Japan’s Debt Sustains a Deflationary Depression

Markets have reacted dramatically to the Bank of Japan’s recent efforts to stimulate the economy with loans to high-growth sectors; an expansion of its asset-purchase program; and a new 1 percent inflation target to combat chronic deflation.

Japanese stocks, especially of major exporters, soared and the yen tanked, starting in early February. Yet the spurring effects of monetary easing on Japanese stocks and the depressing influence on the yen didn’t last long. Since mid-March, the currency has resumed its role as a haven from euro-area turmoil. The “risk off” trade is back in favor. Still, I continue to believe that fundamental changes are occurring in Japan that will weaken the yen considerably in future years.

Last year, Japan’s gross government debt was 220 percent of gross domestic product, according to the International Monetary Fund, by far the largest ratio of any Group of Seven country. All governments lend back and forth among official entities so that their gross debt is bigger than the net debt held by non-government investors, and Japan does this more than other developed countries. Still, on a net basis, Japan’s government-debt-to-GDP ratio is rivaled only by Italy’s and leaped to 113 percent in 2011 from 11.5 percent in 1991.

Ratings Downgrade

Standard & Poor’s has cut the Japanese government-debt rating to AA minus and Moody’s Investors Service cut its rating to Aa3. On May 22, Fitch Ratings reduced Japan’s sovereign grading to A+ and said the government is taking a to dealing with the nation’s debt. Meanwhile, loans from Japanese banks have dropped precipitously since the early 1990s. That was partly due to the write-offs of bad real-estate loans. Even so, the revival of borrowing in recent years has been minimal.

Japan’s traditionally low unemployment rate jumped from 2 percent in the early 1990s to 4.6 percent in April of this year. The male labor-force participation rate ceased its post-World War II decline in the bubble 1980s, though the downward trend has accelerated again since the early 1990s. The female participation rate rose from the late 1970s until the early 1990s as many women decided that working and remaining single were preferable to being confined to the home and rearing children in a male-dominated culture.

Despite aggressive monetary policy since the early 1990s, Japan has suffered bouts of deflation. The two decades of economic stagnation were compounded by the huge earthquake and devastating tsunami last year. The economic disruptions and loss of nuclear-power generation remain considerable. Rebuilding will create jobs and economic activity, but it will simply take things back to where they were, and at tremendous cost to the government, insurers and those who lost property, income and jobs, to say nothing of the thousands of lost lives.

Japan seemed poised to take over the world in the late 1980s at the height of its real-estate and stock-market booms, but it has undergone a huge reversal. Back then, many Americans believed they would soon be working for Japanese companies or would be run out of business by them. Japan’s exports of vehicles, consumer electronics and other goods achieved global dominance from standing starts after World War II, and the Japanese used their export earnings to buy Midwest farmland, Pebble Beach and Rockefeller Center. Japan remains the world’s biggest creditor country with net foreign assets of $3.19 trillion.

Wealthy Country

Does all this mean that Japan is finished as a major economy? Hardly. Despite little growth in GDP per capita since 1995, it is a wealthy country. In 2010, GDP per capita was still more than that of France, Germany, the U.K. and Italy. And China’s economy is now larger than Japan’s because of its huge population, 1.3 billion compared with 128 million, though China’s $5,414 GDP per capita is only 12 percent of Japan’s $45,920.

The Japanese are tough and will rebuild their economy in the aftermath of the earthquake and tsunami. The destruction, excluding the nuclear ramifications, was initially estimated at only 4 percent of GDP.

The nation is well-educated and dedicated. The group decision-making process, called “ringi-sho,” is slow and laborious, but once the group makes up its collective mind, it turns to the task at hand with resolution. This dedication in the face of adversity is summed up by the phrase, “fukutsu no seishin,” or “never give up.”

That attitude revived a largely destroyed economy after 1945, and made it the envy of the world in the 1980s. The World War II defeat was a psychological disaster for the Japanese who previously viewed unconditional surrender and foreign occupation of their country as unthinkable. In the late 1900s, this mentality was responsible for the rapid conversion from a primitive, feudal nation to a modern industrial economy.

This perseverance has driven efforts by the government and central bank to resurrect the economy for two decades, but with little success. Instead, these attempts have set up Japan for a slow-motion train wreck, characterized by leaping interest rates on government debt and a collapsing yen.

The Bank of Japan helped pop the 1980s housing and stock bubbles by raising interest rates starting May 31, 1989. After the bubbles burst, the central bank slashed its reference overnight rate to zero and has kept it close to that level ever since. That pumped money into the economy, to no avail. In any case, even if nominal rates are zero, borrowers are discouraged by positive real rates in periods of deflation. And zero is usually as low as central banks can go, though the U.S. Treasury is considering issuing bills at premiums with the resulting negative returns. Japan’s financial system remains in the classic liquidity trap where no interest rate is low enough to encourage scared borrowers to borrow or reluctant lenders to lend.

Quantitative Easing

Substantial quantitative easing by the BOJ through purchases of government bonds didn’t help much, either. Nor did the 3 percent annual increase in M2 money supply over the last two decades. And so far, the central bank’s attempts to promote borrowing haven’t worked: The trend since the mid-1990s has been to repay loans that weren’t written off. Nevertheless, competitive quantitative easing by central banks is now the order of the day, and the BOJ is being outrun. Last year, it expanded its balance sheet by 11 percent, while the Federal Reserve’s increased 19 percent, the European Central Bank’s rose 36 percent and the Swiss National Bank’s grew 33 percent.

Government deficits are supposed to stimulate the economy, yet the composition of Japanese public spending isn’t particularly helpful. Debt service and social-security payments -- generally non-stimulative -- are expected to consume 53.5 percent of total outlays for 2012, compared with 54.4 percent for 2011. In addition, the gap between public spending and revenue was 9.3 percent of GDP for 2010, the latest data available, so debt service now accounts for 43 percent of government revenue, up from about 4 percent in the early 1970s. More than half of public spending is financed by new debt issues. As a result, the government borrows heavily just to service debt.

Japan wants to double the 5 percent sales tax in two stages by 2015 to help pay for increasing welfare costs as the population ages. The country’s leaders also want to demonstrate some control over the deficit and curtail further rating downgrades. They also want to prevent a sell-off of government bonds: In late March, foreigners sold more than 2 trillion yen ($25 billion) in Japanese obligations, one of the biggest outflows since the collapse of Lehman Brothers Holdings Inc. in September 2008.

But when the government last raised the sales tax to 5 percent in 1997, a recession followed. Furthermore, the military rise of China in Asia, North Korea’s nuclear ambitions and the planned reduction of U.S. defense expenditures have increased pressure on Japan to boost military spending. At $59 billion in 2011, the defense budget was already 5.2 percent of total government outlays, making it the sixth-largest in the world.

(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the second in a five-part series. Read Part 1 and Part 3.)

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 of this story:
    A Gary Shilling at

    To contact the editor responsible for this story:
    Max Berley at

    Before it's here, it's on the Bloomberg Terminal.