With the world's largest debt to GDP ratio and no fiscal surplus in sight, Japan's habit of short-term spending may need to be replaced by deep structural change.

Author: Editorial Board, ANU

For the past quarter of a century Japan has enjoyed stability. Perhaps too much stability: for more than two decades, prices, wages and interest rates have barely changed even though the structure of the global economy, technology and market conditions have changed remarkably.

That stability was achieved largely by failure to confront some difficult structural challenges. The government has spent its way through the problems of the past two decades, accumulating record debt as the population aged and shrank.

What might appear to be an unsustainable strategy has, nonetheless, not faltered in Japan, although that doesn’t mean it will be viable indefinitely.

Japan’s population peaked in 2008 and last year it shrank by 800,000. The working age population peaked a decade earlier and the proportion of elderly in the population continues to rise. Japan is a super-aged society with around 30 per cent of its population over 65, the highest share anywhere in the world.

Living standards remain high. A potential economic growth rate for the country of less than one per cent a year means that living standards or per capita incomes can rise with a shrinking population.

Japan’s headline GDP growth rate has been above one per cent, unemployment remains very low due to labour shortages, corporate profits are high and the stock market is at its highest since the asset bubble burst in the early 1990s.

‘Despite these positives’, Masahiko Takeda explains in this week’s lead article, ‘most of the Japanese populace is unhappy’.

The return of inflation to Japan after the pandemic has seen prices rise faster than nominal wages, reducing real wages with new downward pressure on living standards.

Travellers to Japan in the past year will not have noticed the inflation because the yen is very weak. It has depreciated against the US dollar and most major currencies in the past two years. The depreciation of the yen is one factor that’s made it more difficult to attract migrant workers to fill labour shortages.

‘The weak yen’, explains Takeda, can be explained by ‘the large interest rate differentials between Japan and other advanced economies’. As interest rates were raised in other industrial economies to fight inflation, the Bank of Japan held its headline policy rate steady at essentially zero – where it’s been stuck for the past two decades. Japanese capital has flowed to the United States and Europe where it can earn higher low-risk returns.

Fortunately, Japan’s inflation appears transitory. The headline consumer price index peaked at 4.3 per cent in January 2023 and has now fallen to 3 per cent. That’s still above the 2 per cent target of the Bank of Japan but the BoJ is constrained by the burden of the government’s debt in fighting inflation directly by increasing the interest rate.

The Bank of Japan is starting to normalise monetary policy — from unconventional monetary policy that’s been the norm in Japan for more than two decades — and the yen should strengthen as a result. But the pace of change will be slow. If interest rates rise, the payments on Japan’s outstanding government bonds will increase substantially.

Japanese government finances were ‘very close to collapsing’, according to Finance Minister Miyazawa in 2001. He said the government needed ‘a fundamental fiscal restructuring aimed at rebuilding our finances in the 21st century, looking 10, 20 years into the future’.

Public debt was then 130 per cent of GDP. It has since steadily grown to roughly 263 per cent of GDP. That is the largest debt to GDP ratio in the world, ever.

There is no fiscal surplus in sight — the government is spending more than it earns through taxes, adding to the stock of debt.

Japanese public debt is sustainable so long as the market believes it is. Like any debt, it will have to be paid back eventually, and the best-case scenario – also the one that is most unlikely – is for the economy to grow out of it.

The corporate sector is sitting on huge cash reserves that are not being utilised and Japan is the world’s largest creditor with huge amounts of capital invested around the world. But without changing the trajectory of the debt as a proportion of GDP, most scenarios are destabilising. It’s no wonder the magic of modern monetary theory (which advocates that the government can and should print as much money as it needs to spend because they cannot go broke) is so appealing.

The Kishida government passed a major bill in December 2022 to increase defence spending substantially over the next five years, breaking through the post-war limit on defence spending of 1 per cent of GDP. That’s on top of the rising pension and healthcare costs for the elderly and large-scale subsidies to industry, especially to semiconductors, supposedly a critical domestic industry. Japan has joined the US-led global industrial subsidy race, although not quite so wholeheartedly. It’s a race to the bottom that Japan may not be able to afford.

The New Year begins with the Kishida government and the ruling Liberal Democratic Party in crisis, hit by a major political funding scandal. Kishida’s electoral support is at a decade low of 17 per cent. He has removed all the members of the Abe-faction embroiled in the scandal from the cabinet to try to contain the damage, apparently with little palliative effect.

Kishida’s days appear numbered but frequent leadership changes are not new to Japan.

Kishida has been in office for two years and a change of leader won’t mean that political instability impacts on economic confidence in Japan. Apart from Abe Shinzo, Japan has had a revolving door of prime ministers since 2006, averaging just one year in office.

Even without a unified opposition or an obvious alternative government, Japan’s democracy is mature and political and social stability high. Abe, as Japan’s longest serving leader, figured out that doing just enough on economic reforms helped to sustain his political capital. The hope is that Kishida or his successor will see much needed economic reforms as a way to grow political capital too.

The days of throwing public funds at problems to alleviate short term pain as a substitute for structural change in Japan may be nearing an end.

The EAF Editorial Board is located in the Crawford School of Public Policy, College of Asia and the Pacific, The Australian National University

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