“Great powers and empires are, I would suggest, complex systems, made up of a very large number of interacting components that are asymmetrically organized, which means their construction more resembles a termite hill than an Egyptian pyramid. They operate somewhere between order and disorder – on “the edge of chaos,” in the phrase of the computer scientist Christopher Langton. Such systems can appear to operate quite stably for some time; they seem to be in equilibrium but are, in fact, constantly adapting. But there comes a moment when complex systems “go critical.” A very small trigger can set off a “phase transition” from a benign equilibrium to a crisis – a single grain of sand causes a whole pile to collapse, or a butterfly flaps its wings in the Amazon and brings about a hurricane in southeastern England.
“Not long after such crises happen, historians arrive on the scene. They are the scholars who specialize in the study of “fat tail” events – the low-frequency, high-impact moments that inhabit the tails of probability distributions, such as wars, revolutions, financial crashes, and imperial collapses. But historians often misunderstand complexity in decoding these events. They are trained to explain calamity in terms of long-term causes, often dating back decades. This is what Nassim Taleb rightly condemned in The Black Swan as “the narrative fallacy”: the construction of psychologically satisfying stories on the principle of post hoc, ergo propter hoc.
– Niall Ferguson, “Complexity and Collapse”
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I see a bad moon arisin’, I see trouble on the way.
I see earthquakes and lightnin’, I see bad times today.
I hear hurricanes ablowin’, I know the end is comin’ soon.
I fear rivers overflowin’, I hear the voice of rage and ruin.
Don’t go ’round tonight, well, it’s bound to take your life.
There’s a bad moon on the rise.
– “Bad Moon Rising,” John Fogerty, Creedence Clearwater Revival, 1969
As a college student, I reveled in the sounds of the Creedence Clearwater Revival and its lead singer and songwriter, John Fogerty. Fogerty supposedly wrote “Bad Moon Rising” after watching the 1941 movie classic The Devil and Daniel Webster. The movie is a paean to freedom, the American dream, and the ability of a man, even one who has sold his soul, to find redemption. There is a scene involving a hurricane that supposedly inspired the song. Fogerty claims that the song was about “the apocalypse that was going to be visited upon us.” Barry McGuire had sung “Eve of Destruction” only a few years earlier. A generation that had grown up with the Cold War, the growing conflict in Vietnam, the Free Speech Movement, and a nuclear arms race was increasingly distrustful of adults and government. “Don’t trust anyone over 30” was the maxim first uttered by Jack Weinberg, a leader of the Free Speech Movement in Berkeley. In a small bit of irony, the founders of that movement recently gathered to celebrate its 50th anniversary. As a side note, I find that Boomers are far more susceptible to talking apocalypse than our kids are.
Well, it’s a beautiful night here in Dallas, and there is no bad moon rising; but over in the Land of the Rising Sun, I do see a bad yen falling. As we will see in a minute, the recent yen price chart looks like a frozen rope (in the words of Jared Dillian). Understand, my bet (to use the word forecast would imply a level of precision in modeling that I have not attained) is that the yen goes to 200 against the dollar, so breaching 120 is not exactly a shocker to me. What is a little unnerving is the rapidity of the recent move.
In this week’s letter we’re going to explore some of the ramifications of the currency war that Japan is precipitating. It is more than just Germany, Korea, and China having issues and needing to contemplate their own competitive devaluations. If the yen goes too far too fast, there will be geopolitical repercussions far beyond the obvious first-order connections. As Fogerty ended his song:
Hope you got your things together.
Hope you’re quite prepared to die.
Looks like we’re in for nasty weather.
One eye is taken for an eye.
I’ll try to see if I can help you “get your things together” … and help you prepare your hedges. We may indeed be in for nasty weather.
As I write on a Saturday morning, the yen is 117.8 to the dollar, having fallen modestly from the mid-118’s yesterday. Shinz? Abe was nominated to be Japanese prime minister for the second time on September 26, 2012, and it was clear that he would win. He implemented a program that has since come to be called Abenomics.
Japan was suffering from a 35% loss of competitiveness vis-à-vis their most important trading competitor, Germany, because of a rather steep rise in the yen (for reasons we will examine later). For the first time in generations, Japan’s trade deficit had gone negative. The interest-rate market was beginning to bounce around, which was a death knell for Japan. Abe made no bones about it: he would replace the controlling members of the Bank of Japan with members who agreed with him that massive quantitative easing should be undertaken.
In the graph below, notice that as it became clear that Abe would win, on cue the yen began a nosedive from 75 to the dollar to slightly over 100 to the dollar and then went sideways for about a year and a half. The Halloween 2014 announcement by the Bank of Japan to double down on its quantitative easing started the recent frozen-rope-like plunge, taking the yen almost straight down to 118 and on its way to 120 in very short order. Goldman Sachs has forecast that the yen will be at 130 by the end of 2015, 135 by the end of 2016, and at 140 by the end of 2017. That rhymes with the prediction of my friend Kiron Sarkar, whose target is 125 in the first half of 2015.
Make no mistake: the Japanese are not at all concerned that the yen is going to 130 or 140 or 150. While we tend to see the recent move as precipitous, it may be helpful to walk in the other man’s shoes, so to speak, and see the currency move from the long-term Japanese perspective. A little over 40 years ago the yen was at 350 to the dollar. Less than two decades ago it was at 150. Then it strengthened all the way to the mid-70s. Even if the yen were to eventually fall to 200, as I predict it will, that’s not even a 50% reversal.
Japanese industry has had to suffer the yen’s rising almost fourfold over the last 40 years. If the dollar were to rise as much, there would be much weeping and wailing and gnashing of teeth, and the usual suspects in the Senate would be up in arms about currency manipulation. Japanese businesses just cut costs and improved quality and competed heads up. Oh yes, it’s been nasty for the last two decades as their nominal GDP has been flat, but their corporations are still some of the most competitive in the world. You put a currency devaluation wind at Japanese corporations’ backs and watch how competitive they become. Cue serious worry from businesses located in Germany, Korea, and China.
For new readers, let me briefly describe what is happening in Japan. Japan’s debt-to-GDP ratio is roughly 250%. If interest rates were to rise by 2%, it would take 80% or more of their tax revenues just to pay the interest. That is not a working business model. Therefore they can’t allow interest rates to rise. The only way they can accomplish that is for the Bank of Japan to become the market for Japanese government bonds (JGBs). And that in fact is what has happened. When the Bank of Japan momentarily withdraws from the ten-year JGB market, nothing trades. The Bank of Japan is the market today.
The strategy for dealing with the Japanese debt is threefold:
- They have to create a positive nominal GDP, which means they need at least 2% inflation and 2% real growth. They have had neither for over 20 years, so this is not going to be easy. They have tried “modest” amounts of quantitative easing in the past. The only way they can create inflation is to undertake massive quantitative easing through monetary printing. However, if you do that, you are in effect going to lose control of the value of your currency. It’s one of the basic laws of economics: you can control either price or quantity but not both.
- They need to move an enormous amount (70%?) of that debt onto the balance sheet of the Bank of Japan, thereby effectively erasing it. To point out that a move like that has never been successfully executed in the history of the world, or at least not without significant economic upheaval, is not stretching the point. The Japanese are embarking upon one of the greatest economic experiments in human history. They are doing experimental surgery on their economic body without benefit of anesthesia. See the note below on the willingness of the Japanese population to endure pain.
- They need to slowly balance their budget so that at some point far off in the future they will be able to actually allow interest rates to float at a level where they will be able to manage the debt, which means they have to run a primary surplus (at a minimum) in their budget. Given that they are running 7% deficits (and have been for some time), that point in time is well into the future. Abe himself does not project a balanced budget until 2020. And given the nature of the experiment they are conducting, you can have absolutely zero confidence in any budget projections that far out. Maybe it happens, maybe it doesn’t.
If you live in Japan, you really should be taking precautions. If you don’t live in Japan, you should be anticipating what this is going to do to you. This is not Zimbabwe or Argentina printing money; Japan is important to the global economy. What they do affects everything.
With the recent increase in quantitative easing, the Bank of Japan is now monetizing more than double the amount of the deficit that the government is producing. That means they are slowly moving the debt onto the books of the Bank of Japan, perhaps in the range of 7 to 8% per year. If they can actually begin to reduce their fiscal deficit, then, at the level of quantitative easing they are currently doing, the amount of actual debt monetization will begin to rise slowly, to perhaps as much as 10%, rising to 15% a year over the very long haul. This would get them to the point where they could withdraw from their QE program and allow the market to set interest rates.
This is something you must understand: this process is going to take many, many, many years. They are not going to stop quantitative easing next year or the year after or the year after that. If they don’t get the inflation they need, we will get another “shock and awe” announcement from Haruhiko (“just call him Colin” [Powell]) Kuroda, which will have every bit as much impact as the original shock and awe campaign did in Iraq in 2003. And while it won’t be as physically destructive, let us be clear: this is central banks at war. And there will be collateral damage. And most central banks, especially those of the emerging markets, only have a knife to bring to a gunfight.
Why would the Japanese people tolerate the value of their currency dropping by more than half, increasing the cost of energy and other imports? The answer to that is a point that my friend Louis Gave makes time and time again, as he did in a missive this week:
With Japan in the middle of a triple-dip recession, and Japanese households suffering a significant contraction in real disposable income, it might seem at first that Prime Minister Shinzo Abe has chosen an odd time to call a snap election. But that conclusion would ignore the two iron-clad rules of investing in Japan that we never tire of repeating:
Rule #1: Never underestimate the amount of pain that the Japanese will willingly bear, as long as the pain is taken together, and is seen to be borne for the good of the community.
Rule #2: Never underestimate the willingness of Japanese policymakers to test Rule #1.
I’ve been on the phone a lot this week talking with economists and analysts trying to figure out some of the immediate impact of Japan’s moves. Jack Rivkin (at Altegris and one of the smartest observers of the economic scene I know) pointed me to a blog post from his old friend Bob Barbera (another brilliant economist and an alumnus of Lehman Research). Jack thought so much of Barbera that while he was running Lehman he fired a very famous economist (whose name will go unmentioned) in order to hire Barbera. Barbera argues rather forcefully that the outperformance by Germany vis-à-vis the rest of Europe is an illusion based upon fortuitous economic circumstances that are getting ready to change. He argues that there is no German exceptionalism. The article provides such important insights that I’m going to quote liberally:
The German economy, in stark contrast to most of the rest of Europe thrived, 2010-2012. German successes emboldened their policymakers. Merkel, her finance minister and a succession of Bundesbank members all sternly lectured their European partners. Embrace Germany’s magical approach, or continue to suffer, has been the message. The good news for the rest-of-Europe is that Germany’s mansion