By standard criteria Japan is in worse fiscal shape than Greece. The Japanese government hasn’t balanced a budget since 1992, and runs one of the highest deficits on earth. The stock of debt is eight times as high as annual tax revenue. Would the bank give you another loan if you owed eight years’ worth of income? The familiar ratio of debt to GDP has risen in 20 years from 80% to 243%, the highest level in the world. How did public finances get so rotten?
The road to ruin
Debt dynamics depend on five things which, properly
arranged, get you GIDDY: growth (g),
inflation (i), debt (D), deficit (d),
and yield (y). A short equation
describes the relationship:
D[t] = D[t-1] * (1 + y - g - i) + d[t]
The formula says that this year’s debt-to-GDP ratio, D[t],
is equal to last year’s, D[t-1], multiplied by the
term (1 + y - g - i), plus this year’s
deficit d[t].
The apparent causes of Japan’s debt explosion, then, are
three. First, despite ground-low interest rates, economic growth plus inflation
were even lower, so the term (y – g – i) was positive for most
of the last two decades. The implicit interest rate has averaged 1.9% since
1993. Real GDP has increased a mere 0.9% a year,
while the GDP deflator (a broad measure of prices) has fallen 1% per year.
Deflation more than erased the gain in real output.
Second, the larger the debt balance, the harder it is to pay
it off, as any credit card holder knows. That’s because debt itself, D,
is multiplied by the term (1 + y – g – i). Even a small
positive difference between the interest rate and nominal growth makes a significant
impact, once debt gets as high as Japan’s.
And third is the primary fiscal deficit, d. If expenses exceed
revenues the government must finance the gap by borrowing, which adds to debt.
Japan has averaged a fiscal gap of 5.4% of GDP over
two decades.
Aging weighs down
public finances
At a deeper level the debt problem has a demographic root:
Japan’s population is aging and shrinking, fast.
Demographics touch on each of the five determinants of debt.
The connection between deficit and age structure is the easiest to see. Aging
widens the pool of pensioners while it shrinks the number of taxpayers. In
Japan Social Security payments have almost tripled since 1990, and now eat up 40%
of tax receipts. Seniors go more to the doctor, too, and Japan provides universal
healthcare.
Then there’s economic growth. The working-age
population gets 1% smaller every year. To achieve, then, even a
modest output growth rate of 2%, output per worker must rise by 2.9% a year. No
advanced economy has sustained that pace of productivity gain in the last 20
years. Most countries, including Japan, have been in the 1% to 2% range since the 1990s.
Deflation is linked to
demographics as well. As former Bank of Japan governor Masaaki Shirakawa says
in a recent speech: “Over the decade of the 2000s, the population
growth rate and inflation correlate positively across 24 advanced
economies. That finding shows a sharp
contrast with the recently waning correlation between money growth and
inflation.” Shirakawa then says that aging is undermining real demand growth,
which falls behind potential output growth, fuelling deflation.
An army of pensioners, I
might add, will probably fight inflation. Life is great when you’re on a fixed
income and prices decline, which is what seniors in Japan have come to expect.
Finally, aging puts
pressure on interest rates. The baby-boom generation is selling its bond
holdings to provide income for retirement. That raises bond yields, adds to the
government’s interest bill, and accelerates the growth of debt.
Where is, then, Japan
headed? To estimate the ratio of debt to GDP in, say, 2020, I roll forward the
formula above and plug in projections for the five drivers of debt over the
next seven years. Under those forecasts the debt ratio rises relatively little,
from 243% to 257% (see the table).
Changing assumptions
produces striking results. In a sunnier world of robust growth and inflation,
deficits half what they’ve been since 2009, and a borrowing cost even lower
than today’s, debt shrinks to 218%. Under less favorable, but more credible, conditions
the debt ratio hits 297%. The odds are that debt will keep rising.
Projections of Japan’s government debt
|
|
Assumptions
|
|
|
Optimistic
|
Baseline
|
Pessimistic
|
|
|
|
|
Debt / GDP in 2020 (%)
|
218
|
257
|
297
|
|
|
|
|
Debt / GDP in 2013 (%)
|
243
|
243
|
243
|
GDP growth in 2013-20 (%)
|
1.5
|
0.9
|
0.5
|
Inflation in 2013-20 (%)
|
2.1
|
1.1
|
0.1
|
Primary deficit in 2013-20
(%)
|
3.4
|
4.4
|
5.4
|
Implicit int. rate 2013-20 (%)
|
0.5
|
1.0
|
1.5
|
|
|
|
|
Source: IMF; author’s calculations.
Interest rates are key
Key to the outlook, and
most uncertain, are interest rates. Yields have stayed low due to steady demand
for bonds from domestic buyers. The Japanese private sector produces large cash
surpluses, which get recycled into Japanese government bonds (JGBs) via the
banks. Commercial banks have been more than happy to invest in sovereign debt,
as loan demand is sluggish. Where else would they find an investment with a
real return of 2.5% and no capital requirements?
Financial repression has
played a role too. The Ministry of Finance has used its clout to force pension
funds and insurance companies to buy public debt. The Japan Post Group, which
includes a massive bank and a major insurance company, is owned by the state, and
thus another reliable buyer.
Thanks to this loyal
domestic demand, the government with the highest debt in the world pays the
lowest borrowing costs.
The private sector, however, cannot absorb public deficits
forever. An aging population means the household saving rate is falling. Soonish
it will turn negative. Corporations still produce excess savings, but not
enough to cover the public financing needs. If firms kept buying JGBs
eventually all of Japan’s private wealth would be held in government bonds.
What would happen then?
A recent paper
by professors Takeo Hoshi and Takatoshi Ito answers this question. They argue that,
once domestic savers are tapped out, Tokyo must borrow abroad. Foreigners are
presumably less willing to accept ultra-low yields, so the interest expense
will surge.
Today the Ministry of Finance spends over half of tax
revenues on interest payments, even though the implicit borrowing rate is below
1%. Just a modest increase to 2%, then, would put interest charges above tax
receipts—what Hyman Minsky called “Ponzi finance.” The markets would deem the
government insolvent, and default would follow. Under every simulation run by
Hoshi and Ito, bankruptcy would come by 2023.
Japan’s policymakers are aware of this possibility, which is
perhaps why they’ve turned to the central bank. After winning the November 2012
election, prime minister Abe appointed a new head of the Bank of Japan (BoJ).
Under governor Kuroda the BoJ announced that it would buy 7.5 trillion yen of
bonds a month, or 70% of all new issuance. These purchases have anchored
yields. With a boundless balance sheet, the central bank can keep financing the
government forever, in theory. In practice, as centuries’ worth of sovereign
debt crises show, monetization of the deficits can lead to hyperinflation.
Mr. Abe is betting he can dodge both default and hyperinflation.
If he can keep funding the deficit with long-term bonds at tiny interest rates;
if moderate inflation keeps chipping away at the pile of debt; and if deficits
decline somehow, despite population aging, the government might contain the
swell of debt. That’s a lot of ifs, and they will take years to work. The
question is: Will markets bear with Japan that long?
Leaders in other aging countries might draw a message of
hope. Japan proves that it’s possible to combine slow growth with persistent
deflation, soaring public debt, and cheap borrowing, all while avoiding
unpopular fiscal decisions, for decades. Most prime ministers, who have a four-year
calendar, will take the gamble.
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