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At 233 per cent, Japan is known to have the highest ratio of debt to gross domestic product (GDP) among the world's advanced economies. Greece's figure, at 177 per cent, seems small by comparison.
Unlike Greece, however, there is no sign of fiscal crisis in Japan and the markets seem to confirm it: Interest on a 10-year Japanese government bond is a meagre 0.3 per cent, and the premium on a credit default swap of these bonds, proxy for the probability of default, is hovering around 0.4 per cent. This means that markets are predicting Japan's default once in 250 years.
Why hasn't all this debt created a fiscal crisis for Japan?
One possibility is that the markets are wrong and the participants do not properly recognize the risks. Surely markets can be wrong from time to time, but Japan's debt-to-GDP ratio has been climbing for about 20 years. Could the markets have been wrong for so long?
The simple answer may be that people still believe Japan can manage its debt. But how?
First, it's important to know that Japan's debt-to-GDP ratio is exaggerated. Japan has a considerable number of assets – worth about ¥65-trillion ($650-billion) as of March, 2013. Therefore, its ratio of net debt to GDP is closer to 100 per cent. Simply put, Japan owes a lot, but it owns a lot of assets, too. So even though its net debt-to-GDP ratio remains high, and some of those assets may not be easily sold, the situation is not as bad as many assume.
Second, we must understand why Japan's debt-to-GDP ratio deteriorated in the first place. There are two main reasons: economic stagnation and demographics.
Since the mid-1990s, deflation has really hurt Japan's economy. With deflation, nominal GDP – GDP that has not been adjusted for inflation – stagnates or even shrinks, and tax and other government revenues depend on the size of nominal GDP. Stagnation reduces corporate taxes and government revenues. Moreover, Japan made several policy mistakes. In 1997, the government raised its consumption tax to 5 per cent from 3 per cent, believing that recovery was around the corner, but the move proved premature and backfired. And in 2000, the Bank of Japan terminated its zero-interest-rate policy before Japan overcame deflation.
Japan's famously aging population translates into increasing pension, medical and elder-care expenditures. This is a long-term problem, but related to the economy. When people retire or are unemployed many households stop making contributions to the pension system, while the government has to pay the benefits. The widening gap has been compensated for by government borrowing.
During almost two decades of deflationary stagnation, Japan has recorded an average annual nominal growth rate of 1 per cent, which is dismal. But deflation can be overcome, as the current government and the Bank of Japan are attempting to do. Despite a setback caused by a consumption tax hike in 2014, tax revenue for that fiscal year increased by 12.3 per cent over the previous year, reaching its highest level since 2008.
By going back to the normal nominal growth rate at the level of other advanced economies, Japan can put its fiscal house in order. In short, Japan can still pay its debt by overcoming deflation and resuming economic growth.
What lessons can we draw from the Japanese example?
First, that deflation can be dangerous for an economy and a state's finances. In this regard, Canadians are doing extremely well in maintaining an inflation target of 1 per cent to 3 per cent, but other countries, such as those in the euro zone, face the threat of deflation.
Second, the key to reducing fiscal deficits is not austerity but economic growth. As Japan's 1997 consumption tax increase shows, austerity helped neither the economy nor reducing the deficit. Economic growth remains the primary goal of economic policy: There is no sound finance without a sound economy.
And third, one has to tackle the fiscal problems posed by changing demographics. This is the greatest political challenge ahead, but it is not unique to Japan.
Masazumi Wakatabe is an economics professor at Waseda University in Tokyo.