Tuesday, September 22, 2009

The Mystery of Japan's Private Debt Levels (Solved?)

For the last couple years there has been a lot of discussion of how the macroeconomic situation in the US compares to past historical episodes. Unfortunately the discussion of debt levels has relied mostly on anecdotal data, other than the one well covered comparison of the US today with the US at the time of the Great Depression (see for example Steve Keen's charts here). I'm among those who view post-1990 Japan as a highly relevant additional example. A few months ago I finally found what I hope is reliable debt data for Japan. I'll present charts of the data first but please read the sourcing methodology further down as it's possible this method of measuring of Japanese debt may not be an apples-to-apples comparison with the US Federal Reserve's debt data (please give feedback if you have it, and I will update the post).

Japan's Private Sector Debt From 1980 to 2007

(click on chart for a larger version in a new window)

The above chart shows the total debt in yen for Japan's household, corporate, financial, and government sectors from 1980 to 2007 (the latest available). Private sector debt actually kept rising (much more slowly) after 1990, peaking around 1997! Government debt also rose significantly during this time period. This large expansion of total debt likely contributed to the continued growth in GDP until 1997, seen here:

(click on chart for a larger version in a new window)

The next chart shows the debt-to-GDP ratios since 1980 — i.e., factoring in the impact of economic growth (as measured by GDP) reducing the debt burden relative to incomes. By this measure, total private debt-to-GDP did peak around 1990 when stock and real estate bubbles were bursting.

(click on chart for a larger version in a new window)

This suggests that in the context of a booming global export market and by continuing to increase its debt, Japan was able to keep growing for years after its asset bubbles burst. Interestingly the 1997-1998 time-frame is also when Japan's consumer price levels peaked (see chart here). Confirming anecdotal experience, the corporate sector was highly leveraged (much more so than the household sector), and did work on reducing debt but most notably so after 1997.

But the most striking insight this data yields is that Japan's economy from 1990 until 2005 did not deleverage on aggregate, due to the government increasing debt faster than the private sector was reducing debt, and that the private sector has only reduced debt from 386% of GDP (1990) to 328% of GDP (2007)! This government borrowing most likely explains why Japan did not experience a depression (and is somewhat consistent with the views of Richard Koo, who I have discussed before). But it reinforces the question of what the end-game is for Japan and whether it will ever be able to grow out of or pay down its massive total debt.

Note that I have seen and used in the past a couple other charts of Japan's debt-to-GDP ratios that disagreed with each other and with this data, for example this one: [UPDATE Jan 18 2010: I now believe the below chart is WRONG, see the end of this post]

I played with the Japanese Cabinet Office data I obtained for this post by excluding loan-based debt, excluding non-loan debt, excluding financial sector debt, etc and no matter what combination I tried I was unable to generate a chart that looked like this one. So one of the charts is probably wrong and it could be mine.

This article by Andy Xie, What We Can Learn as Japan's Economy Sinks, is very worthwhile reading on Japan's crisis and more (though there are a few things I'm not sure I agree with). The debt levels he cites for Japan differ a bit from what I derived, for example, he says "total indebtedness of Japan's non-financial sector is 443 percent -- probably the highest in the world, and far higher than the 240 percent in the United States."

Comparison with the US debt-to-GDP ratios around 2007

The following chart shows the rise in US debt-to-GDP levels by sector that many people have seen before:

(click on chart for a larger version in a new window)

It is color coded to match the colors of the Japanese debt chart's sectors for easier comparison. In the US, households carry substantially higher debt than they did in Japan. Here is a comparison of the debt-to-GDP ratios by sector at the start of each crisis (Japan around 1990, the US around 2007, plus also the US around 1929 at the onset of the Great Depression):

(click on chart for a larger version in a new window)

Household debt was much higher in the US in 2007 than past episodes, but Japan had much higher corporate debt and somewhat higher financial sector debt. Government debt was fairly comparable. The chart's debt-to-GDP numbers are in this table.

US 2007US 1929Japan 1990
Private Sector Total288%157%386%

Total Excluding Financials240%163%278%

In one respect this is a mildly optimistic outcome in relative terms — contrary to past claims (by me included), Japan's debt crisis is not dwarfed by the current US debt crisis. Depending on the US's political willingness to provide ongoing fiscal stimulus as Japan did, my opinion is this makes the Japanese style stagnation and mild deflation relatively more likely in the US, as opposed to a deep depression — though employment and GDP have already fallen more than they ever did in Japan (at least until this global crisis hit). Of course, total debt-to-GDP is not the only macroeconomic determinant that matters, so other factors could drive the US today to a different outcome.
  • Substantially higher household debt, especially with non-recourse mortgages standard in the US, could be a much more negative factor relative to Japan. There are far more distressed household balance sheets than corporate ones given the relative number of entities in each sector, so this could increase the system's susceptibility to full-blown debt deflation, especially given that households have less incentive to "extend and pretend" by faking solvency through relaxed accounting rules than corporations do.
  • The global context today is that most nations in the world have been involved in this crisis, many of them with high debt levels of their own. This probably explains in part why the current crisis has been deeper than Japan's post-1990, but the question remains whether this crisis is winding down or whether deflation will intensify and cause even deeper economic pain in the years ahead. With deleveraging barely having begun, there is strong reason to believe that we have years of adjustment still ahead.
  • Other differences in financial markets today such as the huge global derivatives market and associated counterparty risks could be relevant.
Many people summarize the options for removing excessive debt as inflate or default. While the long term result is uncertain, Japan has been carving a third option for nearly the last two decades — reduce nominal interest rates to very low levels to reduce the debt servicing burden while leaving the debt in place in an attempt to grow out of it, even if doing so is accompanied by economic stagnation. Note that this approach does not seem to cure insolvency, except perhaps through the long and slow process of using earnings for balance sheet repair. No doubt demographics are different in Japan compared to other countries and this has some impact, but the US and Europe are also increasingly facing aging populations.

Methodology for Obtaining Japan's Debt Data

I derived the data from selected balance sheet liabilities within the aggregate national accounts stock data provided by the "Economic and Social Research Institute (ESRI), Cabinet Office, Government of Japan." See "Part 2 Stock" under the heading "Accounts classified by Institutional Sectors". The super-set of liabilities listed across households, non-financial corporations, financial corporations, and general government are (the bolded ones are what I used):
  • Currency and deposits
  • Loans
  • Securities other than shares
  • Shares and other equities
  • --> Of which shares
  • Financial derivatives
  • Insurance and pension reserves
  • Other liabilities
Loans are clearly one kind of debt. It seems likely that securities other than shares are a good proxy for all other debt (e.g., bonds). Is this incorrect? This OECD definition of "securities other than shares" is:
"Securities other than shares consist of bills, bonds, certificates of deposit, commercial paper, debentures, and similar instruments normally traded in the financial markets."
The Federal Reserve Flow of Funds guide defines debt as follows:
"Credit market borrowing or lending is defined here as the transfer of funds through certain financial instruments: open market paper, Treasury and agency securities, municipal securities, corporate and foreign bonds, bank loans not elsewhere classified, other loans and advances (such as loans made under various federal programs), mortgages, and consumer credit. Excluded from the definition are a number of other items that are also sources and uses of funds for the sectors — official reserves, special drawing rights certificates, Treasury currency, deposits and interbank items, security repurchase agreements, corporate equities, mutual fund and money market mutual fund shares, trade credit, security credit, life insurance and pension fund reserves, business taxes payable, investment in bank personal trusts, proprietors’ equity in noncorporate business, and miscellaneous items; a sector’s credit market borrowing is thus not the same as the increase in its total liabilities."
It seems quite possible, especially for the financial sector, that the "securities other than shares" contain types of debt that are excluded from the US debt measures (for example, perhaps certificates of deposit). PLEASE TELL ME IF YOU KNOW WHETHER THESE MEASURES ARE COMPARABLE.

I did compare this data to a few individual data points I was able to find on Japan's sector-specific debt levels around 1990, and this data appears to be in line with those data points. The main unconfirmed data is Japan's financial sector for which I have found no other data points to compare.

Another Pre-Crisis Comparison: Sweden

The Swedish government's response to their early 1990s crisis has often been held up as a model for what the US should do, so it would be valuable to have an idea of the relative size of their crisis as well. As I summarized in an earlier post, the data points I've found for Sweden around 1990 so far are:
  • 170% total debt-to-GDP
  • 127% private sector debt-to-GDP (source)
  • 43% government debt-to-GDP (source)
It's not clear whether the private sector measure includes the financial sector, but if it does, Sweden's debt levels were much smaller than Japan's in 1990 or the US in 2007. However, they were more comparable to the US at the start of the Great Depression. Yet like Japan, Sweden was able to grow exports to a booming global economy in the 1990s. So while the absolute debt-to-GDP measure is central, I don't believe it is the only important macroeconomic determinant.

UPDATE 10/14/2009: I added a foreign debt row to the table of debt-to-GDP numbers (a commenter pointed out the numbers do not sum otherwise, so I probably shouldn't have skipped it in the first place).

UPDATE 10/14/2009: After originally posting, I did seek input on the derivation of this Japan debt data from a highly financially-savvy blogger, and he replied that "yes" it was comparable to the US data (though I can't guarantee he looked at it in detail).

UPDATE 1/18/2010: McKinsey has released a study on deleveraging that seems to validate my findings here. The only difference is that their numbers for Japan's financial sector are consistently around 50% of GDP less than what I found (perhaps reflecting exclusion of some specific bank liability such as certificates of deposit?). But the overall shape of the trends do match, most notably that public debt expansion has exceeded private debt reduction. Here is one of their charts:


  1. Again, what does a mild deflation (I do not expect depression) do for equities? Nominal profits would drop in a sustained slow deflation, but the cash flow from these equities would be more valuable too. Thus, I do not know the net effect of a drop in nominal profits combined with deflation. A low nominal risk free interest rate, which is a characteristic of the Japanese deflation, also helps equities by reducing the discounting on the cash flow too.

    If deflation is mild and slow, there woudldn't be massive corporate defaults, and a lower risk premium can be assigned to the various parts in the capital structure. However, since cash flow that might be used for dividends would be directed towards debt service, this would lower the value of the cash flow to investors. The worsing macroeconomic environment, however, might be beneficial for an individual's firms prospects since debt deflation might eliminate some competitors, and give the survivors more pricing power. This might result in lower risk premiums.

    Unless I have good sentiment indicators (such as accurate surveys, and short interest data), I wouldn't touch equities. Equities are only good short term speculative instruments, and again, the dividend yield needs to be more than the 10 year treasury if one would buy and hold. Of course, any other conditions is simply a bet on increasing multiples.

  2. Regarding the mild deflation thesis... it is probably the "best" outcome. I do not buy a Prechter like collapse, although I could imagine the S&P 500 below 500. Do you think globalization (which increased the supply of global labor and labor competition) would make the debt harder to service since the prospect of wage increases are out? It seems like demographics and globalization might be an argument against the mildly optimistic deflation scenario.

  3. Good questions... I can only speculate on answers. My take is Japan is our best model for mild deflation, and the GD for severe deflation... and equities have suffered longer than most expected in both cases. I wish I had earnings and dividend data for Japan, but as you can see from my posts on historical market comparisons and historical price level comparisons, earnings fell by more than 75% during the Great Depression despite the price level falling by "only" a little under 30%. My guess is two primary reasons could be (1) prices falling faster than wages, squeezing profits disproportionately, and (2) deflation increasing the burden of debt AND driving insolvency (with high leverage, it doesn't take much asset deflation to do this, hence Japan's zombie corporations also!)

    On demographics and globalization... I think demographics are an under-appreciated bearish factor for future growth in many modern economies, and globalization has already been a deflationary force (offsetting huge domestic price inflation) for a decade or two... it could become more so, but maybe rising protectionism will restrain global deflationary forces. Of course Smoot-Hawley was in 1930 and that didn't stop a near 30% US price decline then.

  4. Amazing post. I have been trying to find Japan debt levels and how they broke down between private and public. On the comparison pre debt level crises chart for the U.S. 2007 debt you have total debt of 355%. However, that does not balance. Private total debt is listed as 288% and government total debt is 52%. That would equal 340%. Any idea where the discrepency lies?

  5. Anon,

    I had skipped the small "foreign" debt data from the Z1 report for simplicity. However, thanks for pointing out that this is confusing in that they don't add up — I just updated the post to include it.

  6. Deflation - key thing to understand about deflation is that it requires constantly falling wages. Not going to happen everywhere.

  7. As the private sector deleveraged in Japan, the government was able to pick up the slack with borrow and spend. Perhaps they could afford to do that because back in the early 90s their "starting point" debt to GDP was modest by current standards. To what extent do you feel that the US government (starting as it is from a 65% debt to GDP level) now has the same degree of freedom as Japan's government had in the 90s? My own sense is that they don't and that the degree of deleveraging yet to transpire in US banks and households (which would seem to be far larger than in Japan circa 1991) only compounds the problem.

  8. Hi Rob P,

    You didn't say on what basis you think the US government doesn't have the degree of freedom to offset private sector deleveraging that Japan's did... I happen to think that the US government does have just as much freedom to run deficits as Japan's did (see my more recent posts referencing Modern Monetary Theory)... or at least from an economic perspective it does -- the political comparison I'm less sure of.

    Also note in the table above how similar the starting debt to GDP of each government was (52% vs 62%), though since writing this post I've come to realize that the government debt-to-GDP number itself isn't nearly as significant as is commonly thought.

    And as you say, the US private sector does have significant private sector deleveraging to go, and there are additional reasons for concern, however Japan's private sector was quite leveraged also (just more concentrated on the corporate side).

  9. Five reasons concern me regarding the US government's realistic ability to offset private sector deleveraging. 1) The US is much more dependent on foreign capital to fund deficits than was Japan; 2) As the US dollar is the world's major reserve currency, I imagine greater sensitivity of foregeign central banks to a further rapid escalation of US pulic debt; 3) If unfunded liabilites are included, the US may already be closer to a total public debt ceiling than was Japan in the 90s; 4) given the abnormally low starting level of the US savings rate (relative to Japan), any normalization of this rate combined with private sector deleveraging would seem to compound and amplify the government leveraging required to fill the void; 5) Lastly, isn't there also the question of the quality of the demand that is being cultivated or maintained by public leverage: Japan has an export oriented economy with consistent trade surpluses, the US is two thirds consumption! It's one thing surely for Japan to add public sector leverage to promote an industrial export economy. It's quite another to add public debt to essentially promote consumption and then ask foreign governments to finance it. When your central role in the world is that of consumer, doesn't it call into question the ability to finance that with debt? It has long mystified me that China and Japan continue to turn up at US treasury auctions. The argument always suggests some sort of weird sybiosis: recirculating dollars so that the US can continue to consume and buy foreign goods. At some point I think that jig is up and at least China may then focus more on the cultivation of its domestic demand. If that happens, incremental US public leveraging will be monetization.

  10. Rob P,

    Here's my brief response to each of your concerns:

    1) & 2) The ability and willingness of foreigners to buy treasuries doesn't worry me much. For example China accumulates dollars as a result of both the trade surplus with the US and the currency peg. They can choose to buy other currencies (but that would disrupt the peg) or buy dollar-denominated assets, with treasuries being the natural choice. If the trade deficit decreases then that just means more Americans are holding the dollars instead of the Chinese, and can similarly buy treasuries. The dollars in circulation matter more than the nationality of whoever holds them. Look up Michael Pettis and Bill Mitchell -- both have covered this from different angles.

    3) The debt ceiling is a political construct not an economic limit. If unfunded liabilities turn out to be too high and the obligations are not reduced, the most likely outcome would be higher future inflation (way in the future as these obligations become current) as spending exceeded capacity. This says nothing about the economic ability of the government to deficit spend now. Search for 'intergenerational' on Bill Mitchell's blog, for example.

    4) I agree (and have stated in posts) that our low starting household savings rate is a more negative factor as compared to Japan. I think the real test will come if households tried to raise their savings rate quickly, and this has not really occurred so far. If it does, the test may be more political than economic.

    5) To the extent that the "quality of demand" reflects a value judgment, I'm not sure that has any bearing on economic feasibility (but perhaps it does on political feasibility). And US exports HAVE been increasing... Moreover government deficits don't just support consumption spending, they can also support government spending and investment spending.

    I don't think we're out of the woods yet at all and debt deflation remains a significant risk, but I do think the government has a lot of control over this outcome if it understands the situation (which won't necessarily be the case!)

  11. A useful post, sir!

    Following your method I have updated the numbers, which now run from 1980 to 2009. The spreadsheet is accessible via Google Docs; see my notes at the foot of this post.

    hbl, note that your link to "the aggregate national accounts stock data" now turns up an error page from the Cabinet Office. Fortunately(!) the error page provides a link to their home page, and I was able to track down the data.


  12. This is an excellent post. I wanted to find data on Japan and this link popped up on Google. As for the US, I think it's starting to look much better in terms of the private debt issue. Financial debt is down to 89% of GDP from a peak of 123%. Household debt is down to 84% from a peak of 98%. Non-financial debt is down from 83% to 77%. It seems like the deleveraging is happening at a good rate in the US. It might even be a little bit faster than it was initially simply because the overall debt burden is less now than it was then.