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Japan’s Fiscal Crisis Comes of Age

TOKYO – Has Japan’s political paralysis finally lifted? The recent agreement, after a long debate, between the government and leading opposition parties to double the consumption tax – from 5% to 8% in 2014, and then to 10% in 2015 – suggests that it has. But there is a real risk that the government will mistake this measure for the end of the reform process. In fact, it is – or should be – only the beginning.

By virtually any measure, official Japanese debt is the highest in the world. The total outstanding volume of Japanese Government Bonds (JGBs) is an almost unfathomable $9 trillion, only just below the $10.5 trillion in outstanding debt for the full 17-country eurozone, which has more than triple the population.

So grim has Japan’s fiscal position become that bond issuance has exceeded tax revenue since 2009. Taxes cover less than half of government spending. And last year’s earthquake, tsunami, and nuclear disaster only made a grim fiscal picture worse by requiring huge new spending on reconstruction. Japan issued a record ¥55.8 trillion ($693.5 billion), or 12% of nominal GDP, in government bonds during the last fiscal year.

Of course, Japan’s fiscal problems have been mounting for decades. Annual tax revenue has fallen 30% since the country’s property bubble burst in 1989, owing to slow growth and deflation, with tax cuts implemented as stimulus measures during the 1990’s recession playing a subsidiary role.

The only reason that Japan has been able to sustain its fiscal position is that 93% of its debt is domestically held (with the Bank of Japan now buying close to one-third of the JGBs issued each year). Indeed, in contrast to the foreign capital flight that has so damaged Europe, willing foreign buyers of JGBs are currently plentiful, pushing interest rates to their lowest levels ever.

Moreover, Japan’s private sector – its households and companies – sits atop a mountain of savings, which is mostly used to purchase JGBs. Because the government can still borrow mainly from the Japanese people, its balance sheet remains stable. But, given Japan’s aging population, how long can that continue?

Most leading Japanese economists believe that the situation cannot be sustained, given that the large number of households formed by pensioners is increasingly drawing down savings. The share of those aged 65 or over has nearly doubled over the past two decades, to 23%, compared to 13% for the United States and 16% for Europe. If this trend continues, as seems likely, the captured market that JGBs have had for decades will begin to shrink dangerously. At that point, foreign purchasers are unlikely to pick up the slack.

In reaching the agreement to raise the consumption tax, the opposition Liberal Democratic Party insisted that the main squeeze on the budget deficit – the amount spent on social-security benefits for Japan’s retirees – begin to be addressed. But the agreement actually does nothing to fix that problem.

The large number of elderly and retired people means that spending on health care and social security now consumes 29.2% of the budget, a one-third increase since 2000. To meet these demands, Japan’s government has been slashing spending on education and research, the two areas in which the country’s post-war economic rise was forged. And the old jibe that Japan cannot resist building bridges to nowhere if the government is paying rings less true nowadays. Public works and pork-barrel spending fell to 5.1% of the budget this year, from 13% in 2000.

Of course, the tax system will also need to be addressed. Just as Japan’s deficit is monumental by any measure, Japanese income earners are clearly under-taxed. Even after the proposed doubling of the consumption tax, the rate will remain half the 20% (or more) that almost all European countries levy. Overall tax revenue is roughly 27% of GDP, putting Japan in 28th place among the 35 OECD countries.

The government must not overestimate how much revenue can be gained by the consumption-tax increase, and thus how much of the budget hole can be closed. Moreover, it has so far shrugged off any concern that the tax increase might have a chilling effect on consumption, and thus on economic growth.

Hiromichi Shirakawa, the chief economist at Credit Suisse AG in Tokyo, suggests that the revenue increase from the consumption-tax hike will soon begin to evaporate – and disappear completely in 5-7 years. If he is right, the increase will turn out to be little more than a finger in the dyke of Japan’s budget problems.

Despite its two decades of economic malaise, Japan remains the world’s third-largest economy, and will grow by about 2% this year and 1.5% in 2013. Given the economic doldrums in which the world finds itself, that may not seem so bad. But, if Japan is ever to address its fiscal dilemma effectively, it will need to sustain faster growth than that.

Such growth presupposes a credible strategy to pare the deficit, which means a plan that recognizes the reality of the growing cohort of pensioners. Japanese authorities will also need to launch bold liberalizing reforms to unshackle the many areas of the economy that are shielded from competition. These reforms must aim to boost greater workforce participation by women; induce corporations to invest more at home; and increase competition in cosseted sectors of the economy.

If any country has the political tools to undertake a program of comprehensive reform, it is Japan. The unity with which the Japanese population met last year’s disaster demonstrated once again that, when called upon, the national spirit can work miracles. And Japan’s “greatest generation” – the men and women who rebuilt a war-shattered country into an economic powerhouse – should not be deemed unwilling to sacrifice for the greater good. After all, they saved their country once; they are more than capable of doing it again.

Read more from our "Japan's Turning Point" Focal Point.