Stanford economist warns of Japanese fiscal crisis

By Clifton B. Parker

A man uses a mobile phone in front of a securities firm's electronic stock board in Tokyo on Feb. 24, 2014. Japan is risking a debt crisis in the next decade unless it embraces major tax hikes or budget cuts, Stanford economist Takeo Hoshi says. (AP Photo/Shizuo Kambayashi)

Japan – with the world's third-largest economy – is headed toward a debt crisis in the next 10 years unless it embraces significant tax hikes or budget cuts, argues a Stanford scholar.

"We find that the amount of government debt will exceed the private sector financial assets available for the government debt purchase in the next 10  years or so," wrote economist Takeo Hoshi in a study in the journal Economic Policy.

Hoshi is a senior fellow at Stanford's Walter H. Shorenstein Asia-Pacific Research Center. He used computer simulation models to analyze Japan's financial condition and develop future tax and budget-tightening alternatives.

He believes Japan is at an economic crossroads. "Japan's current fiscal approach – in which its fiscal stimulus precedes any credible plan for fiscal consolidation – runs a serious risk of losing credibility in the world market," he said.

Unlike in the European countries, fiscal austerity has not been enacted in Japan, Hoshi said. "Japan has been spending liberally without much success in restoring the economic growth."

Today, Japan has a large amount of government debt after having "stepped on the fiscal gas pedal even harder" in recent years.

Continuing that strategy is risky, according to Hoshi's research.

'Defying gravity'

Japan is unique in that its government bonds continue to enjoy low and stable interest rates – despite the fact it has the highest debt-to-gross domestic product ratio among advanced countries.

"The most plausible explanation for such an apparent anomaly is that the bonds are predominantly held by the Japanese residents, who are willing to absorb increasing amount of Japanese government bonds (JGB) without requiring high yields," writes Hoshi.

Japanese people hold about 90 percent of the government's debt, yet the yield on the 10-year bond is less than 1 percent, he notes. So, bondholders are making very little money – and yet are willing to hold on.

In a sense, writes Hoshi, it's as if the Japanese situation is "defying gravity" despite its "Mount Fuji of debts." Indeed, in the last 10 years, the country's economic condition has "deteriorated substantially."

But even if the Japanese people continue to invest their new savings in government bonds, they will not save Japan from going over the fiscal cliff, according to the paper.

Figures for 2012 put Japan's net debt-to-GDP ratio at about 134 percent. By comparison, the United States is at 87 percent and the United Kingdom is at 82 percent. Japan's debt ratio is higher than southern European countries that have been in crisis. Greece eventually defaulted on its debts when the net debt-to-GDP ratio almost reached 150 percent.

As for Japan, the International Monetary Fund estimates that without a substantial adjustment, its net debt-to-GDP ratio will exceed 200 percent by 2023, Hoshi writes.

"Japan's fiscal situation is not sustainable," Hoshi says.

The reason is that Japan is an aging society, and its household saving rate will likely decline, further slowing the growth of private sector financial assets. The baby-boomer generation will retire in the next 10 years and start using more savings to live on, and its working-age population is expected to decline by 8 percent in the same period, according to the paper.

Overcoming the crisis

The danger occurs when the government's debt is higher than the country's private savings, Hoshi writes.

At this point, new bonds cannot be sold at low interest rates – rather, the interest rates must rise to attract more foreign demand. Ultimately, this means the government will have to pay out more for the bonds.

"We call such a situation a crisis," Hoshi writes. "The Japanese government debt is clearly unsustainable without a drastic change in fiscal policy."

The government can no longer simply rely on a "home bias" among the Japanese private sector to continue buying bonds.

Hoshi recommends that the Japanese government either raise taxes or cut expenditures to close the deficit gap.

Hoshi suggests that Japan's tax revenue may have to increase to 43 percent of GDP from the current 30 percent, a 13 percent hike, to close the gap.

If reducing expenditures, government spending could be cut by 13 percent, down from the current 40 percent of GDP to about 27 percent. These figures can change in the future as the problem is brought under control, Hoshi notes.

Much depends on what the world market thinks about Japan's handling of its looming fiscal crisis.

"If the market believes that Japan will embark on such fiscal consolidation in the next 10 years, at most, the low JGB yields are justifiable. If and when the expectation changes, however, a fiscal crisis can be triggered even before the government debt hits the ceiling of the private sector financial assets," he said.

If the government fails to take fiscal reform steps, expect the worst: drastic cuts in public services, a fall in the Japanese living standard and possibly inflation.

Japan is not alone in its predicament, according to Hoshi. Since the 2008 global economic crisis, interest rates have also fallen in the United States, the United Kingdom and Germany, as these countries like Japan took on more debt through fiscal stimuli.

But they are different from Japan in that they do not have an abundance of domestic investors willing to suffer low interest rates on government bonds.

Still, Hoshi writes, every indebted country must realize that the world's market expectations can change without much warning. This can cause bond yields to suddenly jump and thereby jeopardize a particular country's fiscal condition.

"Our research points to the crucial importance of market expectations," he says. 

As for inflation, Hoshi does not believe Japanese policy makers are much concerned about it. Japan has experienced deflation for the last 15 years, he notes.

"Some inflation would be actually good for the economy," Hoshi says, adding that it would help reverse the intergenerational transfer of financial wealth from the young to the old that happens under deflation.

The research paper was co-authored by Takatoshi Ito, a professor at the University of Tokyo.

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