The long, hard road out of debt

I recently read an article entitled “The Land of the Setting Sun” from John Mauldin which had some great statistical data on the future of Japan. Unfortunately, it painted a bleak picture of things to come.

The original article uses this data to talk about how bleak the future of Japan looks these days and how the government is running into serious debt problems. In this article I wanted to take a look at some of the options available to potentially resolve this problem and hopefully return Japan to prosperity.

First, let`s take a look at the data and some of the points made in the original article:

-Since 1999, the level of debt-to-GDP has risen from 99 percent to over 170 percent. Total government debt is close to 900 trillion yen and growing at about 7-8 percent a year.
-The interest-rate expense on this debt takes up about 18 percent of the annual tax revenue that the Japanese take in. Interest rates are going to have to rise as Japan will have to compete for capital with other nations. If interest rates double to around 2 percent or so the interest-rate expense would be approximately 40 percent of total tax revenue.
-In 2000 the personal savings rate was 18 percent. Now it is 1.8 percent. Much of those savings were used to buy government debt. With low interest rates, the government was able to borrow a lot as the interest costs were not a factor. The lower domestic savings rate does mean that the Japanese government will have to seek financing from outside Japan at higher rates.
-If we look at the demographics we see a problem in that there are currently 1.2 nonproductive citizens (under 15 years old and over 64) for every productive Japanese citizen. This ratio is expected to reach 2.0 by 2020 and will only continue to grow thereafter.

All this does not paint a pretty picture of the future. What does this debt problem hold for Japan`s future and what policy options are available to get us out of this mess?

Well like an individual who is in debt, nations have the same basic options available, either you cut expenses or you raise your level of income.

Solution #1: Raise Taxes.
Just hike up the taxes and let the revenue flow in. Given that government borrowing is still increasing at 7-8 percent a year we would need to raise taxes to very high levels to first balance the budget, then begin to pay down the debt. This could lead to a prolonged period of very little economic growth that will make the so called “lost decades” of the past 20 years look like boom times in comparison. Raising corporate taxes will reduce job creation which is essential for future economic growth. Raising personal income taxes will reduce disposable income and also reduce demand levels, which of course reduces economic activity. Another G8 country with a similar problem successfully reduced their high levels of debt throughout the 1990s, in part, by raising taxes. But that came at great cost. That country was Canada. Should Japan do this the end result will be lowered standards of living for Japanese citizens just as Canadians had during the 1990s.

Solution #2: Cut Spending:
If we can not raise revenue, then we have to cut expenses. But how much and where do we cut? Do we cut health care? Sounds like an idea until we realize that we have an ever-aging society which needs health care funding. How about cutting education then? Not a wise thing to do as this will directly reduce national competitiveness. Again, looking at the Canadian example they made deep cuts to services during the 1990s, in particular, health care was cut a lot. As painful as it was they did reduce their national debt a great deal in 10 years. Again, as with increased taxes, the end result is lower standards of living.

In the end, Japan is going to have to do a combination of both of these no matter what, as at some point this debt is going to have to be repaid or at the very least, the debt is going to have to be rolled over. This is assuming of course that creditors are willing to do so, and this gets more costly the more the debt grows. However, both of the above solutions do not address the long-term issue which really struck me. And this was my motivation for writing this article. The point about the ratio of non-productive compared to productive citizens is my real concern here. The fact the society is getting less productive and is going to have to carry more unproductive citizens is most certainly going to negatively affect the level of GDP growth in the future and the standard of living for all Japanese, even if the debt were not a bad as it is now. Classifying people as “non productive” is why economics is called the “dismal science” but it is the hard reality. So what do we need to do then?

Solution #3: Societal Changes:
The best long-term solution is to restructure the population pyramid that makes up Japanese society. This is the root cause of problem. Non-productive citizens pay less tax and as they age they tend to need more services and hence have a higher carrying cost to society. These are both driving the need to borrow more to maintain the same level of services. This trend is also not getting any better, which means continued negative impacts on long-term growth.

So what can be done to restructure society? One idea that is already being discussed is to try to encourage childbirth. This is a good start and a good long-term solution but it will take time for these new children to grow up and start being productive members of society. They will not start to make an impact until about 20 years from now when they first start to enter the workforce. In 20 years it will be 2029, already too late to change things as the ratio of non-productive citizens to productive ones is already expected to be over 2.0 - nearly double what it is now. A much faster solution is needed and it has to start within the next 2-3 years. Japan needs an influx of young productive workers who will consume goods, driving economic growth while providing the revenue needed to support current and future government spending. This is the key and it is the only solution that will work long-term.

Tax and spending changes are relatively quick to implement compared to the long-term problem with the structure of society which is much harder to deal with. What will happen is unknown but the fact is that something needs to happen and it needs to happen fast.