Sunday, June 09, 2013

The Zero Upper Bound?



A funny thing happened the other day. As part of "Abenomics", the Bank of Japan has been buying long-term Japanese government bonds. This has seemed to have the expected positive effects - Inflation is up, inflation expectations are up, growth is up, consumption is up, exports are up, and the stock market, despite a recent drop, is way way up. But here's the funny thing - Japanese long-term government bond yields kept going up over most of the last month (meaning JGB prices went down).

That's weird, right? Econ 101 says that if you buy more of something, its price should go up, not down! In this long rant, Richard Koo attributes the rise in interest rates to increased inflation expectations. According to Koo, QE doesn't work, and Japanese private investors, realizing this, started to expect inflation without real growth, and ditched JGBs, causing rates to rise.

But Nick Rowe has another explanation. According to Rowe, the rate rise was due to greater expected growth (nominal growth, so both better real growth and more inflation). As the BOJ's easy monetary policy causes the economy to improve, Rowe says, interest rates will naturally rise; investors are simply anticipating that rise, and selling bonds now. Rowe also has these rather harsh words for Koo:
Is Richard Koo really a Keynesian? Or is he just a finance guy, who doesn't really get macro/money?
Ouch!

One person who would probably agree with Rowe is Paul Krugman, who is himself a big supporter of Abenomics. In this blog post, Krugman outlined three "stories" about falling bond prices. Although none of the three stories correspond to Japan's current situation (long-term bond prices are down, stock prices are up, and the yen is down), the "stronger recovery" scenario involves rising stock prices, which we have seen. Rising stock prices indicate positive expectations for real economic growth, not just inflation. (Koo explains away this by conjecturing that Japanese stock investors and Japanese bond investors have different expectations, which I guess is not totally unreasonable given that most JGB holders are Japanese, while most of the recent inflows into the Japanese stock market have been foreign money).

(I have to say, initially I was skeptical of the Rowe/Krugman story. Most models I know would say that the recovery would take a while to raise interest rates above the pre-Abenomics level; the general-equilibrium effect would take years to overcome the partial-equilibrium effect of increased BoJ purchases holding rates down. To get a Rowe/Krugman type of rapid interest rate rise, I think you'd need a "good equilibrium, bad equilibrium" sort of model, where Abenomics kicks the economy out of the bad equilibrium very abruptly, and the economy is shocked back to a sustainably higher rate of NGDP growth. But then again, I guess I do kind of believe in that sort of model. And Japan's deflationary stagnation has lasted much longer than is typically possible in the simpler models I learned in grad school. But I digress.)

So anyway...are Japanese interest rates rising because of an incipient real economic recovery? Let us hope to Amaterasu that they are not. Let us hope that the rising yields are a blip, a trick of expectations and volatile markets and jittery bond investors.

Why do I say such a crazy thing?

Nick Rowe hints at the answer at the end of his post, when he writes:
And we can only regret that Japan did not do this many years earlier, instead of wasting all those years and letting Japan's government debt/GDP ratio climb. Because that high debt/GDP ratio is the only reason why someone might want Japan's economic recovery but not want the higher interest rates that will accompany that recovery. Which is no reason to try to stop the recovery. Though it is one additional reason to regret not having done something like Abenomics a lot earlier.
Rowe is being far too blithe. At very very high levels of debt-to-GDP, a rate rise is disastrous.

Imagine, for the sake of exaggeration, that a country had a debt-to-GDP ratio of three thousand to one. Suppose this was all in 30-year bonds, so that every year the government would have to roll over about 1/30 of its total debt, or 10,000% of GDP. Suppose that interest rates are just barely above zero - low enough to allow the government to maintain this debt burden.

Now suppose that interest rates suddenly "normalize" to 1%. Next year, the government will abruptly owe 1% of 10,000% of GDP in interest on the portion of its debt that it had to roll over. 1% of 10,000% is equal to 100%, so the government would owe all of the country's GDP in interest costs, in the first year alone. In the second year of the recovery, it would roll over another 10,000% of GDP, and thus owe 200% of GDP in interest costs!

How could it pay up? You can't tax 100% of GDP. So the government would have to borrow the rest. It seems clear that the higher the debt/GDP ratio, the less likely it would be that the private sector would be to lend to the government at an interest rate less than the economy's growth rate (the necessary condition for "stable Ponzi finance"; see discussion in comments with Nick Rowe for why this would be the case).

The only entity that would then lend the government the necessary sum is the central bank. In other words, seigniorage would be the only option to avoid default. This would either push interest rates back down to about 0%, or cause hyperinflation. Alternatively, the government could have the central bank buy outstanding bonds to push rates back down to 0%.

Now, Japan is not close to a 300,000% debt-to-GDP ratio. Its gross debt is about 240% of GDP. But a rise in interest rates would still exact a heavy burden on Japan's public finances; according to this guy, an increase in JGB yields to 2.2% would mean that 80% of Japan's current tax revenue would be eaten up by interest costs. Whether that number is correct, it's clear that with debt at 240% of GDP, Japan's growth would have to go up by a lot more than its interest rates in order to avoid a big rise in interest costs.

Also, realize that higher interest costs could easily start to hurt an economy long before they reach 100% of GDP, or even 100% of tax revenue. Why? Because of fiscal Keynesian effects. If fiscal policy affects demand (as most Keynesians and neo-Keynesians believe it does), then raising taxes to pay higher interest costs would stall the economy, as would drastic cuts in transfers or government purchases. (Of course you could borrow to pay the increased interest costs, as mentioned earlier.) So if an incipient recovery quickly causes higher rates, higher interest costs could kill the recovery.

(Now of course, all this time, increased nominal growth would erode the debt-to-GDP ratio. But that takes a long time to work. And Japan, which runs big primary deficits, is probably going to see its debt-to-GDP ratio continue to climb even if a recovery comes.)

So if monetary expansion can only cause the kind of recovery where interest rates rise, Japan is in deep shiitake. Japan's only hope is to cause the kind of recovery where interest rates stay very low for a very long time. If Japan is living in a Nick Rowe type world, that will prove impossible, and Japan's only options will be stagnation, default or hyperinflation. We should pray with all our might that we are living in a Richard Koo world instead, and that there is an economic policy that will allow Japan to boost growth and inflation while keeping interest rates low.

Anyway, this whole exercise raises the possibility that very high debt-to-GDP ratios could act as a long-term growth trap. We often talk about the "zero lower bound" on nominal rates, but very high debt-to-GDP ratios mean that there is also a zero upper bound. If recoveries always cause rates to rise (as Rowe contends), then high-debt-to-GDP ratios force governments to allow their economies to stagnate forever (or default/hyperinflate). In that case, the much-maligned Reinhart and Rogoff would be right.

If you get into a high government debt situation, a long periods of very low interest rates and robust real growth is really your only hope for a clean escape.


Update: Paul Krugman weighs in, saying my concerns are unwarranted. I've been thinking in terms of nominal rates this whole time, but Paul says that what really matters are real quantities; if the real interest rate stays low, it's all good.

Update 2: The more I think about it, the more certain I am that this post (of mine) confused and obfuscated more than it clarified. I think there was a good point somewhere in here, but I failed to make it. Oh well. That happens. For a simpler and (in my opinion) better take on the matter, see this brief post by Brad DeLong.

Update 3: Nick Rowe has a follow-up post in this series that is also much better than mine. This is basically the point I was trying to make, but stated much more cleanly. Excerpt:
Let's assume the worst-case scenario. Let's assume that I am right and Paul [Krugman] is wrong, so r increases [when the economy recovers]. And let's also assume that r increases more than g, so (r-g) increases. (Or (i-n) increases, if you prefer.) So economic recovery, by assumption, makes it harder for Japan to service the debt. [<-- at="" blockquote="" get="" i="" in="" my="" nbsp="" post.="" scenario="" the="" this="" to="" trying="" was="">
Let us also assume that Japan is like an OverLapping Genererations model, where Ricardian Equivalence is false, and where the equilibrium level of (r-g) is an increasing function of the debt/NGDP ratio. 
These worst case assumptions mean that there must exist some maximum Debt/NGDP ratio, call it Rmax, such that if the actual debt/NGDP ratio exceeds Rmax, then it would be impossible for Japan to service its debt if economic recovery causes interest rates to rise. Japan would either have to default, or create a big enough unanticipated rise in the price level to inflate away the old debt and bring the debt/NGDP ratio back down below Rmax. 
Let us further assume that Japan's current debt/NGDP ratio exceeds Rmax. 
In other words, I have deliberately set up a case in which Richard Koo would be right (maybe for the wrong reasons, but let that pass). I have deliberately made worst-case assumptions so that the higher interest rates caused by loosening monetary policy creating economic recovery would cause Japan to default on its debt, either literally or via very high inflation. 
Does this mean that "Japan cannot afford recovery"?
No. It means that Japan is already dead. It just doesn't know it yet... 
If Japan is already past the point of no return, then recovery will mean default. But delaying recovery will simply mean an even bigger default.
Now I feel even more ashamed for writing a sucky post. But at least I can link to similar posts that do not suck.

69 comments:

  1. Now you don't believe in equilibrating debt and rates? A little volatility sure, but not a great concern.

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  2. What is happening seems very obvious to me-

    1. the BoJ wants people to believe inflation will stay at 2% for the forseeable future.

    2. despite that expectation, the BoJ also wants people to continue to buy bonds with yields of under 1%.

    It should be obvious that these two goals are mutually exclusive; if they succeed at one, they will fail at the other. With an effectively negative yield, it becomes irrelevant if the BoJ ups their own buying of the bonds, because all this does is create more of a scarcity of a product that people still have no logical reason to buy in the first place. This was clear to many as soon as the BoJ announced their inflation target, and the theory certainly hasn't taken a beating since the rates went up as predicted.

    Koo is not "explaining away" what we're seeing in the stock market when he points out the influx of money is foreign. He is giving a clear, logical explanation as to what has happened. And for doing that, I must say he really has the jump on a lot of economists who handwave away the obvious as overly simplistic, yet simultaneously admit they have no idea what is going on themselves.

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  3. How about a few years of high inflation: nominal GDP goes up much faster than debt, and the ratio goes down, especially with robust real growth. What's wrong with that solution?

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    1. That solution is good, but you still need to keep nominal rates low. The hope is that the central bank can do that by buying bonds. If you can get low nominal rates with higher inflation, that makes real rates negative and erodes debt very quickly!

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    2. Isn't the interest rated peg of the 40's a proof that financial repression works just fine ? It's no more than a political choice. A power struggle between capital, government and public. I would like to know why the debate is still open or what reopened it.

      Extract from "Before the Accord: U.S. Monetary-Financial Policy, 1945-51", by Barry Eichengreen and Peter M. Garber.


      "The 1951 Treasury-Federal Reserve Accord brought to a close an extraordinary period in the monetary and financial history of the United States. For nearly a decade, U.S. Treasury bond yields never rose above 2,5%. Long-term interest rates may have been low, but short-term rates were lower still: those on 12-month certificates of indebtedness were capped at 0,875% to 1,25%. (...) Interest rates were low despite an inflation rate that reached 25 per cent in the year ending July 1947. (...) They were stable despite swings from 25 per cent inflation in 1946-47 to 3 per cent deflation in the year July 1948-July 1949, to 10 per cent inflation in the year March 1950-March 1951. These pronounced fluctuations in ex post real interest rates did not undermine the stability of financial institutions: there were only five bank suspensions between the end of 1945 and the middle of 1950".



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  4. Noah: thanks!

    Just a short response, on one small part, because I'm a bit tired now:

    The interest burden on the national debt (as a percentage of GDP) should better be defined as (i-n)*(debt/GDP), where (i-n) is the nominal interest rate minus the growth rate of nominal GDP. (This oversimplifies, but it's better than ignoring n). This tells us how big a primary surplus the government needs to run, to keep the debt/GDP ratio from growing over time.

    It is true that loosening monetary policy will increase i, but it will also increase n. (And it increases i *because* it increases n.) If it increases both i and n by roughly the same amount, no worries. If it increases i by more than it increases n (which will depend on whether that parameter in the Euler IS is greater or less than one?), then yes, that will increase the burden of the debt.

    Personally I don't think this effect will be big enough for major worries. And even if it is, it's a price well worth paying to get a recovery.

    And if I'm wrong on this? Oh well, that means that Japan is totally screwed, sooner or later, whatever happens. It "can't afford' recovery. But if it stays where it is, the debt/GDP ratio will keep on rising anyway.

    BTW: I thought Richard Koo used to say that loosening monetary policy could never work in Japan? Now he's saying it does work, and does bad things, and he wants the BoJ to tighten again?? If Japan had ignored him and had loosened monetary policy years ago, the debt/GDP ratio wouldn't be at 240%!! I reckon he's got some explaining to do.

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    1. If (i-n)=-9%, just run a primary deficit of 9% of GDP, and borrow to pay any interest, and rollover any bonds that mature. Yes it's Ponzi-finance, but in this case it's *stable* Ponzi-finance, because the debt/GDP ratio stays constant. It's a dynamically inefficient economy, like Samuelson 195? Exact consumption loan model.

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    2. OK, so for the sake of the thought experiment, suppose Japanese tax rates t remain constant. Now suppose that the nominal interest rate i rises until i*debt > t*GDP. The Japanese government will have to make an interest payment, i*debt, that is greater than its tax revenue, t*GDP.

      Question 1: How does it get the money to make that payment? Does it borrow it, or does the central bank print it?

      Question 2: And won't either of those change i?

      Question 3: And thus, won't expectations regarding the answer to Question 1 place bounds on how i can change?

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    3. Hmm...looks like you weren't as tired as you thought! ;-)

      So your idea is that no matter how large a one-year interest payment is, if i<n right now, the government will be able to successfully borrow in private markets to make this year's interest payment? I am not so sure of that. Or rather, I think the size of the stock of debt matters for whether or not that i can be supported as an equilibrium.

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    4. I'm perking up a little!

      Well, if i < n this year, but i > n next year and all future years, it can't do Ponzi-finance. But if it borrows (n-i)Debt/GDP this year, then next year's debt/GDP ratio won't be any higher than this year's.

      A reasonable assumption about government's ability to borrow is that it depends on current and expected future debt/GDP ratios, rather than on current and expected future debt.

      The big problem for stable Ponzi finance is uncertainty about future i-n. If the government issued Trill perpetuities to finance the debt, that would resolve the uncertainty. If n>i permanently, the price of one Trill perpetuity would be infinite.

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    5. The big problem for stable Ponzi finance is uncertainty about future i-n. If the government issued

      Yes, I agree.

      And I also contend that the size of that risk is an increasing function of debt/GDP. Why? Simple thought experiment. If debt/GDP=0 always, then there is no risk; if i goes above n for a year or two, so what? Now as debt/GDP approaches infinity, it takes a smaller and smaller expected future frequency of i>n in order to run the risk of having to severely inflate to avoid default.

      Thus, I kind of think that at high debt/GDP ratios, i<n might not be supported as an equilibrium...

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    6. Noah:"Thus, I kind of think that at high debt/GDP ratios, i<n might not be supported as an equilibrium..."

      Absolutely. In any OLG model, for example, equilibrium (i-n) would be an increasing function of debt/GDP. In an infinite horizon model, with constant growth, the government should increase debt/GDP until i=n.

      Under uncertainty, it's trickier. But the solution (I think) is to issue *one* trill perpetuity.

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    7. I think that is probably right.

      So I think we are on the same page about pretty much everything, here.

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  5. >BTW: I thought Richard Koo used to say that loosening monetary policy could never work in Japan? Now he's saying it does work, and does bad things, and he wants the BoJ to tighten again??

    His whole point is the *inflation expectation* is what is doing it, not monetary policy in and of itself. Technically you can accomplish that with no monetary policy at all.

    Can you answer me this: Why should it matter to a potential bond buyer if the BoJ is soaking them up if I still think they have a negative yield? What matter is scarcity if its scarcity of something I could not possibly want anyway?

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    1. jjrs: "His whole point is the *inflation expectation* is what is doing it, not monetary policy in and of itself. Technically you can accomplish that with no monetary policy at all."

      ???? Choosing the central bank's inflation target, and thereby expected inflation, *is* monetary policy. Everything else is just footnotes to fill in the details.

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    2. You're missing the point, Dr. Rowe. Koo is stating monetary policy is largely ineffective and expectations of inflation are being generated by other means. No one said anything about there not being any monetary policy at all. The BoJ hasn't been able to hit or maintain an inflation target in twenty years.

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  6. Noah,

    "it's clear that with debt at 240% of GDP, Japan's growth would have to go up by a lot more than its interest rates in order to avoid a big rise in interest costs"

    Megaflerp. If growth rises by the same amount as interest rates, then at constant debt/GDP the *cost* of debt service changes by ... zero!

    "Japan's only hope is to cause the kind of recovery where interest rates stay very low for a very long time."

    "If recoveries always cause rates to rise (as Rowe contends), then high-debt-to-GDP ratios force governments to allow their economies to stagnate forever"

    Uh, no. The only thing that matters is that the *spread* between interest rates and growth doesn't change sign. As long as rates remain below growth, debt doesn't have to be serviced *at all*.

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    1. K, are you misusing the word "flerp"? Don't make me ban you for poor command of the English language...

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    2. A megaflerp is a million flerps- the amount of derp that a million twerps could herp.

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  7. Noah: "Also, realize that higher interest costs could easily start to hurt an economy long before they reach 100% of GDP, or even 100% of tax revenue. Why? Because of fiscal Keynesian effects. If fiscal policy affects demand (as most Keynesians and neo-Keynesians believe it does), then raising taxes to pay higher interest costs would stall the economy, as would drastic cuts in transfers or government purchases. (Of course you could borrow to pay the increased interest costs, as mentioned earlier.) So if an incipient recovery quickly causes higher rates, higher interest costs could kill the recovery."

    No, hang on there. Tighter fiscal policy reduces AD because it reduces the *natural* rate of interest. That allows monetary policy to take offsetting action to prevent AD falling, and also lowers the interest burden of the debt.

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    1. I guess...if Keynesian effects work that way. Which I kind of doubt!

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    2. If the natural rate of interest is where the IS curve cuts Y* where LRAS is vertical, then if fiscal policy shifts the IS curve, that is the way fiscal policy works. Just a different way of looking at it.

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  8. Anonymous12:23 AM

    I'm confused about this whole thing, maybe someone can explain it to me.

    If the concern is larger interest payments, who do these payments go to? Are they buried in a hole somewhere? I was under the impression that they go to either rich or not so rich investors, in which case it could be captured in higher taxes on the rich, or it would be additional income for the not rich to spend.

    If the concern is inflation, where does this additional money go? Is it also buried in a hole somewhere? I was under the impression it is paid out in wages.

    Aren't investors already loaning money to the US at a guaranteed loss (ie, rates below expected inflation)?

    Were you on the debate team in highschool? Why is everything always "hyperinflation" - like there is no percentage between 2% and 100%+? Say they had 7-8% inflation a year - were the 70s really that bad? Would japan prefer our 70s or a repeat of their 00s?

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  9. Reading that Richard Koo piece, I definitely get the impression that he has a fiscal theory of real GDP but a monetary theory of the price level!! In other words, both fiscal and monetary policy affect AD, but when fiscal policy shifts AD it affects Y, and when monetary policy affects AD it affects only P. Ultra Keynesian theory of Y. Classical theory of P.

    Plus, no distinction between real and nominal interest rates. Let alone any distinction between market rates and natural rates.

    Plus, he seems to think that monetary policy can only work if extra spending is financed by extra borrowing because of low interest rates. Which is a total fallacy of composition. Extra spending creates extra income, which finances that extra spending. Good Old Keynesian multiplier.

    Finance guy?

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    1. Reading that Richard Koo piece, I definitely get the impression that he has a fiscal theory of real GDP but a monetary theory of the price level!! In other words, both fiscal and monetary policy affect AD, but when fiscal policy shifts AD it affects Y, and when monetary policy affects AD it affects only P. Ultra Keynesian theory of Y. Classical theory of P.

      Yes. I get that impression too. I think it has to do with his "balance sheet recession" idea. I think he thinks that fiscal policy affects Y by changing the household balance sheet.

      Finance guy?

      Sure. But he almost certainly thinks that people act behaviorally and irrationally. If you think about it, "balance sheet recessions" are irrational.





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    2. How are 'balance sheet' recessions irrational? People being bankrupt is real, people hanging by the skin of their teeth (and/or gaming the rules) to NOT get bankrupt seems pretty real and rational compared to "let's just admit we're bankrupt, fold down and start again somewhere else"...

      As to the substance of the article, it was always my worry about Abenomics and stuff. They raise inflation. Great. Colour me impressed. And what good is inflation?

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    3. Noah: "I think he thinks that fiscal policy affects Y by changing the household balance sheet."

      OK, suppose he does think that. But why does changing HH balance sheets affect Y? Presumably because he thinks that changing HH balance sheets affects AD?

      Theory of Y: Y=C+I+G+NX

      Theory of P: MV=PY

      ?? ;-)

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  10. Higher interest rates will improve the safety of Japan's debt, and this post unintentionally explains why. Because most people intuit that higher deficits indicate a worsening of financial position regardless of the reason, higher interest rates will cause the government to spend less (excluding interest) than it otherwise would, hence debt/GDP will grow at a slower rate than it would with lower interest rates.

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  11. Noah, I think it is a little more complex. The majority of Japanese government debt is owed to Japanese savers. If interest rates rise on that debt, those Japanese savers will receive what amounts to an increased tax credit. That will be paid for either through borrowing - mostly from Japanese savers - or by taxing the Japanese population - including those same savers. And the savers will of course spend that money either now or at some point in the future, at which point it will be taxed again. The problem with government debt is not the interest on domestic holdings, because that all cancels out in a lovely morass of present & future taxes and tax credits. It's the interest on foreign holdings. Do you think foreign holdings of Japanese debt would have to increase disproportionately if the government had to increase borrowing to service rising interest rates?

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  12. Fellers ... are you not missing the fact that when the central bank buys bonds those bonds are then owned by the central bank? A large scale QE exercise changes the debt service dynamics, because it reduces the amount of debt outstanding on which the government has to make interest payments to somebody other than itself.

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  13. Anonymous4:11 AM

    Noah,
    Perhaps I am missing something here,but why should govt yields rise beyond whatever the BOJ might decide they want to see?. By that I am saying we have a quite complex relationship here,but not one that cannot be managed. The BOJ have a buying program of a certain size. The govt debt to be absorbed is also of a certain size. The BOJ can also buy other assets like equity which will be tracking whatever nominal growth they manage to achieve. What is to stop them seesaw buying govt debt and equity in balancing quantities to effectively 'peg' yield relative to nominal growth and equities being a shall we say the proxy for that growth?
    Frankly,I see this not unlike how the Casino decides what it will allow punters to walk away with from the 'house'. In this case the BOJ can be the house.
    If there is a serious problem strategically with carrying out this process I would have thought it lies with the reactions it might attract from other central banks/trading partners.

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  14. @Anonymous above, and for anybody else interested. All figures in JPY, unless otherwise stated.

    The BoJ had a balance sheet of about 135 trillion before Abenomics got started. As widely reported, they have pledged to double this in two years, to about 270 trillion in two years. They may change their mind about that if they reach their inflation target earlier, and I am sure that they will increase it further if they still don't achieve it by this time next year. But that is all just speculation at this point.

    It is a fair assumption that they will achieve the inflation target. Any Central Bank with enough willpower and without policy constraints in its currency area can create inflation (or crush it), the question is only what it will take, and at what cost. To figure that last one out, let's go back to the numbers. The BoJ currently has a balance sheet of about 165 trillion, and it is and will be growing at about 7~8 trillion per month under its vocally announced QE programme.

    Compare and contrast this with the Japanese bond market. That is a 990 trillion (yes, nearly a quadrillion) market. And it is growing, as the Japanese government in FY13 expects to run a primary deficit of over 4 trillion, and a total deficit of 42 trillion. Ie, they will be seeking 42 trillion of new bond investments, taking the size of that bond market to 1,030 trillion or so. But it gets worse. You'd expect that with 30-year yields at 1.8% (even now, not too long ago they were below 1.5%), they would have extended government debt maturity to the max. But nope. Average bond maturity of the JGB market is below 5 years. Every year, the MoF therefore rolls over about 1/5th of the national gov debt, plus issuance for the running deficit. And indeed, the MOF FY13 issuance plan foresees in 180 trillion of debt issuance (this is not even the whole story, there is more issuance that counts as national debt, by regional governments, some SOEs etc.).

    So there we are with a 990 trillion bond market, that turns over >180 trillion every single a year and the BoJ only having a total balance sheet of 170 trillion at the moment, with a monthly 7 trillion growth rate.

    The bottom line is therefore, unlike the Fed in the US (or even the ECB in Europe) the BoJ is not exactly in a position to corner the bond market as things stand. They just don't have that credibility. You can't credibly promise you will control bond rates if you have also said you won't buy more than 1/5 of the market, 1/4th max. You need to use the U(nlimited) word if you want to shake that tree.

    And as another commenter has noted, the goals of getting 2% pa inflation and yet selling investors bonds that yield less than 1% (5-year is the most relevant rate, but even the 10-year is still below 1%) do NOT agree with each other.

    So IF the BoJ succeeds in generating inflation, or rather: increasing future inflation expectations (I assume they will, and if they don't, things look even more grim, the Abenomics can completely pack its bag), one of three scenarios must unfold:

    1. JGB holders are (sorry to say) stupid and are happy to be financially repressed into negative real yields, even though they plenty of other options (assuming Japan doesn't impose capital controls etc). This would seem unlikely to me. It would also defeat the purpose of Abenomics, which is to get those private sector savings out of JGB's into actual capital investments/consumption.

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  15. 2. JGB holders are not stupid and begin getting out of bonds. We now get to the part where analogies are made with a lot of water trying to squeeze through a very small hole. Buyer's strike, funding crisis, it could all be on the cards. One way or another, bond yields will rise, at least to a level close or above the expected inflation (2%?) and as noted by Noah, this is absolutely disastrous for Japanese government finances. Implicit or explicit default will become something we will have to consider. The IMF may have to come to the rescue. Austerity imposed. Abenomics would fail. Even if the economy regains some degree of nominal (let alone real) growth, it remains to be seen how much extra tax revenue this would bring in, not in the last place since the working population is shrinking, productivity growth has been absent for years if not decades and so on.

    3. JGB holders are not stupid, begin getting out of bonds, but the BoJ takes the other end of this deal, precisely because they want to avoid going down the line of scenario (2). This however will require much more of the BoJ than the currently foreseen increase in their balance sheet. The BoJ may well end up owning 30~40% of the Japanese bond market by the end of the stampede (BoJ balance sheet at 300~400 trillion compared to 170 trillion now). How to they will then control inflation overshooting the 2% target is anybody's guess. Debt monetisation might be the next point on the agenda as well. Either way, needless to say, this is the scenario where the JPY gets hammered to I don't know where. 150? 200? Your guess is as good as mine.

    Personally, I think this last one is the most likely scenario. It makes sense after all - the chief goal of Abenomics is trying to put the large pile of excess savings from the private sector back to work in the 'real' economy. These excess savings are largely sitting in JGB's. But size matters, and with the government running the kind of deficits that it is, and the pile of debt that we are dealing with here, the only party left to buy those JGB's (I doubt foreign investors will show any appetite after all) when you squeeze the private sector out of them, is the BoJ. Abe and Kuroda think they can manage this, orderly and slowly, with only minor increase in rates. I think they are wrong about that, simply because the numbers don't add up, and the wild gyrations in rates, the JPY and the equity markets are a sign that I might be right. There is even a possibility that Abe+Kuroda know this, but that they have decided that a much, much weaker yen is a sacrifice worth making, and the only way out for overindebted Japan. An 'accidental' higher inflation would after all also be a godsend for a government with 240% of GDP in debt. Classic default-through-inflation story. Of course, all an accident (hush, don't tell the pensioners!).

    QE in the US, in the UK and elsewhere worked partly because the size of the QE relative to the size of the bond market was so staggering that the Central Bank completely cornered the bond market, and indeed, this was part of the purpose of it all. The BoJ is not in the same position right now. Can it get itself in that position? Sure, it has unlimited firepower after all. It is the Central Bank. But.... it will all but destroy the JPY as a 'hard' currency in the process. And that may not even be the end of the world, if that also brings actual real recovery, defeats deflation and a decrease in Japanese tour buses at the Eiffel Tower.

    ReplyDelete
    Replies
    1. japanese yen pessimist: I'm with you so far. Agreed the BoJ can't both hit it's goal of 2% inflation/recovery *and* at the same time keep on buying bonds/keep interest rates down indefinitely to help the government.

      I'm going for:

      4. The recovery raises tax revenues a bit. The government tightens fiscal policy a bit (which it can do when the economy recovers and interest rates rise off the floor, because those eliminate the excuse that it needs loose fiscal policy to prevent the economy going into recession, since monetary policy can loosen if needed.

      But yes, it would be a lot easier if it had done this earlier and before the debt/GDP ratio had climbed so high. If it wants to bring that debt/GDP ratio down to something more reasonable in a reasonable period of time, it is going to have to tighten fiscal policy a lot.

      And things might get a bit hairy as it switches from one equilibrium path to another.

      But the last thing to do would be to follow Richard Koo's advice now, and tighten monetary policy, and ride this debt/GDP tiger any longer.

      (Not sure if the 240% figure is accurate BTW, because IIRC there's a big difference between gross and net???)

      Delete
    2. >"Agreed the BoJ can't both hit it's goal of 2% inflation/recovery *and* at the same time keep on buying bonds/keep interest rates down indefinitely to help the government."

      Glad to see this point conceded. It's a crucial one, and it seems to have been ignored up until now...

      >"4. The recovery raises tax revenues a bit. The government tightens fiscal policy a bit (which it can do when the economy recovers and interest rates rise off the floor, because those eliminate the excuse that it needs loose fiscal policy to prevent the economy going into recession, since monetary policy can loosen if needed."

      Define "a bit", though. The size of the debt is such it would have to be an awfully big bit. It would have to be a very large bit by which they tighten from fiscal policy too, because currently about half the budget goes to servicing the existing debt as it is. They were piling on big deficits even before this fiscal expansion began.

      And even if the "bit" here was large enough -which is a big stretch, mind you- it's still predicated on the assumption there is a real, lasting recovery to begin with. There seems to be an implicit assumption that this is all psychological, and that GDP will grow if people just get back in the right mindset.

      But the working age population (and tax base) is falling every year, even as liabilities increase as more elderly enter social security and need health care. Given the demographics, it's impressive Japan's economy has even grown as much as it has over the past 10 years. Monetary policy can't fix that. Neither can fiscal.

      Delete
    3. jjrs: "Glad to see this point conceded. It's a crucial one, and it seems to have been ignored up until now..."

      OK. But "conceded" isn't quite the right word. It's part of my background assumptions, that I take for granted and so don't bother stating. I'm pretty sure that's true for Noah too. The only people who would claim otherwise would be some sort of ultra-keynesians. And it's precisely because of that point that the loosening of monetary policy and expectations of recovery *raise* (rather than lower) long term nominal rates. (You don't "concede" a hill that you never held in the first place.)

      "But the working age population (and tax base) is falling every year, even as liabilities increase as more elderly enter social security and need health care. Given the demographics, it's impressive Japan's economy has even grown as much as it has over the past 10 years. Monetary policy can't fix that. Neither can fiscal."

      Yep, that's a worry. But that's a worry regardless of whether Abenomics is successful in getting recovery. If anything, because it increase tax revenue and reduces the apparent need for fiscal stimulus, loosening monetary policy now to create recovery now reduces that worry. (And I can't help cry over spilt milk and wish it had been done sooner.)

      "Define "a bit", though."

      Fair enough. How about "more than would otherwise have happened"?

      "... because currently about half the budget goes to servicing the existing debt as it is..."

      But isn't (i-n) currently roughly zero, or even negative? If so that can't be right. I'm pretty sure that's using the economically wrong measure of debt service, probably i*debt, rather than (i-n)*debt.

      Delete
    4. >"OK. But "conceded" isn't quite the right word. It's part of my background assumptions, that I take for granted and so don't bother stating."

      Well implicit in the concession is also the agreement that the BoJ can't lower yields without buying far more bonds than it currently is. But that concession isn't clear in your own post. You started with-

      >"Suppose I announced I would be buying an asset, both now and in future. And suppose people believed my announcement. It would be paradoxical if my announcement caused the price of that asset to fall. "

      But as "japanese yen pessimist" makes clear, it's not paradoxical at all given the size of the debt. It's a simply matter of the remaining supply still vastly outweighing the remaining demand on the asset. Occam's razor prevails because the numbers back it up.

      If you fully concede that, where is the paradox here?

      >"Fair enough. How about "more than would otherwise have happened"?"

      That's not a good enough answer to create a plausible "Possibility 4" to jyp's list. So far we have (1) bond buyers are stupid and keep buying at a negative yield, and (2,3) bond buyers are not and things get hairy. To escape those seeming inevitabilities, you need a number big enough to warrant a tightening of fiscal policy big enough to decrease debt enough to allow yields to stay low. But that's a very tall order on every link on that chain of assumptions.

      Delete
  16. Noah, in the scary bond and interest rate scenario you sketch, you overlook the balance sheet.

    Japan could buy in all its old debt at a fraction, paid for with new debt that carries a higher rate. But the PVs are equal. Who cares?

    Why oh why do so many great economists only look at flows and not stocks?

    ReplyDelete
    Replies
    1. People who pay taxes to service the debt and prevent debt/GDP rising over time care. In this case we are right to look at flows.

      Delete
  17. Finster7:14 AM

    Then there is the possibility of accepting the losses for the bond holders and not monetizing them to keep the interest rate stable. Accept a crash of the bond market, accept a current interest rate which matches the investment needs and run the monetary transmission on discounting present private paper (CP and liabilities from actual economic action).

    To hell with past liabilities and life on the economy. Japan of all nations would accept a collapse of the real purchasing power stashed in its pension fund if it means a restoration of growth and a refounding of the economy.

    Radical? Certainly...

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  18. bena gyerek8:00 AM

    Yields are rising because of anticipated growth / inflation.
    Yen is weak because of anticipated negative real short-term rates (i.e. BoJ tolerates rising inflation).
    Gov't just rolls debt onto the short end, benefiting from zero t-bill rates, and therefore negative real rates. It's old-fashioned financial repression.
    Inflation cannot get too out of control, as its most direct effect is to erode the real stock of debt. Once the real stock of debt is manageable again, it should be possible to credibly commit to more conservative monetary policy.
    Also, don't forget that recovery in the real economy should also push the gov't back into surplus.
    My guess is we end up getting a short (4-5 year) bout of double-digit inflation, bringing govt debt/gdp down to c100%, at which point the BoJ starts raising rates, and gov't thinks about rolling debt onto the longer term.
    The issue at that stage will be reestablishing BoJ credibility so that govt can benefit from lower long-term refinancing costs. Change of govt may be needed for that.

    ReplyDelete
  19. Doesn't an actual increase in economic activity (recovery) imply higher GDP and higher tax receipts?

    Also, since the BOJ targets rates at the short end, why would they raise rates unless there is undesired inflation? Wouldn't this type of inflation occur only if economic activity has increased tremendously to the point where it is causing inflation? (Given the absence of a supply shock). As a result, wouldn't it make sense for traders in longer dated JGBs to continue buying/holding when rates on the long end rise in order to take advantage of the BOJ's commitment to low short term rates?

    "Japan's only hope is to cause the kind of recovery where interest rates stay very low for a very long time."

    By using the word hope it sounds like you imply that this scenario is not likely when in reality it seems very possible in the current global environment mired in low growth, declining inflation, and near zero rates in the developed world.

    "80% of Japan's current tax revenue would be eaten up by interest costs"

    Why should the current tax revenue matter? It is the future tax revenue that needs to be accounted for which is a function of future economic activity.

    The whole high debt to GDP issue seems to be more problematic in a political sense rather than an economic one as it limits perceived political choices. That said, these political perceptions involving the Debt/GDP ratio could be wrong and causing arbitrary policy limitations.

    "Now, Japan is not close to a 300,000% debt-to-GDP ratio. Its gross debt is about 240% of GDP. But a rise in interest rates would still exact a heavy burden on Japan's public finances"

    Could you write a post coming up with an alternative scenario where debt-to-GDP falls to 100% of GDP and interest rates rise? It would be an interesting hypothetical after stating the case for what could happen if the ratio was 300,000%.

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  20. Ok, but if interest rates rose enough to really be a risk, couldn't Japan just start monetizing the debt? What if Japan's central bank and treasury just said we're going to put a ceiling on interest rates of 0.25%? We have infinitely deep pockets and we'll buy any bonds whose prices go low enough that the yield hits 0.25%. We'll do this even if we have to buy every Japanese government bond outstanding, and we can do it (although with heterogeneity of investor beliefs a lot may still stay outstanding). This would avoid fiscal crisis and default (at least formal). What do you think of this as a way out of what you fear, Noah, if worse comes to worst?

    ReplyDelete
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    1. Not to answer for Noah, but the most effective way to achieve this would be to alter the existing institutional arrangement so the BoJ can fund Treasury spending directly rather than indirectly as it does now. In such a scenario the Treasury would simply cease issuing securities altogether, which in my personal opinion should be done anyway.

      Delete
    2. Right Ben, but I wonder about the politics of these things. They could also, perhaps, say that we'll buy only new Japanese government bonds at a special very high price, and we'll buy all of the new issues if need be -- Has problems, but could certainly be better than a major formal default.

      Delete
  21. Macrotourist11:23 AM

    I do not understand Krugman's rebuttal. As you say: "Rising stock prices indicate positive expectations for real economic growth, not just inflation". How can you have an equilibrium where real rates are to stay low, unless as Koo says that stock and bond markets are segmented.

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  22. Noah:

    It seems the central bank's will to control the interest rate, as Ambrose Evans-Pritchard discusses in his article, is the key to a low-interest rate recovery. Your thoughts please.

    For Evans-Pritchard's discussion of interest rate controls and the U.S. Fed and WWII and the contemporary Swiss central bank and Swiss Franc, go here: http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100024696/the-bank-of-japan-must-crush-all-resistance-and-will-do-so/

    ReplyDelete
  23. From Krugman (or Krugtron):

    "Also, bear in mind that there’s a lot of preexisting long-term nominal debt"

    I was wondering this too. What percentage of Japan's debt is old and locked in for many years anyway at the super low rates?

    ReplyDelete
  24. Noah -

    Wrote something related to this the other day: http://cthorm.blogspot.com/2013/06/sovereign-credit-inflation-and-bond.html

    There are a couple of ways to attribute the rise in yields (credit risk is NOT one of them). Inflation expectations is one, but the more important is opportunity cost. The recent turnaround in real growth, itself brought on by looser monetary policy/higher inflation expectations, is giving JPY investors better alternatives than JGBs.

    ReplyDelete
  25. Noah,

    If you do not repay your debt it grows by the interest rate each period.

    NGDP grows by what rate it grows.

    If Gov does not pay any debt Debt / NGDP can only grow if interest rates are higher than NGDP grow.

    So Abenomics is a problem only if the monetary stimulus raises interest rates more than raises NGDP grow.

    Karl Smith's post on debt dynamics might be of interest: http://www.forbes.com/sites/modeledbehavior/2013/05/04/childless-keynesians-and-the-future-they-made/

    ReplyDelete
  26. "In other words, seigniorage would be the only option to avoid default. This would either push interest rates back down to about 0%, or cause hyperinflation."

    Now why in the world would this happen? I thought guys like Krugman and others had debunked this kind argument. If you were to mint $5 trillion and deposit it to the Fed, with the Fed to write off those checks to the Treasury to finance spending, it would have almost no real effect on the economy save for would-be bond holders needing to find some other avenue to stash their savings.

    Hyperinflation or higher inflation doesn't happen unless there's too much money into the REAL economy that far outpaces its productive capacity. So if the US (or Japan, or UK, or Spain[if they could], etc.) were to suddenly mint and spend $1 trillion on infrastructure (or the Yen/Pound/Euro equivalent), you wouldn't see much inflation there because you'd simply be filling the output gap. If you spent $100 trillion, you'd see hyperinflation. Or if we lost a war with Canada and Mexico, they seized part of our land plus our Midwestern industrial base, and we had to pay them, we could have hyperinflation. Or perhaps if Obama suddenly decided to seize everyone's farmland and give it to homeless people, we'd see some hyperinflation (at least in certain markets).

    Otherwise, how the heck would seignoraging extra spending into an already depressed lead to hyperinflation?

    ReplyDelete
  27. The more I think about it, the more certain I am that this post (of mine) confused and obfuscated more than it clarified. I think there was a good point somewhere in here, but I failed to make it. Oh well. That happens.

    You speak true my friend. You manned up in exemplary fashion.

    ReplyDelete
  28. Don't beat up on yourself too much. It was a flawed post, but clear rather than obfuscatory. It helped me clarify my own thinking. You tried to articulate a worry that was at the back of my mind too. (And it had a great title!)

    I've had another kick at the can too: http://worthwhile.typepad.com/worthwhile_canadian_initi/2013/06/is-japan-already-dead.html

    ReplyDelete
  29. Anonymous8:50 PM

    is a science of macroeconomics possible ? i'd say no. Most (all?) appears to be pulled out of a bayesian posterior. macro = scientology. advice to any grad student...do micro

    ReplyDelete
    Replies
    1. You do realize that New Consensus Macro is based on microfoundations? NC Macro may be useless, but where it gets its foundations may also be as equally useless, albeit not as visibly so.

      Delete
  30. Anonymous3:12 AM

    "Anyway, this whole exercise raises the possibility that very high debt-to-GDP ratios could act as a long-term growth trap."

    Duh.

    Also, on a very related note, what do you think would happen to current US home values (many now carrying ZIRP-influenced mortgages) if US interest rates were *ever* allowed to rise again by Zimbabwe Ben?

    Or bond prices for bonds carrying ZIRP-like coupons?

    That's rise, in both cases interest rate return to normalcy = price collapse = return to ruin.

    Result - permanent midnight and eternal stagnation at ZIRP.

    The real US economy started to seriously die about a decade ago (with the rise of China and the more complete integration of the internet) but the Fed has been papering over the corpse into a Zombie Economy of the Walking Dead (Brains! ZIRP! ZIRP!)

    Let's hear the Krugman kounter-argument in more detail...

    ReplyDelete
    Replies
    1. Anonymous4:11 AM

      The problem with this post is, the US and Japan are 2 very different positions. "Zimbabwe Ben" isn't controlling interest rates at all. If they wanted to rise, they could rise. The demand is so high

      The US is the growth engine of the world. If the economy doesn't grow, dollar collapse will come. You got it backwards and completely wrong.

      Delete
    2. Anonymous4:17 PM

      Allowing me to add on to that:

      Abe is trying to get investers back into the Japanese economy. Now, that may work or not work with its demos.

      The US interest rates have been sharply lowered since early 2011 because of Europe pure and simple. Much like the Asian crisis surged investers into the US and brought interest rates down in mortgage markets, the Europe capital flight to the US is bringing down interest rates in capital goods markets to extremely low levels. It hasn't "bubbled" yet or we would see internal growth of about 5%. But you will know when it does.

      There is not alot the FED can do with this, raising rates to raise the cost of this capital inflight, but it would also potential bring in MORE invester financing causing a bigger bubble than ever that will burst. Hence, when a person tells you leaving ZIRP can improve growth, they are correct, but at a terrible cost. This imo, is why Zirp exists right now, a reason the FED doesn't want you to know. Europe is causing massive misallocations globally. Notice the "FEDspeak" changed after the 2011 mess. It was, "hey we are going to raise rates later this year" to "eh, we better not do anything for awhile".

      There is a reason for this. It isn't the so called "under performing"(which it is not) US economy. It is another stupid financial mess, this time in Europe causing dislocations.

      Delete
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    ReplyDelete
  32. Bill Ellis6:29 PM

    Noah,
    A blogger can be consistently coherent and boring as hell.

    You are constantly very interesting. Sometimes extremely interesting.
    An occasional loopy episode just goes with the territory.
    :-)

    ReplyDelete
    Replies
    1. Jorge Bielsa7:03 AM

      Agreed

      Delete
  33. The thing I don't see sufficiently mentioned in this debate is that Japanese long term govt bond yields went down by quite a bit before they went up. They have up to this point only recovered much of the losses in yield that were "suffered" earlier.

    Noah, if you are right that Japan's only hope is to keep rates depressed at the cost of a true, full blown recovery, since this would probably not lead to sustainable financing of the government debt (deficits are currently near 10% of GDP at 0% NGDP growth; lot of ground to be covered there), why don't the rates already price in a doom scenario, since this is just a catch 22 situation with no possible positive outcome? Aren't bond buyers in for capital losses from rate hikes or default no matter what happens?

    ReplyDelete
    Replies
    1. The fact that Japan is still deemed a solvent country by the markets suggests to me that something entirely different is going on. I would look into the possibility that the BoJ will end up *permanently* monetizing much of the debt, but this will not generate inflation beyond lending a counterweight to deflationary forces. This is because it is Japan's debt overhang (public and private) that causes the deflation in the first place and getting rid of it gets rid of the deflation.

      Delete
    2. Actually at the end of that process the BoJ might lack the resources to normalize interest rates... So don't quote me on it that it would not create inflation. I'm pretty far out on a limb on this.

      Delete
  34. Rothosen4:19 PM

    As a non- economist trying to make sense in a ponzi world when Nick Rowe says:
    " If (i-n)=-9%, just run a primary deficit of 9% of GDP, and borrow to pay any interest, and rollover any bonds that mature."
    Does that mean that if the feds rate is .25% and inflation expectations are 1.25% then any deficit over 170 billion guarantees our debt to gdp is moving in the wrong direction? Is this an identity formula?

    ReplyDelete
  35. This is not an area of expertise for me, clearly, but what I was thinking about was suppose inflation expectations go up a lot right now, so the nominal amount that the Japanese government must pay to issue new debt goes up a lot right now. Well, eventually, if the expectations are right, the inflation will come, and then nominal tax receipts will go up commensurately, so the money is there to pay the higher nominal interest.

    But what if the actual inflation doesn't come for a while? What if it lags the expectations a lot? Maybe the Japanese government will have severe trouble paying the new higher interest until the actual inflation comes, maybe a lot later, to increase their revenues.

    That's what I was thinking could maybe, theoretically, be a problem, an issue of timing, liquidity, and what if the expectations turn out to be wrong and the higher inflation doesn't come later to increase nominal tax receipts.

    ReplyDelete
  36. Abenomics means instead of HFT trading in an 0.05, we go to volatilty for the ZIRP-card monte carry trade. Mrs. Watanabe's going crack-ho.

    ReplyDelete
  37. Nathanael11:37 AM

    "Now I feel even more ashamed for writing a sucky post. But at least I can link to similar posts that do not suck."

    Feel proud of this post.
    (1) You gave it a good shot
    (2) You recognized and admitted when you screwed up
    (3) You found clearer corrected versions of the argument and linked to them

    This is *intellectual honesty* and it's a rare trait these days. Be proud of it.

    ReplyDelete