Herb Stein famously said that when something cannot go on forever, it will stop. Experience teaches that in economics when something unsustainable stops, it often does so with a bang rather than a whimper.
Japan’s economy has all the signs of unsustainability, raising the possibility that the country could soon be the source of global economic shockwaves. That could happen following the appointment of a new Bank of Japan head in April. While the rest of the world’s major central banks are engaged in aggressive monetary-policy tightening, the BOJ might put an end to its long-standing quantitative easing policy.
It would be a gross understatement to say that Japan’s public finances are unsustainable. This would be especially true in a world of higher Japanese interest rates. According to the International Monetary Fund, the ratio of Japan’s gross public debt to its gross domestic product is some 260%. That is around double the corresponding ratio in the United States.
There is little prospect that Japan can grow itself out from under its public debt mountain. Japan’s population is rapidly aging, and its potential economic growth rate is barely 0.5%. Meanwhile, with the country expected to run a primary budget deficit for as far as the eye can see, there is every prospect that Japan’s public debt ratio could grow even higher. That would be especially the case if the Japanese government has to borrow at higher interest rates than the ultra-low rates at which it can borrow today.
The Bank of Japan ‘s ultra-easy monetary policy has been a primary factor in keeping the Japanese government afloat. The BOJ has kept interest rates at artificially low levels and engaged in yield-curve-control. The BOJ has intervened aggressively in the government bond market to keep long-term government bond yields from rising above 0.5%.
This ultra-easy monetary policy has resulted in a massive expansion in the size of the BOJ’s balance sheet. It is now the equivalent of 135% of GDP, more than three times the corresponding ratio for the Federal Reserve and the European Central Bank. The policy has also led to a large drop in the yen and to a spike in inflation. Last year, the yen plunged to a 32-year low against the U.S. dollar, which contributed importantly to Japanese core-price inflation rising to a 40-year high of 4.25%.
The term of Haruhiko Kuroda, the BOJ’s current governor, ends on April 8. His replacement is yet to be named. But it seems highly likely the new governor will want to review the wisdom of Japan continuing with its ultra-easy monetary policy, now that Japanese inflation is running at more than double the BOJ’s 2% inflation target. That would very likely spell the beginning of the end for BOJ’s yield-curve-control as well as for its policy of flooding the world market with liquidity.
A reversal in Japanese monetary policy would likely have major implications for world financial markets. No longer would Japan be providing world financial markets with liquidity at a time when both the Federal Reserve and the European Central bank are withdrawing market liquidity through their quantitative tightening policies. A big bounce in the Japanese yen would likely ensue. It would also add pressure to world equity and credit markets that are already on the back-foot.
Worse yet, an unanticipated hike in Japanese government bond yields could cause an accident in Japanese financial markets by catching financial institutions off guard. They could do so in much the same way as last year’s sharp spike in U.K. gilt yields following then-Prime Minister Liz Truss’s ill-advised budget caused major problems for the U.K. pension funds. The Bank of England had to intervene in the gilt market to the tune of $65 billion to address the problems.
A major central bank could slam on the monetary-policy brakes at a time when the world is drowning in debt. That would be a dangerous turn for the global economy. Yet the BOJ might see no choice in light of rising Japanese inflation. We have to hope that the Federal Reserve is closely monitoring the Japanese economy. The Fed may need to abandon its plans to further tighten monetary policy in the event that the BOJ triggers financial-market instability.
Corrections & amplifications: The yen fell to a 32-year low against the dollar in 2022. A pervious version of this commentary stated incorrectly that it was an all-time low.