is there any trend towards such unwanted real money balances. 14. It would take more than a generation for any unwanted real money balances to go nuclear or thermonuclear as they already have in Japan. And over that long, long time span the U.S. has many things it can do to avoid the disastrous situation that has already befallen Japan. 2

3 Veneroso Associates Global Economy Where Will The Debt Confiscating Inflation Occur? Japan, Not Europe And The U.S. Frank Veneroso August 17, 2011 Recently the yen has been very strong. We are told that it has become the safe haven currency. I believe this kind of talk will go down in financial history as one of the Great Stupidities. Everyone knows that Japan has a sovereign debt to GDP ratio that is far higher than that of Greece and double that of most major economies. Everyone knows that Japan s demographics condemn it to almost zero real economic growth. Everyone knows Japan has had an extremely high fiscal deficit to GDP ratio because of its chronically weak domestic demand. Everyone knows that Japan s current price deflation makes it unable to increase its nominal income as its fiscal deficit powers even higher its already astronomically high sovereign debt. So it is obvious to everyone that Japan is basically on an explosive sovereign debt path unlike any other country in the world, except perhaps Greece. And yet Japan is allegedly a safe haven currency. In the bubble era of casino market behavior, absurd views are embraced again and again. The yen is a safe haven currency takes the cake when it comes to embraced absurdities. So how will Japan s debt trap dynamic end? Many believe it will end in a necessitous debt confiscating inflation. That is the lesson of history. In today s casino market of the absurd it is a consensus view that the U.S. and its Fed under Helicopter Ben Bernanke will surely have a debt confiscating inflation. In sending the sky high yen the casino market players seem to think it won t happen in Japan. The one guy who keeps reminding us that Japan is on the verge of such an inflation is BOJ governor Shirakawa. At first hearing he sounds crazy, talking again and again about the imminent threat of asset bubbles and an uncontrollable inflation. The Japanese stock market is down by three quarters over the last twenty years and is mired near its lows. Japanese real estate is down by more and is mired at its lows. Japan s economy has been woefully weak for a decade and a half and cannot escape its price deflation. But all you have to do is look at the money to GDP ratio in Japan and in the rest of the first world and it becomes obvious why he is so concerned. 3

4 Below is the M2 to GDP ratio for Japan and the U.S. over long periods. Source: Bank of Japan U.S. M2 To GDP Michael Lewis, Free Market Inc. August 15,

5 The rest of the first world does not look much different in this regard than the U.S. Both the U.S. M3 to GDP ratio and the Japanese M3 to GDP ratio are somewhat higher than their M2 to GDP ratios. These two broad money ratios in most first world economies look more like that of the U.S. Though the U.S. M2 to GDP ratio rose into the mid-2000 s cyclical peak of 60%, it is more or less unchanged since then and it is in line with much of the post war historical experience. In any case, it is not that much above its post war nadir in terms of percentage points of GDP. Japan stands in striking contrast. Its M2 to GDP ratio at 100% was in line with most first world countries twenty years ago. It is now above 170%. No first world country can compare. How did Japan get there? It got there by having two decades of an ever rising level of nominal debt, driven mostly by government debt, amidst completely stagnant nominal GDP that resulted from a demographic bust, repeated recessions, and a chronic marginal price deflation. Like in any economy, much of Japan s rising yen indebtedness was placed with the banking system which financed its purchases through the issue of monetary liabilities. It takes twenty years of rising nominal indebtedness and its monetization plus stagnant nominal GDP to get to the current money to GDP ratio in Japan. If Ben Bernanke by hook or by crook can manage to keep U.S. inflation at 2% and real GDP growth close to its trend rate, at the current pace of growth of total U.S. nominal indebtedness it will take an entire generation and possibly two generations to reach a money to GDP ratio anywhere near that of Japan. Long before those several decades transpire the U.S. will probably find ways to slow its rising level of debt and money relative to GDP. As Shirakawa realizes, the Japanese people hold these vast money balances relative to income only because they have trust in the BOJ s commitment to deflation. With deflation they earn a positive return on their zero nominal return money balances. If they thought deflation would end they would not want to hold such large real money balances. Because the chronic large Japanese fiscal deficit ensures further growth in nominal debt and money, they can flee these excess money balances only by bidding up the prices of assets and goods and services. The consequent increase in monetary velocity will generate a high inflation that will feed back into inflation expectations and money demand and set off feedback loop dynamics. This is why Shirakawa says that the inflation threat he faces will be uncontrollable. Many argue that the Japanese people, for cultural and demographic reasons, want to hold higher real money balances than people in other economies. This may be true to some degree. But one does not need to have the Japanese people desire to reduce their current sky high real money balances to levels comparable to the money balances that prevail in other economies. All one needs is a partial move in that direction taking the M2 to GDP ratio from 171% to, let us say, 130% -- to set off Shirakawa s feared uncontrollable inflation dynamics. 5

6 The important point is that this flight from real money balances is inevitable in the case of Japan. The current combination of high fiscal deficits and stagnant nominal GDP has Japan on an explosive debt path. Continued increases in the already sky high money to GDP ratio is the monetary counter party to this rising path of debt to GDP. Japan s monetary overhang will get bigger and bigger. The trust of the Japanese people in the ability of the BOJ to deliver deflation will get evermore untenable. So, though Shirakawa is holding off the day of reckoning, the cake is baked: Japan s monetary overhang has passed the point where an inevitable debt confiscating inflation could be avoided. Nothing like this can be said of the U.S. The money to GDP ratio in the U.S. is not high. It has not risen since the mid-2000s. Though the U.S. fiscal deficit has risen, there has been room to reduce private indebtedness. Meanwhile nominal income has edged higher despite the deep recession and the lousy economic recovery. There is nothing in the U.S. data to suggest unwanted real money balances which the public may someday want to flee, not is there any trend towards such unwanted real money balances. And, as I said, it would take more than a generation for any unwanted real money balances to go nuclear or thermonuclear as they already have in Japan. And over that long, long time span the U.S. has many things it can do to avoid the disastrous situation that has already befallen Japan. 6