Japan: Krugman vs Reality

by James Cox

One of our favourite US Hedge Fund Managers is Kyle Bass. He has a fantastic ability to work through a deductive logical framework, painstakingly check his data and then use his privileged position to contact movers and shakers in both politics and finance to explain to him why he is wrong.

This, coupled with his ability to think outside of the box with regards to ‘non linear events’ has enabled him to make a fortune since setting up his hedge fund Hayman Capital by betting against the US subprime mortgage disaster and the Greek default and betting on Gold.

Now he is betting against Japan via CDS. His argument for this is as impressive as it is concerning. Japan is running a 230% Debt to GDP Ratio and has a declining and ageing population.  Japan is also prone to massive natural disasters as witnessed in 2011’s Tsunami. Indeed, in response to the resultant Fukushima disaster, the Japanese government is still only slowly reopening its 54 nuclear reactors worth 30% of their electricity. This has led to a 70% increase in their Natural Gas imports and this just part of the reason they have slipped into a trade deficit for the first time in decades. Japan is once again reporting negative growth. He comments:

"Japan is in the crosshairs of the market...I've never seen more mispriced optionality in my entire life."

Clearly there will be a great deal of pain should Japan’s economy deteriorate.  Those who bask in the ‘safe haven status’ of the JGB bond should consider that if those bonds rise to just 3% the debt repayments would wipe out their entire tax revenue. On the other side of the Pacific, we hope the Federal Reserve remembers that Japan is the second largest US Debt holder with over $1 Trillion of their Treasury Bonds. The idea that the tab will be picked up by numbers 3 and 4 on the list (Brazil and Taiwan) is ridiculous. Indeed, whilst Bass’s timing may be early, as he is currently running a loss on this trade, it is a huge call that, in the absence of divine intervention will make him yet another fortune and yet leave everyone every one else broke.

In the meantime, Hyper Keynesian in chief, Paul Krugman has recently been celebrating the losses of bets against government profligacy such as this that have not yet been vindicated. Krugman has been lauding the undeniable fact that US Treasuries and indeed Japan Government Bond yields have in fact been dropping to record new lows despite of their spiraling debt over the last 30 years. His message is that the two issues are therefore not related and so governments should step on the spending accelerator. Indeed, given that Japan is still in a slump now it is in its 3rd “lost decade” he must be rather pleased that the Bank of Japan is still following his advice explained in detail in his 1998 essay ‘Japan’s Trap.’

‘The simplest way out of the slump is to give the economy the inflationary expectations it needs. This means that the central bank must make a credible commitment to engage in what would in other contexts be regarded as irresponsible monetary policy.’

You cannot solve a problem of too much debt by creating more debt. What is particularly dangerous about Krugman is that his inductive logic bias is based upon short term data. His basic argument is that no major currency has been taken to the cleaners recently – therefore it is risk free to play chicken with the bond market. Glaring examples of this going wrong are the French Assignat in 1790, the Russian Rouble in 1917 and the German Papiermark in 1923.
It is particularly concerning because, he, like Keynes, is held up as a bastion of common sense by politicians who desperately want to believe in the tooth fairy.
Sadly, by the time they realize that he is wrong it will be far, far too late.