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.