Macro Economics #4 - Keynesian in Japan and USA

So Japan had a demand side recession after a real estate bubble burst in 1989, while the USA is now having a demand side recession that started in 2007. At this point we can see that both Japan and USA were maxed out on their consumer credit because of housing bubble burst. Will Keynesian stimulus work the same way in both country? Are we walking on the same path as Japan? Let's explore.

In my last post, we mentioned that government printing and spending will cause inflation in commodities or imported goods. What if you are an EXPORTING country like Japan, China, or Taiwan? First, let's pull back to 1989 when Japan's real estate bubble all in a sudden popped. Japan has been an exporting country for a long time. When their central bank started to print money, and put this money in bank reserves, it did not re-inflate the housing bubble. Japan was making more USD from exporting than it was spending on raw materials with same USD. It did not trigger commodity bubble as long as government did not spend more than it earned from exporting.

Let me use a simple example to explain this. Japan couldn’t borrow anymore money because it was completely loaded with debt. When there is free money to borrow from the private bank, who can benefit from that cheap JPY? The answer is the firm that produces and exports the finished goods. They can borrow JPY with cheap money, expand the facility, buy more raw materials and then export to USA. The increased revenue in USD will pay off the cost of raw material and still have net income left. This net income may pull them out of recession as long as there are no other country compete with them in the export business and their trading partner can accept the increased output from. Unfortunately, Taiwan, China, South Korean, etc, joined the game and started to compete to devalue it's own currency by printing in order to boost their export market.

In addition to the increased competition, the strict immigration policy of Japan and aging working population also added forces to the deflationary effect of the economy. The net result is that corporations in Japan probably could not earn enough to boost everyone's income in order to increase the borrowing power of the Japanese, while more and more Japanese were heading to retirement and increasing the liabilities of their companies through pension commitments.

What about the Japanese government? Did not they also spend a lot of money? Yes, Japanese government also spent a ton of money and tried to boost up the demand. Again, with tapped out consumers who could not increase their income, government's spending is simply wasted. People may argue that Japanese government built the high speed railroad, and the economy sky rocketed, so how could you say government spending is wasting money? The answer is that there are very few infrastructure construction projects that boosted productivity. Where there are construction projects like that, government spending will successfully boost income and make the economy grow very fast. However such "SMART" spending is rare; it does not happen often. Most of the time when the government hires people to dig a pothole on the road, and fill it next day, it does not boost productivity and the money is simply wasted.

Moreover, we also need to notice that when Japan is borrowing money from the market, the central bank may not need to create JPY from thin air as the US government because with all the foreign currency they made from international trade. The JPY is backed by foreign currency; it is not some blind printing that creates JPY from thin air.
Now, with all these wasted efforts by the Japanese government, we see that their economy goes up and down further and up and down even further, and never fully recovered. I think the main reason is that their economic health is largely based on how much they can EXPORT! So when US is heading for a super depression, I think the lost two decades that Japanese currently experiencing will finally also turn into a super depression. The difference between is that America will NOT go down the same path of Japan and instead jump right into a depression, much quicker since we have not established contact with extraterrestrial life to export and save our demand recession.

See also posts #1, #2, and #3.

Macro Economics #3 - Keynesian stimulus and the Recession

Whenever we have a recession and the government thinks that it is because demand is falling; our government thinks that by using expansionary monetary and fiscal policy it can jolt the economy back to life. This is dangerous if they assume this is a cure-all elixir and start to abuse it.

First, let's discuss how Keynesian stimulus works. Why do demand side recessions happen? It is usually because we overbuild and over-expand our production facility using debt and when the asset appreciation starts to slow down, the profit is unable to keep up with the interest payment on the debt used to expand the facility. When this happens factories and retailers starts to go out of business and rising unemployment causes the demand to fall even further and make the problem worse.

Governments think that Keynes was very smart because he says that when this happens all the government needs to do is simply spend a lot of money by borrowing, and also lower the interest rate by supplying more cash to the market. Then the consumer will start to borrow and spend again, demand will pick up and economy will come back to life. This worked in 2003 but what was the result? We got the biggest housing bubble in history! When the interest rate is lowered, and the government starts to spend money to save people's job, yes, those who got saved and those who still have a job with a smaller house or without a house will upgrade their housing because when mortgages are cheaper they can afford bigger loan amount, i.e. their purchse POWER goes up. Housing bubbles will also produce profits for other industries; it creates construction jobs, and other jobs that supply things like furniture and electronic that people usually also upgrade with their new house. This higher profit leads to increased income and further increases the loan amount one can afford. The virtuous cycle will successfully push the demand back up and the economy is SAVED.

Will it work this time when we already had a housing bubble and when everyone's credit card is already maxed out? My question to the government and Keynesian economists is this: what asset will people now buy when credit card interest rates are around 30% if they already knew it was a bubble when mortgage interest rates were at 5%? Will lowering it to 5% again successfully boost the house market back to the bubble level? Will people be as stupid again?

If we can't find another driver for jobs what will happen if government keeps borrowing money by printing? Remember, Quantitative Easing means government borrow money from the market, while Fed prints money to buy the debt back from the market. Now, we are going to touch the core topic of this analysis: Inflation VS Deflation.

First, when government prints people will start to fear inflation is coming because the money is so cheap. Businesses will expect the economy to come back to life and those who still manage money, like fund manager, will go in and push commodity prices up. We will see commodity prices to go up as a result (inflation on commodity front). The key question is will this introduce inflation on FINISHED GOODS? I doubt it because consumer debt is maxed out. When consumer debt is maxed out, the retailer and producer has little power to increase price. The demand is shrinking, so increased price will make smart consumer find the more efficient stores that can keep price the same and still make some money. When the economy is booming even most efficient retailer can't supply every demand in the country so inefficient stores can profit as well. But when the demand is falling fast, more and more businesses will be driven out by more competitive retailers.

So what can the retailer do to keep profit? They need to be more efficient, and that means they need to cut wasting and fire non-competitive workers. This will make the problem worse for non-efficient retailers. Eventually, big department stores like Macy's will go down first because their cost of operation is too high. When a major department store goes down, so goes the shopping center. A major bankruptcy will take down many other firms with it and the liquidation sale will cause the commodity price and finished goods to crash include housing. Then the surviving firms may or may not raise price because there is less competition but at this time people also will have less money to spend because of higher umemployment. Please remember this is a long process, it takes months to play out and you will still feel deflation at this point because of liquidation crash on consumer goods.

What if the government stops printing and borrowing at this point? We will get super great depression! But what if they keep printing? The entire cycle will repeat but there will be even higher inflation on commodities and even though there are less businesses around to fail, eventually we will cross the point when every business and job is saved by government which will result in Zimbabwe style hyper-inflation.

Another key point to remember is that Japan and US are different because Japan is an exporting country while the US is an importing country. My past analysis is based on an importing country because our business profit is largely based on importing costs. The case will be a bit different in Japan case because they are more exporting oriented. I will analyze Japan in my next post.

So will government keep printing? I think they will because hope is always the greatest when you try something for the first time. When this same trick fails again and again, eventually political pressure will force the governement to try something different. This is why I am expecting super depression instead of hyper-inflation because I believe Americans are smarter than Zimbabweans and won’t let their country create hyper-inflation which is far worse than a super depression. The American will will finally force the bad debt to be purged from the system.

Of course another risk is that America goes the same path as Weimer Germany where we elect a fascist president and wage war against other country to rob their resources. If that happens, then it is time for the third world war. I certainly hope that won't happen.

Next post will compare Japan and USA.

See also posts #1, #2, and #4.

Macro Economists - blind people touching elephant #2

Inflation VS Deflation - The role of Debt plays

We all know what debt is when someone borrows money from someone else. But what kind of role does it play when we talk about inflation or deflation? Let's take an example:
Let's say an average American makes $3,000 a month after taxes. How much can he spend, from 0 to $3,000? No he can spend from zero to $5,000 if he can say borrow $2,000, or even more if he can borrow more. Therefore, the total purchase power for this American is the amount of money he has earned minus his expenses, then plus the credit he can borrow.

Now, let's think about the 1930’s. During that period of time:
1. Consumer debt exploded
2. Government was on gold standard system, so it had no freedom to print money to borrow, they could only borrow every cent from average Americans.

In that scenario, when the economy was expanding by more and more borrowing, we have a great time before the market crash in 1929. It is simple to see that if everyone is borrowing, everyone can spend a lot more than he has earned, and it makes every business happy because things, including houses, get sold very fast. But one day when your income can't even pay your interest, you need to start cutting your spending or sell your inflated asset. But there may be no greater fool left to buy it. That is the day of reckoning. However, with gold standard system, government has limited ability to battle against this situation, since the government cannot borrow unlimited amounts money because the total amount of money is limited by total amount of gold.

So, what about the fiat currency system that started since 1971? It is the system that US is running now, and our money is backed by national debt which is explained by Chris Martenson's website that I mentioned in first post. Now with fiat currency system government can borrow money from the people, or even easier, just from the Fed Reserve Bank. The way to do it is simply auction the national debt, then ask Fed to buy it back, in this case, you have government has unlimited borrowing power. What can government do when it has the power to print money? Keynesian economists says government can use this tool to fight deflation because if government print too much money; we will have inflation and therefore, avoid the deflation. Is it true? We will find out.

In 1973, we had an oil crisis. This was a SUPPLY side recession because our supply of oil was interrupted so companies started to lay people off because they did not have enough goods to sell, didn’t need to employ as many people. The government thought this recession would lead to deflation so it started to borrow money by printing. Guess what happened? STAGFLATION!! why? because when you have supply side recession, print more money will just make the supply even more expensive, and people still lose job while resource price and wages both go up at a crazy rate! Ok, so even neo-Keynesian admit expansionary fiscal and monetary policy is useless to battle adverse change in supply.

What about DEMAND side recession? Well, sometimes it works, like in 2003 we successfully ended the recession fairly quickly. Does it always work? And it seems to be working this time right? Why doesn't it seem to be working in Japan? Again, let's explore the graph of total the US Debt since 1920. We see that our debt is increasing at an exponential rate. We cannot have unlimited debt vs our GDP number, so I think the Keynesian's expansionary policy to borrow more will work until the day we hit a wall that we can not borrow anymore. I personally believe this wall is at where CONSUMER debt is maxed out. When does consumer debt max out? When majority of Americans cannot pay their credit card bills, when Americans housing price is falling so they can not borrow with home equity loans, and when American's can not borrow any more money to boost house price.

Interestingly our government has stepped up to the plate to borrow where the consumer no longer can. The government is now borrowing and using printed money to fill the void left by the missing consumer. Do you think this is going to work? My next post will be: Demand Side Recession, how does Keynesian stimulus work, and does Keynesian stimulus always work?

Modern Macro Economists - blind people touching elephant

We have many so called economists who talk about macro economics by setting many variables constant, as we all do in a chemistry lab, and then try to determine the outcome in the real world. This, to me, is like a group of blind people touching an elephant; some say the elephant is a big wall, some say it is a long tube, ...etc. Well, they are all right describing what they observed with their hand, but the conclusion is wrong because they ignore other parts of the elephant.

The real world economy is like a huge elephant. I was so confused in the past when I read different economists predict what would happen to the US or World economy. There were many conflicting views, but they all seemed reasonable and correct. So who is right? This confused and bothered me so much until I realized that they were all right on what they observed, but some of them had the conclusion wrong because they ignored many other variables. Once we consider all the variables, what we see today makes perfect sense and we can predict the trend more accurately.

I’d like to write on a few topics so I’ll break this into a series of posts.

I'll start the whole economic analysis with this topic: Inflation vs Deflation

Inflationists say gold should be 5000 dollar, while deflationists ask why and they claim everything seems to be cheaper when they go to market. Which side is going to win? Let's discuss by review a series of fact before I can tell you my answer.

1.First topic in the series: Debt

When the money is growing faster than production, we will have inflation, otherwise, it is deflation. This should be simple enough to a lot of people. However, the money here is more than just paper money, it also includes CREDIT. If you are not familiar with this part, please visit http://www.chrismartenson.com/crashcourse . This web site has a clear explainaion on how money and velocity of money works.

Now, let's review a graph of total US Debt VS GDP ratio, and also the graph of US GOVERNMENT Debt VS GDP ratio:

The first graph shows the total US Debt VS GDP ratio; we can see that current total debt is far worse than the 1930s. People claim that government debt is not a problem because in the 1940s to 1950s we had much higher government debt compare with current debt level. Again, this is what I mean when people only look at one fact and ignore the rest when they come to a conclusion. My analysis is: government debt was not an issue in the 1940s because the CONSUMER debt was very low, and we had won the war. Everyone started spending and we could utilize all the technology we advanced during the war. Higher private sector income would boost government tax revenue and paid off public debt, so it was PERFECTLY fine! Now, both consumer debt and government debt is going far beyond dangerous level and some think it is going to be fine? I think it will be worse than great depression based on just the debt level!

In the next post, I will elaborate more on how debt works in our economy, and why it will cause super great depression.