Will We Go the Way of Japan?--Posner

Japan spent the 1990s unsuccessfully trying to recover from a collapse of the Japanese banking industry caused by the bursting of a housing bubble, despite aggressive monetary and fiscal policies. As a result of those policies, Japanese national debt soared, but was financed mainly internally because of the very high Japanese personal savings rate. With its large surplus of exports over inputs, moreover, Japan accumulated dollars (and other currencies), which also reduced the debt burden. Interest rates remained very low, in part because of chronic deflation. The low interest rates stimulated the "carry trade": investors would exchange Japanese yen for local currencies in countries that had high interest rates. This is a form of arbitrage, but tends not to erase international interest-rate differences, as one might expect arbitrage to do. Japan was hard hit by the current economic crisis, in part because of its dependence on exports. It responded with aggressive monetary and fiscal measures, as before--with what appear to be potentially disastrous results, if one may judge from data in a recent article in the Wall Street Journal (Richard Barley, "Japan: The Land of the Rising CDS," Nov. 11, 2009, p. C20). The International Monetary Fund predicts that next year Japan's ratio of national debt to GDP will be an astronomical 2.27, forcing Japan to continue borrowing heavily abroad. Interest rates remain very low, in part because Japan is again experiencing deflation. Rating agencies have reduced Japan's bond rating to AA-, yet the government, lulled by low interest rates, apparently has no sense of urgency about the country's mounting debt burden, a burden aggravated by the rapid aging of Japan's population. International financial markets believe that there is some probability that Japan will default on its debt. The "CDS spread" (the percentage of a debt that someone desiring insurance against the debt's defaulting must pay for the insurance) on Japanese government debt is almost 1 percent (.75 percent). The United States differs in many respects from Japan, but is beginning to look more and more like it. We too experienced a banking collapse in the wake of the bursting of a housing bubble, and our monetary and fiscal responses, though aggressive, may not have been highly effective. The fiscal stimulus--the $787 billion federal spending program enacted in February--was enacted late and is poorly designed, and some think too small. And there is concern that, like Japan, we are babying our weak banks by allowing them to overvalue the assets and underestimate the liabilities on their balance sheets. The stress tests conducted last spring, for example, both underestimated the stress the banks were under (by assuming an unemployment rate--unemployment being highly correlated with bank-loan defaults--substantially lower than it became within a couple of months after the tests) and disregarded likely defaults of bank loans that will mature after 2010. Our government, too, is lulled by low interest rates into believing that we can continue to run huge deficits without raising taxes or cutting spending significantly, simply by borrowing. Our public debt (the amount of federal government debt that is contractually obligated, as distinct from accounting reserves for entitlement programs such as Medicare and social security), of which almost half is owned by foreign governments and other foreign investors, has reached $7.5 trillion, which is more than half our GDP, and is on course to increase by at least a trillion dollars a year for the indefinite future. Like Japan, we have an aging population, which is pushing up entitlement costs. Our government seems not to have any economically realistic or politically feasible plans either to raise revenue or cut spending, but instead plans ambitious new spending programs (notably but not only on revamping health insurance). Proposed economies seem tokens. There is an air of complacency about deficit spending and public debt--again like Japan. Because of our low inflation rate (it is close to zero) and the Federal Reserve's "easy money" policy (as a result of which our banks are holding a total of $1 trillion in excess reserves), the dollar has now become a favorite currency for the carry trade: dollars exchanged for local currencies earn interest more or less effortlessly, though not without risk. The carry trade may be a factor in the recent rises in commodity prices; indeed there is fear of additional asset-price inflation (bubbles) as a result of all the dollars sloshing around in the world economy. Should the U.S. economy grow more rapidly than the public debt, we'll be okay. But the government's focus appears to be not on economic growth, but on redistribution (the major goal of health reform) and on creating at least an aura of prosperity, at whatever cost in deficit spending and future inflation, in time for the November 2010 congressional elections.

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