Former British prime minister Liz Truss’ disastrous mini-budget, which crashed the pound and ended her tenure after just 44 days, has quickly become a cautionary tale for policymakers around the world as they debate how to spur economic growth and address rising inflation.
However, some national leaders — such as Japan’s — have not heeded the warning.
The main feature of the economic plan concocted by Truss and former British chancellor of the exchequer Kwasi Kwarteng was a ￡45 billion (US$54.7 billion) unfunded tax cut for the rich. This kind of fiscal stimulus made little sense amid the worst inflationary surge since 1980.
Accordingly, the pound plummeted and long-term interest rates soared until the Bank of England had no choice but to intervene to protect pension funds. Truss was ultimately replaced by current British Prime Minister Rishi Sunak, who plans to introduce tax increases to fill the fiscal hole created by Trussonomics.
Against this backdrop, Japanese Prime Minister Fumio Kishida’s Cabinet this month approved a ￥29.1 trillion (US$213.6 billion) spending package. Most of these measures, which aim to ease the pain of soaring inflation, are to be financed by issuing new government bonds, bringing total issuance this fiscal year to ￥62.4 trillion — equivalent to 11.4 percent of GDP and 37 percent of the annual budget.
While this is an improvement over the 2020 budget, 73.5 percent of which relied on new borrowing, the increased spending drives up Japan’s already-elevated debt levels. The country’s outstanding government debt is now expected to exceed ￥1.4 quadrillion, or 250 percent of GDP.
By any measure, Japan’s current fiscal path — running larger deficits and amassing more and more debt — is unsustainable. At some point, markets might no longer accept Japanese bonds as a safe asset, resulting in a sell-off similar to the one that recently crashed British government bonds.
So far, Kishida’s extra spending has not triggered the violent market reaction that Truss’ mini-budget encountered, even though the UK’s debt-to-GDP ratio is less than half that of Japan’s.
One frequent explanation of Japan’s ability to amass debt without triggering higher borrowing costs is that most of its government bonds are held by domestic investors and financial institutions that have never questioned the state’s solvency, and are unlikely to do so in the future. Another explanation is that investors expect the Bank of Japan (BOJ) to support the local bond market whenever a sell-off occurs, as it did when speculators targeted Japanese debt in the past.
Another, more questionable interpretation is that Japan’s net debt is actually smaller than it seems because much of it is owned by the government itself.
However, the biggest buyer of Japanese government bonds is the Government Pension Investment Fund, and liquidating it to pay creditors would destabilize the entire pension system.
Then there are those who claim that Japan could just raise taxes in the event of a fiscal crisis. By raising the value-added tax (VAT) to 25 percent, the argument goes, Japan could generate ￥33 trillion in additional tax revenues, since at the current 10 percent rate, VAT revenue is about ￥22 trillion.
Assuming that these proposed tax hikes would not shrink Japan’s GDP, the extra income would still cover only half of the current fiscal hole. Moreover, Japan is likely to need to raise the VAT anyway to pay for social security, pensions and healthcare for its rapidly aging population.
The BOJ introduced a “yield curve control” regime in 2016, capping the 10-year bond rate at 0.25 percent. If the yield approaches that level, the BOJ would purchase long-term bonds, ostensibly to stimulate growth and address deflation.
However, the BOJ has faced renewed pressure from those who say that the policy might be ineffective or even harmful at a time when the yen is depreciating rapidly and government-bond yields around the world are rising.
The yen’s exchange rate against the US dollar has depreciated to ￥150 from about ￥115 since the start of the year, contributing to sharp increases in import prices that have been hurting consumers and small and medium-size companies. So far, the BOJ has refused to raise interest rates or exit the yield-curve-control policy.
Since the BOJ launched a massive quantitative and qualitative easing campaign in April 2013, its share of outstanding Japanese government bonds has increased to nearly half. Traditional central bankers, many of whom were trained long before the era of the easing program, have criticized the BOJ for enabling the government to run unsustainable budget deficits and inducing moral hazard.
However, the BOJ seems intent on maintaining near-zero interest rates, at least for now, citing the economy’s slower-than-expected recovery from the COVID-19 pandemic. Japanese inflation, at 3.7 percent, is also much lower than in the US and Europe, where prices have increased by 8 to 10 percent year-on-year. While current inflation is above the BOJ’s 2 percent target, Japanese authorities expect it to ease next year.
Policymakers must use inflation as an opportunity to shake off the deflationary mindset that dogged Japan’s economy for more than two decades before the shift to monetary tightening. To be sure, exiting the BOJ’s long-standing ultra-loose monetary policy is not without risk. Interest payments would likely rise, and rapid rate hikes could lead to technical insolvency and so-called negative seigniorage, which would require the government to provide subsidies to the central bank.
Still, the sooner Japan exits its yield-curve-control policy, the better. No doubt, monetary tightening would cause some economic pain.
However, remaining on the current policy path of keeping interest rates at near-zero and issuing more and more new debt would only increase the costs of eventual fiscal consolidation. Given Japan’s adverse demographic trends, the burden on future generations would be all the heavier.
Takatoshi Ito, a former Japanese deputy vice minister of finance, is a professor at the School of International and Public Affairs at Columbia University and a senior professor at the National Graduate Institute for Policy Studies in Tokyo.
Copyright: Project Syndicate
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