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Friday, September 28, 2012

After Europe ... Japan

The Atlantic has an article about the impending economic crises in Japan. The authors write:
This summer, many government officials and private investors finally seemed to realize that the crisis in the euro zone was not some passing aberration, but rather a result of deep-­seated political, economic, and financial problems that will take many years to resolve. The on-again, off-again euro turmoil has already proved immensely damaging to nearly all Europeans, and its negative impact is now being felt around the world. Most likely there is worse to come—and soon.

But the economic disasters of our time—which involve big banks in rich countries, call into question the viability of government debt, and seriously threaten the reach of even the most self-confident nations—will not end with the euro debacle. The euro zone is well down the path to severe crisis, but other industrialized democracies are hot on its heels. Do not let the euro zone’s troubles distract you from the bigger picture: we are all in a mess.

Who could be next in line for a gut-wrenching loss of confidence in its growth prospects, its sovereign debt, and its banking system? Think about Japan.

Japan’s post-war economic miracle ended badly in the late 1980s, when the value of land and stocks spiked dramatically and then crashed. This boom-and-bust cycle left people, companies, and banks with debts that took many years to work off. Headline-growth rates slowed after 1990, leading some observers to speak of one or more “lost decades.”

But this isn’t the full picture: after a post-war baby boom, population growth in Japan decelerated sharply; the number of working-age people has declined fairly rapidly since the mid-’90s.
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About half of the Japanese government’s annual budget now goes to pensions and interest payments. As the government has spent more and more to support its growing elderly population, Japanese savers have willingly financed ever-increasing public-sector debts.

Elderly people hold their savings in the form of cash and bank deposits. The banks, in turn, hold a great deal of government debt. The Bank of Japan (the country’s central bank) also buys government bonds—this is how it provides liquid reserves to commercial banks and cash to households. Similarly, Japan’s private pension plans—many promising a defined benefit—own a great deal of government bonds, to back their future payments. Few foreigners hold Japanese government debt—95 percent of it is in the hands of locals.

Given Japan’s demographic decline, it would make sense to invest national savings abroad, in countries where populations are younger and still growing, and returns on capital are surely higher. These other nations should be able to pay back loans when they are richer and older, supplying some of the funds needed to meet Japan’s pension promises and other obligations. This is the strategy that Singapore and Norway, for example, have undertaken in recent decades.

Instead, the Japanese government is using private savings to fund current spending, such as pensions and wage payments. With projected annual budget deficits between 7 and 10 percent of GDP, Japanese savers are essentially tendering their savings in return for newly issued government debt, which is not backed by hard assets. It is backed only by an aging, shrinking population of taxpayers.

Japan’s taxpayers are already rebelling against small tax increases needed to limit escalating deficits. This leaves little room for hope that future taxpayers will accept the larger tax increases needed to repay debts.

Japan’s demographic decline will be hard to reverse—and even in the best-case scenario, the positive effects of a reversal would not be felt for decades. The economy, roughly speaking, is as healthy as it is likely to become. Yet the government seems incapable of steering away from the cliff, a characteristic that should strike no one as uniquely Japanese—just look at how the Euro­pean leadership has behaved over the past half decade, or how you can polarize American politicians with the phrase debt ceiling.

A crisis in Japan would most likely manifest as a collapse of confidence in the yen: At some point, Japanese citizens will decide that saving in any yen-­denominated asset is not worth the risk. Then interest rates will rise; the capital position of banks, insurance companies, and pension funds will worsen (because they all hold long-maturing bonds, which fall in value when rates rise); and fears of insolvency will surface.
 
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The shock felt around the world will result not just from the realization that Japan is unable to meet its pension and other social obligations. Investors will also be horrified to see the disappearance of the private savings previously used to buy government debt, whether through debt defaults and bank failures or through high inflation. For ordinary Japanese, public promises about retirement benefits and price stability will be broken just as their private savings for retirement collapse.

No one can predict the timing, but without radical political change that creates a more responsible fiscal trajectory, this will happen.
Japan is well below the birth rate necessary for replacing their population. For a long time, they enjoyed a technological advantage in manufacturing over surrounding nations, as well as a more highly educated work force, that have allowed them to keep their per capita productivity in line with Europe. However, holding the status quo is not going to be enough to offset increasing pension and health care expenses of a rapidly aging population.  Japan's economic decline will continue, and perhaps accelerate. Nevertheless, I am left with the presentiment that Japan will not go quietly into the night.

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