With levels of sovereign debt – the debt held by national governments – reaching historic peaks worldwide, public borrowing has become one of the most controversial policy issues of our time. While the advocates of public debt stress the benefits of fiscal stimulus for the economy, its opponents point out the financial burden which is put on future generations. Although there are significant discrepancies among experts over the question of which levels of government debt can be considered sustainable and which need to be deemed critical, there is a widely supported consensus that continuously growing debt, and the interest payments on that debt, become problematic at some point. They eat up national budget resources which should be reserved for fundamental government duties such as paying pensions and social welfare, investing in education, or strengthening national security. If debt and interest payments balloon, the room for meaningful public spending obviously becomes limited.
While most of us might perceive national default as an event occurring in history textbooks or in “banana republics”, defaults on national debt are in fact much more common. As Reinhart and Rogoff have demonstrated in their groundbreaking study of financial fallouts, sovereign debt crises have historically rather been the rule than the exception. This applies to countries regardless of any specific economic size, political system or region, or the question of whether debt is held internationally or domestically.
Japan’s sovereign debt has been on the rise since the 1960s. However, it was not until the bursting of the “bubble economy” at the beginning of the 1990s that the accumulation of public debt started to accelerate. From there, it only took ten years for Japan’s budget to go from being the most balanced among G7 countries to having the worst deficit. Despite several attempts by policymakers to reverse the inauspicious trend, the fiscal imbalance could not be halted. As a consequence, government borrowing continued until the size of the debt was 240 percent of the country’s entire GDP, the highest debt-to-GDP ratio ever recorded among OECD countries.
Historically, public debt crises have been the rule rather than the exception
In the face of growing concern, the Japanese language book After the Collapse of Public Finances: Crisis Scenario Analysis (財政破綻後 危機のシナリオ分析) presents a timely, revealing analysis of a worst-case scenario of Japan’s public finances. Edited by Keio University economics professor Keiichi Kobayashi and with contributions by six other authors from academia and think tanks, the book intends to fulfill two purposes. Firstly, it provides an analysis of Japan’s socio-political and economic landscape in case of a sovereign default, with the aim of enabling policymakers to react with adequate measures. Secondly, the publication serves as a wake-up call in a public climate which tends to shun the discourse on a potential default. Kobayashi compares the silence of politics, academics, experts and journalists on this issue, deriving from a “logic of infallibility” (無謬性のロジック) (p3), with the hubristic safety myth of nuclear energy prior to the Fukushima reactor catastrophe. Policymakers, experts and technicians could not openly discuss a potential nuclear accident in public, which resulted in their unpreparedness in the wake of the reactor breakdown. In order to avoid history repeating itself, this time with Japan’s public finances, this work makes a significant contribution to the policy discourse in this context of crisis management.
The book is divided into six chapters, each of which serves as a standalone analysis from a different policy perspective. Apart from analyzing the actual crisis scenario (chapter 2), the authors feature a wide range of diverse perspectives which serve as an introduction to the subject matter – from policy-making in the age of population decline (chapter 1) and the role of the Bank of Japan (chapter 3), via necessary reforms for the social welfare system (chapter 4) and a long-term plan for fiscal restructuring (chapter 5), to fundamental deliberations on the democratic implications of public indebtedness (chapters 1 & 6). Didactically the book is well-thought out; its clear, systematic overall structure helps the reader to get oriented and grasp the content speedily, with each chapter and sub-chapter featuring a synopsis at the beginning. Its target readers are policymakers, but it would be of use to students in political and economic sciences as well as to general interested readers.
Chapter Two can be called the core of the book, since it revolves around the actual events on what the authors call “X-Day” – the moment when the fiscal crisis becomes apparent. They are unambiguous in their diagnosis of the current state: “One can maintain that our country is close to a ‘latent’ default in the sense that our public finances are not sustainable as the present level of public services such as social welfare cannot be covered by tax income anymore” (p59).
The authors dismiss the frequently expressed claim that Japanese debt is relatively safe
The authors dismiss the frequently expressed claim that Japanese government bonds (JGBs) are a “safe haven” as suggested by their low yields. As risk and return always correlate, a country’s risk of default is usually reflected in its bond yields, meaning that a higher default risk normally leads to higher yields, and vice versa. However, in the case of JGBs, yields have stayed at very low levels – despite astronomically high levels of government debt. This “paradox of the JGBs” (p76-85) can be explained by the relatively unique situation wherein around 90 percent of government bonds are held by domestic investors. The large majority is in the hands of institutional investors, most notably the central bank, who are traditionally close to the government and do not demand an appropriate yield. The result is an environment in which a sound market mechanism – high risk equals high yield – is eliminated, and as a consequence the yield has lost its warning function. Using a metaphor, imagine a person putting his hand on a hot plate. Usually this person would react and pull his hand back as he is feeling the pain. But if he is desensitized, he will not react anymore; which does not mean that he is not getting burnt, but that he is simply not recognizing it. Metaphorically speaking, this is the situation around JGB yields. They are not low because there is no risk, but their specific shareholder structure makes it difficult for the risk to be seen.
The abundance of financial assets accumulated by private households and enterprises, which are used by national banks to buy government bonds, and constant low interest rates have created an environment that promotes the continuous issuance of debt bonds. Paradoxically, this long lasting deflationary, i.e. low-interest, environment was a cause for the increase of JGBs, but at the same time it also made the public debt “sustainable”, tempting policymakers into even more borrowing.
This structure is particularly vulnerable to external shocks – such as the COVID19 pandemic. Since interest rates are already at record low levels, the Bank of Japan (BoJ) is left with very few tools to cushion any distress in the financial markets (as is the case for the European Central Bank with its negative interest rates). What remains is fiscal stimulus – but how much credibility do fiscal measures have for a government that is deeply in the red? Fiscal measures originally thought of as a means to calm the markets could easily turn out to be more a source of concern than a remedy. The COVID19 pandemic is about to become a stress test not only for businesses but also for the credibility of government finances around the world.
Japan’s fiscal structure makes it particularly vulnerable to external shocks – like the ongoing COVID19 pandemic
Understanding the correlation between public finance and monetary policy hints at potential triggers that could rattle this fiscal comfort zone. One possible scenario is where the BoJ is not able, or willing, to purchase any more bonds, which could possibly entail a spike in interest rates. Just a small hike would multiply the government’s costs for debt service. Another trigger would be if government debt exceeds the amount of domestically held net financial assets. Due to the ageing population it is estimated that the savings rate of households is going to diminish further, implying that available domestic assets for issuing new bonds will run out sooner or later. If more foreign investors need to be found, they will request an appropriate yield reflecting their risk exposure. In fact, recent years have seen a steady increase in foreign buying of JGBs which threatens to undermine the BoJ’s yield control.
The authors also challenge some of the ideas frequently expressed in political discourse, such as the conviction that economic growth needs to come first, fiscal consolidation second. Drawing upon Reinhart and Rogoff’s extensive research on the history of public indebtedness, Kobayashi argues that it is quite likely that Japan’s debt has in fact reached an extent where it hampers economic growth. The dilemma in which the Japanese government finds itself is that it needs to stimulate economic growth which, in the Japanese case, is primarily domestic consumption. Most economic policy attempts at invigorating private consumption, however, have failed since consumers have been strongly hesitant to increase their spending, which is said to be an indicator of their anxieties about their future financial situation. These fears are mainly related to the government’s continued ability to provide a sustainable welfare system for its citizens. In other words, deteriorating national finances undermine public trust in the system; as long as these fundamental fiscal issues remain unsolved, the recovery of the economy, i.e. domestic consumption, cannot be expected to materialize. This implies that fiscal reforms deserve higher priority in policymaking in order to restore the credibility of government finances, strengthen the public’s trust in the system and thereby lay the foundation for economic growth.
Taken as a whole, the book comes with a straightforward message – it is no longer about the question of whether Japan will face a default, but rather about whether fiscal consolidation will occur in an ordinary, self-determined manner, i.e. by rigorous structural reforms with expenditure cuts and tax hikes, or in an irregular, uncontrolled manner, e.g. by high inflation, accompanied with a banking crisis and a possible intervention of the International Monetary Fund (IMF). As much as debt apologists have always stressed that domestic indebtedness is less of an issue than debt held overseas, it also means that any problems must be solved internally in the first instance. What was implemented with Greece, which defaulted on its external debt with a consequent debt cut by foreign creditors, will not work in the case of Japan. A sovereign default would spark a domestic financial crisis since debt is mainly held by national banks, insurance companies and, first and foremost, the BoJ. The authors criticize this (indirect) financing of government debt by the central bank, arguing that this so-called “monetization” of sovereign debt has historically resulted in unsustainable levels of inflation and loss of credibility for the currency. As a result most countries in the developed world have developed legal frameworks securing the independence of central banks and banning debt monetization.
IMF funds are not even close to being sufficient to bail out the world’s third largest economy
As regards the IMF, its funds are completely insufficient to bail out the world’s third largest economy with a sovereign debt exceeding more than a quadrillion yen (around 9 trillion USD). What remains to be done, then, are those measures which actually should have been implemented many years ago – but which will gain an unprecedented urgency in case of a fiscal crisis. This “triage” of measures, as the authors call it, consists of the immediate suspension and postponement of expenditures, “hemostasis measures” in forms of expenditure cuts, and fiscal structural reforms which ensure a balanced budget in the long run.
With After the Collapse of Public Finances: Crisis Scenario Analysis Kobayashi and the contributing authors present a systematic, excellently substantiated and much-needed analysis of a scenario whose “probability is at least not zero” (p2), as the editor puts it in his cautious wording. Unlike many other recent publications in the market, this one avoids taking an alarmist, hyperbolic tone; it is written in a matter-of-fact manner, underpinned with a plethora of solid supporting data. Other than the suggestion of its emphatic title, it does not cater to sensationalism but attempts to provide a genuinely constructive approach by offering concrete policy recommendations for reforms which appear overdue.
After the 2008 financial crisis, the world witnessed one of its longest economic expansions lasting more than a decade. In recent years, Japanese government officials never tired of stressing that the country has gone through the “longest economic recovery in the postwar period” thanks to Abenomics. This recovery seems to be ending in an abrupt manner in the face of global fears over the COVID19 pandemic. Kennedy once said that you should fix the roof while the sun is shining. Now it might be too late.