Turning Japanese?

by Simon Tilford

Japan has long had the highest level of public debt of any developed economy. The country’s public debt to GDP ratio is around 200 per cent of GDP, far in excess of even the EU’s worst performers. The collapse of real estate and equity prices in the early 1990s and the resulting banking crisis combined with a fast ageing population have condemned Japan to huge deficits, economic stagnation, and deflation, and an enormous rise in overall indebtedness. The country has been able to finance these deficits domestically, and very cheaply, because of Japan’s high domestic savings, and the readiness of Japanese savers to accept a very low rate of return. Deflation (and the strength of the Yen) has meant the Japanese have been willing to invest in Japanese governments bonds despite the low rate of nominal interest rather than invest abroad.

European governments have tended to be very dismissive of any suggestion that Europe is at risk of heading in a Japanese direction. Typically, they argue that the Japanese made egregious policy mistakes, which Europe would not repeat, such as failing to recapitalise the country’s banks quickly enough or tightening fiscal policy before the economic recovery had gained sufficient momentum. These criticisms of the Japanese authorities are probably fair. However, there are structural reasons for Japan’s plight, which many European economies share. And, despite protestations to the contrary, Europe is busy making the same policy mistakes as the Japanese authorities. Much of Europe is now on a Japanese course. Indeed, for some European countries the outlook looks much worse.

One group of EU economies should escape this predicament, largely as a result of favourable demographics. These include the Nordic economies, the Netherlands, and notwithstanding their current fiscal travails, France and the UK. Debt ratios will rise very strongly in all these economies, especially France and the UK, but these should be sustainable because their economies will continue to grow and they should avoid prolonged deflation. Although their populations are ageing, they will largely escape the demographic tsunami which is set to overwhelm much of Europe. For example, fertility rates in France and UK are over 1.9, and hence close to the replacement rate of 2.1 – the level needed to ensure stable populations. It is a similar story in the Nordics, while the picture is bit less favourable in the Netherlands, where the fertility rate is around 1.7.

A second group – basically comprising Germany (and probably Austria) – looks on course to emulate Japan’s experience. Germany has not experienced an asset price collapse equivalent to Japan, or the associated explosion in private sector indebtedness. But there are plenty of similarities between the two countries. Germany is experiencing a similarly drastic population ageing. The country’s fertility rate has been hovering around 1.3 for a generation, guaranteeing – in the absence of mass immigration – very rapid population decline. Like Japan, the country’s economic growth potential is now very low, domestic demand stagnant and deflationary pressures building. Germany also has badly undercapitalised banks. Like Japan, Germany can rely on large trade surpluses to partially offset the weakness of the domestic economy. High levels of domestic savings probably mean that Germany will be able to finance the borrowing domestically and be able to run up a similar debt burden to Japan without running into serious financing difficulties.

However, like Japan, this accumulation of debt will not be sustainable indefinitely. Japan’s household savings rate has fallen steeply in recent years as its ageing population starts to draw down on savings. The only reason the Japanese have been able to continue financing the fiscal deficit domestically is that corporate sector savings have ballooned, reflecting a collapse in investment. Once Japanese firms start to invest or their profitability declines, Japan will have to attract capital from abroad and foreign investors will demand a higher rate of interest than domestic investors are currently prepared to accept. Higher borrowing costs will spell serious trouble for a country as indebted as Japan.

A third group of EU economies – Italy, Portugal and Spain and of course Greece – looks set to fare worse than Japan. These economies combine the worst of all worlds. They have very weak public finances, fast ageing populations, very poor economic growth prospects and current account deficits – in the case of Greece, Portugal and Spain, very large ones. They cannot inflate their way out of their predicament, because they are members of the eurozone. Unlike Germany and Austria, they do not have surplus savings, and rely – to a greater or lesser extent – on foreigners to finance their deficits. Investors have already concluded that the debt dynamics of the weakest of the four – Greece – are unsustainable. Given their very poor growth prospects and dependence on foreign borrowing, Portugal and Spain will struggle to convince investors that they will be able to service steadily rising levels of debt. Italy looks somewhat less vulnerable than the other countries in this group in that it has a higher savings rate. However, it is hard to imagine Italian or foreign investors remaining sanguine about an unchecked build-up of Italian debt.

Simon Tilford is the chief economist at the Centre for European Reform.