Record Japanese government debt risk post-COVID-19

Faculty Fellow, RIETI

COVID-19 has had a substantial adverse effect on the Japanese economy. Lockdowns and the suspension of business activities spurred supply shocks, and drops in income and the resulting hits to consumer sentiment caused demand shocks. The COVID-19 crisis has also brought Japan's fiscal sustainability into sharper focus.

Although the spread of remote work could lead to improvements in Japanese work style and increase efficiency, it is difficult to foresee what kind of impact these changes will have on the Japanese economy in the long run. Forecasts indicate that the economic downturn is severe but cyclical, and that the economy will return to growth near its potential rate in 2–3 years.

Yet Japan's budget deficit has been growing since the economy fell into decline in the 1990s, with government expenditure and revenue diverging from each other. Visual representation of this widening gap is said to resemble the open jaws of a crocodile and led to coining of the Japanese term ‘crocodile mouth’. Due to COVID-19, the crocodile's jaws are said, metaphorically speaking, to have come off.

Fiscal stimulus is needed to smooth out the economic downswing in response to a crisis like COVID-19. But the jaws of the crocodile cannot keep expanding forever. Accumulated debt will continue to grow if government expenditure grows faster than government revenues, and it will not be easy to formulate a clear path to close the fiscal gap in the future.

Though there have been warnings that huge government debt might cause hyperinflation and surges in nominal interest rates, these problems have yet to materialise. The fact that inflation and nominal interest rates have remained low in a country like Japan — where the debt-to-GDP ratio is high even by global standards — has reinforced the view that the crocodile's mouth isn't a big deal.

It is difficult to gauge when and at what level the fiscal situation will become unsustainable. Large debt is not a problem if future net tax revenue grows to cover it. If the public believes that the level of debt will settle down some time in the future — no matter how many years it takes — fiscal sustainability can be maintained without the inflation of interest burden it threatens. Expectations, of course, are rather difficult to gauge.

It is also difficult to calculate what the optimal level of debt might be. Few people would think that the optimal debt balance is zero. Whatever it is will depend crucially on the appetite for government bonds. The issue of government bonds allows governments a line of credit but also plays an essential role as collateral for smooth financial transactions, because of their unique value as a safe asset.

The role of government bonds in enhancing financial transactions is akin to the role of money — utterly worthless in itself but in reality traded as something that represents value. Similarly, the value of government bonds as safe assets and financial instruments is not necessarily fixed and stable but varies depending on economic conditions. This makes it difficult to measure the optimal level of debt — we can say that it is positive, but we do not know how much of it is positive.

If the optimal debt-to-GDP ratio is above the current level, then the crocodile's mouth may remain open for a while yet. Though it cannot remain open forever, some factors will continue to shift the upper jaw further upwards, at least over the next few years as the COVID-19 downturn persists.

Japan has one of the world's most advanced ageing populations. Within a few years, the country will enter an era of ‘super-ageing’.

Between 2018 and 2025 the population aged 65–74 will fall from 17.6 million to 14.97 million, while the number of people aged 75 and over will increase from 17.98 million to 21.8 million, according to Japan's Ministry of Finance. Medical and nursing care costs are expected to increase substantially. Compared to the 65–74 age group, for those aged 75 and over, the per capita cost of medical care will be around four times higher and the cost of nursing care 10 times higher.

How should Japan solve this fiscal problem, and how can it ensure fiscal sustainability? Any policy that sharply raises the crocodile's lower jaw (lifts revenues) will entail heavy short-term costs in the middle of a pandemic-induced downturn. Voters are unlikely to wear a shift in that policy direction. Since the ratio of older people in the electorate is high and the voting turnout of younger people is low, the rational calculations of politicians will favour the elderly.

The difficulty of knowing what the optimal debt level is, and the extent of austerity and when it may be needed, prompt postponement of immediate action and forward strategies that might solve the problem — making it only more difficult to reach a solution when the day of reckoning finally comes.

October 7, 2021 East Asia Forum

October 13, 2021

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