An analysis of Turkey's financial crisis

Mainstream media is hardly covering this and is totally fatuous.

Comments on Facebook are even worse and focus on the statement They have 'their dollars,' we have 'our god'

Read this for real analysis

How Turkey's Currency Crisis Came To Pass

Moon of Alabama,

10 August, 2018

President Erdogan of Turkey often asserts that 'foreign powers' (meaning the U.S.) want to bring him down. He says that the 'interest lobby' (meaning (Jewish) bankers), wants to damage Turkey. He is somewhat right on both points.

Since last week the Turkish lira is on an extended down-slide. Today alone it lost nearly 20% of its value. It will likely take the Turkish economy with it and Erdogan need someone to blame for it.

But while foreign powers and banks surely use the crisis for their own aims, it its Erdogan's economic policy that is foremost to blame. The long boom he created with borrowed foreign money is finally turning into a bus.

Here is a recap of how it came to this.

The larger political picture:

During the U.S. induced 'Arab Spring' U.S. President Obama joined with Qatar and Turkey in an attempt to install Muslim Brotherhood governments throughout the Middle East. When Hillary Clinton left the position of Secretary of State and John Kerry took over, the Obama administration changed its position. It endorsed the coup against the elected Egyptian President Morsi and it refrained from actively using the U.S. military to bring the Syrian government down.

Especially with regards to Syria Turkey was left holding the bag. Erdogan had bet on the U.S. plan to overthrow the Syrian government. His invitation of Syrian refugees and support of radical Islamists fighting in Syria had cost a lot of money and brought a lot of trouble with it. The Turkish trade route through Syria to the Gulf countries  was closed. Economic relations with Iran suffered. Erdogan wanted to get something out of it.

But U.S. policies had turned against him. The Gezi protests in 2013 had all the signs of a  U.S. color revolution attempt. They failed. In 2014 the Obama administration began to support the Kurdish PKK/YPG forces in Kobane. The PKK is a terrorist organization which tries to create its own country in the eastern part of Turkey, north Syria and north Iraq. The U.S. alliance with the Kurds created a PKK/YPG dagger pointed at Turkey's underbelly.

In response to a Turkish led attack on Latakia and Idleb in mid 2015 Russia deployed its forces to Syria. In hindsight it was the point where Erdogan's game in Syria was over. The U.S. would not launch a war against the nuclear armed Russia. Syria would not fall. But Erdogan played on.

In November 2015 the Turkish air defense ambushed and shot down a Russian jet. Russia responded with a total stop of all economic exchange with Turkey.  These were not the needle prick sanctions the U.S. often uses, but a total abrupt end of all trade relations including Russian tourist visits in Turkey. The economic damage for Turkey was huge. Erdogan had to submit to Russia. Putin was gracious and allowed Erdogan to save his face. The Russian government offered a lucrative pipeline deal and other sweeteners. In mid 2016 the CIA arranged for a coup against Erdogan but Russian intelligence warned Erdogan and the coup failed.

Flipping Turkey from the "western" to the "eastern" camp can be seen is as part of Russia's Black Sea strategy. It is repeat of a mid 19th-century plan executed under Tzar Nicholas I. The current plan is so far successful. But it collides with the U.S. plans for revive NATO for another Cold War. Thus the current U.S. plan is to use Turkey's economy problems to finally bring Erdogan down.

The larger economic picture:

Outside of his country Erdogan is much disliked. His arrogance and autocratic style do not leave a good impression. But within Turkey he had a very successful career and continues to be supported by a majority of his people. The reason behind this is the long economic boom he created.

In 2002, when Erdogan became prime minister, Turkey was recovering from a recession. Erdogan's predecessor Kemal Derviş had implemented some significant reforms.  Erdogan took credit for the results. He additionally discarded a number of cumbersome regulations and cleaned up the bureaucracy. He invited foreign investment. The program worked well. The economy grew at a fast pace and many Turks were pulled from poverty. A few became rich. The early years of economic success under his rule are remembered well. Inflation was steady at a relatively low rate even while money was freely available and the economy grew. But Erdogan's expansive economic program also made Turkey more vulnerable.

Turkey has a chronic current account deficit. It imports more goods and services than it exports and has to borrow foreign money to pay for the difference. In the early Erdogan years a lot of money flowed into Turkey. But it was invested in unproductive matters. New housing expanded a booming Istanbul. New splendid bridges and airports, lots of shopping malls and more than 10,000 new mosques were build as well as a 1,000 room palace for Erdogan to use. His cronies in the building industry got very rich.

But productive industries that create products to export to other markets are harder to build than mosques. Erdogan never made them a priority.  Thus Turkey's current account deficitsgrew from 1% of its GDP to about 6% of GDP. This was clearly unsustainable.

During the boom the Turkish central bank interests rates came down from earlier heights but were still kept higher than elsewhere. The industries and banks borrowed in Euros or dollars which carried less interests but this also meant that they took on a high currency risk. If the Turkish lira was to fall the loans would have to be paid back in hard currencies from revenue made in a diminishing lira.

Under normal circumstances Turkey's central bank would have engineered one or more mild recession during the 16 year long boom. Some of the accumulated waste and bad loans would have been discarded. Consumption of foreign goods and the current account deficit would have come down. But Erdogan has a curious understanding of economic theory. He believes that high interest rates cause inflation.

Every time the Turkish Central Bank increased its interest rate to keep inflation in check and to stop the lira from falling Erdogan found harsh words against it and threatened its independence. The relatively cheap money kept flowing, the Erdogan boom kept going, but the structural problems became worse.

Since early 2017 inflation in Turkey picked up. It since increased from 8% to now 15%. The currency went down. The value of 1 lira fell from US $0.30 in 2016 to US $0.20 a week ago. During the last few days it crashed another 25% to US $0.15. It now takes 2,000 lira to pay back the principal of a 1,000 lira loan taken out in U.S. dollars in 2016. The Turkish industries and banks have borrowed some $150 billion in foreign currencies. Only those who export most of their products in hard currencies will be able to pay back their loans. The others are practically bankrupt.

The bill for the long boom is coming through. The Turkish lira is crashing. No foreigners want to loan Turkey more money. For taking such a high risk they demand extremely hight interest. Turkey will soon be unable to pay for its imports, especially for the hydrocarbon energy it needs. Unfriendly relations with the United States will make it difficult to take out an IMF emergency loan. It would come with very harsh conditions such as demands to 'reform', i.e. end, the benefits Erdogan has channeled to his followers.

The current escalation:

The escalation of the currency crisis during the last week coincided with the escalation of a minor conflict with the United States.

After the 2016 coup attempt Turkey imprisoned U.S. pastor Andrew Brunson, who had long worked in the country, and charged him with terrorism. Last week a deal was arranged to exchange Brunson for a Turkish person held in Israel on terrorism charges. Turkey had expected more from the deal. It wants to free several people who the U.S. imprisoned for having breached U.S. sanctions on Iran. (They indeed did so by arranging a gold for oil trade with Iran. A trade from which Turkey, and especially Erdogan's immediate family, profited.)

Last week the U.S. side says that Erdogan went back on the exchange deal:

The deal was a carom shot, personally sealed by Trump, to trade a Turkish citizen imprisoned on terrorism charges in Israel for Brunson’s release. But it apparently fell apart on Wednesday, when a Turkish court, rather than sending the pastor home, ordered that he be transferred to house arrest while his trial continues.

Trump and his evangelical vice president Pence went berserk:

Thursday morning, after a rancorous phone call with Erdogan, Trump struck back. The United States “will impose large sanctions” on Turkey, he tweeted. “This innocent man of faith should be released immediately.”

Vice President Pence chimed in, saying in a speech at a religious conference that Turkey must free Brunson now “or be prepared to face the consequences.” Secretary of State Mike Pompeo called his counterpart in Ankara.

Erdogan would not give in. But the markets reacted to the public sanctions threat. The lira began to crash from 4.80 lira per dollar to 5.20 per dollar. On Wednesday a Turkish delegation traveled to Washington to further negotiate the issue but the talks failed. The lira went to 5.50 per dollar. The financial markets became alarmed. The fall out of the conflict threatened to impact European banks.

This morning Erdogan held a speech in which he dismissed fears of a lira crash:

“There are various campaigns being carried out. Don’t heed them,” Erdogan said.

“Don’t forget, if they have their dollars, we have our people, our God. We are working hard. Look at what we were 16 years ago and look at us now,” he said.

Erdogan said he would not "surrender to economic hitmen". The banks which have loaned a lot of money to Turkey might understand that as a threat to default on Turkey's loans.

At noon the lira was falling minute by minute at a 20% per day rate. Erdogan's son in law Berat Albayrak, who was recently made finance minister, held a planned speech on the economy. He was expected to give some numbers on the deficits and to name some concrete steps the government would take to end the lira problem. But he refrained from doing that. He tried to calm the markets by claiming the the Turkish central bank is independent and would act as necessary. No one believes  that the central bank in Turkey can act without Erdogan's approval. Erdogan is a self-declared enemy of high interests and the central bank did not intervene today when it was urgently needed.

In the mid of Albayrack's speech Donald Trump personally intervened via Twitter:

Donald J. Trump @realDonaldTrump - 12:47 utc - 10 Aug 2018
I have just authorized a doubling of Tariffs on Steel and Aluminum with respect to Turkey as their currency, the Turkish Lira, slides rapidly downward against our very strong Dollar! Aluminum will now be 20% and Steel 50%. Our relations with Turkey are not good at this time!

Steel is one of Turkey's biggest exports. The U.S. imports $1 billion worth of Turkish steel per year. The White House later said the these tariffs are tied to security, not to trade.

Meanwhile Erdogan held a phone call with the Russia's President Putin to "discuss the economic ties". He may have asked for an emergency loan.

Meanwhile the lira dropped to 6.80 for a dollar.

Erdogan then gave another speech in which he lambasted the U.S. pressure without naming Trump or mentioning his tweet.

At the end of the day the lira stood at 6.50 to the dollar after 5.50 yesterday. Turkish stocks were down some 2%. Stocks of some Turkish banks and steel producers fell 15%. Spanish, Italian and French banks, which lent tens of billion Euros to Turkish banks, also lost. Bloomberg documented today's tic-toc in a live blog.

Where from here:

Erdogan now has the weekend to discuss the issue with his advisors. If no measures are taken by Monday morning today's crash will gain pace. The lira will fall further. The central bank will have to raise interest raise to 30+% to stop the slide and to attract urgently needed foreign money. The Turkish economy will go into a deep recessions. A number of its banks and companies will go bankrupt. Unemployment will rise.

Erdogan will blame the U.S. and the "interest rate lobby" for the downfall. His followers will believe him. Any hope that Erdogan will go over this is in vain.

But Turkey's problems are structural. The burst of its bubble was long expected. Its foreign account deficit is simply unsustainable. It will have to cut back on imports and boost its exports. It will need large emergency loans.

Yes, the U.S. is using the issue to put pressure on Turkey. But the U.S. is not the root cause of the problem. It only exposes it.

The U.S. pressure is not about Turkey's economy and not even about pastor Brunson. The pressure is, and has been since 2013, to bring Erdogan in line with the U.S. agenda. He will have to stop his good relations with Russia. He will have to stop his purchase of the Russian S-400 air defense system. He may be ordered to stop the Russian pipeline. He must follow the U.S. lead on Syria. As long as he does not do so the U.S. will try everything to bring him down.

The only chance Turkey has to escape from U.S. demands is to further ally with Russia. Putin knows that Erdogan needs him. He will play for time to increase the pressure and then make his own demands. Erdogan will have give up completely on his plans for Syria. All Syrian land Turkey or its proxies hold must be put back under Syrian government control. Only then will the Turkey's trade route to the Gulf states reopen. Only then will Russia (and Iran) help Turkey though its crises.

On Monday Russia's foreign minister Lavrov will visit Turkey.

Will Erdogan accept the Russian demands or will he flip back to the U.S. side and surrender to Trump and the IMF?  Or will he find a different way to escape from his calamity?

Pepe Escobar on currency war

This is pretty much what Paul Craig Roberts said.

What Putin is not Telling Us: The Raid on the Ruble was supposed to be a Checkmate. It’s Not

Pepe Escobar

Global Research,

20 December, 2014

Even facing what under any circumstances is a perfect storm; President Putin delivered an extremely measured performance at his annual press conference and Q&A marathon.

The perfect storm evolves in two fronts; an overt economic war – as in siege by sanctions – and a concerted, covert, shadow attack to the heart of the Russian economy. Washington’s endgame is clear: impoverish and defang the adversary and force him to meekly bow to the ‘Empire of Chaos’s’ whims. And bragging about it all the way to “victory.”

The problem is Moscow happens to have impeccably deciphered the game – even before Putin, at the Valdai Club in October, pinned down the Obama doctrine as “our Western partners” working as practitioners of the “theory of controlled chaos.”

So Putin neatly understood this week’s monster controlled chaos attack. The Empire has massive money power; a great deal of influence over the world’s GDP at $85 trillion, and the banking power behind that. So nothing easier than using that power through the private banking systems that actually controls central banks to create a run on the ruble. Think about the ‘Empire of Chaos’ dreaming of driving the ruble down by 99% or so – thus wrecking the Russian economy. What better way to impose imperial discipline on Russia?

The “Nuclear” Option

Russia sells oil in US dollars to the West. Lukoil, for instance, would have a deposit in US dollars in an American bank for the oil they sell. If Lukoil has to pay wages in rubles in Russia, then they will have to sell the US dollar deposits and buy in Russia a ruble deposit for their bank account. This in effect supports the ruble. The question is whether Lukoil, Rosneft and Gazprom are hoarding US dollars overseas – and holding back. The answer is no. And the same applies to other Russian businesses.

Russia is not “losing their savings”, as Western corporate media gloats. Russia can always require foreign companies to relocate to Russia. Apple, for instance, may open a manufacturing plant in Russia. The recent Russia-China deals include the Chinese building factories in Russia. With a depreciated ruble, Russia is able to force manufacturing that might have been located in the EU to be located in Russia; otherwise these companies lose the market. Putin somewhat admitted that Russia should have been demanding this much earlier. The – positive – process is now inevitable.

And then there’s a “nuclear” option – which Putin didn’t even have to mention. If Russia decides to impose capital controls and/or imposes a “holiday” on repayment of larger debt tranches coming due in early 2015, the European financial system will be bombed – Shock and Awe-style; after all, much of the Russian bank and corporate funding was underwritten in Europe.

Exposure to Russia per se is not the issue; what matters is the linkage to European banks. As an American investment banker told me, Lehman Brothers, for instance, brought down Europe just as much as New York City – based on inter-linkages. And yet Lehman was based in New York. It’s the domino effect that counts.

Were Russia to deploy this “nuclear” financial option, the Western financial system would not be able to absorb a shock of default. And that would demonstrate – once and for all – that Wall Street speculators have built a ‘House of Cards’ so fragile and corrupt that the first real storm turns it to dust.

It’s Just a Shot Away

And what if Russia defaults – creating a holy mess out of the country’s $600 billion debt? This scenario reads as the Masters of the Universe telling Janet Yellen and Mario Draghi to create credits in the banking systems to prevent “undue damage” - as in 2008.

But then Russia decides to cut off natural gas and oil from the West (while keeping the flow to the East). Russian intel may wreak non-stop havoc in pumping stations from the Maghreb to the Middle East. Russia may block all the oil and natural gas pumped in the Central Asian ‘stans’. The result: the greatest financial collapse in history. And the end of the ‘Empire of Chaos’s’ exceptionalist panacea.

Of course this is a doomsday scenario. But don’t provoke the bear, because the bear could pull that off in a flash.

Putin was so cool, calm, collected – and eager to delve into details – at his press conference because he knows Moscow is able to move in total autonomy. This is – of course – an asymmetrical war – against a crumbling, dangerous empire. 

What those intellectual midgets swarming the lame duck Obama administration are thinking? That they can sell American – and world – public opinion the notion Washington (European poodles, actually) will brave nuclear war, in the European theater, in the name of failed state Ukraine?

This is a chess game. The raid on the ruble was supposed to be a checkmate. It’s not. Not when deployed by amateur scrabble players. And don’t forget the Russia-China strategic partnership. The storm may be abating, but the match continues.

The Australian dollar

Good for exports. Aren't countries printing money in an effort to achieve this?

Australia's Dollar Slides to 19-Month Low gasoline demand at lowest since 2001

The Australian dollar tumbled to its lowest level since October 2011 in early Asia trade on Wednesday, extending this month's sharp slide against a broadly-stronger U.S. currency.

CNBC,

28 May, 2013

The latest catalyst for move in the Aussie dollar was stronger U.S. economic data overnight that pushed the greenback higher against all major currencies. Data published on Tuesday showed consumer confidence rose in May to its highest level in more than five years.

Analysts said the Australian dollar bore the brunt of the selling because sentiment has turned against the currency this month and traders were looking to see how far they could push the battered currency.

The Aussie dollar fell as low as $0.9570. It has shed some 8 percent so far this month, putting it on track to become the world's worst performing major currency. In May, the Aussie dollar has even underperformed the battered Japanese yen, which is down almost 6 percent.

"Over the last 24 hours the Australian dollar has been the weakest currency in the world and the sell-off is not just about a stronger U.S. dollar," said Nick Parsons, global co-head of currency strategy at National Australia Bank.

"People are asking themselves how far the Aussie dollar needs to fall to regain a degree of international competiveness and to look cheap again," he added.

The Aussie dollar, one of last year's best performing major currencies, has taken a beating this month amid weakness in commodities, signs of a slowdown in China, Australia's major trading partner and as talk of an early end to the Federal Reserve's asset purchase program lifts the U.S. currency.

"There is no doubt that sentiment towards Aussie remains highly negative, but with the pair so grossly oversold and so close to the 9500 cent level it now looks like a bargain to many reserve diversification officers across the world," said Boris Schlossberg, managing director of currency strategy at BK Asset

Australia

Australia: The 'New' Switzerland?

Zero Hedge,

17 April, 2013

Submitted by Simon Black of Sovereign Man blog,

Switzerland is the place that has traditionally stood above all the rest in its reputation for financial stability.

Why? Because the currency was well-managed, the banking system was sound, and the country had a long tradition of treating capital well.

Over the last few years, however, these advantages have collapsed.

Switzerland has voluntarily surrendered banking privacy, and the many Swiss banks are now hemorrhaging cash.

Even worse, the Swiss government destroyed its reputation for respecting capital when they pegged the Swiss franc to the euro in 2011 to arrest the franc’s rapid rise.

The country’s top central banker at the time, Philipp Hildebrand, claimed that he would buy foreign currencies in ‘unlimited quantities’ to defend the peg.

This is not something a responsible steward of currency should ever say. The currency peg was nothing more than a form of capital controls… and it effectively screwed anyone that had trusted the Swiss system with their savings.

Since then, the market’s need to find a financial safe haven has only become more desperate. One only needs to look at Cyprus to see why.

Yet just a small handful of countries inspire confidence in the marketplace. And the most popular seems to be Australia.

From a macro perspective, Australia is in much better shape than the rest of the bankrupt western hierarchy.

Though the national budget deficit has been rising over the last few years, Australia’s public debt as a percentage of GDP (less than 30%) is a tiny fraction of the US, France, Italy, etc.

Moreover, as the Australian economy is heavily dependent on resource exports, it’s a ‘commodity currency’, much like Canada. But unlike Canada which is wed to the US, Australia’s economy is much more closely tied to Asia’s growing dominance.

Perhaps most importantly, though, Australia is not printing money with wanton abandon like the rest of the world.

In fact, the RBA’s (Australia’s central bank) balance sheet has actually been -decreasing-, dropping from A$131 billion to just A$81 billion in 2012.

This constitutes a 38% decline in central bank assets in five years. By comparison, US Federal Reserve credit has grown 367% over the same period. This is an astonishing difference.

Plus, Australian interest rates here are typically much higher than in the US, Europe, or Canada. Just holding cash in an Australian bank account can yield over 4% in annual interest. It’s sad to say, but this is quite a bit these days…

(Attendees at our Offshore Tactics Workshop were able to open such accounts on the spot with an Australian bank representative; we’ll soon send out information about how you can do this as well…)

Now, there’s really no such thing as a “good” fiat currency. But given such fundamentals, it’s easy to see why Australia is replacing Switzerland as a global safe haven.

I’ve spent the last few days with some banker friends of mine, and they’ve been telling me about the surge of foreign capital coming into Australia from Europe, the US, and China.

But one thing to keep in mind, they reminded me, is that the Australian dollar has a loose correlation with the price of gold. After all, gold is Australia’s third biggest export.

Consequently, we’ll likely see a decline in the Aussie dollar if the gold correction continues to play out. This may prove to be a good entry point for individuals to get their money out of the US dollar.

Is Australia Next in Competitive Currency Debasement?

Global Economic Analysis,

17 April, 2013

Japan, the US, the UK, Switzerland, China, and even the EU with the LTRO (and upcoming hinted at rate cuts) are all in on competitive currency debasement.

The question at hand is "who is next?" How about Australia?

The Sydney Morning Herald reports RBA May Have to Cap Australian Dollar

Ross Garnaut, one of the authors of the float of the Australian dollar 30 years ago, warns that the Reserve Bank might have to consider intervening to push the currency down to minimise the recession he sees coming as the mining boom goes bust.

Professor Garnaut, of the University of Melbourne, says he would rather see the Reserve cushion the economy's looming fall and bring down the overvalued dollar by cutting interest rates to bring them closer to those of other Western countries.

While the International Monetary Fund forecast Australia will stay on its present track, with growth of 3 per cent this year and 3.3 per cent next year, Professor Garnaut warned that mining investment would fall from 8 per cent of gross domestic product back to its long-term average of 2 per cent.

He said the fall in China's use of coal in electricity generation last year was a forerunner of its shift to a new, less resource-intensive phase of growth, which would trigger a plunge in Australian mining investment. ''We can be pretty sure that we'll be [losing] 5 or 6 per cent of GDP from expenditure, and that's one hell of a fall,'' he said.

The bank's assistant governor for financial markets, Guy Debelle, told the Melbourne Institute that the way mining companies have financed the resources boom has contributed to pushing up the dollar's value to a level ''higher than one would expect, given [the] fundamentals''.

Dr Debelle said 75 per cent of the record investment by mining companies since 2003 has been financed from cash flow. As the mining industry is overwhelmingly foreign-owned, the Reserve estimates that 80 per cent of the investment was funded by overseas owners and lenders. He would not estimate how much it had raised the dollar's value, but ranked it with the massive foreign purchases of Australian government bonds as one of the key factors holding up the dollar's value despite the sharp falls in commodity prices and interest rates.

Interview with Ross Garnaut

In case the above interview does not play, simply click on the link at the top.

Mathematical Absurdity

I would like one of these economic illiterates to explain how Australia can cap the Australian dollar when Japan wants to cap the Yen, when Switzerland wants to cap the Swiss Franc, when the ECB wants to cap the euro, when the US wants to cap the US dollar, when China wants to cap the yuan and the UK wants to cap the British pound.

Competitive currency debasement mathematically cannot and will not work. Period.

The only possible outcome is economic distortion, mispricing of capital, and sponsorship of more bubbles. Yet economic fools everywhere sponsor the idea.

Currency wars

Competitive Easing Madness; Japan to Double Monetary Base; Draghi Signals More Easing; Yen Plunges

Global Economic Analysis,

4 April, 2013

Escape Velocity

Central bankers have gone totally mad. The stunning news of toady is a new pledge by Japan to double its monetary base in two years as the Bank of Japan Unveils Aggressive Easing.

 The Bank of Japan will aim to double the monetary base over two years through the aggressive purchase of long-term bonds, in a dramatic shift aimed at ridding Japan of the deflation that has dogged the country for almost two decades.

Haruhiko Kuroda on Thursday announced his arrival as central bank governor with a “new phase of monetary easing”, a move that comes after Prime Minister Shinzo Abe told the bank to target a 2 per cent rate of inflation.

“We can’t escape deflation with the incremental approach that’s been taken until now,” Mr Kuroda said after the announcement. “We need to use every means available.”

“I am confident that all the policies we need to achieve 2 per cent inflation in around two years are now in place,” he said.

Yen Plunges

As one might expect on such a surprise announcement, the Yen had a spectacular plunge.

Draghi Signals More Easing

Bloomberg reports German Yields Fall to 8-Month Low as Draghi Signals More Easing

 German government bonds rose, pushing 10-year yields to the lowest since August, after European Central Bank President Mario Draghi signaled further stimulus is possible should economic conditions deteriorate.

French and Austrian 10-year yields fell to records as Draghi said monetary policy will “remain accommodative for as long as needed” to boost growth. Spanish and Italian bonds pared gains as the ECB president said the central bank won’t immediately implement measures to ease funding strains for smaller companies.

Fed Uncertainty Principle

This is all in accordance with the Fed Uncertainty Principle corollary three.
Corollary Number Three:

Don't expect the Fed [central banks in general] to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Japan is eventually going to achieve "escape velocity" on deflation, and I assure you Japanese citizens will not like the results when it happens.

When the Japanese bond market finally reacts to this inane policy, there is going to be a global currency crisis.

Why Japan will fail

Forget Cyprus, Japan Is The Real Crisis

James Gruber

Forbes,

23 March, 2013

Forget Cyprus. A much bigger story in the coming weeks and months will be in Japan, where one of the greatest economic experiments in the modern era is about to begin. A country where government debt even dwarfs those of Europe’s crisis-ridden nations, Japan will attempt to inflate its way out of a 23-year deflationary spiral.

The overwhelming consensus among the world’s economists is that quantitative easing (QE) has saved the day in the U.S. and that Japan needs to follow suit, on a larger scale. I beg to differ and suggest this policy will almost certainly lead to a hyperinflationary disaster in Japan. If that’s right, it will have serious ramifications for other countries, dragged down by an acceleration of the so-called currency wars. More broadly though, it is likely to destroy the myth pushed by today’s economists that QE is a cure-all for downtrodden economies. It isn’t and Japan will become the template to prove it.

Monster stimulus on the way

The new Bank of Japan (BoJ) Governor, Haruhiko Kuroda, started work on Thursday and his first day on the job disappointed investors. At a press conference, Kuroda pledged to do whatever it takes to defeat deflation and reiterated the government’s target of 2% inflation. But he provided little in the way of specifics and investors promptly bought the yen and sold stocks.

More concrete measurers will almost certainly come by the central bank meeting on April 3-4. There are good odds that they may come even earlier via an emergency meeting of the bank.

It’s widely expected that the BoJ will expand its 101 trillion yen (US$1.06 trillion) asset buying program by more than 10 million yen. Also, it will start buying Japanese government bonds with remaining maturities of up to five years by scrapping the upper limit of three years by the end of April.

The idea behind the strategy is that you create money out of thin air, use that money to buy government bonds off private institutions and others, thereby increasing money supply and possibly inflation. Also, the institutions will start lending the money out, thereby kick-starting spending and the economy. That’s the theory anyhow.

What was fascinating to watch was the verbal sparring between the outgoing and incoming BoJ governors. In Japan, where group consensus rules, this was almost an outright brawl.

Outgoing Governor Masaaki Shirakawa has never been a believer in the inflationist policies of the new government and he didn’t mince his words in his final days in office:

“Even if prices rise 2% and wages do the same, that won’t mean an improvement in people’s living standards … what we want to achieve is an increase in real economic growth…

… Past figures in Japan as well as in Europe and the U.S. show that the link between monetary base and prices has been broken.”

The latter refers to the fact that printed money in the U.S. and Europe hasn’t flowed through to economies as banks have sat on the money rather than lent it out.

And if Shirakawa wasn’t clear with the above, he was with the following:

“If there was one single measure that would have resolved the problem, just like clearing a fog, then we wouldn’t have been in this state for the past 15 years.”

The new BoJ chief, Haruhiko Kuroda, wasted little time trampling on his predecessor’s legacy. Though couched in economic jargon, his statements were clear enough: Shirakawa was part of a failed era of central banking and something new needed to be done:

“It’s very important for the BoJ to make itself responsible for the 2% [inflation] target by a certain period … We should not make excuses that it wasn’t our responsibility if we fail to achieve it.”

And:

“In the long term, the correlation between money supply and inflation is high.”

In other words, if we print enough money, inflation will come. And we’ll do whatever it takes to get the job done.

Is it the right path?

The sparring between the two central bankers isn’t just an arcane discussion. It’s part of a much larger debate about the effectiveness of stimulus policies. And it matters because Japan is the world’s third-largest economy and it’s about to pursue these policies on a grander scale.

What’s amazing is the extent to which those advocating stimulus in the slow-growth developed world now dominate public debate. Consider a recent article by Financial Times columnist Martin Wolf, entitled “The sad record of fiscal austerity”. In it, Wolf takes Europe to task for enforcing spending cuts while their economies were in dismal shape:

“By adopting [outright monetary transactions], the [European Central Bank] could have prevented the panic which drove the [credit] spreads that justified the austerity. It did not do so. Tens of millions of people are suffering unnecessary hardship. It is tragic.”

He goes on to recommend a mix of stimulus, increased public spend and structural reforms to help Europe’s plight. And he finishes with this:

“In the long run, the fiscal deficit must close. In the short run, the UK has the chance to pursue growth. It should take it. So should the US.”

The arguments of Wolf and others of his ilk can be crudely summarised by three facts, which most of them would regard as beyond dispute.

Fact 1: The U.S. recovery proves stimulus works and the recovery will happen faster if there’s more aggressive QE.

Fact 2: Europe remains in the doldrums because it’s pursued spending cuts which have failed to repair economies.

Fact 3: Japan has never tried aggressive stimulus to overcome its long-term deflation problem and it needs to follow in U.S. footsteps immediately.

Given these are “facts” beyond dispute, let me dispute them.

Fact 1: It is far too early to tell whether U.S. stimulus policies have worked. They have propped up the economy in the short-term, but whether that’s sustainable in the long run is open to question. Even in the short-term though, the recovery has been slow and unimpressive. Consider: 2012 GDP growth of 2.2% vs a post World War Two average of 3.2%, a current unemployment rate at 11.3% if you include that have dropped out of the workforce since 2008, real household incomes are still 10% below levels in 2000 and the velocity of money (M2) is the lowest in more than 50 years (indicating printed money hasn’t circulating into the real economy).

Fact 2: Europe hasn’t pursued austerity. Anyone who says it has is lying. But it makes for a nice political argument in favour of stimulus. European total debt has kept climbing, now at 390%, as the private sector hasn’t paid down any debt, while governments have increased their debt portions. No cutbacks here!

And for the curious, unlike QE, there is some historical evidence that austerity can actually work. In my neighbourhood of Asia, the financial crisis of 1997-1998 brought tremendous pain to many Asian countries, but through austerity and sweeping economic reforms, they recovered relatively quickly and in much better shape.

Fact 3: Those that claim that Japan has never pursued aggressive stimulus are talking rubbish. But again, it’s nice propaganda for Keynesian advocates. From 2001-2006, Japan embraced large-scale stimulus, with its monetary base increasing by a mammoth 36% year-on-year at its peak. During the period, the monetary base rose 82% in total. But economic growth was never revived, the currency rose rather than fell and inflation continued to decline. QE in Japan was dropped because it was seen as failing.

So the question must be asked: will the conventional wisdom advocating enormous stimulus be Japan’s saviour or its noose?

Why Japan will fail

The subtitle indicates where I stand on the matter. Given its over-indebtedness, Japan has few good options left. But the policies being pursued by Shinzo Abe will fast-forward a major debt and currency crisis. It’s a matter of when, not if.

Government debt to GDP in Japan is now 245%, far higher than any other country. Total debt to GDP is 500%. Government expenditure to government revenue is a staggering 2000%. Meanwhile interest costs on government debt equal 25% of government revenue.

There’s no way that Japan will ever repay this debt. It has two main options: either go through extraordinary pain by cutting back on government expenditure or print substantial money to inflate some of the debt away.

Japan is choosing the second option, as are most governments around the world. It would rather print money than cut spending and doom the economy to a substantial contraction. The choice to print money though will result in an even more painful and drawn-out outcome.

It’s inevitable that the yen will fall further from here, potentially much further. I’ve previously said that the yen at 200 or 300 on the dollar would not surprise. This could prove optimistic.

It also seems inevitable that Japanese interest rates will rise and bonds will sell off. Yields have to rise to just 2% for interest costs on government debt to take up 80% of government revenue. The jig will be up well before that though.

Those that argue this won’t happen as 91% of Japanese government bonds are held by domestic investors are missing some key points. Foreign ownership of bonds is rising as domestic investors need more money to fund their retirements (Japan’s rapidly ageing population). Foreigners will demand higher yields for the risks that they’re taking on. And even domestic investors aren’t going to sit by earning 0.6% on a 10-year bond as hyperinflation takes hold and the currency tanks.

Currency wars to begin in earnest

Talk of currency wars has been on the backburner for a few months. Expect that talk to heat up and become a reality as Japan ramps up stimulus in the next two weeks.

The likes of South Korea and Taiwan are already suffering from the sharp fall of the yen. They, and many others such as Germany and emerging countries, aren’t going to sit by and watch their exporters get priced out of the market by the Japanese. They’ll retaliate with currency depreciations of their own and the currency wars will be on in earnest. But the question is whether these countries will be able to keep up with a hyper-inflating Japan. I highly doubt it.