The Zero Bound

In a report released in the lead-up to its big meeting in Tokyo this week, the International Monetary Fund cut its global growth forecasts and sharply warned that the world economic slowdown is worsening. Although the report singled out U.S. and European policymakers, it’s sadly appropriate that the meeting will be held in Tokyo, because Japan’s economy is the one we really ought to worry about — and it’s even more worrisome for the lessons it holds for our own.

To be sure, never a year passes without dire warnings of financial collapse in Japan. The latest comes from economists Peter Boone and Simon Johnson, who see tragedy ahead. They write:

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.

It is easy to dismiss such concerns, as they have been regularly voiced over at least the past 12 years and thus far proven wrong. After all, Japanese interest rates have not skyrocketed, so clearly the crisis has not arrived.

Yet.

To be blunt, the debt situation in Japan is not sustainable. The fiscal deficits supporting the Japanese economy appear never ending; the Japanese economy never gained enough strength to eliminate the dependency on fiscal stimulus, leading to an excessive buildup of government debt that now exceeds 200 percent of GDP. (While there is no clear line at which debt loads become a problem, in October the IMF identified 100 percent of GDP as the threshold that will create political and economic pressure to reduce the debt.)

Japan needs to close its fiscal gap, but has yet to find the political will to do so via tax increases or spending cuts. As Greek or Spanish politicians can testify, fiscal austerity is easy to say, hard to do; raising taxes or cutting spending would only deepen the malaise, just like it has elsewhere. If fiscal policy is off the table, it’s up to central bankers to boost growth. But with Japan’s economy now operating at the zero bound — a situation in which interest rates are extremely low and cannot be expected to go lower — the Bank of Japan has fewer tools to counteract the recession.

Assuming austerity is economically or politically impossible, bondholders — Japan’s creditors — will eventually take a hit as Tokyo is forced to default or tries to inflate away its debts. But the longer Japan waits, the more painful it will be.

Japan has long moved past the point where its citizens have the luxury of worrying only about lost income from low interest payments. Because almost all Japanese government debt is held internally, their citizens must also worry about capital preservation. Fear of losing that capital further prevents the implementation of either a "hard" default, where the government does not make full payment on its debt, or "soft" default, where the debt is repaid in inflated currency; either choice will erode the real value of bondholder assets.

Put another way, being at the zero bound means that there is a growing group of people in Japan that has a lot to lose by anything that increases interest rates, including inflation, and that opposes what seems to be Japan’s best path: a gradual erosion of the real value of that debt through moderate inflation. 

I expect that inflation is inevitable because the Bank of Japan will be forced into cooperating with the fiscal authorities by printing money to finance government spending, producing a soft default in the form of inflation that could become disruptively high. Indeed, Federal Reserve Chairman Ben Bernanke raised this possibility in a 2003 speech about Japanese monetary policy. Japan has not had inflation for two decades; imagine that pent-up inflation exploding over a few years. Would this be preferable to a long period of moderate inflation? I think not. In other words, Japan can take its inflation medicine a little bit at a time, or a whole bunch at once.

For now, Japan will likely continue its recent pattern of choppy growth, which fell to negative 0.8 percent in 2011. The IMF report states that growth in Japan will rebound to 2.2 percent in 2012 before subsequently slowing to just 1.2 percent in 2013. Perhaps this burst of growth is the last hurrah before the debt problem finally catches up to Japan.

What would a financial crisis in Japan mean for the United States and Europe? Geopolitically, it would undermine the strength of a key ally in the Pacific Rim region, leaving room for China to expand its influence. Economically, a financial crisis in Japan would likely result in a recession and a rapid depreciation in the value of the yen, swelling Japan’s trade surplus via a combination of reduced imports and rising exports, biting into the economies of Japan’s trading partners. In 2011, the United States and the European Union exported $65 billion and $49 billion of goods to Japan, respectively.

Still, that is not much when measured against the size of the U.S. and European economies. More of a threat is that a Japanese crisis could send an alarming message to investors in U.S. and European government debt. The United States shares many similarities with Japan, including an economy operating at the zero bound for interest rates. And while the U.S. economy has avoiding Japan-style deflation by maintaining positive inflation rates, it’s still plagued with similar large fiscal deficits.

The U.S. Congressional Budget Office (CBO) expects the debt load to level off at just over 100 percent of GDP before declining in 2014, assuming impending spending cuts and tax increases go through (a situation commonly referred to as the fiscal cliff). Such fiscal austerity, however, is unlikely and unwelcome; the CBO warns that going over the fiscal cliff would be sufficient to push the U.S. economy into recession in the first half of 2013.

In other words, the United States could be stuck in very similar situation to Japan, one of permanent near-zero interest rates and ongoing fiscal deficits. And while Japan’s experience shows that high debt loads need not trigger financial crisis in the near term, a Japanese financial crisis would be a signal that debt cannot build forever, perhaps moving forward the day of reckoning for the United States. A similar story holds for Europe, which is already struggling to contain a crisis of confidence in sovereign debt.

Japan’s meltdown — and the contagion scenario outlined here — is not imminent or inevitable. The continuing period of low interest rates in Japan despite high levels of deficit spending suggests that U.S. deficit spending is unlikely to trigger a financial crisis in the near term. But a crisis in Japan would reveal that deficit spending has a limit. The United States and Europe should learn from the Japanese experience and plan for fiscal consolidation, supporting economic growth, and normalizing the interest rate environment to move off the zero bound. This may involve a greater degree of cooperation between fiscal and monetary authorities than either finds comfortable. But such cooperation would be preferable to letting the seeds of the next crisis grow, fertilized by a combination of weak economic growth, rock-bottom interest rates, and fiscal deficits as far as the eye can see.