Our future is Japan

I like to tell people who are concerned about the large amount of debt we have floating around in the global economy that if they want to know how the future looks like, they have to look at Japan. In Western Europe and North America, we are essentially following in Japan’s footsteps. During this year’s Jackson Hole central banking conference, my view was reinforced by an analysis by economic historians Serkan Arslanalp and Barry Eichengreen.

In their research, they looked at how advanced and emerging economies managed to reduce large debt overhangs after wars and other calamities.

The chart below shows how advanced economies did it after World War II. At the end of the war, the average debt/GDP-ratio of advanced economies was 112%. Thirty years later the average debt/GDP-ratio had dropped to a mere 26.2%. Primary surpluses (i.e. budget surpluses before interest costs on existing debt) helped take the debt level down by 33.3% of GDP. That sounds a lot, but it was almost entirely offset by stock flow adjustments (SFA in the chart below) of 27.7% of GDP. These stock flow adjustments are the combined effect defaults and restructurings, nationalisation of private debt after the war and exchange rate effects from exchange rate devaluations.

Debt reduction in advanced economies after WWII

Source: Arslanalp and Eichengreen (2023)

Essentially all the debt reduction came from a negative r-g. r-g is the difference between real interest rate paid on debt and the real GDP growth of the economy. If r is smaller than g, the economy slowly grows out of its debt over time. And for much of the three decades after World War II that is essentially what happened. GDP growth was strong and financial repression through a combination of interest rate caps and high inflation led to low real rates.

But that was then, and this is now.

Arslanalp and Eichengreen look at the drivers of the debt reduction this time around and come to similar conclusions as I do.

They say that a primary budget surplus is only possible if a country can unite behind a policy of lower government spending or if a bond market crisis forces it to do so. I agree with their assessment that in our divided political landscape a national consensus about government spending and the need for primary budget surpluses is something seen only in countries where pigs can fly. Hence, budget surpluses will not be of any help in the coming decade unless politicians are disciplined by a bond market crisis.

And no matter what the Institute of Economic Affairs or columnists of The Telegraph will have you believe; this is what happened almost exactly a year ago in the UK. In reaction to mini budget of Liz Truss, which essentially amounted to large deficits now at the hope of more growth later, bond markets threw a major tantrum and started to treat the UK like it does emerging markets like Brazil when they engage in irresponsible fiscal policies. When a country is running large amounts of debt, no matter how developed or safe it is considered in normal times, it takes very little to shake the confidence of bond investors and create a bond market crisis that forces the government into a U-turn.

Is it any wonder that not only the current Conservative government insists on fiscal prudence but that the opposition Labour Party emphasises everywhere and all the time that it will not spend money they don’t have and not increase the deficit? This of course drives left-wing columnists at the Guardian mad, but it is exactly what needs to happen. Governments saddled with large amounts of debt have to be fiscally prudent or bond investors will force them. As James Carville famously said in reaction to the Great Bond Massacre of 1994: “I would like to come back as the bond market. You can intimidate everybody.”  

But fiscal prudence does not mean governments will run large budget surpluses. Because the debt is so large, getting a budget into a primary surplus would mean substantial tax increases and (not either or, but as well as) spending cuts in important areas such as social security, pensions or defence, something that no party is willing to do. Thus, we are trapped in a world of small fiscal deficits or at best balanced budgets, neither of which will reduce debt in the long run.

Second, Arslanalp and Eichengreen note that there are different ways to reduce the real rate of interest r below the real rate of growth g. However, with our demographic headwinds, real economic growth is going to be lower than after World War II when rebuilding Europe and Asia after the destruction of the war added a boost to real GDP growth.

So, how do we get the real rate of interest below a low rate of real GDP growth?

One way to do that is to let inflation run above the nominal rate of interest. This can be done for short-term bonds which are essentially determined in the nominal interest as set by the central bank. But longer-term debt is priced in the bond market and there, bond yields will inevitably drift higher if investors expect inflation to remain high. Hence, only unanticipated inflation like the inflation spike we saw in 2022 is able to reduce government debt/GDP-levels in the long run. Any inflation that is anticipated will simply drive-up borrowing costs for governments without any long-term reduction in debt/GDP.

Unless, of course, the government is able to control the level of nominal interest rates for long-term debt. And this is where I slightly disagree with Arslanalp and Eichengreen. They say that in a world of globalised finance and free capital flows, governments that try to impose a limit on interest rates charged on long-term debt like they did in the 1950s to early 1980s will face a flight of capital and a bond market crisis. This is true in a free market view of the world. But if you look at Japan, you can see how that problem can be avoided via the central bank. In Japan, the central bank has been manipulating the bond market through its interest rate targeting policy for years. This has kept long-term bond yields close to zero and helped the government sustain debt levels well in excess of 200% of GDP.

In a week from today I will discuss in detail how I think monetary policy can be conducted going forward in order to ensure that real bond yields will remain below real growth rates even if growth is very low. So, keep an eye out for that one and set an alert for 12 September.

But of course, the argument of free capital flows still stands. Investors in Japanese bonds may be happy to get zero yield on long-term bonds, but would investors in US Treasuries or British Gilts and for it? In particular, would Chinese holders of US Treasuries not sell them and tank the Treasury market? This is where a chart from the paper of Arslanalp and Eichengreen is instructive. It shows who owns government debt in advanced economies and developing markets as well as the US. And if you look at these charts, you will find that foreign governments have already substantially reduced their holdings in US Treasuries for more than a decade. Yet, nothing happened because all that was necessary was for the central bank to step in and buy what foreigners don’t want to own anymore. It is a systematic monetisation of government debt by the central bank, and it is anything but a market that determines the price of debt freely. But it is what has happened and will continue to happen as long as we have these large amounts of debt. And no matter how much anyone complains about that, it is what in my view will happen because if it doesn’t happen, we will have the biggest financial crisis ever recorded in human history. And as I have said in my series on Cassandras: What cannot happen will not happen.

Ownership structure of government debt

Source: Arslanalp and Eichengreen (2023)