Article: Consequences of Yen Devaluation

[LWPD]

An outstanding article on the state of Japan's economy, and the nuclear option in their arsenal of Yen devaluation. Consequences could be far reaching.

The yen’s looming day of reckoning
As Japan looks set to weaken yen, China must brace for impact
By Andy Xie

Japan is on an unsustainable path of a strong yen and deflation. The unprofitability of Japan’s major exporters and emerging trade deficits suggest that the end of this path is in sight. The transition from a strong to weak yen will likely be abrupt, involving a sudden and big devaluation of 30 to 40 percent. It will be a big shock to Japan’s neighbors and its distant competitors like Germany. The yen’s devaluation in 1996 was a main factor in triggering the Asian Financial Crisis. Japan’s neighbors must have a strong banking system to withstand a bigger devaluation of the yen.

Self-inflicted Deflation

Japan’s nominal GDP contracted 8 percent in the four years to the third quarter of 2011, and six percentage points of that was due to deflation. Without increased government expenditure, the contraction will be one percentage point more. Japan has not seen this kind of sustained deflation since the 1930s.

Without government deficits, Japan’s economy will decline much more. Central government bonds and borrowings plus its guaranteed debts rose by 116.3 trillion yen during the period, equivalent to one-fourth of the level of the nominal GDP in the third quarter of 2011. If Japan had adopted balanced budgets, its economy would have contracted two to three times more. This will lead to a debt crisis in its private sector.

A strong yen, deflation and rising government debt form a short-term equilibrium that lasts as long as the market believes it is sustainable. The yen has seen a relentless upward trend since it depegged from the dollar in 1971, up to 83.4 from 360 again to the dollar. When wages and asset prices rise, a strong currency can be justified. When wages and asset prices fall, a strong currency is suicide. Japan’s nominal GDP peaked in 1997 and its nominal wages did too. Its property prices have declined every year since. The Nikkei rose in only four out of the last fifteen years and is still close to a three-decade low.

Japanese policymakers, businesses, academics, currency traders and the average Mrs. Watanabe all believe in a strong yen. This belief is wrong but self-fulfilling. It has lasted so long because the Japanese government adopts policies to offset the destabilizing effects of deflation due to a strong yen. Hence, Japan’s national debt has marched upwards along with the value of yen. It is expected to top yen 1,000 trillion in 2012, 215 percent of GDP, 7.8 million yen (or roughly US$ 94,000) per person, and about half of net household wealth per capita.

The sustainability of Japan’s deflationary path depends on the market’s confidence in Japan’s debt market. As Japanese institutions and households hold almost all of the government’s debts, their faith in the government’s creditworthiness is the mojo for Japan’s seemingly harmless deflationary spiral.

A Vast Bubble

In a normal market, greater supply leads to lower prices. The opposite occurs in a bubble; faith in price stability or appreciation exaggerates demand. Japan has the highest level of government debt and the lowest bond yield. The later is necessary for the former. Even though the yield on 10-year Japanese Government Bonds (JGB) is only 1 percent, the interest expense is expected to top 22.3 trillion yen in the fiscal year that begins next month. This is one-quarter of the general account budget. If the bond yield rises to 2 percent, the interest expense would surpass the total expected tax revenue of 42.3 trillion yen.

In addition to its fiscal vulnerability to a rising interest rate, Japan’s budget deficit is still too high. The government budgeted 44 trillion yen in net additional borrowing in the next fiscal year, nearly half of its expenditures. It needs to double its tax revenue to balance the budget. But, as the economy is deflating with declining private consumption, a major tax increase would cause the economy to go down more, shrinking the tax base and requiring even bigger tax increases to balance the budget. Even though the government plans to achieve a primary fiscal surplus, i.e., revenue above non-interest expense, by fiscal 2020 to 2021, it is difficult to see how.

The justification for the low JGB yield is deflation. The real interest rate (the nominal rate plus deflation) is comparable to that in other countries. This rationale requires deflation to persist. But, deflation shrinks the nominal GDP or tax base. How could the government pay back its escalating debt by taxing a shrinking economy? It can only sustain its debt by borrowing more. This fits the definition of a particular type of Ponzi scheme.

The JGB bubble explains the seeming lack of pain in Japanese society. A strong yen and deflation haven’t led to an employment crisis because the government deficit is pumping up aggregate demand. As long as wages decline in line with prices, one doesn’t feel the pain. Japan’s household debt is only half of GDP, about half of the level in the United States. Deflation doesn’t cause much balance sheet trouble.

The Strong Yen Bubble

Yen bulls usually point at Japan’s trade and current account surplus as supporting factors. A trade surplus can reflect a country’s competitiveness or lack of it. Current account surplus is savings minus investment. When investment declines, the trade surplus is boosted. When a country cuts investment, it signals declining competitiveness. Hence, the current account surplus shouldn’t be viewed as a supporting factor for strong currency.

The combination of a weak economy and strong currency are always suspect. But it has lasted for so long that even foreigners take it for granted. I think this is some sort of mass hysteria. Most people only remember a strong yen. On the other hand, most people haven’t seen rising property or stock markets either.

Japanese culture is group-oriented. Individuals usually embrace group activities. This psyche was the reason that Japan’s property bubble became so big in the 1980s. In terms of value above the normal level, Japan’s bubble was five to six times the size of the bubble in the United States. After the property bubble, the group psyche shifted its power to a strong yen, pushing Japan’s economy onto the path of a rising yen, deflation and rising government debt.

Japan’s paralyzed political system is the reason the government has accommodated the deflation path by running up national debt. The Japanese people, on the other hand, buy the debt because deflation makes property or stocks bad investments and a strong yen discourages them from buying foreign assets and deflation.
Despite the fact Japan has had a bad economy for so long, the yen has remained strong. It reinforces the Japanese psyche on the issue. The strong yen has become a cult.

The international financial market believes in a weak yen from time to time. In 1998, the short-selling by foreigners briefly caused the yen to touch 140 against the U.S. dollar. But, as the Japanese hold all of the yen, if they believe in the yen, foreign short-sellers get punished eventually. Over time, yen bears are all weeded out of the market. The remaining yen traders are all believers in a strong yen.

The End is in Sight

No bubble is sustainable. While the Japanese can always take care of business within, they cannot control the outside world. The country’s Achilles heel is losing trade competitiveness due to the destructive impact of deflation on business confidence and the strong currency itself. When a trade deficit emerges, it signals the beginning of the end.

Japan has lost competitiveness in a swath of industries that it used to dominate. Its automobile industry is losing out to Germany, South Korea and the United States. Japan’s automobile industry used to be competitive in cost and far superior in quality to its global competitors. But the world has changed. The yen has dropped below 110 from as high as 160 against the euro. The South Korean won was about ten against the yen and is now 13. Cost-cutting cannot offset such a big change in exchange rates. The U.S. auto industry cut its labor costs and debt burden through the government bailout. It is now more competitive than Japan’s.

The automobile industry is the pillar of Japan’s economy. Its decline leaves Japan’s economy nowhere to turn. Indeed, if the auto industry leaves Japan, it will become a poor country.

Japan’s electronics industry, still significant to its economy, is losing out big time to its Asian competitors. Nothing hot in electronics is made in Japan now. U.S. companies like Apple leverage China’s manufacturing sector to turn out hot products. South Korea is embracing the vertically integrated model and churning out competitive products like Japan used to.

Nothing symbolizes Japan’s decline like its electronics industry. It was the envy of the world and had all the ingredients to take the industry into the mobile internet era. Instead, it embraced insulation and made products just for the Japanese market. Now it is almost irrelevant to the outside world.

Japan isn’t just facing macro troubles. Its micro competitiveness is rotting away. It is just bizarre to see that the whole world believes in a strong yen when Japan is failing on such a grand scale.

Japan’s trade balance may swing into surplus from time to time, but the negative trend is irreversible. Japan will face rising trade deficits. That makes foreigners’ views important because Japan would need foreign money to fund its deficit. When foreigners change their views, which they surely will, the yen will crash.

The Only Way Out

Japan has only one way out – a massive devaluation. If the stable national debt is 120 percent of GDP, the yen needs to be devalued by 40 percent because devaluation is ultimately equal to the nominal GDP increase. The devaluation is likely to sustain 2 percent to 3 percent of nominal GDP growth for Japan beyond the repricing induced increase, which is necessary to restore Japan’s tax revenue. Deflation has caused Japan’s tax revenue to decline as a share of GDP. It can be only reversed through restoring nominal GDP. A devaluation of 40 percent can restore Japan’s competitiveness against Germany and South Korea, which will lay the foundation for Japan’s industrial recovery.

The Bank of Japan is trying to weaken the yen through expanding its balance sheet. It has an asset purchase program of 65 trillion yen and a lending program of 5.5 trillion yen. The two are equivalent to 15 percent of GDP, comparable to what the Fed or European Central Bank have done. The effectiveness is limited so far. Because Japanese businesses, households and investors believe in a strong yen, the printed yen largely stays in the country and just slows down money velocity. The U.S. dollar has risen 10 percent against the yen from last year’s bottom. This is probably due to the financial market upgrading its view of the U.S. economy rather than the BoJ’s action.

Yen devaluation is likely to unfold quickly. A financial bubble doesn’t burst slowly. When it occurs, it just pops. The odds are that yen devaluation will occur over days. Only a large and sudden devaluation can keep the JGB yield low. Otherwise, the devaluation expectation will trigger a sharp rise in the JGB yield. The resulting worries over the government’s solvency could lead to a collapse of the JGB market. Of course, the government will collapse with the JGB market.

The day of reckoning for the yen is not distant. Japanese companies are struggling with profitability. It only gets worse from here. When a major company goes bankrupt, this may change the prevailing psychology. A weak yen consensus will emerge then.

China and South Korea

A yen collapse will impact China and South Korea most, just like in 1998. It will trigger substantial weakness in their industries. If a banking system succumbs, the shock can bring down an entire economy, as South Korea’s experience in 1998 demonstrates.

Both China and South Korea have weak banking systems. South Korea’s banking system is one of the most leveraged in the world due to high level of household loans. In 1998, a similar shock sank its banking system that was overleveraged with industrial loans. Now it is overleveraged with household loans. A shock could sink it again.

Overinvestment and a property bubble make China’s banking system very vulnerable to such a shock. Unless China substantially increases the capital in its banking system, a big yen devaluation could cause China’s banking system to sink. China suffers from overinvestment and a property bubble, as Southeast Asia and South Korea did in 1997. In terms of the magnitude of leverage, China’s situation is much worse. Hence, a yen devaluation could wreak havoc to China’s economy.

[LWPD]

Below is an excellent supplement to the original article. While deeply in debt, Japan has long been a creditor nation that ran large budget surpluses. That reality has now changed. Servicing interest on debt becomes far more difficult in an environment where revenues are declining and other nations are benefiting from mercantile trade policies. Some form of far reaching action (and reaction) is inevitable.

Courtesy of China Financial Markets Blog
The Japan debt disaster and China’s (non)rebalancing
By Michael Pettis

In this issue of the newsletter I want to sketch out a scenario in which rather than analyze policy announcements or make predictions I try to lay out what are the various possible paths open to China. The scenario concerns trade. China’s current account surplus has declined sharply from its peak of roughly 10% of GDP in the 2007-2008 period to probably just under 4% of GDP last year. Over the next two years the forecast is, depending on who you talk to, either that it will rise significantly, or that it will decline to zero and perhaps even run into deficit. The Ministry of Commerce has argued the latter and the World Bank the former.

I am not sure which way the surplus will go, but I would argue that either way it is going to be a very strained and difficult process for both China and the world. On the one hand if the Ministry of Commerce is arguing, as many do, that the rapid contraction in the surplus indicates that China is indeed rebalancing and will continue to do so, I think they are almost certainly wrong. China is not rebalancing and the decline in the surplus was driven wholly by external conditions. In fact until 2010, and probably also in 2011, the imbalances have gotten worse, not better.

For proof consider China’s total savings rate as a share of GDP relative to China’s total investment rate. The current account surplus, of course, is equal to the excess of savings over investment – any excess savings must be exported, and by definition the current account surplus is exactly equal to the capital account deficit. This is the standard accounting identity to which I have referred many times in my newsletters.

The savings and investment numbers show that the last time investment exceeded savings was in 1993-94, and during that time China of course ran a current account deficit. This was just before Beijing sharply devalued the RMB, after which it immediately began running a surplus, which has persisted for 17 years. Since 2007 savings have climbed from 50% of GDP to nearly 53% in 2010. During this time investment has climbed from just over 40% of GDP to nearly 49%. the difference between the two has declined from just over 10% of GDP to just under 4%, and this of course is just another way to say that China’s current account surplus has dropped from just over 10% of GDP to just under 4%.

Savings are rising

From the accounting identity it is clear that if the current account surplus declines, there are logically only two ways it can happen. One way is for the savings rate to decline. In that case the investment rate must either rise, or it must decline more slowly than the savings rate. The other way is for the savings rate to rise. In that case the investment rate must rise even faster.

In the first case a declining savings rate indicates that Chinese consumption is indeed rising and Chinese investment is declining (or at least rising more slowly than consumption). This is the “right” way for the trade surplus to decline because it represents a rebalancing of the Chinese economy away from its dependence on investment and the trade surplus and towards consumption. In the second case – the “wrong” way – consumption is actually declining further as a share of GDP, and the reduction in China’s dependence on the trade surplus is more than matched by an increase in its dependence on trade.

So is China rebalancing? Of course not. Rebalancing would require that the domestic consumption share of GDP rise. Is the consumption share of GDP rising? Clearly not. If consumption had increased its share of GDP since the onset of the crisis, the savings share of GDP would be declining.

And yet savings continue to rise. This is the opposite of rebalancing, and it should not come as a surprise. Beijing is trying to increase the consumption share of GDP by subsidizing certain types of household consumption (white goods, cars), but since the subsidies are paid for indirectly by the household sector, the net effect is to take away with one hand what it offers with the other. This is no way to increase consumption.

Meanwhile investment continues to grow and, with it, debt continues to grow, and since the only way to manage all this debt is to continue repressing interest rates at the expense of household depositors, households have to increase their savings rates to make up the difference. So national savings continue to rise.

What then explains the decline in China’s current account surplus over the past three years? The numbers make it pretty obvious. The sharp contraction in China’s current account surplus after 2007-08 had was driven by the external sector, and in order to counteract the adverse growth impact Beijing responded with a surge in investment in 2009. You can argue whether or not this was an appropriate policy response (yes because otherwise growth would have collapsed, or no because it seriously worsened the imbalances), but certainly since then as consumption has failed to lead GDP growth, investment has continued rising too quickly.

Can China’s surplus rise further?

It is, in other words, rising investment, not rebalancing towards higher consumption, that explains the contraction in the current account surplus. The savings share of GDP is still actually rising. By coincidence on Wednesday I received a piece from Louis Kuijs, formerly of the World Bank and now of the Fung Global Institute, that supports this interpretation. In it he says:

Many a headline has highlighted how rising costs in China are putting pressure on profit margins and reducing the competitiveness of the country’s huge labour-intensive, export-oriented manufacturing industry - prompting multinational companies to start shifting production to other countries in Asia.

However, a closer look at trade data shows that China’s overall exports are still gaining market share. In 2011, Chinese exports grew by around 20 per cent in US dollar terms and 10 per cent in real terms, compared to an increase in real global imports of around 7 per cent.

Kujis goes on the argue that China’s export growth will remain strong in the future, and he may be right, but for me what is important here is that while the world is struggling with weak growth in demand, and surplus countries are being forced to rein in their surpluses, China’s share of total surpluses are probably actually expanding. This suggests that China is restraining, not leading, global trade rebalancing, and given China’s difficulty in raising the consumption share of GDP this shouldn’t be a surprise.

So which way will China’s current account surplus move over the next few years? If we could ignore external conditions, I would argue that the current account surplus should grow in the next few years. Why? Because Beijing is finding it impossibly hard to raise the consumption rate, and yet it is extremely important that it reduce the investment rate before debt levels become unsustainable. Under these conditions I would argue that we should expect the savings rate to hold steady as a share of GDP or – if we are lucky – for it to decline slowly over the next few years.

Investment, on the other hand, should decline quickly unless it proves difficult for the post-transition leadership to arrive at a consensus about the need to slow investment growth. I would expect investment to begin dropping erratically sometime in 2013, but I confess that I have no sense of whether or not those who understand how dire the economic situation is can convince the others within the leadership during this period.

If investment rates drop more quickly than the savings rate, by definition this would result in an increase in China’s current account surplus. This is why I would argue that if we ignore external conditions I would predict a rise in China’s trade surplus over the next few years. But of course there is a huge constraint here. Can the world accommodate China’s need to absorb more foreign demand in order to help it through its own transition?

Here I am pretty pessimistic. The first problem is that the big deficit countries have little appetite for rising imbalances. Clearly the US wants to reduce its trade deficit and at the very least it will resist a rapid increase in the trade deficit. The deficit countries of peripheral Europe, who with the US represent the bulk of global trade deficits, are going to have to adjust quite quickly as the financial crisis continues and as their growth slows, and their deficits will contract sharply as their abilities to finance them contract.

Declining trade deficits around the world require declining trade surpluses. Part of the adjustment in Europe I suspect will be absorbed by a contraction in Germany’s surplus, but the Germans of course are resisting as much as possible since they, too, are dependent for growth on absorbing foreign demand. I don’t know how this will pan out, but certainly Europe as a whole expects its trade surplus to rise, and if instead it begins to run a large deficit, German growth will go negative and the debt burden of peripheral Europe will be harder than ever to bear.

Don’t expect Europe, in other words, easily to accommodate China’s need for a growing trade surplus. If foreign capital flows to Europe increase – perhaps as China and other BRICs lend money to Europe – Europe’s exports will certainly decline relative to imports, but because this means much slower growth for Europe, I don’t think it is sustainable.

The problem of Japan

But a much bigger problem may be Japan, and I am surprised that no one seems to be discussing the very adverse Japanese impact on the future development of global trade balances. Japan, as everyone knows, has an enormous debt burden that is only made manageable because it is financed domestically at extremely low rates. Here is Peter Tasker of the Financial Times on the subject:

When Japan’s bubble economy imploded in the early 1990s, public finances were in surplus and government debt was a mere 20 per cent of gross domestic product. Twenty years on, the government is running a yawning deficit and gross public debt has swollen to a sumo-sized 200 per cent of GDP.

How did it get from there to here? Not by lavish public spending, as is sometimes assumed. Japan’s experiment with Keynesian-style public works programmes ended in 1997. True, they had failed to trigger durable economic recovery. But the alternative hypothesis – that fiscal and monetary virtue would be enough – proved woefully mistaken. Economic growth had been positive in the first half of the “lost decade”, but after the government raised consumption tax in 1998 any momentum vanished. Today Japan’s nominal GDP is lower than in 1992.

Tokyo is clearly worried that it is running out of time to manage the debt, and the indications are that it has finally become serious about reducing its debt burden. What’s more, Japan’s current account surplus has already contracted substantially in the past two years, and in January it ran the biggest monthly trade deficit it has ever run – $5.4 billion, although the early Spring Festival this year may have distorted the number.

This January deficit comes on the back of Japan’s 2011 overall trade deficit, the first time Japan has had an annual trade deficit in many decades. If Japan runs a current account deficit, of course, it means that Japan must turn to foreign sources to finance government debt – a very unwelcome prospect.

How can Japan reduce its debt? I am no expert on Japanese policies but according to much of what I am hearing Tokyo is planning to raise taxes further, especially consumption taxes, and to use the proceeds to pay down the debt. According to an article in the Financial Times that appeared two months ago;

The government and the ruling Democratic party of Japan agreed on Friday on a draft plan to raise the country’s controversial sales tax from 2014, taking a key step towards improving the country’s stretched finances.

Prime minister Yoshihiko Noda has faced an uphill struggle to convince some members of his own party, the opposition and the public that the tax is needed to help restore Japan’s fiscal health at a time of global fears over sovereign debt. The tax has been opposed on the grounds that it could damage an already weak economy. The consumption tax, which is the government’s most stable income stream at about a fifth of total revenues, has long been an obvious candidate for reform.

In addition Tokyo and the business community are putting downward pressure on wages in order to increase the competitiveness of the tradable goods sector. Here is another article from the Financial Times:

Bonuses have been coming under heavy pressure in Japan for years as part of a wider effort to restrain incomes. And while workers around the developed world have been complaining of a squeeze on incomes over the past two decades, in Japan thinner pay packets fuel wider deflation. That makes it even harder for the government to rein in its runaway debt and for the central bank to use monetary policy to boost growth.

The National Tax Agency says average annual salaries, including bonuses, fell in nominal terms every year but one in the decade to 2010, sliding from Y4.61m to Y4.12m. The Japanese Trade Union Confederation (Rengo) says the average size of workers’ bonuses has fallen from a peak of 4.27 times monthly salaries in 1992 to just 2.83 times in 2010.

More recently, a faltering of Japan’s recovery from its deep 2008-2009 slump is threatening to further tighten the screws. Total cash earnings for Japanese salaried workers were down 0.2 per cent in December compared with the previous year, while special payments, which are mainly winter bonuses, fell 0.3 per cent.

Japan reverses course

Yikes! This could turn out to be a huge problem for China and the world. Why? Because raising consumption taxes and reducing wages will push up the Japanese savings rate substantially. Either action pushes the growth rate of disposable income down relative to GDP growth, and lower disposable income usually means lower consumption – which is the same as higher savings.

These policies will probably also reduce the investment rate. Lower Japanese consumption, after all, should reduce business profits and so reduce the incentive for expanding domestic production, while pressure for austerity should restrain or even reduce government investment.

By definition more savings and less investment mean that Japan’s trade surplus must rise. Japan, in other words, is planning to move backwards in terms of rebalancing. Remember that until 1990 Japan had the same problem that China did: its rapid growth was largely a function of policies that transferred wealth from the household sector to subsidize growth.

These policies – an undervalued currency, repressed interest rates and low wage growth, which of course are the same as China’s – restrained consumption and encouraged debt-fueled investment. This investment, we now realize, was wasted on a massive scale and the eventual government absorption of all the bad debt caused government debt to rise.

After 1990 Japan began the slow rebalancing process, but rather than privatize assets and transfer wealth directly to the household sector, the Japanese did it by having the government assume private sector debt. This was politically much easier than privatizing and removing interest rate and capital allocation distortions, but it also meant much slower growth and burgeoning debt.

Now Japan is faced with the same difficult options that it faced twenty years ago and that China faces today. It can privatize government assets, or it can revert to the bad old days of consumption constraining policies. But if it constrains consumption growth and does not replace consumption with a surge in investment, how can it possibly grow except with explosive growth in the trade surplus? Domestic consumption, domestic investment, and the trade surplus are, after all, the only sources of demand growth for any economy.

So where does all this leave us? It’s all pretty clear to me. Of the two big trade deficit entities, neither the US nor peripheral Europe can allow their deficits to rise and we may even see, in the latter case, a sharp drop in the deficit. Of the three big surplus countries, Germany is reluctant to allow it’s surplus to decline by much, and certainly if it declines faster than the European deficits decline, Europe’s debt crisis will be much worse than ever.

China’s surplus can decline only if we see a very improbable decline in its savings rate or a very unwelcome increase in its investment rate – and my guess is that the internal pressures are for the savings rate to hold steady as the investment rate declines. And Japanese reluctance to solve its debt problems by privatization requires that it resolve them with an increase in the trade surplus.

Needless to say this isn’t going to work, and at least one of the above is going to be extremely disappointed. The “good” news is that if this conflict leads to much slower global growth, as it certainly will, the resulting reduction in commodity prices, including oil, will help absorb some of the changes in the trade imbalances as commodity exporting countries see their exports fall sharply. But I don’t see much other relief.

[LWPD]

The European Soverign Debt Crisis dominates the current news cycles, and those problems aren't going away any time soon. Yet just as daunting will be the economic and demographic challenges facing Japan. A great analysis below by Boone and Johnson.

Courtesy of The Atlantic
The Next Panic
By Peter Boone and Simon Johnson

This summer, many government officials and private investors finally seemed to realize that the crisis in the euro zone was not some passing aberration, but rather a result of deep-­seated political, economic, and financial problems that will take many years to resolve. The on-again, off-again euro turmoil has already proved immensely damaging to nearly all Europeans, and its negative impact is now being felt around the world. Most likely there is worse to come—and soon.

But the economic disasters of our time—which involve big banks in rich countries, call into question the viability of government debt, and seriously threaten the reach of even the most self-confident nations—will not end with the euro debacle. The euro zone is well down the path to severe crisis, but other industrialized democracies are hot on its heels. Do not let the euro zone’s troubles distract you from the bigger picture: we are all in a mess.

Who could be next in line for a gut-wrenching loss of confidence in its growth prospects, its sovereign debt, and its banking system? Think about Japan.

Japan’s post-war economic miracle ended badly in the late 1980s, when the value of land and stocks spiked dramatically and then crashed. This boom-and-bust cycle left people, companies, and banks with debts that took many years to work off. Headline-growth rates slowed after 1990, leading some observers to speak of one or more “lost decades.”

But this isn’t the full picture: after a post-war baby boom, population growth in Japan decelerated sharply; the number of working-age people has declined fairly rapidly since the mid-’90s. Once you account for that, Japan’s economic performance looks much better. The growth in Japan’s output per working-age person—a measure of productivity for those who have jobs—has actually kept up with most of Europe’s, and has lagged only slightly behind that of the United States. Japan is a rich country with low unemployment. Its private sector is by no means broken.

So why is Japan’s government now one of the most indebted in the world, with a gross debt that’s 235.8 percent of GDP and a net debt (taking some government assets into account) that’s 135.2 percent of GDP? (In the euro zone, only Greece has government debt approaching the Japanese level.)

After World War II, Japan built a financial system modeled on those of Europe and the United States. Financial intermediation is an old and venerable idea—connecting people with savings to other people wanting to make investments. Such a sensible use of savings was taken to a new level in Japan, the U.S., and Europe in the decades following 1945—helping to fuel un­precedented growth for entrepreneurs and a genuine accumulation of wealth for the burgeoning middle class.

But such success brings vulnerability. Modern financial systems also permit governments to borrow large sums from investors, and as finance has evolved, that borrowing has become easier and cheaper. In the most-advanced countries, governments have increasingly taken advantage of expanding markets for short-maturity debt, whose principal is due soon after the loan is made. This has allowed them to borrow far more, and at cheaper rates, than they otherwise would have been able to do. Typically, these governments then take out new loans as the old ones come due, “rolling over” their debts. This year, for example, the Japanese government needs to issue debt amounting to 59.1 percent of GDP; that is, for every $10 that Japan’s economy generates this year, the government will need to borrow $6. It will probably be able to do so at very low interest rates—currently well below 1 percent.

Devastating crises characterized the pre-war global financial system; these would typically raze banks and other institutions to the ground. In the whipsaw economy of those times, the widespread bankruptcy of borrowers would also ruin a generation of creditors. Over and over, these disasters repeated; some featured sharp inflation, others deflation.

Repeated financial ruin limited the buildup of savings, and the rising middle class was wary about borrowing and lending. The idea that government debt was a safe investment was also typically viewed with skepticism—and for many countries, correctly so.

New policies (and some good luck) dispelled extreme crises from the core of the world economy after WWII. Governments found ways to insure individuals’ deposits, regulate financial markets, and press for banks to become better-managed—and thus less prone to collapse. Central banks became more willing and able to provide emergency assistance. The big financial innovations of the immediate post-war period strengthened the public backstops behind private financial arrangements, and these arrangements proliferated.

So too did publicly provided pensions. These pensions were initially an amazingly good deal for retirees, who paid in little. And as life expectancies increased, retirement benefits were extended. Throughout the rich world, these benefits were predicated on rapid economic growth powered by ever-expanding populations; workers were not expected to put in as much as they would eventually take out. The demographics began changing years ago, but the political incentives did not, nor did the availability of cheap, short-term financing, rolled over regularly.

About half of the Japanese government’s annual budget now goes to pensions and interest payments. As the government has spent more and more to support its growing elderly population, Japanese savers have willingly financed ever-increasing public-sector debts.

Elderly people hold their savings in the form of cash and bank deposits. The banks, in turn, hold a great deal of government debt. The Bank of Japan (the country’s central bank) also buys government bonds—this is how it provides liquid reserves to commercial banks and cash to households. Similarly, Japan’s private pension plans—many promising a defined benefit—own a great deal of government bonds, to back their future payments. Few foreigners hold Japanese government debt—95 percent of it is in the hands of locals.
For ordinary Japanese, public promises about retirement benefits and price stability will be broken just as their private savings collapse.

Given Japan’s demographic decline, it would make sense to invest national savings abroad, in countries where populations are younger and still growing, and returns on capital are surely higher. These other nations should be able to pay back loans when they are richer and older, supplying some of the funds needed to meet Japan’s pension promises and other obligations. This is the strategy that Singapore and Norway, for example, have undertaken in recent decades.

Instead, the Japanese government is using private savings to fund current spending, such as pensions and wage payments. With projected annual budget deficits between 7 and 10 percent of GDP, Japanese savers are essentially tendering their savings in return for newly issued government debt, which is not backed by hard assets. It is backed only by an aging, shrinking population of taxpayers.

Japan’s taxpayers are already rebelling against small tax increases needed to limit escalating deficits. This leaves little room for hope that future taxpayers will accept the larger tax increases needed to repay debts.

Japan’s demographic decline will be hard to reverse—and even in the best-case scenario, the positive effects of a reversal would not be felt for decades. The economy, roughly speaking, is as healthy as it is likely to become. Yet the government seems incapable of steering away from the cliff, a characteristic that should strike no one as uniquely Japanese—just look at how the Euro­pean leadership has behaved over the past half decade, or how you can polarize American politicians with the phrase debt ceiling.

A crisis in Japan would most likely manifest as a collapse of confidence in the yen: At some point, Japanese citizens will decide that saving in any yen-­denominated asset is not worth the risk. Then interest rates will rise; the capital position of banks, insurance companies, and pension funds will worsen (because they all hold long-maturing bonds, which fall in value when rates rise); and fears of insolvency will surface.

Japan has some buffers against calamity—­particularly, its assets held outside the country (including more than $1 trillion in foreign-exchange reserves) and its unmatched ability to export. Nevertheless, the real value of the roughly $14 trillion in government bonds will fall significantly once people fully realize that the tax base is aging and shrinking. Presumably, the yen will also depreciate, perhaps sharply.

The fact that government debt is held mostly by Japanese citizens is not sufficiently reassuring. The same was true in Germany during the 1920s and Russia during the 1990s, yet in both cases the elderly lost their savings to high inflation. Today, Italian and other European savers who hold their own government’s debt are already nervously edging toward the exits. As in Europe, the financial system in Japan could face a wave of insolvencies, triggering a broader loss of confidence.

The shock felt around the world will result not just from the realization that Japan is unable to meet its pension and other social obligations. Investors will also be horrified to see the disappearance of the private savings previously used to buy government debt, whether through debt defaults and bank failures or through high inflation. For ordinary Japanese, public promises about retirement benefits and price stability will be broken just as their private savings for retirement collapse.

No one can predict the timing, but without radical political change that creates a more responsible fiscal trajectory, this will happen.

The most worrisome implication of Japan’s increasingly precarious position, particularly in the wake of the 2008 crash and Europe’s ongoing crisis, is that our financial systems appear to be returning to their inherently unstable nature, which plagued the 19th and early 20th centuries. Financial institutions back then were not too big to fail—they were too big to save. Their balance sheets dwarfed most governments’ ability and willingness to provide support.

Through the development of central banks and active fiscal and monetary policy, the rich world has managed to avoid serious depression for seven decades. Yet big finance—which tends to grow ever larger when crises are rare and credit risks seem muted—hides deep political flaws, the costs of which compound over time. Relative to the size of the world economy, global debt markets overall are two to three times their size in 1970.
Our financial systems appear to be returning to their inherently unstable nature, which plagued the 19th and early 20th centuries.

Bankers and politicians seem to enable the worst characteristics and behaviors of the other. The past few years have led us to focus on half of that phenomenon: the degree to which government guarantees have facilitated irresponsible risk-taking on Wall Street. And this is, of course, an issue that demands continued attention.

But Japan illustrates the other half of the phenomenon—the extent to which finance has allowed and encouraged politicians to make attractive short-term decisions that are eventually damaging. This may ultimately yield worse crises than the one we faced in 2008 or the one now unfolding in Europe. Greece, Ireland, Portugal, Spain, and Italy found their own ways to eco­nomic devastation, but each road was paved with easy credit. Those whom the gods would destroy, they first encourage to borrow cheaply.

Of course, the U.S. is not immune. The immediate problem is not Social Security: that program’s promises can still be covered by modest taxes, and significant immigration has helped prevent a demographic decline like the one Japan is seeing. Nonetheless, the U.S. needs to issue government debt worth about 25.8 percent of GDP this year, to roll over its debts and finance the deficit. About half of the federal government’s debt is already held by foreigners. And a tax revolt has been building since the mid-’70s. Today, one side of the political spectrum refuses to consider rebuilding revenue to the pre–George W. Bush levels—and proposes to cut taxes further. The other side resolutely defends spending programs and middle-class tax breaks. Health-care spending, meanwhile, keeps rising—­largely because powerful lobbies can veto meaningful cost control.

Perversely, interest rates on U.S. government debt are lower than at any other time in living memory—the result, largely, of economic dangers elsewhere. The Europeans have ruined their economies—­and we have benefited from the consequent inflow of capital to our government debt, which has pushed rates down. When Japanese investors begin abandoning their home country, we will benefit again.

These benefits are temporary. Yet politicians have a hard time paying serious attention to fiscal deficits while foreign capital floods in. Even once the U.S. economy recovers, will the government really get its debt under control?

The financial sector is a powerful lobby. What policies does it demand? Financiers want pro-bailout policies kept in place—particularly the massive implicit guarantees against failure that they receive. And they want continued deficits. Our financial titans pay lip service to fiscal responsibility, but they primarily want to pay fewer taxes—­irrespective of what this means for government debt. Indeed, bigger deficits create larger markets for government debt and all of its derivative products, which in turn allow the financial sector’s profits to grow larger. Many politicians are only too happy to oblige.

Elderly Japanese refuse to consider changing their pension system. The euro elite have closed their eyes to the unsustainability of their currency union. And the U.S. has Wall Street in the driver’s seat. We all have political systems that have figured out how to promise far more than can be repaid, and how to work with the financial sector to opaquely transfer resources to powerful groups—at a cost, it is often said, to be paid by future generations.

Increasingly, however, it appears that future generations will not be the only ones harmed by our decisions; we are already feeling the negative impact. In recent decades, financial sectors throughout the rich world grew at historically unprecedented rates; now they are dangerously outsize relative to the rest of the economy. Changing that dynamic in any orderly way looks extraordinarily difficult. Yet history suggests it will change, and soon. The era of large-scale, uncontrolled financial booms and busts—last seen in the 1930s—is back.