I approach all of this macroeconomic stuff from a very different perspective than most economists. As an investment manager I’ve had to learn how to connect the dots or die. And scenario analysis like the following is one reason why I’ve had a pretty good track record over the years of avoiding bad predictions like “bond bubbles”, USA defaults, attacking of the bond vigilantes, hyperinflation, etc. As an investment manager, I can’t just say things like “I am bullish on Apple because of their strong balance sheet”, then buy the stock and wish for the best. The process has to be a prudent and in-depth analysis of potential scenarios and the various dots that could unfold. And then I have to connect those dots, understand the risks and decide whether the risk is justified given the potential outcomes. What is the risk to Apples balance sheet, what could cause XYZ to happen, how likely is XYZ, etc etc.
That’s why I am confused by economists when I see things like this by Nick Rowe discussing some macro things that he’s concerned about:
“3. The national debt in countries like Japan. When nominal interest rates are below the nominal growth rate of the economy, national debt is not only not a worry; it’s a good thing. It’s a sustainable Ponzi scheme, and the solution to a problem of dynamic inefficiency. Sure it’s a bubble, but economies where the interest rate is below the growth rate need a bubble. The trouble is, what happens if and when the interest rate rises above the growth rate, and we re-enter the normal world where the long run government budget constraint is well-defined, if the debt/GDP ratio is very large?” (emphasis added)
That’s like saying: “Apple is certainly in a bubble so what happens when their business collapses?” Okay, totally plausible, but where’s the analysis? Why will their business collapse? Where are the details? This reminds me of the endless comments from hyperinflationists over the last 5 years who respond to me saying “just you wait! It’s coming”. I am still waiting. So a comment like the one above has absolutely no merit without further detail. And in this case I am not sure Nicke Rowe has really taken the time to think through the details. So let’s do it. Why might rates rise in Japan? Let’s consider some scenarios.
First, Japan is an autonomous issuer of Yen. So their central bank can always control interest rates, unlike in Greece where the ECB is essentially a foreign central bank and interest rates are left to the control of the bond market because the ECB won’t commit to Greece’s solvency. Like the Fed, they have unlimited quantity of reserves at their disposal allowing them to pin rates across the curve however they like. If the Fed wanted to set the 30 year bond at 1% tomorrow they’d step up to bond market and say “say hello to my little friend” and they’d challenge bond traders to trade against their 1% price target. The bond traders would lose. In fact, they probably wouldn’t even step up to the plate because the communication itself would likely do all the heavy lifting. Ben’s got a bazooka and every bond trader on Wall Street knows it.
So the question really is, what will make the BOJ raise interest rates in Japan? Higher inflation in all likelihood. And what will cause higher inflation? Higher growth or possibly a stagflation. Higher growth is obviously what Japan wants. They’d love to have to raise interest rates because their fight with deflation is over and growth is booming. So that would be a good thing. In a stagflation scenario it’s possible that inflation rises for a multitude of different reasons (cost push shock from oil for example). But this would also be an environment in which the BOJ raises rates because they are trying to simmer inflation.
What’s not going to happen in Japan is an environment where bond markets just say “oh screw these bonds, sold to you!”. Why? Because as long as growth remains muted and inflation appears low bond traders are going to continue to clip those coupons with the understanding that Japan can always be good on debt payments because they are an autonomous issuer of the Yen. So, unlike Greece, the likelihood of rates surging because of default is very low unless Japan decides to do something silly and default by choice (which they could I guess). But the other scenarios are due to inflation constraints and the BOJ willingly raising rates to combat inflation.
So, Dr. Rowe, scratch numero tres off your list and halt your worries. Japan isn’t “running out of Yen” and rates aren’t going to rise because of the mythical Japanese bond vigilantes and their concerns over government debt levels (assuming there are even any left after they’ve spent the last 20 years jumping out of the windows of their high rise banks thanks to the many rising rate predictions from the various macro economic arms relaying “research” to their bond traders). Rates might rise for other reasons, but the BOJ will attack that issue when and if necessary.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.