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The most important country to follow to understand where the rest of the world's fiscal, social and market situation may be headed is Japan. It's been more than a year since that country launched its latest and greatest government policies targeted at reinvigorating the economy: Abenomics.
The essential policy tools of Abenomics are massive monetary and fiscal stimulus aimed at forcing the yen lower, which should cause exports to rise and domestic production to increase, leading to increased domestic job production and consumption: the virtuous cycle. In the process, Japan also increased sovereign debt, which must be serviced by the government. The servicing of that debt is supposed to come from an increase in tax receipts to be made available by the increased domestic production and consumption.
But it isn't working.
The failure of Abenomics to stimulate economic activity and raise tax receipts enough to pay for the stimulus is now causing the government to double back on these programs with a counter-cyclical consumer tax increase of about 3%, which will be implemented in April. In other words, Abenomics is making the real economic and fiscal situations in Japan worse, not better. They are digging a bigger sovereign debt hole and accelerating the trajectory toward insolvency.
Nobody will discuss this insolvency trajectory, however. Economists and government officials prefer to use the more opaque and nebulous term "crisis" as they debate how long Japan has before that crisis occurs without saying what that crisis entails. That crisis is sovereign default and insolvency, which is now inevitable. I first addressed this in 2010 in a column that is no longer available in the archives (if you would like a copy, email me email@example.com). I also addressed it a year ago in "Why Japan Is Doomed to Insolvency."
That doesn't mean that you can't trade the Japanese markets profitably, as I wrote in "How to Play the Impending Yen Depreciation" in January 2013, when Abenomics was getting started. The two issues I discussed in that column, Sony (SNE) - Get Report and Panasonic (PCRFY) , went on to more than double over the next 12 months. They've pulled back as speculators and investors have begun to question the ability of Abenomics to be successful, but both are close to twice what they were when I wrote that column.
The broader issue, however, is that many economists are beginning to realize that insolvency for a country issuing its own currency is possible and that Japan either is, or may be, on that terminal path.
At some point soon, it is probable that these same economists, along with global government and private sector financial leaders, will have a "simultaneous collective epiphany" borne out of the empirical evidence of policy failure -- that not only is it possible that a currency-issuing country can become insolvent, but that Japan cannot avoid it. And all policy prescriptions not only won't alleviate the concern in the near term, but will accelerate the trajectory toward insolvency.
The policy and market implications of this realization for all other world governments cannot be overstated. It's like following the smart kids in your geometry class, copying their work, and realizing when they arrive at the wrong conclusion to the proof that your work will eventually result in the same erroneous conclusion.
The question then becomes did the Japanese do something wrong, or is their situation indicative of the trajectory of all of the other large sovereigns with increasing debt levels. I'll address those issues as this process unfolds further. But, for now, the prudent action for speculators in Japanese equities is to sell. Policymakers in Japan will logically have no choice but to force the yen even lower; playing the currency markets that way looks safe.
Investors would be wise to avoid Japan altogether now, and probably permanently.
Editor's Note: This article was originally published at 6:21 p.m. EDT on Real Money on March 20.
At the time of publication, Arnold had no positions in the stocks mentioned.
Roger Arnold is the chief economist for ALM Advisors, a Pasadena, Calif.-based money management firm specializing in income-generating portfolios. Concurrent with his other business responsibilities, Arnold was a radio talk show host for 15 years. He focuses on behavioral economics and chaos theory, better known as the "butterfly effect." He explains the relationships between political, economic and social systems, and how they are all reflected in the financial markets -- stocks, bonds, commodities, currencies and real estate.