Opinion

Felix Salmon

Lessons from Japan’s fiscal disaster

By Felix Salmon
December 27, 2010

When it comes to overindebted countries which can’t stop spending, it’s pretty hard to compete with Japan. The fact that everybody picks up on when reporting on the 2011 budget is that debt issuance is going to exceed tax revenues for the second year running — or, to put it another way, that more than half the budget is being paid for by borrowing rather than taxes. For me, however, the scarier fact is that more than half of government tax revenue is going to go straight back out the door in debt-service payments.

If you’re at all interested in Japan’s budget, the Yomiuri Shimbun editorial on the subject is excellent; for a shorter version, James Simms has a good overview in the WSJ. The problem is a familiar one: politicians are happy spending money and incapable of implementing budget cuts, and the result is a slow-moving fiscal trainwreck.

The situation in Japan is particularly depressing because the country has no major ethnic or political rifts. Sure, there’s political jostling, both within and between the parties. But it’s nothing compared to the vitriol and mistrust that we see in the US, and somehow I can’t imagine Greece-style riots in Japan either. But still the technocrats can’t make any headway.

The lesson here, I think, is that it’s very, very hard for a government to enact a serious fiscal adjustment unless and until the bond market forces its hand. The Brits are trying, of course — and we’ll see whether or not the coalition government can succeed. But as we saw with George W Bush, the fiscal rectitude of one administration can be more than wiped out during the course of the next.

Even now, with the attention of the world more concentrated on sovereign fiscal issues than ever, the Japanese government can still contrive to raise agricultural subsidies by 40% and send child-care payments soaring, including payments to families who don’t need the money. It’s even getting rid of highway tolls. Oh, and it’s cutting the corporate tax rate.

From a bond-market perspective, this basically just means an ever-greater supply of JGBs: we’re still a very long way from any real credit risk, given the political power of the owners of those bonds. But as a lesson in fiscal political economy, Japan is much more worrisome. Everybody agrees that the budget must be cut and the country put onto a sustainable fiscal course. But no one is capable of doing that, and instead they go in the opposite direction entirely. It’s the see-no-evil easy choice to make. And I suspect that we’ll see continue to see similar choices being made in other highly-indebted countries around the world. Including the US.

Comments
13 comments so far | RSS Comments RSS

The dollar is held back by the US printing money; the euro loses value because enough small economy countries there are in trouble; and China fixes its exchange rate. So what does Japan need to worry about? Which currency will overwhelm the yen?

Posted by OnTheTimes | Report as abusive
 

“Lesson’s”? And six hours standing, so far… does no one care?

Posted by bxg9 | Report as abusive
 

To paraphrase John Connolly — Japans fiscal disaster, our problem. Japan’s net savings far exceed its liabilities. To meet its obligations, it will redeem these savings, which include among other things, a vast holding of US Treasuries. When that day comes, it’s our problem, not Japan’s.

Posted by maynardGkeynes | Report as abusive
 

^ How will Japan “redeem” its vast holding of Treasuries?

They are not convertible into gold. Japan has USD because they sell us STUFF. They want to earn interest on these dollars so they buy Treasuries. There’s nothing very scary going on.

Looks like Felix is really starting to appease his deficit terrorist overlords at the Peter Peterson Foundation. Sad to watch him write this garbage.

Posted by petertemplar | Report as abusive
 

@bxg9, um. Sorry. Fixing now, but that’s bad.

Posted by FelixSalmon | Report as abusive
 

I would argue that this is in Japan’s competitive interest. If Japan underissues compared to the US and EUR, yen increases in value, leaving their corporates worse off. Japan freaked out when they heard about Chinese JGB purchases, as the last thing they want is China propping up their currency. Until the liquidity Deepwater Horizon of China is stopped, Japan should issue as much as possible.

Posted by Derrida | Report as abusive
 

You are on a roll, this week! A great series of posts and discussions!

One sentence may need revising, I think:
“we’re still a very long way from any real credit risk, given the political power of the owners of those bonds”

I would say enormous credit risk is present at this very moment. Someone buying JGBs at this minute should definitely do so with the expectation that they are making an donation to their Japan out of love and not with any illusion that they are making a loan.

I don’t think anyone can say how long before a bond crisis comes but when it does, I feel certain that there will be massive principal losses in the blink of an eye. It could happen in January, or perhaps later, but I cannot imagine that we will get very far into the new decade before it happens. Probably there will be no escape for traders in long term JGBs. The crisis may be such that Japanese bond markets do not even stay open. In history, markets enduring extreme repricings normally do not stay open during the interim.

Particularly relevant for the United States is the fact that a Japanese bond crisis would bring crisis to our treasury market with 100% certainty. Japan’s primary external financial asset is its US treasury portfolio which must then necessarily be liquidated.

At that point, with the US and global interest rates suddenly launched skyward, the pressure on the Fed will be enormous. The Fed has already folded repeatedly under milder circumstances, i.e. single-digit unemployment. The intelligent inflationist understands that actions undertaken by the Fed so far are not by themselves enough to send inflation soaring given parallel credit destruction, but the intelligent inflationist is certain that major Fed actions will continue. Principal losses on Treasuries sitting on the Fed balance sheet are unsanitized monetization. Bonds not sold back into the market in a timely manner are also unsanitized monetization. Is there any way the Fed unloads its portfolio back into the market under these conditions?

Posted by DanHess | Report as abusive
 

@DanHess: The financial burden Japan’s net debt — as opposed to gross debt — is quite manageable. About half of the gross debt in Japan consists of debts that one government agency owes to another, debts that in fact cancel each other out. Another substantial portion of the debt consists of surpluses in the social security account. The Ministry of Finance’s ability to borrow from the social security system reduces the need for fund-raising from the private sector. It is also important to keep in mind, Japan’s external surplus/deficit position. Much of Japan’s current account surplus is coming back to sit in banks as savings. These ‘risk free’ assets gain a high capital weighting on banks’ balance sheets, and allow absorption of a greater amount of debt. This is why the G-20 exempted Japan from the necessity to reduce its fiscal deficits.

Posted by maynardGkeynes | Report as abusive
 

DanHess, I wouldn’t go so far as to call myself an “intelligent inflationist”, but I don’t see any realistic way that the Fed can unwind its monetization before the end of the decade.

So what happens when the credit destruction slows?

Feels to me like we’re caught between a rock and a hard place. If anything shifts (and doesn’t it always?), we have no leeway to avoid getting crushed.

It will make some people happy. Those who hate the banks more than they care about national prosperity will be overjoyed. Those who are betting against debt instruments will be happy IF they manage to collect that debt before the system folds. Those who believe the government shouldn’t be taking care of the poor, the sick, the unemployed will be thrilled when suddenly the government can’t afford to do anything.

Or maybe we pull through this in good shape? I know you’ve expressed some optimism in the recent path that the slow recovery will continue and the situation will stabilize, but every step we take results in LESS flexibility and I don’t yet see the instability easing.

Posted by TFF | Report as abusive
 

@Maynard –

You wrote,
“About half of the gross debt in Japan consists of debts that one government agency owes to another, debts that in fact cancel each other out. Another substantial portion of the debt consists of surpluses in the social security account. The Ministry of Finance’s ability to borrow from the social security system reduces the need for fund-raising from the private sector.”

I disagree that ‘debt that one agency owes another’ can be simply canceled out. In particular, with a society as demographically upside-down as Japan, the enormous money flow from the social security system to the government will not only stop but strongly reverse course. In a nation with Japan’s demographic profile, this kind of borrowing from the pension system for present spending is pure Madoff.

Your words do point to an important exit, which is that Japan may partially default on its own pensioners in attempt to keep its honor intact in the bond market. That would be very Japanese.

Posted by DanHess | Report as abusive
 

“Japan may partially default on its own pensioners in attempt to keep its honor intact in the bond market. That would be very Japanese.”

That would be an interesting case… a democratic society denying itself benifits in the present for the good of future generations.

I think a gradual devaluation of the yen destroying the debt through inflation and gradually lowering living standards relitive to other countries is more likely.

Posted by y2kurtus | Report as abusive
 

Would that even work, y2kurtus? At least in the US, the Social Security promises are indexed to inflation. So inflation alone doesn’t successfully devalue the promises.

I guess that a devaluation of the currency *without* a corresponding increase in wages would tend to devalue the living standards for everybody? Is this what you are envisioning? But I don’t see how this “destroys the debt”, it simply shares the pain of the debt with everybody equally.

Posted by TFF | Report as abusive
 

“I guess that a devaluation of the currency *without* a corresponding increase in wages would tend to devalue the living standards for everybody? Is this what you are envisioning?”

That is exactly what I’m expecting… and it’s not much of a reach. Compare the Euro, Yen, Pound, and Dollar against the Brazilian Real, The Korean Yaun, and whatever currencies they use in Tawian, or Vietnam.

I think the trend of stagnant wages and lower living standards relitive to those fast growing countries has been inplace the last 10 years. If you want to get ahead in the U.S. you’ve got to increase the value of your job skills, or take some risks… like buying equities in March of 09 or buying some destressed property and fixing it up.

Working hard and staying out of trouble will still get you bye but they won’t get you too far ahead. Westerners need to get use to the idea that we’re all competing with younger and smarter people from away… people who are willing to work for the good life that we consider our birthright.

Happy new year and good luck!

Posted by y2kurtus | Report as abusive
 

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