Olivier Blanchard is one of the world’s leading macroeconomists. In addition to a long and distinguished academic career, in his tenure as the chief economist at the I.M.F. he turned its research department into a major producer of cutting edge research. In particular, the research department was instrumental in producing work that undermined the case for austerity that was being widely pushed across the globe. Unfortunately, politics was able to overcome the research, and austerity won.
But that is the past. In an interview with the Telegraph, Blanchard warned that Japan will soon switch from combating deflation to a struggle to contain inflation. The core problem is its debt burden, which now stands at almost 250 percent of GDP.
This concern seems more than a bit bizarre, especially coming from an economist as knowledgeable as Blanchard. The first point is that, in spite of the high ratio of debt to GDP, Japan actually has a low interest burden. According to the OECD, Japan’s net interest payments on its debt were 1.0 percent of GDP in 2015. By contrast, U.S. payments were well over 3.0 percent of GDP in the 1990s.
This matters, not only because the interest payments represent the actual drain on resources, but also because the value of the debt is largely arbitrary. If that sounds strange, it’s worth thinking about what happens to the value of debt when interest rates rise. The current interest rate on a 10-year Japanese government bond is -0.09 percent. On a 30-year bond it’s 0.41 percent. Suppose that the interest rate on a 10-year bond rose to a still historically low 4.0 percent and the 30-year bond to 5.0 percent.
According to my bond calculator, the market price of a newly issued 10-year bond would drop by almost one-third and the price of a newly issued 30-year bond would fall by more than 75 percent. Of course not all Japanese debt is long-term, nor is it all newly issued, but the point is that the market value of its outstanding debt would drop sharply if interest rates rose to even modest levels. If the 30-year rate got as high as 7.0 percent (lower than the U.S. rate in much of the 1990s), then the market price of the newly issued 30-year bond would drop by more than 85 percent from its current level.
The way governments typically keep their books, this plunge in the market price would not affect Japan’s debt to GDP ratio. But if the markets were actually troubled by the high ratio of debt to GDP, Japan could simply issue new debt to buy up old debt at a fraction of its face value. This would quickly send its debt to GDP ratio plunging. (This is why the Reinhart-Rogoff 90 percent cliff story never should have passed the laugh test even before the exposure of the famous Excel spreadsheet error.)
The other issue with Blanchard’s analysis is that we have look behind the debt question and ask what he is claiming about the real economy. Japan has been facing a persistent shortfall in demand ever since its stock and housing bubbles burst more than a quarter of a century ago. The situation Blanchard is describing is one in which Japan will suddenly face too much demand. The argument is that the interest paid on its bonds will effectively push the economy above its full employment level of output.
But is this story really plausible? Of course one possibility open to Japan is to keep having the Bank of Japan buy up new government bonds. To take an extreme case, suppose no new bonds are issued to the public at higher interest rates because the Japanese central bank simply buys up all new debt. In this scenario, where does Blanchard envision the new demand that will spark the higher inflation? The yen could fall, leading to an increase in the trade surplus, but even with a sharp decline in the yen this is likely to be a fairly gradual process. Also, as a practical matter, it is not clear that many other countries would be anxious to see their trade deficits with Japan explode any time soon. This would lead other countries to intervene to prop up the yen, regardless of whether the Japanese government desired this outcome.
In short, it’s difficult to envision the mechanism that would lead Japan’s debt to suddenly impose the sort of burden on the country that would lead to high inflation, given that the current burden is so low. Even if a loss of market confidence led interest rates to soar, Japan’s central bank could offset the domestic impact by buying up much or all of the newly issued debt. This is in addition to the opportunity to quickly reduce the book value of the debt by buying back old issues at radically depressed market prices. (The loss of a massive amount of wealth by Japanese households in this story would presumably lead to a reduction in consumption.)
There is one other point that is worth making in this sort of discussion. Debt is just one way in which governments obligate their public to future payments. Patent and copyright monopolies commit the public to paying rents that greatly exceed the free market price for the protected products. In the United States these payments are approaching 2.0 percent of GDP ($360 billion a year) for prescription drugs alone. It is remarkable that public finance economists seem to almost completely ignore rents for patents and copyrights when considering the financial burdens of various governments.