Global Reaction to Lowered Rating of US National Debt
Risaburo Nezu, Senior Executive Fellow
October 6, 2011 (Thursday)
On August 7, American rating company Standard & Poors lowered the US’s national debt rating from AAA to AA+, sending a violent tremor through the world’s stock and exchange markets. This also stirred up worries that core Eurozone countries such as France and Italy will also have their debt ratings lowered, thus ruining the vancances of those countries’ leaders. Amidst this turmoil, Japan is seen as a stable country and foreign funds continue to flow in, further appreciating the yen. The government has intervened in the exchange market for the second time since March, but to little effect. By looking at the prevailing opinions in newspaper and magazine articles, I examined how western economists and people involved in the market view the changes over this past month. As the country with the highest national debt to GDP ratio in the world, there are many lessons that Japan should take to heart.
First of all, everyone is saying that there was no economic reason for the US to default on its debt, and there still isn’t. Even if the US’s financial deficit increases, investors should have no problems in terms of safety and trust, and the debt will be smoothly broken down in domestic and foreign markets. In fact, far from stabilizing after the rating drop, interest on US bonds actually fell (i.e. bond prices rose). The truth is that Japanese national bonds have had their rating lowered many times in the past, but there is never any effect on interest. What is the point of lowering the ratings in the first place? Morgan Stanley, a large American securities company, says there is “no real basis” for it. An editorial in the Financial Times on August 9 asserts that “rating companies should not be rating national debt in the first place,” and writes off as meaningless the argument over the debt ceiling which has continued since spring, saying “we should repeal the law which sets a ceiling on national debt.”
The above statement may seem radical, but it really is not at all. Within the Eurozone, as a condition of unifying their currencies, member countries had to promise to keep their debt below 60% of GDP and hold their annual financial deficit under 3%. This so-called Stability and Growth Pact (SGP) which was included in the Maastricht treaty was broken long ago. In particular, after the 2008 Lehman Shock, the pact existed in no more than name. Currently, there are no Eurozone countries which adhere to this pact, and there have been no vestiges of serious discussion of late. A while back, some economists proposed that Japan should have a similar debt ceiling to that of the Eurozone, but what recent experience has shown us is that there is a large risk that such an artificial constraint can become political capital and lose its meaning for financial soundness.
The reason such artificial limits don’t work is because we are trying to measure economic health using only the ratio of government debt to GDP despite the fact that the government is no more than a small part of the larger national economy. We are looking at only annual government revenue and spending without paying attention to the overall balance of the national economy. The amount of national bonds a country can issue will obviously vary depending on whether the private sector has plenty of excess savings or not. We can only decide whether the level of national debt is within an acceptable range by looking at the entire economy. Peter Tasker, an active economist in Japan, warns against using national debt to GDP ratio to decide things such as this % is dangerous or that % is safe, saying “There is no magic level of debt to GDP that will automatically trigger a fiscal crisis.”
In contrast, a British economic magazine, The Economist, writes: “Despite such criticism, ratings are useful, and investors should pay proper heed to S&P’s reducing the US’s debt rating.” More than the US’s economic policy, this magazine is especially critical of politicians who used US debt as political capital and threw the world’s economy into turmoil.
Importance of Issuing National Bonds in One’s Own Currency
Second, the recent uproar has taught us that we must think much more carefully about what it means to default on a national debt. According to an article in the Financial Times, there is an essential difference between the national bonds issued by the US and UK and those issued by Eurozone countries. The former are true sovereign debt, i.e. bonds issued by a sovereign state in its own currency. The government can print as much currency as it needs to, so defaulting is basically impossible. Professor Paul de Grauwe of Catholic University of Leuven in the Netherlands says, “Unlike in the Eurozone, the financial markets cannot provoke a liquidity crisis that could force the UK government into default…. There is a superior force of last resort that can prevent a liquidity crisis: the Bank of England….” This example talks about England, but the same thing is true of Japan. In other words, as long as a country is a completely sovereign state, as a last resort its central bank can take on the national debt to avoid default. Conversely, the countries of the Eurozone which are currently in much trouble have “quasi-sovereign debt.” The issuing body, i.e. the European Union government, cannot decide independently to issue bonds, and consequently default is possible. This is the cause of the Euro’s dire straits.
There are many people in Japan who say that issuing large amounts of national bonds at the current pace is unsustainable and eventually the country will go bankrupt. However, the word “bankrupt” is rarely used in a well defined way. If we take it to mean that the government becomes unable to pay the interest on national bonds or return the principle of bonds that have matured, then in Japan’s case “bankruptcy” is impossible, because the Japanese government issues all national bonds in yen. Yen will be necessary for returning principle, but the printing of said yen is the job of the Japanese government and the Bank of Japan, and they are under no constraints regarding printing whatsoever. What currency a country issues its bonds in is a decidedly important point, one that those who speak of Japan’s fiscal default have absolutely failed to take into account. There are many examples of economies all over the world going bankrupt, but except for the gold standard era, these were all due to the country becoming unable to return debts in foreign currencies. Nevertheless, this doesn’t mean that it’s acceptable for a country to continue to issue national bonds in its own currency ad infinitum. If a country relies too much on its national bonds, eventually interest will start to rise, debt may snowball, and inflation will lead to dropping national bond prices until they are worth no more than the paper on which they are printed. This, however, is completely different from saying that the Japanese government will become unable to pay its debts and go bankrupt.
Fiscal Discipline or Growth
Third is a comment by Professor Stiglitz that is well known even in Japan. He and many other economists say that the recent problems are due not to large government debt, but to insufficient economic growth. We shouldn’t think of financial deficit as the cause of the problem, but rather insufficient economic growth is causing the problem of financial deficit. That’s why fiscal austerity will not solve the problem. According to Stiglitz, Ireland and Spain were both in the black right up until the financial crisis, but even so they were swept up in it because their growth stopped.
In fact, this is the same thing that happened in the Southeast Asian financial crisis in the late 90s. At the time, Asian countries had financial surpluses, but the private sector created a real estate bubble economy, and when it burst the economies fell into negative growth which resulted in financial deficits. In general, it is incorrect to say that when finance is healthy there will be no economic crisis and when there is financial deficit there will be economic crisis. There are many counterexamples to this, starting with Japan. However, it is almost always the case that when growth stops, finance will worsen. From 2005 to 2007, Japan’s exports to the US were central to its accelerated economic growth and a significant decline in its deficit was seen, but it suffered from the effects of the Lehman Shock and fell into negative growth, resulting in a resurgence of its deficit.
Even so, it does not seem like developed countries have the wherewithal to use increased public spending to boost the economy as they did in the fall of 2008. However, we should look on the bright side of things. In an editorial on August 10th, the New York Times wrote: “The current crisis is a problem of national debt; the private sector is in much better shape than three years ago, and the private sector’s activeness can be used as impetus for growth.” The recapitalization of private financial institutions has advanced compared to three years ago, bad debt has been reduced, and resistance to shock has increased greatly. Consumers have also reduced debt and household budgets are showing signs of improvement.
What of Japan, on the other hand? Most agree that Japan must set its hand to reducing its deficit through increased taxes in the near future. The most likely candidate for this tax hike is sales tax, but the problem lies in the timing. If done at a stage when a large supply-demand gap remains, raising sales tax will suppress consumption and slow the economy, possibly rendering the tax raise ineffective. The tax raise must be in effect by the time domestic savings become unable to absorb national debt, i.e. before the current-account balance goes into the red. Exactly when that will be is a matter of debate among economists, but it will likely be in the mid 2010s at the earliest and around 2020 at the latest. The next election will be the first opportunity for political leaders to give clear indication as to when Japan needs to raise taxes.
