Strategy

International finance: Japan's woes are a cautionary tale

Twenty years of stimulus spending has produced debt, deflation, little recovery.

Japanese Prime Minister Yukio Hatoyama has a problem. His Democratic Party of Japan (DPJ) trounced the Liberal Democratic Party in a historic election on Aug. 30, shattering the latter’s virtually unbroken reign since 1955. The DPJ’s platform included doling out money to disadvantaged farmers and families, raising minimum wages and eradicating highway tolls. Additionally, the International Monetary Fund is calling on leaders of developed countries to boost government expenditures to cover shortfalls in business and consumer spending. Unfortunately, Hatoyama’s exchequer probably can’t afford any of this.

Japan is a fiscal basket case. The Organization for Economic Co-operation and Development (estimates the country’s debt-to-GDP ratio (a measure of public debt burden) at around 190% this year. That’s double the OECD average, and worse even than Italy’s. And deficits are expected to persist for years. How Japan got into this bind is a story other advanced countries (like Canada) should study as they run large deficits to stimulate their economies.

In the 1980s, many thought Japan would one day surpass America as the world’s leading economy. Instead, the collapse of stock market and real estate bubbles forced its government to commence one of history’s greatest Keynesian experiments. Japan began running significant deficits in the early 1990s to jump-start its economy. Pundits debate still whether it could have averted disaster by spending more aggressively than it did. What’s clear is that those deficits did not prompt a return to prosperity. Over the past two decades, Japan’s economy meandered sideways, suffering two prolonged bouts of deflation.

Now that Japan’s election euphoria has cooled, observers wonder how Hatoyama will repair his country’s balance sheet. Though he promises to release a detailed plan in December, his options are few and prospects for progress grim.

He might simply keep piling on more debt. Unlike other developed countries, the bulk of Japan’s debt (well over 90%) is not held offshore but rather by its own citizens ? who have thus far shown a willingness to buy more despite Japan’s relatively high debt-to-GDP ratio. That could soon change, however. “Japan is already undergoing rapid population aging, which will likely limit the market’s future absorptive capacity of public debt,” wrote IMF economist Kiichi Tokuoka in a paper this year. “Under current trends, funding may need to rely more on foreign sources.” Foreigners, though, will be a tougher sell. Japan has already lost its AAA status, and Fitch Ratings recently warned it might downgrade the country’s sovereign debt if it issued more than the planned ¥44 trillion in bonds next year.

A more responsible solution might be to reduce spending. The DPJ has already said it may break election promises to accomplish that, and surveys suggest the public would support it. It has also created a Government Revitalization Unit that is now attempting to pare trillions of yen of what Hatoyama calls “wasteful spending” from next year’s ministry budgets. Still, meaningful progress would likely mean ending Japan’s pork-barrel tradition, which will not sit well with coddled special interests.

Japan might choose to simply grow out of the problem. A larger economy, after all, can support the same debt more easily. Yet its rapidly aging population seems to preclude that escape route. Ditto for the final option of raising taxes. In short, Hatoyama needs a miracle that never materialized for his numerous predecessors.

Among the more obvious lessons from this experience is that increased debt limits flexibility. Japan’s economy recently exited recession but remains precarious; it is now an open question whether Hatoyama’s government could embark on a fresh round of stimulus if the situation again deteriorates (as it has so often before). More important, Japan demonstrates the folly of ill-conceived stimulus. During the 1990s, it became famous for white-elephant spending, the most notorious example being its penchant for lining riverbeds with concrete. That practice is now widely recognized as wasteful, ecologically damaging and corrupt. If a nation insists on racking up debt, better make it count.