Japan's Debt Trap

It's hard to see how Japan's fiscal situation is anything but a crisis. Its national debt is fast approaching 200% of GDP. Its population is shrinking, meaning transfer payments rise as tax revenues fall. Additionally, Japan's life expectancy is one of the highest in the world. Japan is in a debt trap, where interest expense increases faster than its ability to pay it off.

Though Japan's debt has ballooned, yields have actually decreased. The reason for these low yields is the commitment of Japanese firms and households to Japanese bonds. Japanese debt is very unattractive to an investor, yielding only 1.4% for 10 years. Unsurprisingly, foreign ownership of Japanese bonds is only 6.4% as of last March, down from 7.9% a year ago.

The recent financial crisis might have been the tipping point for Japanese bonds, meaning yields could finally rise to appropriate levels. The difference maker is the enormous purchasing power of Japanese households. Japanese households, which have saved more than other OECD countries, have funded much of Japanese and American debt. However, the recession has had a drastic effect on the purchasing power of Japanese households. The savings rate has plummeted to about the same levels as Western nations. There are no signs this will reverse. The Japanese economy is still caught in a deflationary cycle (consumer prices are expected to decline 1.3% this year, and 1% next year). Furthermore, the Yen has strengthened and the dollar has weakened, hurting Japan's export-based economy. These factors indicate that savings could continue to stay muted in Japan for an extended period of time. The decrease in purchasing power of households should theoretically decrease demand and increase yields.

This week, Japanese yields hit a 4-week high. The Japanese Finance Minister Hirohisa Fujii expressed worry over rising yields. But bond prices will not fall too far. The culture and economic structure in Japan will allow the government to decrease yields if it really needs to.

This is a crucial difference between the US fiscal situation and that of Japan. A recent WSJ article discussed how some Americans are reassured that Japanese yields stayed low even as their debt grew at an exponential rate. But people buy Japanese debt for different reasons than they buy American debt. Furthermore, different people buy Japanese debt than American debt. In Japan, buying bonds is patriotic as well as a good hedge against an ingrained deflation. In the US, 50% of the buyers of bonds are foreign. These foreign buyers are not bound by patriotic or deflationary constraints.

As for Japan, the unique balance between deflation, low bond prices, and exponentially growing debt is tenuous at best. Ironically, one of the greatest triggers for trouble in the government bond market might be an economic recovery, though I wonder at times whether that is even still possible. The effect of Japan's deteriorating fiscal situation is more likely to be evident in other parts of the country. As David Hume wrote (hat tip Edward Chancellor), "when a government has mortgaged all its revenues... it necessarily sinks into a state of languor, inactivity and impotence."