The Next Panic

Europe’s crisis will be followed by a more devastating one, likely beginning in Japan

By PETER BOONE - SIMON JOHNSON

This summer, many government officials and private investors finally seemed to realize that the crisis in the euro zone was not some passing aberration, but rather a result of deep-­seated political, economic, and financial problems that will take many years to resolve. The on-again, off-again euro turmoil has already proved immensely damaging to nearly all Europeans, and its negative impact is now being felt around the world. Most likely there is worse to come—and soon.

Who could be next in line for a gut-wrenching loss of confidence in its growth prospects, its sovereign debt, and its banking system? Think about Japan.

Japan’s post-war economic miracle ended badly in the late 1980s, when the value of land and stocks spiked dramatically and then crashed. This boom-and-bust cycle left people, companies, and banks with debts that took many years to work off. Headline-growth rates slowed after 1990, leading some observers to speak of one or more “lost decades.”

But this isn’t the full picture: after a post-war baby boom, population growth in Japan decelerated sharply; the number of working-age people has declined fairly rapidly since the mid-’90s. Once you account for that, Japan’s economic performance looks much better. The growth in Japan’s output per working-age person—a measure of productivity for those who have jobs—has actually kept up with most of Europe’s, and has lagged only slightly behind that of the United States. Japan is a rich country with low unemployment. Its private sector is by no means broken.

So why is Japan’s government now one of the most indebted in the world, with a gross debt that’s 235.8 percent of GDP and a net debt (taking some government assets into account) that’s 135.2 percent of GDP? (In the euro zone, only Greece has government debt approaching the Japanese level.)

After World War II, Japan built a financial system modeled on those of Europe and the United States. Financial intermediation is an old and venerable idea—connecting people with savings to other people wanting to make investments. Such a sensible use of savings was taken to a new level in Japan, the U.S., and Europe in the decades following 1945—helping to fuel un­precedented growth for entrepreneurs and a genuine accumulation of wealth for the burgeoning middle class.

But such success brings vulnerability. Modern financial systems also permit governments to borrow large sums from investors, and as finance has evolved, that borrowing has become easier and cheaper. In the most-advanced countries, governments have increasingly taken advantage of expanding markets for short-maturity debt, whose principal is due soon after the loan is made. This has allowed them to borrow far more, and at cheaper rates, than they otherwise would have been able to do. Typically, these governments then take out new loans as the old ones come due, “rolling over” their debts. This year, for example, the Japanese government needs to issue debt amounting to 59.1 percent of GDP; that is, for every $10 that Japan’s economy generates this year, the government will need to borrow $6. It will probably be able to do so at very low interest rates—currently well below 1 percent.

Devastating crises characterized the pre-war global financial system; these would typically raze banks and other institutions to the ground. In the whipsaw economy of those times, the widespread bankruptcy of borrowers would also ruin a generation of creditors. Over and over, these disasters repeated; some featured sharp inflation, others deflation.

Repeated financial ruin limited the buildup of savings, and the rising middle class was wary about borrowing and lending. The idea that government debt was a safe investment was also typically viewed with skepticism—and for many countries, correctly so.

New policies (and some good luck) dispelled extreme crises from the core of the world economy after WWII. Governments found ways to insure individuals’ deposits, regulate financial markets, and press for banks to become better-managed—and thus less prone to collapse. Central banks became more willing and able to provide emergency assistance. The big financial innovations of the immediate post-war period strengthened the public backstops behind private financial arrangements, and these arrangements proliferated.

So too did publicly provided pensions. These pensions were initially an amazingly good deal for retirees, who paid in little. And as life expectancies increased, retirement benefits were extended. Throughout the rich world, these benefits were predicated on rapid economic growth powered by ever-expanding populations; workers were not expected to put in as much as they would eventually take out. The demographics began changing years ago, but the political incentives did not, nor did the availability of cheap, short-term financing, rolled over regularly.

About half of the Japanese government’s annual budget now goes to pensions and interest payments. As the government has spent more and more to support its growing elderly population, Japanese savers have willingly financed ever-increasing public-sector debts.

Elderly people hold their savings in the form of cash and bank deposits. The banks, in turn, hold a great deal of government debt. The Bank of Japan (the country’s central bank) also buys government bonds—this is how it provides liquid reserves to commercial banks and cash to households. Similarly, Japan’s private pension plans—many promising a defined benefit—own a great deal of government bonds, to back their future payments. Few foreigners hold Japanese government debt—95 percent of it is in the hands of locals.

Given Japan’s demographic decline, it would make sense to invest national savings abroad, in countries where populations are younger and still growing, and returns on capital are surely higher. These other nations should be able to pay back loans when they are richer and older, supplying some of the funds needed to meet Japan’s pension promises and other obligations. This is the strategy that Singapore and Norway, for example, have undertaken in recent decades.

Instead, the Japanese government is using private savings to fund current spending, such as pensions and wage payments. With projected annual budget deficits between 7 and 10 percent of GDP, Japanese savers are essentially tendering their savings in return for newly issued government debt, which is not backed by hard assets. It is backed only by an aging, shrinking population of taxpayers.

Japan’s taxpayers are already rebelling against small tax increases needed to limit escalating deficits. This leaves little room for hope that future taxpayers will accept the larger tax increases needed to repay debts.

Japan’s demographic decline will be hard to reverse—and even in the best-case scenario, the positive effects of a reversal would not be felt for decades. The economy, roughly speaking, is as healthy as it is likely to become. Yet the government seems incapable of steering away from the cliff, a characteristic that should strike no one as uniquely Japanese—just look at how the Euro­pean leadership has behaved over the past half decade, or how you can polarize American politicians with the phrase debt ceiling.

A crisis in Japan would most likely manifest as a collapse of confidence in the yen: At some point, Japanese citizens will decide that saving in any yen-­denominated asset is not worth the risk. Then interest rates will rise; the capital position of banks, insurance companies, and pension funds will worsen (because they all hold long-maturing bonds, which fall in value when rates rise); and fears of insolvency will surface.

Japan has some buffers against calamity—­particularly, its assets held outside the country (including more than $1 trillion in foreign-exchange reserves) and its unmatched ability to export. Nevertheless, the real value of the roughly $14 trillion in government bonds will fall significantly once people fully realize that the tax base is aging and shrinking. Presumably, the yen will also depreciate, perhaps sharply.

The fact that government debt is held mostly by Japanese citizens is not sufficiently reassuring. The same was true in Germany during the 1920s and Russia during the 1990s, yet in both cases the elderly lost their savings to high inflation. Today, Italian and other European savers who hold their own government’s debt are already nervously edging toward the exits. As in Europe, the financial system in Japan could face a wave of insolvencies, triggering a broader loss of confidence.

The shock felt around the world will result not just from the realization that Japan is unable to meet its pension and other social obligations. Investors will also be horrified to see the disappearance of the private savings previously used to buy government debt, whether through debt defaults and bank failures or through high inflation. For ordinary Japanese, public promises about retirement benefits and price stability will be broken just as their private savings for retirement collapse.

No one can predict the timing, but without radical political change that creates a more responsible fiscal trajectory, this will happen.

The most worrisome implication of Japan’s increasingly precarious position, particularly in the wake of the 2008 crash and Europe’s ongoing crisis, is that our financial systems appear to be returning to their inherently unstable nature, which plagued the 19th and early 20th centuries. Financial institutions back then were not too big to fail—they were too big to save. Their balance sheets dwarfed most governments’ ability and willingness to provide support.

Through the development of central banks and active fiscal and monetary policy, the rich world has managed to avoid serious depression for seven decades. Yet big finance—which tends to grow ever larger when crises are rare and credit risks seem muted—hides deep political flaws, the costs of which compound over time. Relative to the size of the world economy, global debt markets overall are two to three times their size in 1970.

Bankers and politicians seem to enable the worst characteristics and behaviors of the other. The past few years have led us to focus on half of that phenomenon: the degree to which government guarantees have facilitated irresponsible risk-taking on Wall Street. And this is, of course, an issue that demands continued attention.

But Japan illustrates the other half of the phenomenon—the extent to which finance has allowed and encouraged politicians to make attractive short-term decisions that are eventually damaging. This may ultimately yield worse crises than the one we faced in 2008 or the one now unfolding in Europe. Greece, Ireland, Portugal, Spain, and Italy found their own ways to eco­nomic devastation, but each road was paved with easy credit. Those whom the gods would destroy, they first encourage to borrow cheaply.

Of course, the U.S. is not immune. The immediate problem is not Social Security: that program’s promises can still be covered by modest taxes, and significant immigration has helped prevent a demographic decline like the one Japan is seeing. Nonetheless, the U.S. needs to issue government debt worth about 25.8 percent of GDP this year, to roll over its debts and finance the deficit. About half of the federal government’s debt is already held by foreigners. And a tax revolt has been building since the mid-’70s. Today, one side of the political spectrum refuses to consider rebuilding revenue to the pre–George W. Bush levels—and proposes to cut taxes further. The other side resolutely defends spending programs and middle-class tax breaks. Health-care spending, meanwhile, keeps rising—­largely because powerful lobbies can veto meaningful cost control.

Perversely, interest rates on U.S. government debt are lower than at any other time in living memory—the result, largely, of economic dangers elsewhere. The Europeans have ruined their economies—­and we have benefited from the consequent inflow of capital to our government debt, which has pushed rates down. When Japanese investors begin abandoning their home country, we will benefit again.

These benefits are temporary. Yet politicians have a hard time paying serious attention to fiscal deficits while foreign capital floods in. Even once the U.S. economy recovers, will the government really get its debt under control?

The financial sector is a powerful lobby. What policies does it demand? Financiers want pro-bailout policies kept in place—particularly the massive implicit guarantees against failure that they receive. And they want continued deficits. Our financial titans pay lip service to fiscal responsibility, but they primarily want to pay fewer taxes—­irrespective of what this means for government debt. Indeed, bigger deficits create larger markets for government debt and all of its derivative products, which in turn allow the financial sector’s profits to grow larger. Many politicians are only too happy to oblige.

Elderly Japanese refuse to consider changing their pension system. The euro elite have closed their eyes to the unsustainability of their currency union. And the U.S. has Wall Street in the driver’s seat. We all have political systems that have figured out how to promise far more than can be repaid, and how to work with the financial sector to opaquely transfer resources to powerful groups—at a cost, it is often said, to be paid by future generations.

Increasingly, however, it appears that future generations will not be the only ones harmed by our decisions; we are already feeling the negative impact. In recent decades, financial sectors throughout the rich world grew at historically unprecedented rates; now they are dangerously outsize relative to the rest of the economy. Changing that dynamic in any orderly way looks extraordinarily difficult. Yet history suggests it will change, and soon. The era of large-scale, uncontrolled financial booms and busts—last seen in the 1930s—is back.