Japan reported this week that gross domestic product (GDP) contracted by 0.4%, or 1.6% on an annualized basis, during the second quarter.
Meanwhile, Japan is carrying out the most aggressive money printing program in the world right now, and its budget deficit is also the largest among the world’s rich countries. Oh, and its public debt is also the world’s highest in terms of GDP.
All of which suggests that something is seriously wrong in the Land of the Rising Sun. Indeed, it’s Japan’s – and not China’s – economic policies that are most likely to collapse in ruin.
When Prime Minister Shinzo Abe took office in 2012, he vowed to get the Japanese economy moving back toward the 2% annual growth rate that was thought to be its natural “speed limit.”
One of his first steps was to appoint a new governor for the Bank of Japan, Haruhiko Kuroda. Kuroda instituted a bond-buying program that, relative to the country’s economy, was about three times larger than Ben Bernanke’s “quantitative easing” at its peak.
Abe also promised a program of reforms, including an overhaul of the labor market. A few reforms have been implemented, and others – such as the partial privatization of the gigantic, government-owned Japan Post – are at least underway.
But the real problem is the third leg of Abe’s program, a series of fiscal “stimulus” spending initiatives that have given Japan the largest budget deficit in the rich world. For 2015, The Economist’s team of forecasters projects a deficit of 6.8% of GDP.
To reduce the deficit, Japan sought to increase its sales tax – but the first increase, from 5% to 8%, caused the economy to relapse into recession. The second hike, to 10%, has been postponed from 2015 to 2017.
Approaching the Tipping Point
Before 1990, Japan had a conventionally cautious fiscal policy with surpluses in some years, spending below 30% of GDP, and debt below 60% of GDP.
However, during the prolonged recession of the 1990s, Japan’s Ministry of Finance was caught in the grip of Keynesian bureaucrats. Wasteful spending spiraled to around 43% of GDP, deficits soared to as much as 8% of GDP, and debt began its long rise to more than 200% of GDP.
Junichiro Koizumi, Japan’s prime minister from 2001 to 2006, partially cut spending and trimmed the deficit, but the recession of 2008-09 saw both spiral out of control.
The current Prime Minister, Shinzo Abe, was originally a disciple of Koizumi – but he hasn’t followed Koizumi’s policies. The result is that Japanese spending consistently exceeds the tax base, with net bond issuance currently 38% of spending and debt around 230% of GDP.
If Abenomics had worked, GDP would have increased and at least slowed the increase in debt. But Abenomics is producing neither real growth nor inflation. The current forecast from The Economist is for growth of 0.9% in 2015 and inflation of 0.7%. Both estimates – each of them probably too high – would still see the debt-to-GDP ratio increasing at a rapid clip.
Now, there are two mitigating factors at work currently.
First, Japanese savers hold the great majority of the debt – though this is of little help, as a government default would merely translate into national insolvency, and that’s not much of an improvement. Second, markets are liquid, confidence in Japan remains strong, and the Bank of Japan is covering the government debt with its bond purchases.
Still, the debt-to-GDP ratio is nearing a tipping point. The highest ratios that have ever been brought down successfully without default were about 250%, by the United Kingdom at the end of world wars in 1815 and 1945.
The first time, it was achieved through economic growth (the Industrial Revolution) and massive government austerity without inflation (the United Kingdom went back on the gold standard in 1819). The second time, it was done by suppressing interest rates and allowing inflation to erode the savings of the holders of government bonds – mostly the British middle class.
If Japanese bureaucrats give up Keynesianism and embark on a massive program of government austerity, without major tax increases, the problem might still be solved. But we’re close to the point at which it will become impossible, not just (to the Japanese political class) unthinkable. At that point, confidence will erode rapidly, and a crisis will ensue.
What form this crisis will take is unclear.
The yen’s value would likely collapse, perhaps halving to JPY250-to-USD1, impoverishing the Japanese people and causing hyperinflation but reducing the debt burden (since almost all the debt is yen-denominated at a low fixed interest rate).
If the Japanese economy has stopped growing, collapse has become not only unavoidable, but also imminent – and its effect on world markets won’t be pretty.