Half of the equation.

Photographer: Yoshikazu Tsuno/afp/getty images

Japan's Debt Trap Won't Fix Itself

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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When even Paul Krugman is worried about the national debt, you know you have a problem. The country in question isn't Greece or the U.S., but Japan.

With low unemployment and high labor force participation, Japan has essentially no idle resources. The scope for boosting the economy with fiscal stimulus or easy money is almost nil. But Japan continues to run an enormous budget deficit every year. In 2014, the government had a deficit of 7.7 percent of gross domestic product, with a primary deficit -- which excludes interest payments -- of just under 6 percent.

Things are looking somewhat better for 2015. A hike in the consumption tax in 2014 has swelled revenues. Government coffers have also been boosted by increased profits at Japanese companies -- which is then subject to the country's high corporate tax rate. As a result, the primary deficit is projected to be only about 3.3 percent in 2015.

But 3.3 percent is still way too high. In the long run, any deficit that stays higher than the rate of nominal GDP growth is unsustainable. Japan's nominal GDP growth is now about zero. Its long-term potential real GDP growth is no more than 1 percent (due to shrinking population), and the Bank of Japan has not managed to increase core inflation to the 2 percent target despite Herculean efforts. Even if interest rates stay at zero forever -- allowing the country to eventually refinance all its debt in order to bring interest payments down to zero -- borrowing 3.3 percent of GDP every year is just too much. And if interest rates rise, deficits would explode.

The government, of course, knows this, and has pledged to cut the primary deficit to 1 percent by 2018 and to zero by 2020.

But its projections rely on unrealistically fast growth assumptions; it would require Japan to expand well above its long-term potential rate. As in the U.S., Japanese administrations are in the habit of over-optimism. The Ministry of Finance, full of sober-minded bureaucrats, projects that under more realistic growth assumptions, the primary deficit will shrink only to 2.2 percent. Even that improvement would require tax hikes, spending cuts or some combination of the two.

A primary deficit of 2.2 percent would be at the very edge of long-term sustainability. If we assume a 1 percent real potential growth rate and 1.5 percent inflation, then a 2.2 percent deficit will be just barely under the maximum sustainable level of 2.5 percent.

So Japan does have a chance to avoid disaster. But the risk is still high. A growth slowdown, a rise in interest rates or a fall in corporate profitability could easily nudge the government back to excessive debt growth. A secure future will require more serious deficit reduction.

That will mean either spending cuts or tax increases. Tax hikes hurt the economy, in the short term by damping demand and in the long term via economic distortion. Spending cuts are a better bet, but there's a big political impediment. Japan's society aging and shrinking, and an ever-greater share of spending goes to pensions and other transfer payments to the old. The elderly are numerous and they vote in great numbers, so there is little scope for cutting their payouts. Unless there is an attitude change -- an increased willingness by the baby boom generation to make sacrifices for the good of the country -- the government will probably continue to support the boomers at the expense of Japan's beleaguered millennials.

It looks as if tax hikes are the only way to bring the deficit down to sustainable levels. At some point -- no one knows quite when -- a primary deficit at current levels will lead either to a default or to direct monetary financing, with the central bank printing money to buy new government debt issues. Direct monetary financing will lead eventually to hyperinflation, which acts much like a total default on all public and private debts.

Either a default or a hyperinflation would cause every Japanese financial institution, and most Japanese businesses, to fail. Maybe Japan would be OK, since it wouldn't owe very much to foreigners -- most of Japan's debt is domestically financed. Businesses would eventually reorganize, new financial institutions would emerge to lend them money and workers would find something to do. But the disruption to economic life would be so huge that it might put the country in danger of an extremist takeover -- probably by right-wing elements, since Japan lacks a powerful left wing. An extremist regime would probably wreck the economy with bad policy, pushing Japan out of the ranks of rich developed countries.

If all goes perfectly, Japan can avoid this kind of nightmare scenario. But it’s far from a sure thing. More measures are needed. Spending cuts, especially on transfers to the elderly, would be ideal, but tax hikes may be the only way.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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

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