Thursday 25 February 2010
US and Europe dig themselves in fiscal hole
The fiscal time bomb is ticking ever louder, from Greece to Japan and from Britain to the United States, not to mention Portugal, Spain and Ireland. But the ominous sound is being muffled by the clamour for economic growth to be maintained at all costs, even at the expense of bankrupting governments.
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US and Europe dig themselves in fiscal hole
Japan has lessons for countries being drawn along the path it has slid down in recent years
By ANTHONY ROWLEY
24 February 2010
The fiscal time bomb is ticking ever louder, from Greece to Japan and from Britain to the United States, not to mention Portugal, Spain and Ireland. But the ominous sound is being muffled by the clamour for economic growth to be maintained at all costs, even at the expense of bankrupting governments.
Greece is most in the firing line from bond markets, because of domestic political and social resistance there against fiscal tightening. But the fact that various countries are now being drawn inexorably along the path that Japan has slid down in recent years should be worrying markets more than it is.
Japan is a special case because it has been at the game of running up mega fiscal deficits for well over a decade while European nations and the US got into it only after global economic crisis erupted in 2008. If Japan has something to teach the world about financial bubbles, it has a lot to say about fiscal black holes too.
The first lesson Japan has to offer is that once a government digs itself into a fiscal hole to compensate for a burst monetary bubble it takes much longer to get out of it than advocates of ‘Keynesian’ stimulus care to admit. And, debt requires ever more indebtedness in order to service borrowing.
Japan was much derided for the way in which it ‘engineered’ a huge asset bubble in the late 1980s, lifting its real GDP (gross domestic product) growth rate to an unsustainable annual average of 5 per cent, sending stock prices soaring and inflating land values to the point where the Imperial Palace grounds in Tokyo became worth more than the entire State of California. Whether this was monetary madness on Japan’s part, as some in the West argued, or the result of financial loosening forced upon Japan by a massive revaluation of the yen after the so-called (G-5) Plaza Accord in 1985 is not the point. What is of wider relevance now is the fiscal consequence of Japan’s bubble economy collapse.
Japan lost 1,500 trillion yen (S$23.3 trillion) of value in land and stock prices once the bubble burst, equal to three years of national output or GDP. Banks teetered on the brink of collapse (some did fail), private capital investment crumbled to a fraction of the 435 trillion yen spent during bubble period, corporate debt soared relative to profit. Japan did not consciously embrace a Keynesian solution to the gigantic mess it found itself in during the 1990s. It took years of recession, banking crises and a slide into deflation before the government really became serious about fiscal stimulus, and once it did, the national finances deteriorated catastrophically.
At the end of the bubble in 1990, outstanding government debt (national and local) was around 170 trillion yen and it has gone on climbing inexorably since then to where it stands now at 637 trillion yen - equal to almost 200 per cent of GDP or 17 years of tax revenues.
Nearly 20 years later, a similar scene of financial devastation was to be seen in the US, Britain and other countries that had stumbled into similar bubble economy situations, having learned, it seemed, to do things in ‘the Japanese way’.
They had no alternative to follow Japan also in plunging into massive fiscal deficit in order to compensate for the devastating effect that the collapse of financial bubbles had on the real economy, employment, the financial system and on asset values in general. This is where we are now.
The assumption that Japan is ‘different’ has been punctured so far as susceptibility to mega financial bubbles is concerned. But the conventional wisdom remains that the US and others can escape the drawn-out plunge into fiscal distress and deflation that Japan has suffered since its economy began unwinding in the 1990s. The absolute level of government debt in Japan is much higher than that elsewhere, it is argued. According to Finance Ministry projections, the outstanding balance of central and local government debt in Japan at the end of fiscal 2010 will be 862 trillion yen, equal to 181 per cent of GDP.
The Organisation for Economic Co-operation and Development (OECD) has suggested that government debt will reach 200 per cent of GDP in fiscal 2010, while the International Monetary Fund (IMF) puts the ratio at 227 per cent. On a ‘net’ basis (allowing for the fact that a large part of Japan’s debt is held by state institutions), the debt/GDP ratio is estimated to reach around 105 per cent in fiscal 2010, although this is still the highest among advanced economies.
By comparison, the US government debt to GDP ratio is estimated by the OECD to reach 92 per cent this year while that of Britain will be 83 per cent and only Italy will push well over 100 per cent. But these are early days for all major economies except Japan in terms of governments getting deeply into debt and the future looks ominous. A common assumption is that more virile consumers in the West (compared to those in Japan) will help revive leading economies and enable governments to claw back in tax and other revenues what they have spent by way of fiscal stimulus. But this ignores demographics and the impact on fiscal revenues.
One reason Japan’s government is plunging ever deeper into debt is that social security spending has tripled (to 30 per cent of the total budget) in recent decades and most mature economies are headed down that road. The IMF has estimated that such spending will raise the debt to GDP ratios of these economies by 50 percentage points over the next two decades.
Demographics have a lot to do with deflation too, and this is another reason mature economies may be destined to follow Japan down the deflation road, however much more proactive their central banks may have been in seeking to reflate their economies than was the Bank of Japan after the bubble economy collapsed.
Deflation began afflicting Japan in 1997, two years after the ratio of working to total population began declining in Japan from 1995 onwards and spending attitudes became more cautious. The ratio began declining in the US in 2005 and deflationary trends began appearing in 2008. (China’s working population ratio is set to peak out in 2015). Then there is the problem of debt feeding upon debt. As the quantity of Japanese government debt has soared, in order to keep the economy from imploding and to enable the government to pay interest on its debt, the national debt service ratio has risen dramatically to 22 per cent of the total budget.
Only low interest rates, reflecting low demand, have saved the government from a catastrophic rise in debt service. It may save others too as interest rates remain subdued in a Japanese-style post-bubble environment. But unlike Japan, where just 6 per cent of government debt is held outside the country, the US has one-half of its public debt held by foreigners and the UK one-third, and they are vulnerable to a creditor revolt.
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