The Japanese exception

A crisis looms in the Indo-Pacific.

Up until last year, Japan was an asterisk in economic theory. A stock market bust that turned into a prolonged deflationary period placed the island nation into a category of its own when it came to widely accepted relationships in economics. It became the exception to most rules.

Now, Japan faces an exceptional challenge not unique in its nature but in its size.

This blog has gone on a crusade against mounting government debt levels as of late. One post mournfully regretted the state of national finances across rich economies, another one bashed irresponsible policies, whilst two others lamented an inability to engage in structural reform due to this level of debt. This post is an amalgamation of all of these, whilst adding a central banking dimension.

Japan’s national debt amounting to 2.5 times its yearly economic output does not have any modern parallels. You could call it exceptional. Poor demographic fundamentals and spending-oriented fiscal policy have caused the government primary balance to remain in deficit for the last 35 years.

With interest revenues dutifully flowing from the central government to domestic investors in an endless cycle, Japan has created the world’s most inefficient government handout program––specifically targeted at those with surplus funds.

The narrative has traditionally been that Japan’s exceptional position of low and negative inflation (thereby low interest rates) as well as investor confidence have allowed it to sustain debt that would be fatal to other countries. Crucially, about 90% of its debt never leaves its shores. A savings-oriented society that holds its own debt domestically is far less prone to bond vigilantism than international institutional investors.

What’s more, half of the debt is owned by the Bank of Japan, the country’s central bank. The loyal customer with hard-to-match purchasing power has historically driven yields low, giving no incentive for foreign investors to step in. This has created a vicious cycle of sorts: the 2024 budget features almost a quarter of total expenditure going to service ongoing national debt. Deficit-financing bonds are almost as big of a source of revenue than income and corporate taxes combined. With interest revenues dutifully flowing from the central government to domestic investors in an endless cycle, Japan has created the world’s most inefficient government handout program––specifically targeted at those with surplus funds. Talk about getting high off their own supply.

Things are only going to get worse. 30 years of free money has made it a political impossibility to properly address the world’s deepest structural deficit. With elections being weeks away, talks in the upper house revolve around whether tax cuts or subsidies are more appropriate in this point in time. But the real concern comes with inflation. Although a long-awaited return of rising prices lowers the value of debt in nominal terms, it also means a return of positive interest rates.

The BoJ cannot increase interest rates without dealing a lethal blow to already rising bond yields. As shown by the graph above, many bonds are maturing within the next few years, so an increase in interest rates would quickly transmit through to borrowing costs. Looking through the current 3.5% inflation episode, although causing nominal wage growth, risks depreciating the Yen further. For a structural net importer of price inelastic energy, this is a one-way road to imported inflation.

Thus, the BoJ faces a policy dilemma. During post-Covid inflation, many economies faced high inflation after a period of slumped activity. Central banks had, in part, contributed to this through their QE programmes. The BoJ is now experiencing the same problem, only that the slump—–and thereby the period of expansionary policy–––lasted decades instead of a couple of years.

Whilst others were able to mitigate the inflation spike through aggressive increases in interest rates, the BoJ cannot do anything without risking bankruptcy on the world’s second-biggest debtor. With almost €7.5tn in outstanding debt owned primarily domestically, failure to pay back would be catastrophic––however small the possibility of total bankruptcy is.

Although the risk of a so-called Minsky moment is small, the case of Japan outlines how central banks can lose sovereignty due to reckless fiscal policy. Money supply is created through the government, not monetary policy decisions (although the bank encouraged it by buying government bonds at a time when it was needed). Such is the reason the ECB is in theory barred under the Treaties from purchasing government debt in primary markets. Unless countries around the world are careful, their central banks could soon face a similar predicament. In the meantime, central banks ought to reestablish fiscal discipline by reconsidering their relationship with asset purchase programmes.