Government Defaults - Why is Japan Not Bankrupt?

In the previous post the fundamentals of government defaults were examined. Given the fundamentals, how is Japan not bankrupt? The debt level is over 2x GDP and there is no end of deficits in sight. Why isn't there a run on the Yen today?* One approach is look at the Japanese situation under the national accounting formula (see twin deficit theory), propensity to pay, and ability to monetize.
1) According to the national accounting formula, Budget deficit = Savings + Trade Deficit - Investment. Japanese savings rates are high, have not shown to decrease significantly despite an aging demographic, and the residents tend to keep their cash within the country. Japanese households not only save, but they save in Yen. There have been signs that high savings have recently begun to slacken.
2) Because of deflationary trends over the last twenty years, the Japanese government has been able to monetize its current debt through the central bank. The central bank has expanded its balance sheet significantly.
3) The Japanese government has been able to monetize its current debt from investors through negative real rates. Simply put, over the last eighteen months Japanese bonds have paid less than the inflation rate. This is similar to having someone pay you for the opportunity to lend you money.
4) The Japanese governments have shown political will to pay. There aren't rumors flying about minority parties saying that they will simply default.

That keeps things limping along. However, according to the fundamentals, Japan has no good options left. Escaping the present problem is not because of a fault of courage or competence, and it is not driven by government corruption. It is not like the movie "Dave," where if those in charge can just put their heads together and put special interests aside they can find the solution and come up with the money. Defining "survival" as "not defaulting, technically or otherwise," the historical survival rate for countries in similar situations is zero. The Japanese miracle would be navigating the next ten years without default. What are some potential options?
- Productivity improvements, which necessitates upending many aspects of the social and labor structure. This was supposed to be the "third arrow" of Abenomics (reforms named after the Prime Minister) but it is politically difficult and has yet to make its appearance. Mark as doubtful.
- Population growth, which necessitates either having more children or importing immigrants preferably at least a medium skilled or high potential. Incentivizing people to have more children is very difficult, and concerning immigration, those that are more familiar with the political conditions in Japan tell me this is a complete non-starter. Mark as doubtful.
- Narrow or zero out the current deficits, then thread the needle between nominal interest rates, inflation, and GDP growth. This is theoretically possible, especially because of the prefecture system. It is similar to the United States in that the federal government runs deficits and transfers money to smaller government sub-entities. The Japanese national government can dramatically lower the transfers to prefectures and run at least primary surpluses (revenue minus spending excluding interesting payments). Mark as possible.
- Monetize - Central bank threads the needle between hyperinflation and hitting the print key and gobbling up the debt. This is already occurring, as the central bank's balance sheet has nearly doubled over the last two years, but it will prove ever more difficult to implement.
- Asset/liability balancing - The Japanese government has a huge relative amount of assets on its balance sheet compared to other countries. If these assets are only tapped at critical junctures to navigate this process, it might be just enough lifeline to pull through.

It is a very difficult situation, and I would put even odds on a technical default in some form in the next ten years.

*For the sake of both simplicity and the fact that there are others leagues more knowledgeable than I, I won't delve into the complex banking/government financing structure and its corresponding risks

Government Defaults - Why is Venezuela Bankrupt?

Japan's debt to GDP is over 200%, while Venezuela's is around 50%. Why is it that Venezuela is in the middle of a cash crisis but Japan is not yet? A few facts on the Venezuelan economy:

- Accuracy: Exact numbers on debt, GDP, and inflation do not have high confidence. Negative impact.

- Debt to GDP: Estimates of debt to GDP put it around 50%-65%. This can be positive (low) or negative (high) depending on the other factors.

- Propensity: The government has defaulted five times in the last twenty-five years. Negative impact.

- Collateral: Overseas seizable assets. Positive impact.

- Budget deficit: Venezuela's budget deficit zeroes out only when oil is above $117.

- National Account Theory: Budget Deficit = Savings + Trade Deficit - Investment. Savings are low in a high inflation environment. Investments have been historically low as well. In order to run a trade deficit, a capital inflow is needed.

- Oil: Oil has accounted for 96% of its export revenue, and the price of oil has dropped by nearly half over the last year. Negative impact.

- Cutting spending: There are a few options, many of which have historically led to coups and unrest. Negative impact.

On net, this is why Venezuela's government is in dire straits. There are some holding out, believing that the upside is there, but the consensus is heavily in the default camp barring a dramatic increase in oil prices in the near-term.

Understanding Government Defaults

With the recent fall in oil prices, the analysis and rumors have been flying about the government default by oil revenue-dependent nations. Also, there has been a resurgence of prediction of the imminent demise of the Japanese government's finances by its mind-boggling debt ball. Now is an opportune time to review the fundamentals of government defaults, and why they are not nearly as simple as many believe.

Assuming that a nation's government will continue to exist and will attempt to make interest payments on debt in good faith, there are fundamental economic and demographic variables to predicting a government default. Below are six of the primary fundamentals that analysts utilize to evaluate the near to medium-term viability of government debt. While others exist, the below six hit the primary categories.

Current load - The ratio of the government's debt to GDP. This is similar to the proxy for the gross debt to revenue used to analyze the default risk of companies. At a certain point, it does not matter how good the product or service is, there is simply too much debt to service and stay solvent.

Current trajectory - The current and near-term forecast of deficit spending.

Cut/Tax your way out I: Ratio of government spending to GDP. In theory, the higher the level of government spending, the easier it would be to find non-critical services to cut. In reality, many countries with high level of spending would have civil unrest even with minor cuts. However, the theoretical basis remains, and to a certain degree it is practical. Conversely, if spending to GDP is low, there should be ways to close some of the gap with types of taxation that do not result in massive deadweight social losses that strangle the private sector (e.g., Laffer curve).

Cut/Tax your way out II: Deficit / Spending. If a government is relatively close on a percentage basis to its total spend, it is more likely that a mixture of tax and spend policies can close the gap. Closing the gap on a 40% spend with a 25% tax base is going to prove politically difficult to impossible. However, closing 60% spend with a 45% tax base is extremely difficult, yet plausible.

Populate your way out - At a basic level, it is more credible for 100 people to pay off a given debt than 50. Debt risk is evaluated on streams of future payments. If there are few people to produce those future payments, the risk rises. Also, even if per capita GDP is constant, it is politically easier to freeze government spending and grow population than to cut spending on a falling population.

Market confidence - 10 Year Bond Yields. This is a bit of circular reasoning, but if others believe that the bonds are sound, then the bonds are sound and the debt will roll over. If others do not believe that the bonds are sound, then it will be difficult to roll the debts over. If it's difficult to roll the debts over, interest rates will go up. If interest rates go up, more debt will need to be borrowed.

With this framework in mind, examine the table below, which includes a few countries that have a high level of "chatter" on their debt levels.

Type	Variable	Japan	Greece	Italy	Spain	US
Load	Gov Debt to GDP, 2013	227%	175%	133%	92.1%	102%
Trajectory	Federal Deficit, % GDP, 2013	-7.6%	-12%	-3%	-6.8%	-2.8%
Cut/Tax I	Total Gov Spend / GDP, 2013	42%	52%	50%	45%	42%
Cut/Tax II	Fed Deficit / Spend	-53%	-26%	-6%	-18%	-19%
Grow	GDP Annual Growth, 2014	-1.9%	1.9%	-0.5%	1.6%	2.4%
Populate	Population 5 year CAGR	-0.1%	-0.2%	0.4%	0.2%	0.7%
Market	Bond 10Y, Dec 2014	0.4%	7.3%	2.0%	1.8%	2.3%

(Source: tradingeconomics.com)

While the framework does give an idea of the medium-term fiscal health of the entity, its primary use is to act as a launching board to ask additional questions. How is Japan not in default with a debt to GDP of 230%? Why does Italy pay a lower yield than the US? This second level of analysis then takes us into the near-term variables with more qualitative aspects, namely, current access to capital, currency effects, and perception of the propensity to pay. The next two posts will examine the narrative around two extreme cases that seem to defy the fundamentals, but for much different reasons -- Japan and Venezuela.

Body Snatchers

Continuing on the Management Frameworks post, I'd like to think that I have a good eye for evaluating employee potential. Of course, in interview situations I side with Google in that I, like most managers, haven't much of a clue how the employee could turn out. However, in the day-to-day grind in a collaborative work environment, I am pretty good at looking past what most consider glaring flaws and evaluating characteristics that drive value. A principal reason for this is that I've been considered at various points in my careers as someone with glaring flaws. For example, two complaints I have received in the past are that I talk too fast and do not possess enough gravitas, Nevertheless, I was able to demonstrate this to others as a strength as I deconstructed a potential decision into the assumptions underpinning the framework. I could then not only make recommendations based on data and assumptions, but also point out critical weaknesses where the decision could come crashing down if certain events did not go as planned. The management decision could be made (make vs. buy, acquire vs. divest, expand vs. contract) together with parallel decisions to contain the risks of taking that action. I am now better at talking slower, assuming the listener is less familiar with the issue than I am, and even, perhaps, letting my dulcet baritone voice lend to my gravitas. Over time I gained a reputation for structured decision making and providing a clear framework for my direct reports. Perhaps because I have gone through an experience like this, I've learned to ignore a little better my natural biases (e.g., He's tall, dark, and handsome; he must be leader!) and look for underlying traits that drive value creation. I have my mental checklist to check off as I'm working with colleagues: understands quickly and asks questions when they do not understand, takes a holistic approach on the impact to the company, does not "write off" colleagues and does not take criticisms as a personal affront, etc.

About two years ago I stole a "low value" employee from another team with little protest. He was performing glorified data entry/adjustments for account reconciliations. He was very young (23) and a bit rough around the edges in some areas, but he definitely possessed nearly all of the primary characteristics of a dream candidate. I would certainly score him as higher potential in the critical attributes than I was at his age. A year later he was considered one of the highest potential employees. Two years later he was rotating through teams, mostly independently of my work, and doing the same restructuring and optimization that I had done for the last two years. He was slated to move into a mid-management position in 2015, with a target of senior management within four years. Then the other shoe drops. A competitor swoops in, based on the recommendation of a former employee who was let go and jumped to the competitor, and makes an offer for a very solid mid-management position at a great salary. He isn't quite ready for the position, but I know that after some missteps and learning, six months from now he will be doing fine. The position accelerates his career and will probably be more entertaining than his current path. All I could say to him was good luck. This was the first time that one of the high value employees that I have grabbed and groomed has jumped ship.

Some would make the argument, "what's the point of developing them if they are only going to head to another company?" I would answer that I had 15 months of stellar performance from an employee, and if I can't develop other employees to perform similarly I am not much of a manager or leader.

Mixed Messages in Housing Policy

In the school of hard knocks, you graduate either through class participation or observation. However, some never seem to graduate.

In 2009 there was a rare moment of consensus between Main Street, Wall Street, K Street, and every street in between: over-leveraged individuals, companies, commercial banks, and investment banks create an unstable system, even if you really really think this time is different and this nifty model says so right here. On the mortgage side of the equation, the Boston Fed released a landmark study:

"The empirical evidence on the role of negative equity in causing foreclosures is overwhelming and incontrovertible. Household-level studies show that the foreclosure hazard for homeowners with positive equity is extremely small but rises rapidly as equity approaches and falls below zero. This estimated relationship holds both over time and across localities, as well as within localities and time-periods, suggesting that it cannot result from the effect of foreclosures on local-level house prices." (emphasis mine)

Two years later, mainstream opinion writers like Felix Salmon (among many others) were still pointing out that, "If you take one group of loans with a 20-25% down payment, and a second group of loans with a 15-20% downpayment, then the second group, on these numbers will have a delinquency rate 56% higher than the first."

But five years later... well, a lot can change in five years. And, if it cannot change, at least it can be forgotten. This past week the director of the Federal Housing Finance Agency (the US agency that regulates Fannie Mae and Freddie Mac) announced:
"As I said earlier, there are creditworthy borrowers in today’s market who have the income to afford monthly mortgage payments but do not have the money to make a large down payment and pay closing costs. Purchase guidelines that allow for 3 percent down payments will provide an opportunity for access to credit for some of these borrowers."

Yes, the majority are creditworthy borrowers, but a large interconnected and securitized financial system cannot be sustained if 20% of the borrowers default during the next downturn. Let us hope that this time truly is different.

Macro Instability - The Ring of Fire

One benefit of aging demographics is that it decreases the percentage of the most volatile demographic of society, 18-30 year old males. Generally, a key ingredient in a country's internal instability is young men that have too much time on their hands. (There is far more controversy over this statement than you might think in terms of which ways the causation go, but here is one place to start if you're interested.) Youth unemployment is a step to understanding instability, which is why this interactive graphic from ILO is intriguing:

To aid the visual, the colors could have been toned down to a maximum of 40%. Upon closer examination, both visually and in the underlying data, there is a clear hot spot. It's what one could call "the ring of fire." Average youth unemployment for the region is over 25%.

Whether it's called Arab Spring, Mediterranean discontent, separatism, or Southern European unrest, this is a factor that a lot of on the ground managers have in the back of their minds, but is rarely explicitly stated. Greater unrest translates into lower tolerance for capital commitments. If "stuff can go south," there's a natural inclination to hedge, and those who commit the most into these situations are either very savvy on local conditions or subject to a series of winner's curses. Whether it's the world of leveraged buyouts or multinational expansions, one should take a good look at local players before making the leap.

Dealing with Certainty

I don't struggle dealing with uncertainty. I can gauge assumptions and risks quite well. Despite this, I also have no problems with a "ready, fire, aim!" mentality when urgency is required. If the train is pulling away from the station and the debate is jump or not, now is the time to make the decision. We move forward confidently knowing that we are acting with the best available information.

However, I do struggle with those that cannot deal with uncertainty, or rather, those that are 100% confident all of the time. Those few moments in which they do change their minds, they flip to 100% certainty the other way and say, "I was so dumb before, because I didn't know everything I know now." These are the "passionate" that show no difference in knowing 10% of the relevant information and 100% of the relevant information. In my experience, this is far more common in large corporations than small companies. One gets found out too quick in the small company.

When collaborating with this type, I've tried an array of strategies, but the vast majority of the time it bounces off like frozen marshmallows on a tank. Eventually I end up simply discounting their opinions and information, but that's not a long-term play at building a coherent team. I don't plan on giving up, and, like many things, the best approach, in most situations, is "one of these twenty approaches might work, because everyone is different." What is under my control is developing the toolkit to handle the situation. Here are a few approaches I've used with varying success:
- Unassuming simple questions: "What are some of the potential outcomes for this decision?"
- Redirect: "I see what you're saying, but there are also a lot of different ways to attack this problem. Let's brainstorm a few different ways we can go at this."
- Backup request: "Send me over the data you have after this meeting so I can combine it with what's already been submitted and distribute. We can finalize the decision on Wednesday."
- Direct feedback: "Good input. Thank you. We still need to make sure we cover all of our bases and have a sure footing if this is the direction we take. How can we further develop these specific points?"
- Buddying up: "What do we have so that we can convince others and defend this decision?"

In my personal experience, the most successful long-term executives are those who maintain a positive attitude and outlook with others, regardless of position and they have a solid understanding of the assumptions that they are making in the thousands of business decisions that they make throughout the year. However, when they were not in a position of direct power, I've seen executives with a solid history of success hit a brick wall attempting to collaborate with the "certain." Those that have succeeded demonstrated Herculean patience, which I know is an attribute that, because of necessity, I have worked to develop further.