Monday, November 03, 2014

Anatomy of a Failing State: Japan's Budgetary Nightmare

Once the global economy rolls over into contraction, the tide will recede and Japan's fiscal and monetary bankruptcy will become painfully apparent.

What do you get after 25 years of stagnation and Keynesian Cargo Cult monetary stimulus? A failing state, that's what. The intellectually bankrupt ruling Elites of Japan have no solution for Japan's slow stagnation, as real reform would diminish their wealth and power.

So their only "solution" is to double-down on monetary stimulus: flood the enfeebled Japanese economy with more credit and fiscal stimulus, a.k.a. building bridges to nowhere: Japan's Monetary Pearl Harbor.

But reality isn't as immobile as failed policies. While Japan's ruling Elites fiddled away the past 25 years propping up sclerotic cartels and phantom loans, Japan's population has aged and its primary sources of wealth creation have atrophied.

We can see these trends in Japan's national budget. Before we dig into the numbers, we need to note that Japan's Ministry of Finance routinely announces an austerity budget for the next fiscal year around 92-95 trillion yen (TY), and then supplemental spending during the fiscal year pushes actual expenditures up to 100 TY.

According to Highlights of the Budget for FY2013/2014, the initial 2013 budget was 92 trillion yen, while the actual 2013 spending came in 10 trillion yen higher, at 102 trillion yen.

According to Japan's government looks to trim budget deficit, the national budget has hovered around 100 trillion yen for years.

So we have to take these 2013 spending estimates as lowball estimates that are 5%-10% below actual spending.

REVENUES: 92.6 trillion yen
Tax revenues: 43.0 TY
Other revenues: 4.0 TY
Government Bond Issues (borrowing): 42.8 TY

National Debt Service (interest & bond redemptions): 22.2 TY
Social Security: 29.1 TY
Other: 41.2 TY

Debt service and Social Security are 120% of tax revenues. In other words, tax revenues don't even cover debt service and Social Security.

An astonishing 46% of the governments budget is borrowed money. Even with near-zero yields on Japanese government bonds (about 1%), 51% of tax revenues in 2013 were spent on national debt service.

The 2014 increase in the national consumption tax rate from 5% to 8% is expected to raise an additional 6 trillion yen of revenue in 2014, but that remains to be confirmed. If history is any guide, increases in national consumption taxes (a.k.a. value-added taxes or VAT) fail to generate the expected windfall of additional revenue, as consumers spend less.

Since Japan's GDP fell an astounding 6.8% after the tax increase took effect in April, it seems likely the revenues will disappoint official expectations.

Even if this new revenue comes in as expected, the amount being borrowed to fund government spending will only drop a modest amount, from 42.8 trillion yen to 41.2 trillion yen. Yee-haw.
Meanwhile, national debt service is expected to rise from 22.2 trillion yen to 23.2 TY.

It's difficult to see the tax increase as a panacea, as borrowing barely declines and debt service costs actually increase.

For context, we need to look at Japan's tax revenues, borrowing and spending over the past decade. Only then can we see why Japan is a failing state: tax revenues are as stagnant as the real economy, while spending rises as Japan's population of retirees soars.

In the decade since 2005, tax revenues actually declined slightly while annual borrowing increased by 8 trillion yen and expenditures rose by 10 TY. Virtually all of this increased spending comes from higher Social Security costs, which rose from 20 TY to 30 TY as the demographics of Japan's aging population inexorably pushes retirement and healthcare costs up.

You see what's happening: tax revenues are unchanged while interest and Social Security costs keep rising. A relatively modest increase in the consumption tax triggered a major meltdown in Japan's gross domestic product, and the planned increases in this tax from 8% to 10% are attracting criticism: Next consumption tax raise painting Abe into a corner.

If it turns out that the tax hike generates little additional revenue, Japan's path to failed-state will be set: a stagnant economy generating stagnant tax revenues, a central state that funds half its spending with new debt, and rapidly rising social welfare and debt service costs that are already consuming all the tax revenue and then some.

Can Japan continue down this path indefinitely? Many believe the answer is "yes," but we cannot base the next 10 years on the previous 25 years. Since Japan's financial bubble popped in 1989, the Internet and China greatly boosted global growth, enabling Japan to live off its well-oiled export and debt machinery.

But the engines of global growth have reached diminishing returns, and a prolonged global recession looms just ahead. Playing games such as devaluing Japan's currency and monetizing Japan's ballooning debts with freshly issued money does nothing to fix the rot beneath the bright neon lights of superficial wealth.

Once the global economy rolls over into contraction, the tide will recede and Japan's fiscal and monetary bankruptcy will become painfully apparent.

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