Is there something to celebrate?

Japan's Debt Trap

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Japan's government has a lot of debt. Not as much as people think -- since much of that debt is owed by one branch of the government to another, net debt held by the public is only 134 percent of gross domestic product, not the widely quoted figure of 240 percent. But 134 percent is still a lot. About 15.6 percent of Japanese tax revenue goes to pay interest on this debt every year -- about the same as for the U.S. This is a moderate burden on government finances, but one that would quickly become unsustainable if interest rates were to spike.

How do governments deal with a rising debt-to-GDP ratio? There are three basic ways: consolidate, monetize, or default. Figuring out which of these Japan will do is the key to predicting the nation's economic future.

When I talk to Japanese government officials, academics and business leaders, they all seem to be in agreement -- Japan's government will do whatever is necessary in order to fiscally consolidate and reduce its annual budget deficit. Since spending on wasteful infrastructure projects and the like has already been slashed, most spending increases are due to population aging, which is more severe in Japan than in any other country on the planet. This means that fiscal consolidation would have to come in the form of tax increases.

How much would Japan have to raise taxes to stabilize its debt-to-GDP ratio? The numbers are daunting. A 2013 paper by economists Gary Hansen and Selahattin Imrohoroglu found that in order to put the debt on a sustainable path, Japan would have to increase tax revenue to 40 percent to 60 percent of GDP. That would be unprecedented; currently, the most taxed countries are Denmark and Sweden, which collect 44.7 percent and 44.3 percent of their GDP, respectively, in taxes. Fiscal consolidation would put Japan at or above this level. A 2011 paper by economists Takeo Hoshi and Takero Doi was a little more optimistic, putting the needed revenue at 40 percent to 47 percent of GDP. But much has happened since that paper was written to make the outlook more grim, so the higher estimates may be the better ones.

Could Japan cut spending? In the 1990s and early 2000s, huge amounts were lavished on white-elephant construction projects to keep up employment, but in the mid-2000s most of this spending was cut. Nowadays, Japan's huge government outlays are almost entirely a function of its aging population. Old people vote and Japan has a very high and growing percentage of old people, so cutting retirement and medical benefits is probably a political nonstarter. That leaves taxes.

Taxes now take about 28 percent of Japan's GDP, so if Japan raised the consumption tax by 12 to 32 percentage points, it could whip the debt. But this may be politically impossible, because of the economic pain involved. When Prime Minister Shinzo Abe recently succeeded in raising the tax from 5 percent to 8 percent, Japan's economy experienced a severe contraction. That echoes a similar experience in 1997. Why exactly Japan's economy is so vulnerable to tax increases isn't clear -- after all, the U.S. recently carried out a similar tax hike with far less pain. But whatever the reason, the pain associated with tax increases means that getting to a sustainable level of taxes looks politically unlikely as well.

So if my friends in Japan are wrong, and consolidation isn't in the cards, that leaves monetization of debt as the only option to avoid a sovereign default. The Bank of Japan will be asked to pick up more and more of the burden of buying Japanese government bonds. Printed money will replace corporate savings and household pension funds as the chief source of demand for bonds. This is already happening.

What will be the result of debt monetization? That depends on whether it leads to inflation. Without inflation, interest rates will simply go lower and lower, and the government will be able to roll over its debt more and more cheaply. In other words, the situation that has prevailed for the past two decades will continue. But if inflation strikes, it could rise high enough to hurt growth, and therefore tax revenue, severely. That would mean game over -- Japan's government would be forced to default (or to hyperinflate, which amounts to a messier version of the same thing).

The fact is, no one really knows what causes high-inflation episodes to begin. The Japanese central bank is embarking on a road that no country has ever traveled before -- a bold experiment to test the hypothesis that debt monetization can sustain an infinite ratio of government debt to GDP. It is being forced to do this by the dysfunctional nature of the Japanese political system, combined with Japan's unfavorable demographics. I, for one, am interested to see where it goes.

But I'm not worried. In the end, a sovereign default is just an accounting exercise -- marking down the assets of some Japanese people and marking up the assets of others. It would redistribute wealth from the old to the young. And after a default, Japan would still have all the same factories, all the same land, all the same people with all the same education. There would be plenty of short-term pain, fear, disruptions to the international financial system, but at the end of the day, Japan would still be standing.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net