Financial Times January 27 2011
http://www.ft.com/intl/cms/s/0/56a10136-2a06-11e0-997c-00144feab49a.html#axzz1WV4KM3Sy
S&P’s downgrade of Japan’s credit-rating raises a disturbing prospect. Is this stage two of the global credit crisis, featuring chain of sovereign defaults amongst the largest economies?
No less a figure than Kaoru Yosano, Japan’s new minister for economic and fiscal affairs, seems to think so. “We face a dreadful dream,” he said in an interview last week.
After the disasters of 2008, such fears are understandable, but misguided. The risk is they lead to policies that, far from solving the world’s economic problems, make them a whole lot worse
The case for the prosecution is simple. Japan’s ratio of government debt to GDP is above 100% and shows no sign of declining. The political systems seems gridlocked, with a succession of uninspiring leaders coming and going with bewildering rapidity.
On this reading, Greece and Ireland were just the hors d’oeuvre. The main course is yet to come. Japan is still the world’s third largest economy, and the aftershock from a bond market crash would be like the fall of Lehmans cubed.
But a key piece is missing from this picture. Unlike the spendthrifts of euroland’s periphery, Japan is entirely self-financing. The state may be in deficit, but the cash-rich private sector saves enough to cover domestic needs and in addition export capital equivalent to around three percent of output every year. The result is a vast nest-egg of overseas assets.
In this respect Japan resembles not Greece or Ireland, but another small European country. Belgium, l has sported a government debt to GDP ratio over 100% for the best part of two decades. At the same time, it has been in current account surplus year after.
Citizens of deficit countries like Greece , Ireland and Portugal – or indeed the US and the UK – are in the reverse position. They must pay dividends and interest to foreigners, including Belgians and Japanese, who own their liabilities.
Furthermore, Japan’s budget deficit is caused, not by heavy government spending, but by steady erosion of the tax base due to the long years of deflation. Income, corporate taxes, asset taxes, estate duties – all have suffered.
But surely such dizzying levels of government debt are unsustainable? If so, nobody has told the markets. As Japan’s government debt has snowballed, the interest rate demanded by investors has fallen ever lower. Last year as yields on Greek debt soared into double digits, Japan’s ten year bond yields plunged to a paltry 0.8%.
Rather than a “dreadful dream,” Japan’s leaders a face a mouth-watering reality. They have the opportunity to issue more and more bonds at the lowest interest rates seen – according to Sydney Homer’s “History of Interest Rates” – since the Babylonians invented accounting .
The smart move would be to copy Britain’s funding of the Napoleonic War and issue perpetual bonds. That would make explicit what everyone knows. Government debt is never going to be “paid back” – just rolled over ad infinitum. As long as the interest payments can be comfortably serviced, no problem need arise.
The way to ensure this happens is not by demand-shrinking austerity measures, but by durable economic growth – which requires a combination of monetary and fiscal stimulus and structural reform. A higher consumption tax, Mr. Yosano’s favored remedy, would likely mean less consumption. This is what happened in 1997, despite the Ministry of Finance’s Polyanna-ish view that consumers would be enthused by fiscal rectitude and go on a spending spree. Instead, a deep recession eroded tax revenues further and left an even bigger budget deficit.
What about Japan’s political instability? Again, Belgium has been there and got the T-shirt. In both 1978 and again in 2007, the country’s post-election stalemate meant no government could be formed for six months. There was no obvious damage; life went on, and the beer and frites tasted as good as ever. Perhaps Belgians’ low expectations of their leaders is a more mature attitude than the cycle of hyped-up “change” and inevitable disillusion seen elsewhere.
The reality is that in an aging, high-saving countries like Japan and Belgium there is consistent demand for low risk financial assets like government bonds Private sector assets and public sector liabilities are two sides of the same Godzilla-sized balance sheet.
Upsetting this delicate equilibrium could have dire international consequences. If major surplus countries squeeze domestic demand, there is no hope of righting the global imbalances that contributed to the credit crisis. More trouble will follow.
With the deficit countries having used most of their policy bullets, the next phase will likely feature protectionism, a rollback of globalization and a rise in nationalist and nativist political movements – a prospect as stomach-churning as a sushi waffle.
Japan needs to forget about the views of the credit agencies, which have not had a terribly good track record recently, and concentrate on exiting deflation. That’s the only way to wake up from Mr. Yosano’s “dreadful dream.”