The conventional wisdom in both Japan itself and the west is that the country has an unmanageable public debt problem. I find this quite unpersuasive. All the country needs to do is generate, say, expectations of 3 per cent inflation and the public debt problem should melt away like snow. But the longer it waits the bigger the ultimate adjustment will need to be.
In 2010, according to the Organisation for Economic Co-operation and Development, Japan will pay net interest of 1.1 per cent of gross domestic product on net financial liabilities of 105 per cent of GDP. Since 2000, Japan’s average rate of deflation (on the GDP deflator, the widest measure of inflation) was 1.2 per cent. So let’s treat the expected real rate of interest on Japanese government borrowing at 2 per cent.
So here is the plan.
First, extend the maturity of debt to at least 15 years from the today’s average of 5.2 years. (Whoever was responsible for allowing Japanese debt to be so short term when the government can borrow at incredibly low long-term interest rates seems utterly incompetent.) That would bring average Japanese maturities above the far more sensible UK level of 13 years.
Second, hire a central bank governor who knows how to create inflation – an Argentine, for example. I am quite sure that any moderately determined central banker could do this, if he wanted to do so, by direct purchase of public and private sector assets on a sufficiently large scale. The government should prod this along by giving the Bank of Japan an inflation target of 3 per cent, after maturities have been extended, while informing the policy committee that all its members will be sacked, ignominiously, if they fail to hit the target within two years.
Third, let us suppose inflation indeed goes to 3 per cent. That should raise the interest rate on JGBs to 5 per cent. Other things equal, the market value of the outstanding net government debt would fall by 40 per cent. So now the Japanese government buys back the outstanding debt at its new market price, reducing the face value by 40 per cent of GDP. In the new inflationary environment, the Japanese find the real value of their huge holdings of cash falling sharply. So they buy real assets and consumer goods, instead, and, at last, the economy expands vigorously.
Fourth, now the government raises taxes and cuts spending, moving into a small primary surplus. Assume that the government only needs to borrow to roll over its debt and the debt ratio stabilises. How big a primary surplus is needed depends only on the relation between the real rate of interest and the rate of growth of the economy.
So there we have it. By extending maturities of debt, moving from deflation to modest inflation, Japan eliminates almost half of its outstanding debt, relative to GDP, and normalises the economy, in the process.
It is simple, really. The government has baited the trap. Now all it needs to do is spring it.
Countries with their own central banks do not need to default; they can inflate, instead. Provided they can borrow at long enough maturities and on favourable terms, the amount of inflation needed to eliminate huge debt overhangs is not enormous, provided it is unexpected. In Japan, any inflation would now be unexpected, given current long-term interest rates. So the solution there seems to be perfectly straightforward. What do you think? Leave your responses below.
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