By John Rapley
Recent developments in Japan have revealed the kind of bind a country gets into it when its debt rises to extraordinary heights.
In the days when China was still on holiday from the world, Japan was lionised as the powerhouse of Asia. After its wartime devastation, Japan roared back, its annual economic growth rate hitting 10 per cent in the 1960s. When it slowed into a more mature phase, in the 1980s, it was still topping out at annual rates of four per cent, which, for a rich industrialised country, is an exceptional performance.
Then it all came thudding to a halt. In 1989, the stock and real-estate markets, which had been driven to unsustainable heights by the excess investment in the country, came crashing to earth. The Japanese government then responded in time-honoured fashion, pumping money into the banking system. But this merely kept 'zombie' banks alive. Zombie banks, in turn, lent money to zombie firms. There was no restructuring of the Japanese economy, and it failed to get back on to a growth path.
Japan's economy stagnated. Even if their way of life was disrupted, as some companies abandoned employment-for-life practices for example, ordinary Japanese did not necessarily feel the pain of their Lost Decade. This was because the government was able to maintain its level of service delivery, and keep the economy from falling into a deep recession, by borrowing.
And borrowing. And borrowing. Japan today has a debt-to-GDP ratio nearly twice Jamaica's - which is, of course, saying something. Most anywhere else, this level of debt would have already provoked a crisis. The reason Japan has been able to postpone its day of reckoning is that its ageing population, already thrifty, has been willing to continue putting a large share of its income into the bank. And since the sluggish economy creates few opportunities for private-sector investment, the banks have been willing to lend that money to the government.
Provided they get returns above the rate of inflation - which has stayed at zero or less for more than a decade - the banks are no worse off. That means the government can borrow money for nearly free.
But that ageing, thrifty population is itself a problem. Japan is not producing enough new workers to maintain its long-term prosperity, and it doesn't want to import them either. So Japan's long-term prognosis is for a steady decline. It now looks like the country is ready to throw its remaining chips on the table in a last bet on sparking the economy before it's too late.
Late last year, Japan elected a new government to power. Led by Prime Minister Shinzo Abe, the Liberal Democrats ran on a platform of restoring growth by stimulating inflation. Pressing the Bank of Japan to loosen monetary policy, the government has committed to ending the country's deflation and raising inflation to about two per cent.
Optimism is returning
So far, so good. With expectations that inflation might return to Japan, the stock market has resumed growing and the yen has started depreciating. The weakening currency heralds a good year for exports, as Japanese goods get cheaper abroad. So for the moment, optimism is returning.
But here's the problem. If inflation rises, so, too, will interest rates. If interest rates rise, the debt will suddenly become a lot more burdensome. So the country is damned if it returns to growth, and damned if it doesn't.
Already at debt auctions, we are seeing signs that the big institutional investors, like the country's pension funds, are moving away from government paper. For as long as their bonds were yielding more than the rate of inflation, these funds could assure their investors they were at least not going to get poorer.
The new government's gamble will be that growth will be sufficient to generate the added revenues needed to pay the debt. It may work out. But I wouldn't want to bet too much on it. Being rich and powerful means you can bend the rules of finance. But you can't always escape them forever.
John Rapley, a political economist at the University of Cambridge, is currently on a visiting professorship at Queen's University in Canada. Email feedback to email@example.com and firstname.lastname@example.org.