Everybody remembers the February 27, 2007 Shanghai contagion that slashed 15 percent off the Shanghai stock index (SSI) and catalyzed the evaporation of over a trillion dollars from global equity valuations. Rarely mentioned is the smaller move that took place six days before: the Bank of Japan’s decision to raise interest rates from .25 percent to .5 percent (very widely expected by the market).
In the days between February 21 and February 27, Japan’s politicians howled at what initially appeared to be the first in a string of rate increases – with good reason. Japan’s economy had appeared to finally be awakening from a fifteen-year slump in 2004, when the Koizumi government was taking baby steps towards fiscal discipline and entitlement reform. Japanese politicians made utterances about leashing the BoJ, expectations of future rate increases ebbed, and the yen’s value dropped back to a low of 121.5 yen/USD. (The SSI crash was accompanied by a spike in the yen’s value to 115 yen/USD.)
The BoJ and the Japanese parliament have very different priorities in terms of economic policy. The short-term-oriented Japanese parliament wants low rates, period. To the BoJ, this is unacceptable.
As long as economic reform was politically possible – which, under Koizumi’s surprisingly principled leadership, they were – the BoJ’s zero interest rate policy (ZIRP) made some sense beyond forestalling deflation: it would cushion the blow of slashed government spending and hiked taxes that Japan must undertake in order to ensure long-term solvency.
The Japanese economy has by far the worst debt and pension crises of any advanced economy. Its national debt, local debt and pension debt probably exceed 250 percent of GDP (well over $10 trillion USD), although the figure is so stupendous that that is a guesstimate at best. Japan runs annual budget deficits of 8% of GDP per year. (It would be akin to the United States running annual budget deficits of over $1 trillion.) As long as interest rates remain low, Japanese politicians pay virtually no price for out-of-control deficit spending. If interest rates rise, the government will have to reduce its borrowing and meet higher interest payments on its stupendous debt. Taxes will have to go up, and spending down, drastically.
At the same time, Japan’s population is graying at a faster rate than any other country in the world. Its pension obligations are increasing exponentially, its population has begun to decline, and thus its ability to repay its debts diminishes further with every passing day. Japan’s window of opportunity for reform is closing very quickly; the fiscal situation may be dire now, but it will only get worse. The Japanese parliament has shown no willingness to use its time wisely – so it is up to the BoJ to give them a reason to act, now, by raising interest rates and sacrificing short- and medium-term Japanese prosperity for long-run economic solvency.
Raising interest rates is the BoJ’s only option. Whether or not the BoJ has the will to inflict that necessary pain on Japanese society remains to be seen -- but until it does, the yen will continue depreciating relative to all other currencies, and barring a suicidal change of heart by Japanese politicians, the state of Japan’s economy will only worsen.
The BoJ has stated that it will not raise interest rates again until after upper-house elections in July. At some point, the BoJ will have to start raising rates again; it probably does not want to provoke a panicked reaction from legislators, and recent economic statistics do not argue strongly for a rate increase anyway. But at some point – probably very soon after the next elections – the long-term outlook, and necessity to increase rates, must become the primary driver of Japanese monetary policy, bringing with it more falls in the Nikkei, appreciation of the yen, and poor medium-term economic performance.
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