Abenomics

This post will look at Japan's recent economic performance under the policy of Abenomics. Policy recommendations are made at the end.

Japan's Prime Minster, Shinzo Abe

In 2012 Japan's prime minister, Shinzo Abe, ushered in a new set of economic policies which have been termed Abenomics. The policy involves "three arrows": fiscal policy, monetary policy and structural reform.

For further in depth analysis and details on Abenomics please read: Abenomics and the Japanese Economy.

Japan's recent performance

The latest GDP print is disappointing; Japan's economy shrank 1,6% (annualised) in the last quarter. Exports where down 16.5% (annualised) highlighting the flaws the export reliant model. When global growth or export markets slow, the export economy suffers.¹

Private consumption fell 3% (annualised), which is significant given Japan's economy is 60% consumption. The falling Yen added to problems for the Japanese consumer with food prices rising.¹

The large drop in growth seen in 2014 (see above chart) was the result of an increase in the consumption tax from 5% to 8%. 

Is Abenomics a success?

The rise in the consumption tax hurt consumer spending at at time the economy didn't need it. The result was a recession in late 2014 (two quarters of negative economic growth). Increasing government spending while increasing taxes is like having one foot on the accelerator and the other on the brake. The government must focus on generating growth today and address fiscal sustainability in a few years or expect the jittery economic growth to continue.

Raising domestic demand is paramount and the government should not only cancel future consumption tax increases but also reverse the previous increase. Additionally, the government could lower taxes for low-income earners to increase disposable income. It must be noted that Japan's income tax is very progressive.

Relying on a currency devaluation to boost exports is a less effective tool to boost growth. Firstly, the gains are marginal given the increasingly global supply chain. Secondly, it acts as a consumption tax on imports which reduces household real incomes. As mentioned above, rising food costs have become a problem for Japan.

The demographic challenge Japan faces must be addressed either through higher birth rates or net migration and getting more women into the workforce. This is one of the major aims of the structural reforms proposed under Abenomics.

Conclusion

The failure of Abenomics is political (not economic) with the deficit hawks continually demanding policies to reduce the deficit when the exact opposite is needed to propel Japan out of its protracted economic malaise. The more difficult task will be establishing the structural reforms which challenge the politically strong vested interests. If Japan can overcome these hurdles, they will be the shining example of an economy that escaped the debt deflation global epidemic.

References

1. Warnock, E. and Obe, M. (2015). Japan’s Economy Shrinks in Second Quarter. [online] WSJ. Available at: http://www.wsj.com/articles/japans-economy-shrinks-annualized-1-6-in-second-quarter-1439769883 [Accessed 23 Aug. 2015].

Austrian Malinvestment Theory

A new train station in Wuhan (Central China) completed at the end of 2009

While a lot of what the Austrian School of Economics says is just political theory dressed up as economics, some of their theories may be sound in the real world. One such theory is the theory of malinvestment.

Malinvestment is a mistaken investment in the wrong line of production, which inevitably leads to wasted capital and economic loss, subsequently requiring a reallocation of resources to more productive uses.¹

The theory of malinvestment is a critical part of the business cycle according to the Austrian school. They blame the government either through its spending decisions or through the central bank for causing these market distortions resulting in misallocation of resources and the malinvestments which inevitably have to be liquidated.

To the neutral observer, one may be quick to dismiss this as the standard Libertarian anti-government rhetoric. However, it is widely accepted that poor central planning can lead to massive investments that are proven to be unproductive and misaligned with consumer demand.

This blog post follows the post on Minsky's Financial Instability Hyporthesis and tries to explain the business cycle phenomenon. The question is whether the government, the central bank and the fractional reserve system are the cause of the bad investments or is it more along the lines of Minsky's FIH - that the boom-busy process is inherent to a capitalist economy. I believe that both can be correct. The private and public sector are prone to making bad decisions. The government's decisions have greater economic impact but the private sector can also generate asset bubbles that can have greater consequences than any government decision ever could.

Krugman's Criticisms of Malinvestment Theory

Paul Krugman describes this as "Hangover Theory". He first states that investment cycles should not be assumed to correlate with the economic cycle. He makes the point that any reduction of investment will result in an increase in consumption because someone's spending is another's income. He also points out that every industry feels the pain, not just the investment sector.²

Krugman then states "A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time." He then suggests an increase in the money supply after the private sector writes off its bad investments because after the write off, there is only idle productive capacity left.²

Krugman attributes the appeal of "Hangover Theory" to counter the perceived statist implications of Keynesianism and describes the theory as "intellectually incoherent."²

Examples of malinvestment

The clearest examples of malinvestment are those government projects that cost billions and eventually prove to be white elephants because the economic and social benefits are tiny compared to the cost of the project. However, the worst malinvestments occur when the private sector AND the government work together to create gargantuan investment and asset bubbles.

A great example is the property and construction boom in China. After 2008, the Chinese government instructed its banks to lend and finance the construction sector. We saw the creation of ghost cities and the demand for iron ore (used to create the steel needed to build) sky-rocket. The Austrians would describe this as a false price signal, which caused iron ore miners around the world to increase their production capacity. Australia was one of the chief beneficiaries with mining investment driving much of the economic growth seen post-2008. In the last year or two, we have seen the Chinese economy roll over and with that the price of all commodities. The demand for steel has plummeted and the iron ore price has crashed. Just a few days ago BHP announced its third round of job cuts which reflects the adjustment to the overcapacity now laid bare in the mining sector.

Other examples from history include the US housing bubble. Interest rates reached 1% in 2002-2003 before slowly rising. Government policies encouraged and supported lending to sub-prime individuals through mandates and GSEs like Fannie Mae and Freddie Mac. Of course there was also widespread fraud on the part of the private sector. But the question remains, if interest rates bottomed at 2% instead of 1%, would the fallout have been far more limited?

Conclusion

One should be cautious when reading anything from the Austrian school, simply because of the political bias that is the foundation of their economic thought process. If an objective observer sees government intervention in an economy leading to investment booms and later a bust, it would be apt to fault the original government decision. It must be said that the government is not the only one making bad investment decisions. The private sector does it all the time and as Minksy's theory postulates, it may be inherent to a capitalist economy. Both theories importantly point out that the private sector makes mistakes, which many mainstream economic models seem to ignore.

References

1. Wiki.mises.org, (2015). Malinvestment - Mises Wiki, the global repository of classical-liberal thought. [online] Available at: https://wiki.mises.org/wiki/Malinvestment [Accessed 16 Aug. 2015].
2. Krugman, P. (2015). The Hangover Theory. [online] Slate Magazine. Available at: http://www.slate.com/articles/business/the_dismal_science/1998/12/the_hangover_theory.single.html [Accessed 16 Aug. 2015].

Minsky's Financial Instability Hypothesis

Ponzi finance is like an unstable house of cards

The boom-bust cycle in economics is one which has many explanations. The Austrians blame malinvestments caused by central banks setting interest rates too low, Keynes blamed animal spirits and Marx warned it was falling profits that caused the bust. An increasingly popular explanation for the boom-bust cycle is the Financial Instability Hypothesis proposed by Hyman Minsky. The theory suggests that the rising proportion of debt relative to cash flow causes financial instability. This phenomena is inherent to a market economy and it is often summarised as "stability breeding instability."

I think there are some similarities with the Austrian malinvestment theory which I'll be covering in a future blog post.

This blog post is mostly a summary of journal articles from the Levy institute which are references at the end.

What is the Financial Instability Hypothesis?

The hypothesis refers to phases in which economic units go through as the economic cycle develops.

There are three phases that economic units can involve themselves in:

• Hedge financing occurs when units can fulfil all of their contractual payment obligations by their cash flows. The more equity in the liability structure, the more likely they are a hedge financing unit.
• Speculative finance units can meet their payment commitments on their liabilities, even though they cannot pay back principal from income cash flows. Such units will "roll over" their liabilities.
• Ponzi finance units' cash flow from operations are not sufficient to fulfil either the repayment of principal or interest on outstanding debts. Such units can sell assets or borrow. Borrowing to pay interest lowers their equity. A unit that Ponzi finances, lowers the margin of safety that it offers the holders of its debt.

If hedge financing dominates, the economy is stable. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood the economy is in a deviation amplifying system (simply put, a big boom or bust).

Financial Instability Hypothesis Theorems

1. The first theorem of the Financial Instability Hyphothesis (FIH), the economy has financing regimes under which it is stable and regimes in which it is unstable. 
2. The second theorem is that over long periods of prosperity, the economy transitions from a stable financial system to an unstable system. Capitalist economies transit from hedge financing units to a structure in which there is a large weight of speculative and Ponzi finance.

If the economy is in an inflationary state and monetary policy tightens, speculative finance units will become Ponzi finance units and previously Ponzi finance units will see their net worth decline. These units will have to sell assets and thus asset values decline.

The FIH model does not rely on exogenous shocks to generate business cycles of various severity. The hypothesis holds that the business cycles of history are compounded by internal dynamics of a capitalist economy and the system of interventions and regulations that are designed to keep the economy operating within a reasonable bound.

Link to behavioural economics?

The paradigm shift away from assuming we are rational economic units to accepting the real world proof of the opposite, is a recent occurrence. Minksy refers to the "euphoric economy" which can be linked to biases such as the overconfidence bias and the herd mentality. There is no doubt that these traits exacerbate the bubbles and provide a fertile ground for speculative and Ponzi finance to emerge.

Other important notes from Tymoigne (2010)

• Government deficits directly improve the financial strength of the private sector.
• Government deficit may be a problem if there's a stringent exchange rate regime (e.g. Greece - monetary sovereignty surrendered to the Eurozone) or if debt is issued in foreign currency (e.g. Argentina)
• Financial fragility is not a measure of the size of the leverage but the quality
• Bell (2009) found good indicators of banking crises include rapid loan growth, slow output growth, and rising real interest rates.
• Speculative and Ponzi finance haver a higher mismatch between assets and liabilities, which most of the time means that there is a high proportion of short-term debts and low liquidity buffers. 
• Under Ponzi finance, it is expected that net worth and liquidity will decrease given asset values. This decline in net worth and liquidity will not be recorded in data until defensive position-making needs actually occur. If assets are valued on a market basis, and if their prices grow fast enough to compensate for higher debt or lower liquid assets, the decline in net worth can be avoided (Minksy 1964: 213ff.) In that case, the growing solvency of economy unit involved in a Ponzi process depends highly on the continuation of rising assets, rather than on the capacity to generate an income from the ownership of the asset. In fact, an economic unit involved in Ponzi finance is guaranteed to record very high short-term profits and so a very high increase in net worth for a short period.

Where are we now?

A few examples in recent weeks of Ponzi finance come from the China/commodity boom.

The most obvious economy in the Ponzi finance phase is China. Just read this: (oringal here: http://english.caixin.com/2015-03-11/100790192.html)

"In years past, Rongsheng found it easy to get bank support for building orders. But according to a ship financing expert, banks changed their tune after Rongsheng started having trouble repaying loans. The repayment woes surfaced after the company apparently overstretched its order books to the point where it couldn't deliver vessels on time.

Rongsheng's weak financial position was highlighted by a third-quarter 2014 financial report in which the company posted a net loss of 2.4 billion yuan. It also reported 31.3 billion yuan in liabilities, including 7.6 billion yuan worth of outstanding short-term debt.

A source close to the company said Rongsheng's capital crunch has worsened since February 2014, when the CDB demanded more collateral after the company failed to make a scheduled payment on a 710 million yuan loan. When Rongsheng refused, the CDB called the loan. Other banks that issued loans to the shipbuilder have taken similar steps, said the source."

Just the other day another example of Ponzi finance came to light when Fortescue (ASX: FMG) tried to refinance their debt only to change the structure and then cancel the transaction. (original here: http://www.abc.net.au/news/2015-03-18/fortescue-debt-debacle-highlights-perilous-position/6328668 )

That initial deal was for a $US2.5 billion syndicated loan. It was scrapped yesterday in favour of the "Senior Secured Note Offering" which also has been junked in what can only be interpreted as a worrying development for the nation's third biggest iron ore exporter.

This sums up the situation well:

Imagine having nearly 9 billion of debt maturing in next 2-5 yrs & you sell one product.....at a loss.
— Greg (@macromusing) March 18, 2015

It is clear that FMG can no longer payback the principal and is in the speculative finance stage. As the price of iron ore falls below the cost of production, Fortescue is no longer profitable. At this stage paying interest becomes a problem as cash reserves drain and Fortescue enters the Ponzi finance stage. As long as iron ore prices continue to fall, Fortescue is guaranteed to become a Ponzi finance unit.

I have been a China bear for a few years now (see last year's detailed post here) and it looks like the wheels are finally coming off.

Conclusion

Minsky's FIH is an important theory for understanding how an economy can become unstable due to the debt financing decisions of economic units. It is a theory that should stand the test of time as most recessions and financial crises involve economic units that end up financing low quality investments. Recessions could be mitigated if  policy makers monitor the quality of investments and take action before the financial system becomes extremely fragile.

References:

Minksy, Hyman P. 1992. Financial Instability Hypothesis. http://www.levyinstitute.org/pubs/wp74.pdf

Tymoigne, Eric. 2010. Detecting Ponzi Finance: An Evolutionary Approach to the Measure of Financial Fragility http://www.levyinstitute.org/pubs/wp_605.pdf