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January 2002
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By John H. Makin

While there is plenty of argument about where the U.S. economy is headed next year, the argument about Japan's economy is over. During 2001, Japan passed from a prolonged and serious recession into outright depression. The bad news is that a depression in the world's second-largest economy will make it more difficult for the world economy to recover in 2002. The (not very) good news is that depressions as acute as the one that has emerged in Japan do not usually last very long. However, Japan's exiting its depression will require a large write-down of an unsustainable debt burden either through reflation or outright default.

Japan Chooses the Road to Default

Japan appears poised to follow the passive route of outright default rather than the more active route of reflation. Reflation, even if it leads beyond price stability to some inflation, is a better strategy than default because moving from deflation to rising prices taxes evenly the holders of government debt as rising prices push up interest rates and push down the value of the debt. The default approach toward which Japan is heading will be more abrupt, arbitrary, and disruptive to Japanese and global markets. Beyond financial market turmoil, abrupt default entails a significant additional risk that jeopardizes further employment and growth in Japan and worldwide. Japan's deflation and debt crisis now constitute systemic risk to the global economy.

Japan's efforts to reflate have failed essentially because such efforts have been pursued along normal monetary channels that are appropriate for an economy with a functioning banking system. Japan's banking system is insolvent. Efforts by the Bank of Japan to boost economic activity and to reflate by increasing reserves in the banking system and cutting short-term interest rates virtually to zero amount to beating harder a dead horse. The dead horse is the Japanese banking system, which by virtue of its insolvency is unable to act as a financial intermediary borrowing short from the central bank and lending to Japan's private sector. Rather, Japan's banks have taken to borrowing overnight from the central bank at virtually zero interest rates and buying government securities of slightly longer maturity to pick up an additional 15 or 20 basis points of yield on those government notes.

The Bank of Japan's unsuccessful efforts to stimulate the economy by providing more liquidity to the banking system have essentially amounted to underwriting ever-rising government debt and a continuation of wasteful government programs, exactly what Bank of Japan governor Masaru Hayami has said he wants to prevent. In this process, Japan's banks have acquired a huge stock of government debt bearing very low interest rates that mirror the absence of any other investment opportunities in Japan and the total risk-aversion of the banks.

The Lesser of Evils

The large acquisition by Japanese banks of Japanese government securities has, of course, created a dilemma for the government and the Bank of Japan. Successful efforts to stimulate the economy or reflate would result in higher interest rates and a collapse in the value of the low-interest rate government bonds acquired by the banks. This "dilemma" has caused the government to pause in its efforts to encourage reflation by the Bank of Japan.

An economy in depression, as Japan's is, presents its government with no attractive alternatives. Rather, the government must choose the least bad alternative, and that is to reflate, either proactively or reactively, to reduce the rising burden of debt that is being compounded by prolonged heavy government borrowing and by accelerating deflation. The alternative, to do nothing, simply ensures that the problem will get worse and the pain caused by a transition from deflation to reflation will be greater.

Time and again, the Japanese government and the Bank of Japan have demonstrated a preference for passivity with respect to the need to reflate. The inevitable outcome will be the failure of one or several large banks that ultimately precipitates the failure of the banking system. By failure I mean simply that depositors, convinced that the liabilities of Japan's banks far exceed their assets, will continue to withdraw funds from the Japanese banking system. There will be a full-scale "run" on the banks. Concern over this outcome is already evident in Japan's stock market, where bank stocks through early December were down 44 percent on the year against the overall stock market decline of 24 percent. Meanwhile, the market prices of some money market funds, which are supposed to be safe assets, have fallen below par by virtue of their questionable holdings.

The problem with the collapse of Japan's already dead banking system will be especially acute for depositors. Bank shareholders have long since seen the positive equity value, or net worth, of Japan's banks disappear.  But as the banking system collapses, the Japanese government will face the need to avoid additional losses by household and business depositors in the banks.

Specifically, the negative net worth of the Japanese banking system is somewhere above the yen-equivalent of $1 trillion. When the banking system collapses, in order to avoid compound losses by Japan's households, the Bank of Japan will need to inject at least $1 trillion into the banks to protect depositors from losses that would constitute a further setback for the Japanese financial system and economy.

Default Collapses Japanese Currency and Government Bonds

The mechanics of an operation whereby the Bank of Japan injects $1 trillion of liquidity into the banking system will require a huge increase in government debt that is immediately monetized by the Bank of Japan. In order to acquire the funds to protect Japan's bank depositors, the government will issue $1 trillion worth of securities that the Bank of Japan will buy and inject into the banking system. Such steps will probably result in nationalization of Japan's banking system, since the government will have underwritten its solvency. In the process, Japan's public debt will jump immediately by about 15 percent. The resulting surge in liquidity, coupled with a huge increase in government debt with the prospect of still further increases, will cause Japan's currency and bonds to collapse. Led down by bank shares, the stock market will fall further. The collapse of the currency and the increased need for liquidity will initiate the sharp reflation and inflation that the Bank of Japan ought to have initiated several years ago in order to avoid this calamity.

While such a disastrous outcome may seem a remote possibility, it is one that has occurred specifically to market participants. There is a market for default protection on Japanese government bonds, and since early November the cost of such protection has risen from about 0.15 percent of the value of one's holdings of such bonds to 0.25 percent.

Japan's currency has started to weaken in anticipation of the coming default. The yen has fallen in value against the dollar and the euro by an average of about 10 percent since September. In the short run, the falling yen serves to re-export the virulent strain of deflation that Japan and much of Asia is importing from China. Over the medium-term (a year), yen weakness signals a prospective run out of Japan's last safe havens for Japanese investors-government bonds and cash.

Japan faces another proximate threat to the viability of its banking system. Deposit insurance on large deposits at Japanese banks is scheduled to end March 31, 2002. As that date approaches, large deposits will flow out of the banks at an increasing rate. Depositors will want to purchase government securities directly in order to avoid the rising default risk on direct deposits at banks. Of course given the large increased borrowing needs facing the government to underwrite the solvency of the banking system, these securities will become increasingly risky. In short, Japan's financial crisis ultimately leaves bank depositors with no place to hide domestically from heavy losses.

The Japanese government, foreseeing a run on the banks, may postpone the March 31, 2002, termination of deposit insurance on large deposits. That step will only delay the outright collapse of the banking system, since without a massive direct injection of liquidity into the economy-not into the moribund banking system-through the direct purchase of foreign bonds, corporate bonds, and land by the Bank of Japan, deflation will continue to raise the negative net worth of the banking system and its depositors. Alternatively, if the government allows the March 31 deadline to stand, it may be signaling recognition of the need to precipitate a crisis in order to induce reflation by force.

Anticipating Japan's Financial Crisis

The official recognition of this process is, at present, far behind the reality. Early in December 2001, three bond rating agencies-Moody's, Fitch's, and Standard & Poor's-downgraded yen-denominated debt to a level three notches below the top rating, or to the same rating given to countries such as Italy and Slovakia. As Japan's deflationary debt crisis intensifies, further discussion has arisen about additional downgrades of Japanese debt. But do not look for the credit agencies to downgrade debt before the Japanese bond market collapses. They will not do so, because the Japanese government will insist that any such preemptive downgrade would collapse the market. Rating agencies in Russia, Latin America, and Asia have repeatedly demonstrated their inability to signal coming crises in the market for the debt of governments because they persistently heed the admonitions of governments that it would be "irresponsible" to warn investors to get out of assets whose value is about to collapse. A similar issue comes to mind when thinking about the way accounting firms have dealt with companies such as Enron.

Japan's Debt Dynamics

Japan's government is in an inescapable debt-death spiral by virtue of the fact that nominal GDP is falling at an annual rate of about 5 percent. Stabilizing the Japanese government's debt-to-GDP ratio would require that nominal GDP rises at a rate equal to the interest rate on its outstanding debt, or about 1 percent. The fact that nominal GDP is falling at a 5 percent rate means that Japan's debt-to-GDP ratio will rise at least 6 percent a year, even without a sudden need to recapitalize insolvent banks. That debt ratio is now 130 percent, and at 6 percent a year it will double in just over a decade. That fact will itself accelerate the collapse of Japanese government bonds unless deflation is reversed.

Actually, the debt burden of Japan's government is worse than the 130 percent debt-to-GDP ratio widely reported in the press. First, accelerating deflation will cause that ratio to rise even more rapidly as government revenues collapse. Further, the contingent liabilities of the government, including its responsibilities to protect bank depositors, will jump abruptly once the increasingly likely crisis in the banking system emerges.

Some have suggested that the Japanese government possesses assets that it could sell to improve its ability to deal with large losses in the banking system. The problem with such sales, for example the sale of government-owned shares in Japan Tobacco or NTT (Japan's telephone company), is that they further depress the value of these shares on the stock market. This is just another example of the dangers of a deflationary environment in which assets that had been viewed as reserves can no longer function as liquid reserves because attempts to realize liquidity further depress their value.

Japan's policymakers have reached the stage where loss minimization instead of a selection among desirable alternatives is the only option open. An inability to choose the least undesirable option-preemptive reflation-has frozen the Bank of Japan and the government into a state of inertia. The result will be a collapse of the banking system that requires a surge in bond issuance and the byproduct of reflation anyway. It is only a matter of time.

Japan's Depression; America's Recession

The only positive aspect of Japan's desperate situation is to help define how far away from a true depression the American economy is. It has taken Japan a decade and a series of seemingly incredible policy errors, which have been recounted many times, to reach the sad state it now faces.

American policymakers, facing an unusual and perhaps lengthy recession, have responded aggressively by cutting interest rates, increasing liquidity, and cutting taxes. While additional fiscal stimulus will probably be needed in 2002, especially in the form of lower tax burdens, because tax cuts stimulate both demand and supply, such attractive options remain open to American policymakers. The sad example of Japan's economy probably increases the likelihood that such options will be used.

John H. Makin is resident scholar at the American Enterprise Institute. #13626

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