Friday 08 Oct 2021 | 03:58 | SYDNEY
Friday 08 Oct 2021 | 03:58 | SYDNEY

Deficits: The special case of Japan


Stephen Grenville

17 February 2011 12:53

Sam is right in finding Richard Koo's arguments on government deficits compelling. As usual, however, there are two sides to every argument.

For Japan, it's only just over a month ago that The Interpreter linked us to a warning that, with government debt issue equal to tax revenue, the budget deficit might not be sustainable.

One thing is clear: Japan is special, and its experience (for better or for worse) may not be transferable. Thanks to this on-going budget deficit, it has accumulated a world-beating level of government debt (twice the level usually considered the upper limit). Although the rating agencies have recently downgraded Japan largely because of this, most commentators are relaxed because Japan's interest rate has been consistently far below the international norm, so the cost of servicing this debt is manageable.

Leaving aside the possibility that Japanese interest rates might rise enough to cause problems, other countries don't have the luxury of funding their deficits from pliant domestic bond-holders who put up with the low investment returns: almost all Japanese government debt is held at home. This means Japan is not subject to the threat most large debtors face: that the foreigners who hold this debt, worried by the possibility of deprecation, will take their money and run, triggering a disruptive fall in the exchange rate.

But there have to be some residual concerns here: when half the budget is being paid for by debt issue rather than tax revenue, even a small increase in interest rates would quickly expand the deficit.

In any case, the Japanese might not worry too much about a fall in the exchange rate, because they would see it as a boost to their export sector. This sector has already been doing much of the heavy lifting in keeping the economy going. As a result, Japan runs a very large current account surplus. That's helpful for Japan in keeping demand growing: like China and Germany, Japan gets the advantage of net demand from overseas.

But not every country can do this. The world as a whole has to balance, and the current account surplus that has helped sustain Japanese demand has meant the US (one of the counterparts to this surplus) has to work harder (run bigger budget deficits) to sustain demand at home.

How much longer can the Japanese budget go on compensating for the balance-sheet repair of Japanese companies' One balance sheet problem is being solved at the expense of another being worsened. Future generations of Japanese taxpayers will pay for the repair of these private sector balance sheets. Later on, some may ask whether it might not have been better to require the company management and shareholders whose misjudgments took Japan into its 'lost decades' to turn in their badges, and let someone else have a go at running the businesses.

The alternative was a more 'cold turkey' approach: more company bankruptcies. Of course these are painful, but it is financial wealth that is destroyed in bankruptcy, not real physical capital. The business assets would have been bought by other companies, demand would have flowed to new firms rather than to failed companies and zombie banks. We might have seen a renewed and restructured Japan, not an economy still requiring continuing budget stimulus, even two decades after the bubble burst.

Enough on Japan: it may well be that this was the right strategy for Japan, and Richard Koo's detailed understanding must win the day. What about other countries' More on that in a follow-up post.

Photo by Flickr user Straws pulled at random.