The Next Country To Collapse Isn't In Europe

From Street Authority

Despite the recent market correction threatening the four-year bull market, investors should be partying like it's 2006.

Easy-money programs from the world's central banks and a recovering global economy could push stocks and other assets higher. So why is the comparison to 2006 relevant?

September 2006 was two years before the collapse of Lehman Brothers and a 28% drop in the markets in the span of less than a month. And two years is about the amount of time we may have until the next great market crash.

So what will be the proverbial straw that breaks the market's back? Europe? China? Market contagion from a collapse in commodities prices?

None of the above. While the rest of the market worries about those issues, there is a bigger threat that could pull down world markets and change the way we measure safety investments.

The next great collapse is unlikely to come from any of these problems. It is more likely to come from a country that has been a haven for investors for more than 30 years and accounts for nearly 10% of world growth.

A look at this country's debt situation, especially relative to the United States, is truly amazing.

This country is paying 21% of government revenue on interest payments to support a 236% debt-to-GDP ratio. With annual spending twice as high as its revenue, the government is running a deficit of $455 billion a year and adding to its $11.2 trillion debt. This is all before the monetary stimulus programs announced recently by its central bank.

If you thought the United States government was a financial basket case, Japan is exponentially worse. A collapse in the yen and the stock market is all but certain -- the only question is when.

The recent easy money program by the Bank of Japan gives us a good idea of the timetable.

The announcement by the Bank of Japan to buy 7.5 trillion yen (about $75 billion) in bonds per month and double the monetary base during the next two years is exponentially higher than anything the country has tried in the past two decades. If you think U.S. Federal Reserve Chairman Ben Bernanke and the Fed's $85 billion monthly purchases is extreme, consider that Japan's economy is a third the size of the United States' and that its growth has stalled in the past decade.

So the bank wants to increase inflation to 2% from its current negative rate of 1% deflation. If they are even partially successful, interest rates on the government bonds could jump. If inflation increases to 1% and the rate on the 10-year bond increased to just 1.5%, the government would need to pay out 65% of revenues just to service the interest.

Kyle Bass of Hayman Advisors recently told Barron's that a debt crisis that will rival Argentina's 2001 collapse is "the most obvious scenario of my adult life. The question is when."

The U.S. stock market is up more than 50% since November with the currency depreciating 25% since government officials started pushing their monetary plans. Just like 2006, everyone is talking about the money to be made in the Japanese stock market.

Japan Monetary Base

(trillions of yen)

After two years, the assets held by the Bank of Japan may be as much as 60% of GDP, compared with just 25% for the Federal Reserve. The bank won't be able to sell these assets without driving up rates, and the government will no longer be able to fund its massive deficits with the skyrocketing interest burden.

Why should investors care about a country that represents less than 10% of global growth? To put Japan's importance in perspective, Greece's economy is less than one-twentieth of Japan's -- and brought the market to its knees last year.

Like the 10-year Treasury note, Japan's government bond has been used by the market to evaluate risk for more than 30 years. A collapse in this market could send shock waves across markets worldwide.

Why do I think the scenario could play out over two years?

The Bank of Japan's monetary program will involve buying most of the government's bond issuance for the next two years, which should help keep rates down. As the program winds down, the bond issues are unlikely to attract many buyers, sending rates higher. The government won't be able to pay the high interest burden, and the Bank of Japan will not be able to sell its bonds to fight inflation.

The analogy to 2006 almost certainly will not play out along the same two-year timetable, however. The Bank of Japan's monetary program covers two years. The stock market is fairly reliable as a six-month predictor of the economy, so investors could start running for the exits in as little as a year and a half.

Of course, anyone jumping out of the market in 2006 would have missed out on the remainder of the bull market. The trick is to ride the market further -- while gradually rotating into safer names and assets.

The iShares MSCI Japan Index (NYSE: EWJ) is up 30% since its November 2012 low, but it has underperformed the SP 500 by 74% since its launch in 1996, with a 31% loss in that time. The fund is extremely expensive at 21.5 times trailing earnings and may have a tough time adding to gains.

U.S. automakers like General Motors (NYSE: GM) and Ford (NYSE: F) have more to lose than most other domestic companies. The yen could collapse along with the financial system, which could make Japanese exports cheap compared with those of international competitors.

While Japanese automakers like Toyota (NYSE: TM) have factories set up internationally, the country still exports about 1.5 million cars a year to the United States. As the yen weakens, these companies may shift more production back to the mainland, driving the cost of Japanese vehicles down further.

The CurrencyShares Japanese Yen Trust (NYSE: FXY), down almost 20% since November, could eventually implode as a debt crisis ruins the currency's status as a safe haven and massive depreciation follows. Investors may be able to use the fund as a hedge against market losses in their portfolio if a collapse does happen.

Risks to Consider: As the great economist John Maynard Keynes said, "Markets can stay irrational longer than you can stay solvent" -- so shorting the Japanese market may not be recommended as the bubble inflates. Japan is still the third-largest global economic power, and it could stave off the inevitable for a couple of years.

Action to Take -- I firmly believe this event could send the world into a recession. Japanese stocks and the yen could be the hardest-hit, and shorting them may provide a good hedge against drops in other markets. Take your profits on Japanese equities and keep the situation on your radar.

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13 thoughts on “The Next Country To Collapse Isn't In Europe

  1. Is the world economy going through a world order adjustment or correction, or is this just a zero sum game?
    If this is a zero sum game and correction then there is money to be made in Japan.

    1. Good question.

      Mostly economics is zero sum when it comes to dollars with the non-zero sum parts of it feeding into either inflation or deflation (or quality shift).

      The big exception to that has to do with distribution of wealth. The great paradox of economics is that wages come out of a subset of revenue and revenues come out of wages. Of course there is a solution to that and which solution you focus on largely determines which school of economics you belong to. To look at this clearly, you need to factor inflation or deflation out, and you do that by dividing wages by revenues. If this ratio is very close to 1 then you are likely to be leaving production efficiency on the table, whereas if this ratio is very far from 1, then you probably have lots of production efficiency in reserve that you are not able to tap because you have no consumers for it.

      One way you can tell you are living in the latter world today is by noting return on capital dollar investments. Physical return on physical capital investments is when you (for example) build a factory that increases production of a good and you get more of that good at a lower price as measured in labor hours. I mention this only for contrast, as Monetary capital investment is not required to actually be reflected in physical capital investment. If there are not customers out there trying to buy those goods, then we are less likely to see new physical capital investment even if the investment dollars are there. Instead what you see is the price of physical capital investments is bid up without any significant change to the quantity. Needless to say, each physical asset will have its monetary return on investment go down at least by the same degree that the price was bid up - more if the capital dollars doing the bidding are lost consumer dollars.

      What we are seeing in the US, Europe, Japan, and many other places is interest rates are heading toward zero. In fact, this is a subset of a larger phenomenon in which all types of return on capital dollars is headed toward zero. After all, bonds are simply one of many types of capital investments and since 1980 and Reaganomics started, capital investment has been supply-driven and the various asset classes have gone from uncorrelated to correlated. If you have faith in supply and demand, interest rates heading toward zero and other rates of return on capital heading toward zero are the only possible result of more and more capital dollars fighting for return coming from fewer and fewer consumer dollars.

      So, back to your question. Is this a zero-sum game or is this a world order adjustment? My response is that we have been going through a world order adjustment for 30 years and it has reached dangerous levels. However, unlike supply and demand for physical goods, supply and demand for financial assets is very hard to predict, and in fact depends largely on fancy and imaginings of a relatively small number of asset holders.

      I would say that at some point in our future we will have a very painful correction, but it could be anywhere from 6 months to 60 years and in the meantime we need to make sure that the right economic ideas are floating around so that we have some place to turn when the Smith-Ricardo-Pareto-Friedman-Laffer paradigm gets discredited.

  2. Similar analysis of china is also required, will be interesting, and may provide some strange findings.

    Actually, the fiscal policy makers world wide, are big big big fools as an economists and crook as well corrupts as a person, as a cost and consequences of common man.

    1. China has committed to growing the middle class and is growing nearly 10% a year. I read an article recently that they were increasing minimum wage by 13% a year.

  3. Japan has doubled its monetary base in a short period before. I seem to recall it tripling the monetary base in a short period. Needless to say those times were not disaster, but as they say, eventually, this time eventually *is* different, if you can just string together enough "this times".

    The real question that no-one is asking is, "Why has Japan needed to increase its money supply?"

    In the neoclassical model, monetary expansion is equivalent to near future price inflation, however this model posits that Japan by now would be in severe danger of hyperinflation, which is clearly not the case.

    In a more cautious model, you can claim that monetary inflation can feed into either price inflation, asset inflation, or economic growth depending on other variables in the economy. This model is more satisfactory in many ways, because you can make the claim that monetary expansion is not able to create price inflation when the monetary surplus is not in the hands of the consumers and monetary expansion is not able to create asset inflation when the monetary surplus is not in the hands of asset holders and economic growth is possible exactly whenever both consumers and producers have some liquidity and either untapped appetite or untapped creativity or effort, as appropriate.

    The question, though, is where does Japan fit into this?

    If Japanese consumers had yen in excess of their production and wages, then you would expect the extra money to show up in inflation. If Japanese yen were winding up in the hands of rich Japanese, then you would expect lots of asset bubbles in Japan, however my understanding is that asset bubbles peaked in the late 80s and assets have been basically flat since then. If Japanese yen where winding up in the hands of rich foreigners, then you would expect a financial flow of dollars away from Japan that would put selling pressure on the yen and buying pressure on other currencies. This would in turn help Japanese export markets and hurt Japanese imports. But Japanese imports and exports have been flat (zero delta to slight deficit) and Japanese currency has been a little bit weak recently, but mostly stable, meaning that capital flows in and out of Japan have been mostly stable.

    So the question comes in, Where's the money? One possibility is that Japan has been increasing the monetary base rapidly while the monetary multiplier has been decreasing rapidly, but I thought I saw evidence recently that M2 and M3 were also increasing for Japan. Further, if excess money causes a slowdown in the multiplier, you would expect the effect to be divided between the monetary base and the multiplier just due to entropy and both should stop at a higher (or in the case of the multiplier, a lower) equilibrium level.

    I suspect that a big portion is simply that I underplayed the importance of Japan's current bond asset bubble in my discussion of bubbles above.

    Here is another interesting question. If Japan owes a record level of debt, then who do they owe that debt to? Certainly any question of bubbles popping could just as easily have been asked at 100% and 150% as at 236%. As I said before, though, trees don't grow into the sky, and eventually you have to reach a "this time" for which this time is different. Starting from the other end of things, the bond bubble is an equal and opposite seeming example of trees growing into the sky, and in fact, the debt and the surplus arguably make each other possible.

    If you take a monetarists perspective, but you turn your back on the Friedman monetarists and instead claim that capital dollars behave completely differently than consumer dollars and can be considered as monetary oil and water, then you can say that doubling the number of consumer dollars will not magically double the number of consumer goods out there and in fact a more likely alternative is a doubling of the price of those goods, and similarly doubling the number of capital dollars will not magically double the amount of physical capital assets and instead doubling the price of those physical assets is a more likely scenario, then what's a monetarist to do? Well, for starters, increase payrolls, and decrease taxes on the poor whenever you see price deflation and decrease payrolls and increase taxes on the poor whenever you see price inflation. Next, increase taxes on the rich whenever you see asset inflation and release money into capital markets whenever you see asset deflation. Then presumably with both consumer and capital levels of money supply relatively stable, the traditional factors that people think of going into economic growth can regain their importance.

    Of course, going back to the question of Japan, if they are unwilling to fix the problem by reasserting their sovereignty and draining the excess capital liquidity, I assume that this liquidity will simply continue to pool and hold interest rates down until and unless the capital leaves the country, driving yen down and finding another way to reach balance. If the pooling continues, then it has to show up at auctions, so regardless of the numbers, I predict more muddle-through until the yen weakens significantly, which Ironically could build export industries and increase Japan's sovereignty.

    The rich people had better hope that Japan doesn't collapse because if it does, the lesson learned will be you have to prevent asset inflation before it gets started, and the more the pain, the greater you see lessons get "over-learned", as we saw in the French Revolution.

  4. Japan is setup for a hyperinflation death spiral. As the central bank buys more bonds with new money, fewer people will want to hold those bonds. But as fewer people hold JGBs, the central bank will have to buy more bonds so the government has enough cash. This feedback loop will soon get out of control. I will be amazed if it takes 2 years.

    1. hyper-inflation is possible when you have a short-squeeze on necessary foreign currency. If fixed requirements for foreign dollars become a large part of your national budget (for example if you have a punitive SAP forced on you) then you can see a violation in the normal law of supply and demand in that increases in the price of the foreign currency that you own in, rather than causing a decrease in demand as theory requires, will actually cause an increase in demand, at least as measured in the local currency (the important one). Of course simple math says that if the demand for local currency by foreigners is pushing prices down and demand for foreign currency by locals is also pushing prices down, then the result is you move very, very fast.

      Since Japan has a trade balance, this scenario seems unlikely and it seems like one that the government could react to. True, there is always the possibility that the excess liquidity could stay in Japan and *not* buy bonds, which would push interest rates up, but gee, are there really enough mattresses for that? I am halfway kidding there, but if you realize that a country's monetary power rests not on its credit history so much as on its ability to tax, and if you realize that the debt crisis is just the other face of it's liquidity crisis, then one would assume that the country would be able to do something to get out of this mess.

        1. It is good to see people putting a lot of thought into this, but at first glance at the model, I am concerned that it includes bad categories.

          As background, one of the bad categories I see a lot is the "National Savings Rate". I was amused by a reference in an economics textbook I saw at the local University saying something like "One of the great mysteries of economics is that you see the predisposition to spend going down faster than the savings rate is going up during the 80s." This is amusing when you understand that the fastest way to increase the national savings rate is to take money from poor people, who spend it, and give it to rich people, who save it.

          My example metaphor for this is "National Pregnancy Rate". It turns out that each and every one of us, man, woman, and child, is on average 3 days pregnant. I knew we should have put Grand-pappy on the pill!!!

          Instead of Money supply feeding into price levels, it would be better to first introduce a concept, "radius of consumption" to cover the amount of earnings that could reasonably go into consumption and are therefore fair game for innovative products seeking customers. The importance of this is underscored by the fact that you and I have a better chance of winning the lottery than one of Charles Koch's dollars has of being used to buy his lunch.

          With that in place, then the relationships would be:
          Money supply within the radius of consumption feeds into either demand increase or price increases on goods.

          Money supply outside the radius of consumption feeds into either asset price increase or supply infrastructure increase.

          Obviously when consumption demand is against a brick wall, money supply increase outside the radius of consumption will feed into asset price increases only and no infrastructure increase.

          By the way, have you seen Steven Keen's tool for doing simulations like this? He has an online economics class on Youtube and one of the things he covers is an open software tool that is really good at doing financial models in dynamic systems. I will look it up later if need be.

        2. I followed a trail of links and found the following amusing passage from wiki:QuantityOfMoney...

          " (The Cambridge economists also thought wealth would play a role, but wealth is often omitted for simplicity.)"

          You can't make this stuff up.

        3. http://www.sjsu.edu/faculty/watkins/infldynamic.htm

          "It is convenient to represent the equation of exchange in terms of the ratios of the variables at two different times, say time 1 and time 2. Thus in this form the equation of exchange is "
          (P2/P1) = (M2/M1)*(V2/V1)/(Q2/Q1)

          "Now the source of the astronomical prices increases involved in hyperinflation can be explained. Suppose the amount of money in circulation doubles; i.e., M2/M1=2. This will lead to an increase in the velocity of money, say 50 percent, so V2/V1=1.5. Furthermore suppose the level of output drops by 50 percent so Q2/Q1=0.5. The ratio of price levels is then"
          P2/P1 = 2(1.5)/(0.5) = 6

          I don't see any reason to assume supralinearity here.

          1. If the M2/M1 ratio is 2 and P2/P1 is 6 then prices are not just going up with the money supply. The velocity of money going up and the real GNP going down make the prices go up much faster than the money supply goes up.

            I have not seen the other simulation tool you mention but I am very happy with insight maker. It does just what I want really.

            This idea that spending on consumption is good and spending on investment is not is just wrong. I tried to find something on the net explaining it but did not really find anything good. Sorry. Why do you think that spending on consumption is good but spending to build a factory is not?

        4. "Why do you think that spending on consumption is good but spending to build a factory is not"

          Funny, I don't remember saying that. Maybe you misunderstood my comments on the difference between consumer price inflation and asset inflation.

          "If the M2/M1 ratio is 2 and P2/P1 is 6 then prices are not just going up with the money supply. "

          Extraordinary claims require extraordinary evidence. The idea that gnp growth is a continuous function of independent variable money supply is not tenable. There are circumstances where increase in the number of dollars will help the economy and circumstances where increase in the number of dollars will hurt the economy and which one occurs depends not only on the number, but also on the method of introduction. I see nothing here regarding the mechanics of either scenario.

          On the other hand, if you let me assume that increasing the money supply will decrease GNP independent of existing money supply, independent of population, independent of physical asset base, independent of our education status, etc., then I can prove that the correct money supply to encourage maximum GDP is zero dollars in circulation.

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