Is Japan the next major world economy to tank?

Commentary about business and finance.
Dec. 21 2010 6:29 PM

Too Big To Bail

Is Japan the next major world economy to tank?

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Another way for Japan to dig itself out of this hole would be to cut spending. But already, Grice says, Japan's tax revenues can't cover debt service combined with social security. So where the hell do you start?

Those who believe in historical precedent point to examples like Weimar Germany and say Japan is going to swing from deflation to hyperinflation. The Bank of Japan, they say, will print yen in order to pay down debt. "Cash-strapped governments," observes Grice, often resort to "currency debasement." That story never ends happily.

But at least so far, the consensus is that this dire scenario won't, can't, happen. Indeed, it's often said that you aren't a real macro trader (someone who bets on global trends) until you've gotten burned shorting (i.e., betting against) Japan. "You'll find 10,000 people saying I'm an idiot and that people have been saying this, and been wrong, for 15 years, and kid, shut up," laughs my source. The Bank of Japan says the economy is improving; analysts say the government has lots of options, including raising the value-added tax or having the banking system put even more assets into government bonds. (Already, the Bank of Japan is engaged in its own form of "quantitative easing," or purchasing government bonds, which, just as in the United States, is supposed to help the economy recover.) Japan's relatively healthy corporate sector could take over from households in investing its surplus cash into government bonds. "Everyone acknowledges the long term seriousness of Japan's fiscal position," writes Grice. "But people seem almost fatigued with the idea that a country which has defied bond market logic for so long now is ever going to change."

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But just because things haven't changed doesn't mean they won't. While any deterioration in Japan's finances should, mathematically speaking, happen gradually—savers don't yank their money out of the system all at once—modern markets have a way of accelerating underlying problems into crises with remarkable speed. If there's a lesson we should all have learned, it's that once fear takes hold, anything can happen. And if Japan is a problem, it's a problem for all of us. After all, Japan is still the world's third-largest economy. Unlike Greece and Ireland, it is simply too big to bail out, even if the world were willing to do so. China and Japan are the largest foreign holders of U.S. debt. One obvious question is, what happens here if Japan starts selling?

There's another way in which Japan's problems might matter, too. In some important ways, the United States is following in Japan's footsteps—for instance by taking advantage of low interest rates to issue a slew of cheap debt. Japan's "more profound influence might be psychological," Grice writes. What he means is that Japan's benign experience with debt (so far) has led other countries (notably ours) to think that it can have a worsening fiscal condition yet still pay a low interest rate on its debt. If bond markets begin to act like that notion is wrong, this story doesn't end happily for anyone.

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