ONE of this week's new NBER working papers is a fascinating look at Japanese government debt, by Takeo Hoshi and Takatoshi Ito. I appreciate this paragraph:
Economic research has been accumulating overwhelming evidence against the fiscal sustainability of Japan. Many international financial institutions, credit rating agencies, and private-sector analysts agree over this assessment. Yet, the JGB interest rate has been low and stable. The 10-year JGB rate has been below 2% since 1999, and between 0.8% and 1.5% in the last few years. The rate is much lower than the bond rate of other advanced countries. This is despite the fact that Japan has a higher debt to GDP ratio than the European countries that have suffered from sovereign debt crises in the last two years—Greece, Ireland, Portugal, Spain, and Italy. JGB yield actually fell as the Japanese debt to GDP ratio increased in the 1990s and 2000s as Figure 3 shows. Why has the JGB yield not risen?
Overwhelming economic evidence! And yet the yield refuses to rise. Still, the frustration is understandable. Gross government debt in Japan is north of 230% of GDP, the government continues to borrow about 9% of GDP each year, and yet the yield on 30-year government debt is under 2%. How does this work?
The key to this feat appears to be the fact that the overwhelming majority of Japanese government bonds are held domestically, most of it by commercial banks and insurance companies. Some of this appetite for government bonds, among households especially, may be attributed to the fact that in a deflationary environment even low nominal rates translate into a decent real yield. Yet as Noah Smith indicates here, part of the answer is financial repression; banks are encouraged to hold government bonds to meet capital adequacy requirements, and insurance and pension funds may be herded toward government debt.
The funny thing about this repression is that it hasn't been used to erode away the value of the debt stock. If you have domestic savers locked up in government bonds, then a short burst of moderate inflation can make a signficant impact on the burden of debt. As Carmen Reinhart and Belen Sbrancia explained here, America and Britain used repression and inflation to dispatch much of their postwar debt. But Japan, of course, has not used inflation in this way. Monetary policy has been used to protect and enhance the value of savings held in government bonds rather than erode it. That may be down to political awareness of the desires of an aging population, to some extent. As the NBER paper makes clear, however, it may also be due to the potential for large bank losses if banks' enormous holdings of Japanese government debt start losing value.
So, the dynamic in Japan has been steady growth in government expenditures associated with ballooning pension and health costs but flat revenues, leading to a large deficit and growing debt. That borrowing has so far been absorbed by domestic saving, strongly encouraged by the government and then amplified by deflation. Alternatively, consumption has been suppressed. Tellingly, Japan has run a current account surplus for decades.
As the authors of the paper note, however, this model is doomed (seemingly) to end. Japanese saving rates are rapidly falling as the population ages. The share of the working-age population in Japan is plummeting, and total saving rates are falling as a result and may eventually turn negative. Correspondingly, Japan's current account surplus is shrinking fast. But Japanese government liabilities are only growing. At some point, the stock of government liabilities will grow larger than the stock of total domestic saving, so that even if everything the Japanese saved was used to buy government bonds, the government would have to rely on foreign lenders to cover some of its borrowing. Foreign investors, it is assumed, will demand better rates of return, particularly given the possible risk of eventual default. Rates will rise, and the jig will be up. The authors estimate when this point might be reached under several different scenarios. Even under optimistic assumptions, the end is only a decade away.
When the end comes, Japan's political system will have to figure out how to distribute the losses. It could try to solve its problem through large increases in taxation. Other old economies manage large welfare state costs and high rates of taxation, though those that do it successfully—Sweden is perhaps the best example—aggressively reformed their banking sectors, liberalised their economies, and deployed effective monetary policy. Japan could instead (or additionally) try to rein in growing pension costs and increase inflation, which would effectively transfer resources from old retirees to younger workers and businesses.
Of course, Japan might also opt for and stumble into default. Or, Mr Smith speculates, it could find itself propped up by aggressive buying from a mercantilist People's Bank of China. Or—getting into more outlandish suggestions—it could open itself up to immigration from abroad.
That's assuming, of course, that it doesn't continue to defy gravity. The tricky thing about Japan is that if the end really is inevitable, markets ought to anticipate that and bring it about long before Japan actually hits hard limits on domestic borrowing. And so far, that hasn't happened. Potential triggers for a flip in the equilbrium (downgrades, disasters) have come and gone without having the anticipated effect. But as they say one goes bankrupt very slowly, then all at once.