Japan: The Ministry That Cried Wolf

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Japan: The Ministry That Cried Wolf

Japan’s Finance Ministry has been predicting a government bond crash since the 70s.

Japan: The Ministry That Cried Wolf
Credit: sepavone / Deposit Photos

The first cry of “wolf” came in 1975 when, during the post-oil shock recession, Japan did what countries do in recessions: it ran a deficit. Nonetheless, the Ministry of Finance (MOF) issued a “declaration of fiscal emergency.” Three years later, as deficits continued, the MOF said that, unless Japan quickly restored budget balances through tax hikes and spending cuts, it would “collapse.” In 2010, it told Prime Minister Naoto Kan that, unless he raised the consumption tax, Japan could experience a catastrophic debt crisis like the one wracking Europe. So, when Vice Finance Minister Koji Yano recently criticized new Prime Minister Fumio Kishida’s budget package, insisting that his deficit spending was like “the Titanic heading into an iceberg,” he was simply continuing a long tradition.

If the Ministry’s warnings had been accurate, it would have been serving the nation. In reality, it has been repeatedly, lengthily, and stubbornly wrong. To be fair, the MOF has some allies among well-respected economists. In 2012, two of them predicted that, without a consumption tax at 15-20 percent (up from today’s 10 percent rate), the market for Japan government bonds (JGBs) would crash sometime between 2020 and 2023.

The MOF’s Track Record

Back in the mid-1990s, the MOF convinced Prime Minister Ryutaro Hashimoto to raise the consumption tax from 3 percent to 5 percent, which would have been no problem for a healthy economy. Unfortunately, as Washington warned, Japan’s health had been sapped by a growing mountain of bad bank debt. Sure enough, the April 1997 tax hike sent the economy into a severe recession, which greatly magnified the banking crisis, further deepening the recession. When Washington urged a rollback to 3 percent, the General Secretary of the ruling Liberal Democratic Party (LDP) lashed out. “You have no idea how many Prime Ministers were sacrificed…to introduce the consumption tax.” Months later, Hashimoto joined the list of sacrifices when voters punished the LDP in the Upper House elections, and he had to resign.

In 2010 and 2012, two more prime ministers, including Kan, suffered defeat when they bought the MOF’s scare stories about a European-style debt crisis and passed a law setting the date for two more tax hikes. In reality, the only European countries in crisis were those which had “twin deficits,” i.e., lots of government debt at home combined with international debt. Japan, by contrast, is a net creditor internationally.

Other victims of the MOF’s bad advice were all the investors who repeatedly bet on a JGB price crash and who repeatedly lost big. Betting on a JGB crash became known as a “widow-maker.”

Slashing Pensions and Healthcare for the Elderly

The MOF swears that, without fiscal austerity, the growing portion of seniors among the population will compel the government to spend larger and larger portions of GDP on social security and healthcare, and that will lead to a fiscal crisis. The numbers tell a different story. Outlays hit a peak of 12.5 percent of GDP in 2013, and then flattened. How did this happen? Even though there were more elderly, the government cut spending per senior, with social security per senior down a fifth from its 1996 peak and healthcare per senior down 15 percent from its 1999 peak.

These cutbacks are one of the reasons that, among women over age 65 living alone, the poverty rate has risen to almost half. In 2018, 45,000 seniors were arrested, mostly for shoplifting, up from 7,000 in 1989.

In any case, the rise in seniors is flattening out, lessening the danger of a fiscal crash.

BOJ Buys JGBs, Slashing The Odds of a Crash

The reasoning offered by the MOF offers sounds plausible: the ratio of government debt to GDP keeps mounting; that cannot go on forever; eventually, investors will panic.

However, the MOF is talking about “gross” government debt, which reached 237 percent of GDP in 2020. That, however, is a meaningless number. That’s because it includes debt that one government agency owes to another. The Bank of Japan (BOJ) is not about to dump JGBs. What really matters is the “net” debt, namely the debt held by private investors, and that has plummeted since 2013 when, in the name of fighting deflation, the BOJ has bought up almost half of all JGBs. As it did so, JGBs owned by others, mostly private investors, tumbled from 145 percent of GDP in 2012 to 103 percent today.

Moreover, what really triggers bond crises is not the size of the debt per se, but fears that the government can no longer pay the interest bill. Japan has no such problem. In 2021, because the BOJ pushed interest rates to the cellar, interest payments were down to just 0.4 percent of GDP. That’s negligible compared to the peak of 1.9 percent almost 40 years ago. If Japan did not suffer a crisis when both privately-held debt and the interest bill were so much higher, why should it suffer one now?

The MOF rejoinder is that interest rates will not stay low forever. When they inevitably rise, then comes the crisis. Again, it sounds plausible, but it defies Japan’s experience. The BOJ has proved it can keep interest rates super-low, as it has done for more than a quarter of a century. Since Japan does not need borrow from the rest of the world, it can control its own interest rates. Would the BOJ really allow a financial cataclysm rather than continuing to flood the system with money if necessary?

The MOF Blind Spot

To be sure, the MOF has hardly been alone in worrying that large chronic budget deficits might lead to a crisis. There’s a difference, however, between making a judgment call which turns out to be wrong, and then changing one’s mind, versus being impermeable to new evidence. The MOF suffers from the latter syndrome.

Like generals still fighting the last war, or even the war before that, the MOF is still tortured by the national trauma of hyperinflation in the years following World War II. In the MOF’s mind, that inflation was cured by the “balanced budget” policy of a banker named Joseph Dodge whom U.S. Occupation appointed in 1949 to dictate budget policy. The side effect was a recession that ended when the Korean War boosted demand for Japanese exports. Economists still debate whether Dodge’s cure was worse than the disease, but the MOF is still in thrall to his doctrines. Prior to Dodge’s arrival, the MOF had no commitment to a balanced budget, but, from that time forward, fear of hyperinflation and adherence to the “Dodge Line” became imprinted in the DNA of the MOF and BOJ. When Japan faced an economic downturn in 1965 and the World Bank suggested deficit spending to spur recovery, MOF officials retorted, “Mr. Dodge told us not to.” New recruits are still indoctrinated in that creed.

Not Crisis, But More Corrosion

No one denies that Japan’s chronic deficits have consequences. The impact, however, is not a financial crash but continued slow corrosion of the economy. That difference in diagnosis requires a very different prescription.

First, the deficit itself is not the cause of Japan’s economic maladies, but rather a symptom of weak private demand. So, the first priority is to address the root causes of that weak demand, which are the sluggishness of real wages and cash hoarding by corporations.

Effective reform requires that taxes and spending policies be harmonious with long-term growth, so as to expand the tax base. There are some countries where a consumption tax is fine, but Japan is not one of them. That’s because it makes weak consumer demand even weaker. Other, better taxes are available. On the spending side, paving over riverbeds and providing credit guarantees for zombie companies not only depresses growth but make the public distrust any kind of tax increase since it feels the money would be wasted.

Finally, the chronic deficits increase pressure on the BOJ to maintain its ultra-low interest rate policy and, while it’s necessary now, prolonging that indefinitely weakens the economy’s foundations. For example, 36 percent of all bank loans now charge less than 0.5 percent interest, and 17 percent less than 0.25 percent. These negligible rates keep zombie companies in business, and that hurts other, healthier companies, dragging down GDP growth. Interest on deposits used to provide seniors a big chunk of their income. Not today. If you put down ¥10 million ($88,000) on a time deposit of a year, your interest will be just ¥1,000 ($8.85). No wonder that 40 percent of retirees’ household spending each year comes from drawing down their savings. How many will run out of savings before they run out of years?

Better growth will not solve all the budget problems, but it would make them far more manageable. On the other hand, undertaking tax hikes and spending cuts without structural reform will make the budget problems even worse.