Japan’s new Prime Minister, Shinzo Abe, is pressing ahead with what he calls “bold monetary easing”. His goal is to generate inflation by printing, and thus diluting, the value of the Japanese yen. On Tuesday Abe pressured the Bank of Japan into adopting a 2% inflation target which paves the way for open-ended asset purchases similar to those being undertaken by the US Federal Reserve.
The problem however, is that Abe’s cure could very well prove worse than the disease.
In this excellent article, Michael Pento, a high profile proponent of Austrian economics, spells out just how dangerous 2% inflation would be for a nation as indebted as Japan.
From the article:
“Japan has already suffered through a quarter century’s worth of economic malaise because they have refused to allow the free market to work its reconciliation magic. Their reliance on government borrowing and spending to rescue the economy has proven to be a miserable failure. Because of this fact, Japanese politicians have succeeded to increase the debt to GDP ratio to 237%, which should have already caused a collapse in Japanese Government Bonds (JGBs) and the Yen.
However, JGBs have held their value for two reasons: The Japanese own 92% of their sovereign debt; And, up until now, deflation has reigned over the island”.
Pento notes that if Abe does achieve his goal of at least 2% inflation, “it will remove the most important support pillar for Japanese debt. In effect, the Japanese government has pulled the pin on a debt grenade that will explode in the very near future”.
The problem in a nutshell is this. With the current interest rate of just 0.75% on 10-year bonds, Japan is already spending nearly 25% of its revenue on debt service payments. If the average interest rate on outstanding debt were to rise above 2%, Japan would be paying more than 50% of all government revenue on servicing the national debt.
Under this scenario, “Domestic investors will flee the sovereign bond market in search of a real return on their investments, as they collectively realize that there is zero chance of being repaid their principal and interest in real terms”.
The BoJ now finds itself going head to head with the US Federal Reserve in the global currency war, with both central banks (not to mention others around the world) looking to cheapen their currencies “vis a vis the other”.
Pento concludes that in this environment history shows us that, “The absolute losers will be the middle classes of both countries. And the winner will be those who have the intelligence and foresight to eschew fiat currencies and the sovereign debt they support.”
It’s looking increasingly likely that Japan will be the first major G8 economy to enter the final stages of the sovereign debt bust. France may well be a close second, but the UK, US and Italy are all in the running.
Also see the recent 247bull.com article Bond bubble could see the sky-fall.