Mon, Jan 21, 2013 - Page 9 News List

Japanese growth strategy could lead to disaster

Shinzo Abe may be putting Japan at risk of a combination of exploding debt and rising interest rates, a recipe for economic turmoil

By Martin Feldstein

Japan’s new government, led by Prime Minister Shinzo Abe, could be about to shoot itself in the foot. Seeking to boost economic growth, the authorities may soon destroy their one great advantage: the low rate of interest on government debt and private borrowing. If that happens, Japanese conditions will most likely be worse at the end of Abe’s term than they are today.

The interest rate on Japan’s 10-year government bonds is now less than 1 percent — the lowest in the world, despite a very high level of government debt and annual budget deficits. Indeed, Japan’s debt is now about 230 percent of GDP, higher than that of Greece (175 percent of GDP) and nearly twice that of Italy (125 percent of GDP). The annual budget deficit is nearly 10 percent of GDP, higher than any of the eurozone countries. With nominal GDP stagnating, that deficit is causing the debt/GDP ratio to rise by 10 percent annually.

Japan’s government is able to pay such a low rate of interest because domestic prices have been falling for more than a decade, while the yen has been strengthening against other major currencies. Domestic deflation means that the real interest rate on Japanese bonds is higher than the nominal rate. The yen’s rising value raises the yield on Japanese bonds relative to the yield on bonds denominated in other currencies.

That may be about to come to an end. Abe has demanded that the Bank of Japan (BOJ) pursue a quantitative-easing strategy that will deliver an inflation rate of between 2 percent and 3 percent and weaken the yen. He will soon appoint a new BOJ governor and two deputy governors, who will, one presumes, be committed to this goal.


The financial markets are taking Abe’s strategy seriously. The yen’s value against the US dollar has declined by more than 7 percent in the last month. With the euro rising relative to the dollar, the yen’s fall relative to the euro has been even greater.

The yen’s weakening will mean higher import costs, and therefore a higher rate of inflation. An aggressive BOJ policy of money creation could cause further weakening of the yen’s exchange rate — and a rise in domestic prices that is more rapid than what Abe wants.

With Japanese prices rising and the yen falling relative to other currencies, investors will be willing to hold Japanese government bonds only if their nominal yield is significantly higher than it has been in the past. A direct effect of the higher interest rate would be to increase the budget deficit and the rate of growth of government debt. With a debt/GDP ratio of 230 percent, a 4 percentage point rise in borrowing costs would cause the annual deficit to double, to 20 percent of GDP.

The government might be tempted to rely on rapid inflation to try to reduce the real value of its debt. Fear of that strategy could cause investors to demand even higher real interest rates.

The combination of exploding debt and rising interest rates is a recipe for economic disaster. The BOJ’s widely respected governor, Masaaki Shirakawa, whose term expires in April, summarized the situation in his usual restrained way, saying that “long-term interest rates may spike and have a negative effect on the economy.”

A spike in long-term rates would lower the price of the bonds, destroying household wealth and, in turn, reducing consumer spending. The higher interest rates would also apply to corporate bonds and bank loans, weakening business investment.

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