Japan's government has borrowed so much and for so long, without having to pay higher interest rates for the privilege, that we've come to assume it can go on for ever. At the same time, this gravity-defying feat may lull us into thinking that public debt can also rise far, far higher in the US without giving rise to serious problems. James Hamilton links to a study that casts doubt on both points.

As is well known, Japan has benefited from low interest rates despite its high debt ratio because nearly all of its public debt is domestically owned, and its savers are a compliant lot. But as Hamilton explains, a demographic transition is getting under way that will thin their ranks. The study by Hoshi and Ito shows that the household savings rate is going to fall, forcing the government--by this time with a debt ratio approaching 300% of GDP--to borrow more heavily from abroad. The pressure would be worse if interest rates start rising in anticipation of the problem.

Remember, what's not sustainable won't be sustained. The only questions are how and when the trend changes.

If the Japanese government is soon forced to offer higher yields to foreign lenders, the result could be very troubling. Again from the paper:

"the crisis would have a large adverse impact on financial institutions, because the majority of long-term government bonds are held by Japanese banks and insurance companies. When the interest rate rises, they suffer valuation losses. For example, Japanese banks collectively hold about 142 trillion yen of central and local government bonds as of the end of March 2010. This is about 32% of total bank loans. The interest rate risk is large, too. According to Bank of Japan (2010), 100 basis points increase in JGB yields is estimated to cause about 4.7 trillion yen of losses for Japanese banks collectively (BOJ 2010, Chart 3-2-3, p.39). This is about 11.7% of the Tier I capital at the end of March 2010 and about twice as much as the income before tax for the accounting year ending on March 31, 2010. The interest rate risk as of March 2008 was estimated to be around 3.5 trillion yen. This may not reduce regulatory capital immediately because the banks are not required to mark all the securities to the market, but many will none the less tighten their credit provision."

As concerns about Greek sovereign debt and continuance with the euro intensified over the last two years, the troubling question became, "who's next?", a contagion of fear that continues to rattle Europe at the moment. If the scales tip for Japan as well, it is hard to imagine that the willingness of the world community to continue to buy U.S. Treasury debt would continue to be unaffected.

Don't forget Japan.

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