The Japanese solution

THERE are four kinds of countries in the world, the Nobel-prize-winning economist Simon Kuznets supposedly said: developed, undeveloped, Argentina and Japan. Yet much of the rich world now looks remarkably Japanese, with chronically low interest rates and inflation, and eye-watering levels of sovereign debt. Many governments are therefore watching keenly as Shinzo Abe, the prime minister elected in 2012 on a platform of economic rejuvenation, takes on Japan’s economic mess. His task is harder than many appreciate. What is needed is not simply growth, but growth fast enough to allow Japan to come to grips with its massive public debt.

Mr Abe promised three expansion-boosting “arrows”—fiscal, monetary and structural—to deliver a much more powerful stimulus than the half-measures taken by previous governments. In September of this year he gave a clearer sense of the end-goal: a 20% rise in Japan’s nominal GDP (NGDP), to ¥600 trillion ($5 trillion) from the current ¥500 trillion, where it has stood for the past 20 years, more or less.

Mr Abe’s archery has moved the economy in the right direction. NGDP, which measures growth without adjusting for inflation, is up by about 6% since the end of 2012. Higher prices account for about half of the increase. The unemployment rate has also fallen, from 4.3% to 3.4%. Yet this progress is still woefully inadequate. The recovery has been halting: growth slumped in the second quarter. Prices are falling again, and even the “new core” inflation index cooked up by the Bank of Japan (BoJ) over the summer remains short of its 2% inflation target. A return to monetary-policy normality looks as distant as ever. The BoJ disappointed markets on October 30th by failing to increase the pace of its asset purchases, but it is still buying ¥80 trillion in government bonds a year, and may add to that if inflation stays weak.

Meanwhile, Japanese sovereign debt, at more than 240% of GDP, is easily the highest in the world and still growing. Bond markets have been remarkably tolerant of this: the yield on Japan’s 30-year bonds is just 1.36%. That is partly because the Japanese, prodigious savers, own so many bonds. The central bank owns most of the rest. Yet few economists reckon the borrowing spree can continue for ever. As more Japanese workers retire, domestic saving is falling and spending on the old soaring. Even a modest rise in borrowing costs could bring insolvency.

Mr Abe had hoped that a quick return to rapid growth would allow for an eventual turn to austerity, but the pivot to parsimony is proving tricky. Japan will run a structural budget deficit of more than 5% of GDP this year. After a rise in the country’s consumption tax in April of 2014, from 5% to 8%, both household spending and GDP tumbled, leading the government to postpone a second rise to 10% that had originally been scheduled for October of this year. That experience is especially worrying given the modesty of the rises. An analysis published in 2013 estimated that stabilising Japan’s debt would require tax revenues of between 30% and 40% of total consumption, equivalent to a consumption tax rate of about 60%. Other studies are less dire, but nonetheless suggest that far bolder measures than anything under consideration will be needed to stabilise the debt.

At current growth rates, any big tax rises or spending cuts would tip Japan straight back into recession. Yet generating faster growth is a tall order. Supply-side reforms could be more vigorous: Japan remains far too willing to protect favoured sectors, like agriculture and cars, despite some recent concessions in trade negotiations. Yet the scope to improve productivity in Japan is smaller than might be imagined. Real output per worker is similar to that in Germany and the Netherlands. A more welcoming attitude to immigrants would help: recent growth in output per person has been offset by Japan’s shrinking population. In 2012 net migration to Japan was equivalent to just 0.3% of the existing population, compared with 1.6% in America. Yet Mr Abe has shown little interest in admitting a rush of new workers.

The price is wrong

The only way out is higher inflation. Had NGDP grown at even 2% a year since 1992, its debt-to-GDP ratio would be just 82%—close to America’s. Yet pushing up wages and prices has proved devilishly hard. In the past year alone the BoJ’s asset purchases lifted the share of Japanese government debt that it owns from 23% to 32%. Despite low unemployment, a tumbling yen and soaring stock prices, inflation has barely poked its head above zero at any point in the Abenomics era. A more ambitious inflation target, of 4% perhaps, would help if markets believed it. But having failed to hit the 2% mark it adopted in January of last year, the BoJ lacks the credibility to make bolder promises without further action to prove its resolve.

Japan is not without options, however. At the current pace of purchases, the share of government bonds held by the central bank will rise to two-thirds by 2020. Were purchases to rise to ¥100 trillion a year, the BoJ would own nearly all of the government’s outstanding debt by 2026. The government would in effect owe the money to itself; debt payments made to the BoJ would be returned to the government as seigniorage.

A plan to monetise the debt meets any standard definition of economic insanity. Orthodox economics suggests it must inevitably generate rapid inflation. Yet given that faster inflation is what Japan has sought in vain for two decades, and that the only alternative seems to be waiting patiently for a debt crisis, monetary madness does not look so bad. It has the further advantage of following the path of least resistance.

Other governments would understandably recoil should Japan take this route or stumble into it inadvertently. Monetisation would open a Pandora’s box of economic risks. Yet recent experience suggests that where Japan leads, other economies may eventually follow.

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