Friday, April 9, 2010

Japan's debt problem - Sleepwalking towards disaster

To prevent a looming economic disaster, Japan urgently needs radical change

FOR years foreign observers gave warning that Japan’s combination of economic stagnation and rising public debt was unsustainable. Over the past two decades the country has stumbled in and out of deflation, slipped down the global league tables on many social indicators and amassed the largest gross public debt-to-GDP ratio in the world (a whopping 190%). Yet government-bond yields have remained stubbornly low and living standards, by and large, are high. Visit the country and you will see no outward sign of crisis. Politicians and policymakers have bickered and schemed, but have mostly chosen to leave things as they are.

That cannot go on much longer. The figures are getting worse. Japan urgently needs radical policies to tackle the problems, and new leaders to implement them.

Triple troubles

There are three big reasons why the crisis in Japan’s public finances will eventually come to a head. The first concerns government bonds. The state has for years relied on domestic savers to buy them. But as Japan’s people age and run down their savings, they will have less money to invest in government bonds. An IMF paper calculates that even if the savings rate remains close to where it is now, gross debt may exceed gross household assets by 2015. Japan might then have to rely on foreigners to finance its debt, and they will want much higher returns. That will, at the very least, provide an acute reality check. Goldman Sachs says some foreign investors are already positioning themselves for a “meltdown”.

The second, more immediate problem is deflation. Falling prices may have helped the government by providing its bondholders with invisible gains, but in other ways deflation is a menace. It pushes the debt-to-GDP ratio inexorably higher. As expectations of deflation become entrenched—35% of Japanese expect prices to be the same or lower in five years’ time—they will continue to depress consumption.

Third, despite the recent pick-up in global economic activity, Japan cannot count on foreign demand being strong enough for it to sustain export-led growth, as it did in the past decade. Without a stronger domestic economy, growth will not generate enough tax revenue to reduce the debt. One ominous sign is that in the 2010 budget implemented on April 1st, borrowing, at ¥44 trillion ($468 billion), is for the first time forecast to exceed tax revenues, at ¥37 trillion.

Japan’s efforts to tackle these problems have resembled a big whimper (see article). What is needed is a big bang. That means structural reforms to raise productivity, fiscal reforms to boost growth and a strong monetary stimulus, all at once, to shock the economy back to life. These could range from an overhaul of the tax code to deregulation of farming and the opening up of protected areas of the economy, such as transport and energy, to foreign competition. A sensible short-term aim for the government would be robust nominal GDP growth. That would help stop the debt-to-GDP ratio rising, and would also ensure that the authorities did not prematurely choke off a recovery because of concerns about inflation.

But all this assumes that policymakers want to be bold. The current crop is anything but. Last September, when almost 55 years of one-party rule came to an end, there were faint hopes that the Democratic Party of Japan (DPj) might take a fresh approach. It has not done so. Yukio Hatoyama, the prime minister, and his most influential backer, Ichiro Ozawa, have since been caught up in election-funding scandals that have shredded the government’s credibility. They are clinging to their jobs, more concerned with their own futures than that of the DPj, or indeed Japan.

Enlightened economic policymaking suffers most. Mr Hatoyama prevaricates over fiscal reform, arguing that Japan should wait until the next general election in 2013 before shaking up the tax system. He is wrong. Japan urgently needs cuts in business taxes, perhaps, as well as a gradually higher spending tax. The ousted Liberal Democrats are just as out of touch (see article). When a group of supposed reformers left the splintering party this week to set up a new outfit, it could have grabbed the fiscally conservative, business friendly centre. Instead it moved to the right, as if anti-immigrant nationalism were the tonic Japan needs.

It is time for more fiscally astute members of Mr Hatoyama’s government to set the agenda. The main opposition, too, needs regime change. Japan’s old guard worries that radical steps will precipitate an economic crisis, and so prefers the status quo. It does not realise how inherently dangerous the status quo is. The Economist

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