Too Big To Bail
Is Japan the next major world economy to tank?
When the financial world tries to anticipate the next meltdown, all eyes turn to Europe. Greece needed a bailout, then Ireland did. Talk is that Spain will follow, though the country denies that it has a problem.
But a few contrarians think everyone is looking in the wrong direction. Forget Europe, they say. Check out Japan instead. "A global fiasco is brewing in Japan," predicted Société Générale analyst Dylan Grice in a recent report. "It's like the Titanic has already hit the iceberg and you know it's going to sink, you just don't know how long it will take to go down," said Vitaliy Katsenelson, a Denver-based money manager, in a recent interview that was printed in well-known analyst John Mauldin's newsletter. One hedge fund analyst I spoke to recently noted that Japan has had no fewer than nine finance ministers in the last 4½ years—one of whom apparently committed suicide after resigning.
Japan was thought to possess a miracle economy before it all went to hell in the early 1990s following a spectacular real estate bust. Today the popular perception is that Japan is stagnant but stable. After the economy slowed down, the Japanese government lowered taxes and increased spending, sending deficits, and also government debt, way up. But the debt hasn't been a problem, because Japan's risk-averse populace—which became even more risk averse after the collapse of the technology bubble a decade ago—has sunk its considerable savings into government bonds, known colloquially as JGBs. What could be safer than government debt? As a result, the vast majority of Japanese debt is funded by its own residents—in stark contrast to the United States, which sells a sizable chunk of its debt overseas. And as deflation struck the Japanese economy, the interest rate on its outstanding debt has fallen to an average of a mere 1.5 percent.
In sum, the Japanese government has been able to increase its debt without driving borrowing costs up because of falling interest rates. That fortunate circumstance has allowed Japan to ramp up government spending even as tax revenue has dropped by nearly one-third .The not-so-lucky part is that even at today's low interest rates, Japan's interest on its debt is eating up a scary proportion of its tax revenue—more than 25 percent (not including the funds that come from issuing yet more debt), according to government figures. In addition, much of Japan's debt is relatively short-term in nature, meaning that the government last year had to "roll" at least 140 trillion yen in debt (i.e., replace retiring debt with new debt) even as it issued some 50 trillion in fresh debt to fund the growing gap between what the government spent and what it took in.
As Bernie Madoff would tell you, this is a game you can play only so long. Japan's savings rate, which was once in the mid-teens, is quickly approaching zero. Meanwhile, the country has the oldest population in the world, with basically no immigration. When people retire, what do they do? They start to withdraw money from the banking system. You begin to see the problem.
Why, you might ask, can't Japan do what us profligate folk in the United States do—sell its debt to international investors? Well, it could, but it would likely have to pay a much higher interest rate than 1.5 percent. After all, if you were an investor, why would you buy Japanese debt yielding 1.5 percent when you could buy U.S. or German debt that paid you more? My source thinks Japan would have to pay roughly 4.5 percent interest on 10-year debt to be competitive, and he says that's a conservative estimate. But that would create a different problem. If Japan's interest rate merely doubled, from 1.5 percent to 3 percent, then interest expense would be more than half of the government's tax revenues. "Any meaningful re-pricing of Japanese sovereign risk would push yields to a level the government would be unable to pay," writes Grice.
Bethany McLean is a contributing editor at Vanity Fair and the co-author of All the Devils Are Here: The Hidden History of the Financial Crisis.
Bethany McLean writes a weekly business column for Slate and is a contributing editor to Vanity Fair. She is the author (with Joe Nocera) of All the Devils Are Here: The Hidden History of the Financial Crisis and (with Peter Elkind) "The Smartest Guys In The Room."
Photograph of crowd in Japan by Yoshikazu Tsuno/AFP/Getty Images.