Welcome to our next stop in the Sovereign Crisis World Tour
What's old, slow, and deep in debt? If you said "Europe," you're absolutely right. If you said "Japan," you're even more absolutely right.
An aging population, weak economic growth, and prodigious debt pile all conspired to push up Italy's borrowing costs to unsustainable levels this past fall. But they all apply to Japan, and then some. Japan's government debt now stands at an incredible 230 percent of GDP, which is double Italy's. So how come Japan can borrow for 10 years at a measly 1 percent versus 5.45 percent for Italy, the world's eighth-largest economy. And why isn't anybody talking about the unthinkable: that Japan, the world's third-largest economy, could default?
Japan can borrow much more cheaply than Italy can for two reasons. First, Japan borrows in a currency it controls. Second, almost all of Japan's public debt is money it owes to its own people. Conversely, consider Italy. Because only the European Central Bank can print euros, it's actually possible for Italy to run out of euros. If investors think that this might happen -- or if they think that other investors think this might happen -- they'll dump Italian bonds and send interest rates soaring. It's a classic bank run, but on a national level.
The same can't happen to Japan, because it has its own central bank, the Bank of Japan (BOJ). Japan can't run out of yen. If a panic did grip Japanese bonds, the BOJ could step in as a buyer of last resort. More importantly, it's rare for a country to default on itself. Usually countries that default, like Iceland, are stiffing foreign creditors. Japan, however, has run massive current account surpluses for the past thirty years. They are net lenders to, rather than borrowers from, the rest of the world. Put simply, they don't at all rely on foreigners to finance their debt. Italy does.
But that might be changing. With their nuclear plants idled following the tsunami, Japanese energy imports have skyrocketed in the past year -- pushing them much closer to a point where they would need to borrow from abroad. It's not clear if is just a one-time blip, or the beginning of a new long-term trend. If it's the latter, Japan could be in trouble.
Foreign investors would probably demand higher interest rates on Japanese bonds than domestic investors. This isn't a question of patriotism. Rather, Japanese banks and insurance companies can be regulated into buying their government bonds, even at negligible interest rates. International investors don't face that pressure. They can shop around the globe for the best deal. So Japan would have to pay more to borrow. And that could be toxic. A vicious circle where higher interest rates increase deficits, causing investors to demand even higher interest rates could set in. The BOJ could intervene, but, in the nightmare scenario, all other buyers would disappear. Japan would be left with a grim choice between outright default and hyperinflation.
It's enough to get Japanese bureaucrats worried. So far Japan's technocrats have floated hikes to the sales tax as a way to tackle their long-term debt. More revenue is certainly needed. But Japan needs robust growth and a return to a strong current account surplus even more. Luckily, there's a way to achieve both.
Japan needs to devalue the yen. This is trivially easy. The BOJ just has to promise to print yen until it's worth what they want it to be worth. As Jim O'Neill of Goldman Sachs pointed out in the Financial Times, Switzerland successfully did this with its own overvalued currency back in the fall. A weaker yen should boost Japanese exports by making their goods cheaper abroad. Renewed export-led growth would both boost tax revenues and forestall a situation where Japan would need to turn to foreign investors to buy up their bonds. Risk of default would be averted.
Unfortunately, the BOJ is not known for its boldness. (In the 1990s, a professor named Ben Bernanke notably critiqued the BOJ for its "paralysis" in the wake of Japan's burst bubble). Just consider this mind-boggling fact: The total size of Japan's economy has fallen since 1992. That constitutes an epic, epic failure by the BOJ, which should aim to keep the total size of the economy growing steadily. And the BOJ hasn't seemed to learn much, either. It recently announced that it would target inflation at just 1 percent a year (as opposed to 2 percent most everywhere else). That's a simply flabbergasting decision considering Japan's depressed economy and titanic public debt load. Japan should have a higher inflation target than other advanced economies, not a lower one. A higher inflation target -- say 4 to 5 percent -- combined with a devalued yen would let Japan work off a decent chunk of its debt, and inflate away the rest over the period of a decade or so. A 1 percent target is planning for failure.
It's tempting to ignore the rock-bottom interest rates Japan pays and think that it simply has too much debt to not default. For nearly two decades, investors have been betting on a Japanese default. And for nearly two decades, investors have been losing money betting on a Japanese default. Of course, that doesn't mean it won't happen. Just substitute the word "subprime" for "Japanese default" in this story, and you remember how quickly the unthinkable can become thinkable. If the BOJ continues to treat subpar growth as an acceptable result, it's even more thinkable.
But whether Japan does finally topple under the weight of its public debt is entirely within the BOJ's control. Indeed, Great Britain has twice managed to work through even larger debt loads -- incurred while fighting the Napoleonic Wars and World War II. The specter of default should be enough to give the BOJ some of that old-time Bernanke religion -- hopefully.