Since the collapse of Japan’s housing bubble in 1990, the country has suffered more than two decades of deflation, stagnant growth, and ballooning public debt. Like Japan, the United States has been suffering from weak economic growth since 2007 because of the bursting of a real estate bubble; both countries have experienced rapid growth of deficits and public debt accompanied by a decline in interest rates. Japan’s deflation has only worsened its public finances situation, leading to a decline in tax revenues. Responding to Japan’s long-lasting economic woes, the country’s new prime minister, Shinzō Abe, has pushed the Bank of Japan to print more money and enacted an ambitious public spending stimulus package that amounts to 2.6 percent of Japan’s gross domestic product (GDP). Despite the similarities in the two countries’ economic situations, the United States should not respond the same way as Japan because it does not share that nation’s deflation. Congress and President Barack Obama should take away from the Japanese situation that excessive austerity regarding fiscal policy can slow growth and not improve the situation of public finances. The United States should instead reform the tax code and enact entitlement reform legislation to increase tax revenues and stimulate economic growth.
Key points in this Outlook:
- After nearly two decades of economic stagnation and deflation, Japan’s new government is pursuing aggressive polices of monetary and fiscal stimulus aimed at restoring sustainable growth and achieving 2 percent inflation.
- Japan’s debt-to-GDP ratio, the best metric of fiscal health, is twice that of the United States, but its benchmark 10-year interest rate on government debt is less than half the US rate. Japan’s deflation explains much of the difference.
- Japan’s experience with debt, deficits, and deflation can teach the United States important lessons: use monetary policy to avoid deflation, aim for gradual deficit reduction, close tax loopholes to lower the marginal tax rate, and reduce the budget deficit.
After experiencing nearly 20 years of economic stagnation and deflation, Japan has elected a new prime minister, Shinzō Abe, who has promised to get Japan’s economy moving again. Abe, the head of a recently elected new parliamentary government, has already pushed through a massive public spending (stimulus) program worth about $150 billion—or 2.6 percent of gross domestic product (GDP), about equal to the average scale of post–financial crisis US stimulus packages—in a country legendary for its massive accumulation of government debt. Simultaneously, Abe has sharply elevated the pressure on the Bank of Japan to print more money and end Japan’s deflation by pushing inflation to about 2 percent.
To accomplish this goal, Abe has threatened the reticent Bank of Japan with a new governing law that would take away much of its cherished independence. The current governor of the Bank of Japan, Masaaki Shirakawa, who as recently as February 2012 promised an aggressive program of reflation and then reneged, citing years of inflation, is in Abe’s sights. Shirakawa’s term as the Bank of Japan’s governor ends early in April of this year, and Abe has left no doubt that inflation fighters need not apply for the job. More likely, one of the numerous, persistent critics of Shirakawa’s too-timid deflationary policy, the most prominent of whom is University of Tokyo professor Kazumasa Iwata, will be appointed to replace Shirakawa. Iwata was deputy governor of the Bank of Japan in 2007, when he was the sole policy board member to vote against hiking interest rates. The interest rate hike, motivated by then-governor Toshihiko Fukui’s unfounded fear of inflation, proved disastrous, coming just before a global financial crisis that substantially harmed Japan’s economy.
A Close Look at Japan
Japan’s economy has been both fascinating and awful since its massive real estate bubble burst over 20 years ago in 1990. It offers many lessons for the United States as it struggles, after the bubble and global financial crisis, with tepid growth, large deficits and debt, and controversial monetary policy. Nearly everything the United States has suffered since 2007, Japan has suffered more intensely in its extended postbubble period.
The big difference between postbubble Japan and postbubble United States, leaving aside the fact that Japan’s postbubble suffering has been four times as long as in the United States, has been the absence of deflation in America. As it turns out, that has been a great blessing for the United States, one that Federal Reserve Chairman Ben Bernanke, based on his extensive study of the Japanese economy, sought to achieve and delivered.
Japan’s massive property bubble, over 50 percent larger than America’s 2000–07 bubble, burst in 1990, 18 years before America’s less-extended real estate bubble burst in 2008, ushering in the global financial crisis. Since its bubble burst (figure 1), Japan’s economy has stagnated (figures 2 and 3), while its debt burden has risen from about 15 percent of GDP in 1990 to nearly 140 percent today (or 220 percent, including debt held by Japan’s government agencies like the post office). Most of this sharp rise in Japan’s debt-to-GDP ratio (from 40 to 140 percent), has come since 1997, and like America’s ratio, the pace of increase rose sharply after 2007. In Japan’s case, this was due to a collapse in nominal growth rates that caused a collapse in tax revenues.
Figure 4 shows the post-1982 history of US and Japanese debt-to-GDP ratios. Japan’s ratio rose sharply, by 75 percent, during the five years from 2007 to 2012, while the US ratio also rose by 75 percent from a more moderate 48 percent to 84 percent over the same period. America’s debt burden has risen at a pace as fast as Japan’s since 2007, though from a lower base. The rapid increase in the US debt burden has attracted more global attention than Japan’s identical pace of increase, perhaps because it, unlike Japan’s rise, followed a 25-year period of relative stability
Japan’s huge debt buildup, like America’s, has occurred alongside widespread cries of unsustainability and warnings of an imminent bond market collapse, soaring inflation and interest rates, and financial calamity. The actual outcome has defied the predictions, as many sad speculators who have bet on a collapse in the Japanese government bond (JGB) market can attest. The interest rate on five-year JGBs, Japan’s benchmark rate, has dropped steadily from 4 percent in 1994, after the bubble burst, to a mere 20 basis points (0.2 percent) today (figure 5). The comparable US rate has dropped even more sharply from 7 percent in 1994 to about 0.8 percent today. The postbubble experiences of both Japan and the United States do not support the widespread claim that large deficits and debt increases cause a spike in government borrowing costs.
Japanese inflation has turned to a persistent deflation that has sharply reduced tax revenues because taxes are levied on nominal income. The yen value of GDP has remained virtually stagnant since 1992 (figure 3), far weaker than the average US nominal growth rate of 4.7 percent. Nominal GDP growth is the sum of real growth and inflation. Japan’s very modest real growth, at an average rate of 1.5 percent (figure 2), has just offset its deflation (figure 6) at about the same rate, leaving nominal GDP—importantly, the tax base—stagnant. Meanwhile, the US inflation rate has averaged 2.5 percent since 2000.
Because its interest rates have fallen so low, Japan’s government interest expense as a share of GDP has dropped from a high of 3 percent in 1985, when the debt-to-GDP ratio was about 25 percent, to about 2 percent today with a debt-to-GDP ratio of 140 percent (figure 7). In 2006, before the financial crisis, which sharply boosted Japan’s debt burden, the interest expense on its national debt had dropped to about 1.4 percent of GDP, about where the US interest expense burden is today. Recall from the December 2012 Economic Outlook that the US interest cost burden has dropped from just over 3 percent of GDP in 1995 to about 1.4 percent today. The drop has occurred while the US debt-to-GDP ratio has climbed from just over 50 percent in 1995 to 84 percent today.
Japan has outdone America in the realm of surging “unsustainable” debt and deficits. Since 1998, when American and Japanese debt-to-GDP ratios were identical at 45 percent, the Japanese ratio has more than tripled to 3.11 while the American ratio has nearly doubled to 1.87. Over the same period, the interest rate on five-year government debt in Japan has dropped from 1.4 percent to 0.2 percent while the comparable rate in America has dropped from over 5 percent to 0.8 percent. Relative to the United States, Japan has experienced a far more rapid rise in its debt-to-GDP ratio and a much sharper drop in its government borrowing costs. Much of the credit, if one can call it that, goes to Japan’s persistent deflation, as I will explain further.
Lessons for the United States
Congress, take note. Although American deficits do need to be reduced and debt accumulation does need to be slowed and eventually reversed, cries of imminent disaster from “unsustainable” deficits and a supposed bond market collapse will not accomplish this goal. Persistently rising bond prices in Japan and the United States have undercut the “sky-is-falling” rationale for deficit reduction.
Instead of bellowing about a disaster that never comes and saps the momentum from sound fiscal policy, Congress should be cutting deficits through reforming entitlement programs and lowering tax rates while closing tax loopholes. The aim of these measures is to enhance economic growth. Recognizing and striving to achieve the benefits of a sound fiscal policy will produce more progress on deficit reduction and debt stabilization than will empty threats of soaring interest rates and bond market collapse.
Clearly, the debt-to-GDP ratio, the most frequently mentioned metric of “unsustainable” deficits, is not a reliable guide to the sustainability of deficits, notwithstanding frequent warnings that ratios above 80–90 percent represent a danger zone. These warnings have not been prescient for Japan, where the ratio is 140 percent and headed higher.
The debt-to-GDP ratio rises for one or both of two reasons: (1) the primary deficit (the difference between government spending and tax revenues) rises and (2) the interest gap, or the difference between government interest cost (the yield on government debt) and the growth rate of nominal GDP, is positive. After 2007, Japan’s primary deficit as a share of GDP surged because tax revenues collapsed along with nominal GDP (figure 8). The collapse in nominal GDP growth also caused a second component of debt-to-GDP growth—the interest gap—to surge, adding sharply to the rise in Japan’s debt-to-GDP ratio (figure 9).
Japan’s interest gap, along with that of the United States, dropped sharply after 2009 but has since rebounded because of slow nominal GDP growth. At the same time, the rebound in US nominal growth has helped to slow the rise in its ratio of debt to GDP by holding its interest gap steady at below –2 percentage points (figure 9).
Japanese Prime Minister Abe is taking a double-barreled approach to shock Japan out of its deflationary torpor. As already noted, he has initiated a huge public works program worth about 2.6 percent of GDP, which will sharply boost government spending and its bond issuance. Simultaneously, Abe has pressured the Bank of Japan in a way that amounts to virtually ordering it to print money to finance that increase in government borrowing. The Bank of Japan has room to grow in asset acquisition and money printing relative to other central banks. Since 2007, Bank of Japan assets have risen by only about 50 percent, while the assets of the Fed have risen from about $800 billion to $3 trillion, or by nearly 275 percent.
The Abe government has made no secret of the fact that the aim of the Bank of Japan’s money printing and foreign bond purchases should be to depress the value of the yen so as to increase the competitiveness of Japanese goods in global markets while changing Japan’s deflation into inflation. But Abe is also boosting domestic demand with a big surge in public works projects. The boost in domestic demand will help to reduce criticism from Japan’s trading partners, like the United States, over the weaker yen policy. Japan’s reply can be that it is part of a concerted effort to save the Japanese economy from total collapse, something that would certainly not be in US interests.
Prime Minister Abe can and will dismiss complaints about his weak yen policy, citing Japan’s persistent deflation and stagnation over the past 15 years. The US Treasury has not cited China as a currency manipulator over the past decade when it undertook a huge yen-selling intervention to avoid appreciation of its currency. Is President Obama going to take a tougher stance against our ally Japan for yen selling to push the yen lower? I doubt it.
Abe has strongly telegraphed his double-pronged approach to reignite Japanese growth since November of last year, in frequent public statements during and since his successful election campaign. His announcement of the new growth initiative has produced results. The Japanese yen has depreciated by about 12 percent from 80 yen to the dollar to 90 yen to the dollar over the past two months.
Simultaneously, Japan’s stock market has risen by nearly 25 percent from a low of about 8,200 on the Nikkei last fall to nearly 11,000 today. The stock market is forward looking, and the price rises signal anticipation that Japan’s additional monetary and fiscal stimulus will help domestic companies increase their expected profits. The weaker yen will help trading companies, and the rising stock prices enhances the wealth of Japanese households and helps boost domestic demand through higher consumption and growth. Abe will answer critics of a “weak yen” policy by pointing out correctly that a Japan growing at 3 percent nominal rate, even with a weaker yen, is a better trading partner than a stagnant, deflationary Japan with a stronger yen.
It is likely, given the Abe government’s determination to pursue expansionary fiscal and monetary policies even in the face of foreign criticism, that Japan’s stock market will rise further, perhaps even doubling in value over the coming year. Most global portfolio managers have long since given up on Japan as a viable investment, having been repeatedly burned by trying to predict a recovery in Japan. They are underweighting Japanese assets by at least $60 billion, according to Goldman Sachs.
A primary reason for investor caution on Japan was underscored last February when stocks rose quickly by over 8 percent and the yen weakened based on the Bank of Japan’s quickly abandoned promise to boost money growth and inflation. I was fooled, too. Bank of Japan Governor Shirakawa reneged in March 2012 on his reflation stance. The stock market fell sharply by about 15 percent while the yen appreciated.
That said, once global investors realize that this time Japan is serious about boosting growth, since the government is now in charge and Shirakawa is on the way out, portfolio reallocation toward Japan will increase, boosting Japan’s stock market growth even further. The yen could well weaken to above 100 per dollar from 90 in mid-January.
Japan’s own investors have shown a strong preference for government bonds over stocks during the long period of stagnation and deflation. This is largely because even though Japan’s government bonds yield only 0.2 percent on five-year notes, its 1.5 to 2 percent deflation rate makes the real return on those low-risk investments a relatively attractive 2 percent (0.2 percent plus 1.8 percent deflation). That return is considerably more attractive than the real return on US government bonds of about –1.2 percent (0.8 percent minus 2 percent inflation). (See figure 10.) As the stock market rises, Japanese households and domestic investors will switch from bonds to stocks, further boosting the value of the Nikkei.
Japan’s stimulus measures are unambiguously inflationary. They are meant to be so. The Bank of Japan has been instructed to target 2 percent inflation for a good reason. This benchmark will boost nominal GDP and thereby boost tax revenues. It will further elevate expected profits in Japanese firms, push up the stock market, and may even push up the value of the housing sector and commercial real estate. The resulting wealth recovery, which could be substantial, could put Japan back on a sustainable path of positive growth through higher productivity.
Japan has an underlying problem with long-term growth because of its stagnant to shrinking population. (See figure 11.) Ultimately, a strong recovery of the Japanese economy, if sustained over time, may help to stabilize population growth, but Japan’s long-run need is to allow immigration so as to buttress its modest, shrinking domestic workforce.
Eventually, inflation in Japan will push up bond yields and increase the burden of financing Japan’s large stock of outstanding debt. If the Japanese five-year interest rate rose from 0.2 to about 0.8 percent (the level of interest rates on US government bonds with 2 percent inflation), the result would be a 0.6 percentage point increase in the cost of financing the nation’s net debt, currently worth 1.5 times GDP. Other things equal, the cost of financing its debt would rise sharply to 8 percent of GDP.
But the rise in Japan’s debt-to-GDP ratio would be slowed by faster growth in heretofore stagnant nominal GDP. A rise in nominal GDP growth from 0 to 3 percent would cause tax revenues to grow by 3 percent at steady tax rates. Simultaneously, with the interest rate at 0.8 percent, 2.2 percentage points below the new 3 percent growth rate on nominal GDP, the growth of the debt-to-GDP ratio would slow by 2.2 percent per year. In sum, ending deflation and engineering a higher growth rate of real and nominal GDP could put Japan’s economy and debt-deficit structure back on a sustainable path.
During the first year of operation, Japan’s aggressive money printing program would hold steady the current level of nominal interest rates. As Japan’s deflation ebbs and prices and growth begin to rise, heavy bond purchases by the Bank of Japan will keep interest rates low and further stimulate the economy. Holding five-year interest rates steady at 0.2 percent once nominal growth rises to 3 percent would reduce the growth of Japan’s debt-to-GDP ratio by 2.8 percent per year. Eventually, higher growth and inflation will require the Bank of Japan to rein in its expansionary policy to keep inflation from rising above 2 percent, but this problem is far down the road. First, Japan needs to pursue expansionary monetary and fiscal policy to get its economy growing again.
Policy Choices: Japan versus America
Japan’s more acute problems—deflation and stagnation—make its policy choices simpler than those of the United States. Although the United States has a lower debt burden, it has already implemented expansionary monetary policy to hold inflation at 2 percent. If fiscal austerity is applied too rapidly, US growth will drop and the debt-to-GDP ratio will rise, boosting the nation’s debt burden. If the Fed tries to stem the rise with too much money printing, inflation could rise and drive up interest rates, exacerbating the US debt burden. If five-year US yields rose by 1 percent to 1.8 percent while nominal growth fell from 3 to 1 percent, the interest gap would boost the debt-to-GDP ratio by 0.8 percent a year (1.8 – 1 = 0.8), instead of reducing it by 2.2 percent (0.8 – 3 = –2.2) a year, as is currently the case (figure 9).
Congress and the president need to avoid excessive austerity with respect to changes in fiscal policy this year. Over the past four years, on average, the fiscal boost applied to the American economy has been worth about 3 percent of GDP. This year, with tax increases and sequestration, fiscal drag will be about 1.5 percent of GDP.
That huge 4.5 percent of GDP collapse in fiscal thrust is virtually unprecedented, especially coming as it does when the US economy has been growing at a tepid 1.9 percent rate over the past four years with the help of highly expansionary fiscal and monetary policy. What will growth be with fiscal drag at 1.5 percent of GDP, as is currently the case? We could see an abrupt halt of growth or even negative growth if fiscal remedies are applied too abruptly, especially with the Fed unable to offer additional help with another round of quantitative easing.
The lessons from Europe and Japan are that austerity, per se, is not the way to move to a sustainable fiscal stance. Rather, the US economy needs a combination of tax reform to boost growth and legislation enacted now to stabilize the future growth of outlays on entitlement programs. That approach would slow overall spending growth enough to stabilize the debt-to-GDP ratio over the next five years. After 2018, sustained economic growth and slower growth of government spending would put the debt-to-GDP ratio on a negative long-run path. Holding the deficit steady at $500 billion per year would achieve this goal of stabilizing and then reducing America’s debt-to-GDP ratio.
Japan’s experience cautions that a monetary policy aimed at avoiding deflation coupled with a fiscal policy aimed at sustaining growth of domestic demand is the best long-run stance to achieve a sustainable level of debt and growth. America has done the monetary part; now it is time for the fiscal part.
1. John H. Makin, “Trillion-Dollar Deficits Are Sustainable for Now, Unfortunately,” AEI Economic Outlook (December 2012), www.aei.org/outlook/economics/monetary-policy/trillion-dollar-deficits-are-sustainable-for-now-unfortunately/.
2. See John Authers, “Optimism Stirs as Japan Emerges from Irrelevance,” Financial Times, January 19, 2013, 16.
3. John H. Makin, “Is Japan Set to Boom?” AEI Economic Outlook (March 2012), www.aei.org/outlook/economics/international-economy/is-japan-set-to-boom/.