By Roger Bootle
We can all breathe a sigh of relief that the world is not going to come to an end as a result of a default by the US government. Well, for now, anyway. But this does not mean that debt problems have gone away. Indeed, across the Pacific a serious debt problem is still building in Japan.
Whereas the US debt crisis has been triggered by a disagreement between Democrats and Republicans over the role of the state in the economy and society, and specifically over “Obamacare”, Japan’s debt problem is a slow burner.
As a share of GDP, government debt has been growing since the early 1990s. This is the result of the long-running weakness of economic growth, repeated fiscal stimulus packages and a long period in which the overall price level has stagnated or fallen. Japan has managed to muddle through, but it now looks as though it is close to a tipping point.
The scale of the problem is staggering. Japan’s net government debt is about 140pc of GDP. This is way ahead of the US, which is on 87pc, and not that far below Greece. What’s more, it is easy to see the ratio increasing further. The IMF expects net debt to rise to 148pc of GDP over the next five years. In fact, if the economy performs badly, inflation remains low or borrowing costs rise, debt could easily follow an explosive path, with the ratio quickly rising towards 300pc of GDP.
So what to do? If Japan followed anything like this path, then some form of default would eventually become inevitable. Accordingly, why not cut the whole process short and get the thing over and done with by defaulting now?
Quite apart from all the usual objections to default, Japan suffers from another major obstacle, namely that its debt is overwhelmingly held by Japanese financial institutions, including banks. A default would land the financial sector with massive losses and could cause a catastrophic financial crisis.
The orthodox way to tackle debt is to impose austerity via cuts to government spending or increases in taxes. In fact, Japan will increase its consumption tax in April and quite considerable deficit reduction is promised for the next few years.
But this runs into two problems that are familiar from a European perspective. First, such austerity is not popular and the politicians in Japan may yet baulk at the scale of the tightening to be imposed.
Second, austerity tends to reduce GDP – even though George Osborne may believe that it hasn’t done so in the UK. If it does reduce GDP, then the debt to GDP ratio would probably rise.
Faster economic growth would help but is in practice difficult to achieve. The government is pursuing some supposedly radical structural reforms but it is unlikely that, even if these are pushed through, they will have much of an impact soon enough. And in trying to grow its way out of the debt problem, unlike America, Japan faces a huge demographic hurdle. It simply isn’t making enough Japanese. The size of the workforce is already falling and will continue to do so for decades.
The way out for Japan is to try to engineer a higher rate of inflation, perhaps much higher than the current 2pc target. For any given rate of increase of real GDP this would give a higher rate of growth of nominal GDP, that is to say, expressed in money terms. With debt fixed in money terms this would, other things being equal, bring down the debt to GDP ratio.
Admittedly, other things may not be equal. The danger is that markets would force up the rate of interest on Japanese debt and thereby increase the amounts that the government had to pay out in debt interest. That could easily offset the effect of higher inflation.
In fact, it could lead to the debt ratio ending up higher. Yet in the Japanese case, this is unlikely.
The Bank of Japan would continue to hold short-term interest rates at close to zero for several years. That would ensure that the rates on short-term debt remained subdued. Moreover, it would continue to buy huge quantities of Japanese government debt. It might also consider obliging financial institutions to hold extra amounts of government debt.
How would Japan achieve higher inflation? Quantitative easing (QE), or printing money, as it is colloquially known, will eventually give you higher inflation – provided that you do it on sufficient scale. This is what the Japanese central bank now seems prepared to do.
A fall of the yen would be a crucial part of the mechanism by which inflation moved higher.
This is what has happened recently. Japanese inflation has risen to 0.9pc, but almost wholly as a result of the fall of the yen from the high 70s to the dollar to about 100. There has been hardly any domestically generated inflation. But if the yen continued to weaken, that would surely follow.
Throughout the past 30 years, Japan has been a testing ground both for problems and their possible solutions that have appeared later in the West. It experienced a bubble economy in the late 1980s and then experienced the pain of a long drawn-out balance sheet recession, brought on by the collapse of asset prices and the drying up of credit.
It also went through a slow dragging deflation of consumer prices before anyone in the West thought that this was an issue. And for some time now it has faced the problems caused by an ageing and falling population.
Could it also show the way on the inflation solution to the debt problem which continues to bedevil so many countries in the West? For the UK, a deliberate embrace of higher inflation remains only a risk rather than a probability. For we are in a very different position from Japan. Our debt ratio is nowhere near as high and our potential to grow our way out of the problem is much greater, not least due to our more favourable demographic prospects. The same is true for the US.
But there are several members of the eurozone for whom this is not true. Greece and Italy spring to mind. Unless their debt is “forgiven”, some form of default appears inevitable.
While they remain in the euro, of course, they cannot default through inflation because they do not control their own monetary policy.
But if they were to leave the euro, the Japanese experience might be highly influential.
Roger Bootle is managing director of Capital Economics firstname.lastname@example.org