Politics & Policy

Japan’s Financial Aftershock

Japan’s high debt burden threatens to create a second catastrophe.

As costly as the Japanese earthquake was in both property and human lives, it could have been immeasurably worse. Because Japan is a wealthy nation, it can afford to earthquake-proof buildings, construct a resilient infrastructure, and maintain an emergency-response capability that has saved many lives already and will save many more in the immediate future. Moreover, Japanese wealth almost guarantees a rapid recovery, and that the long-term effects of the earthquake are likely going to be minimal. I use the word “almost” because Japanese officials have done quite a bit of damage to the country’s fiscal structure in the last decade, enough that there are some who question if Japan can find the funds that recovery requires without causing a financial panic. Still, if we take as a benchmark the 1995 Kobe earthquakes, which caused over $100 billion in damage and killed almost 6,500 people, then many of this catastrophe’s impacts are predictable.

After the 1995 earthquake, the Nikkei and the yen each plunged by approximately 25 percent over several months. Both, however, had mostly recovered by year’s end. Most of Kobe’s residents were back at work within a week, the subway was reopened in three months, and round-the-clock work crews had the port fully operational in weeks. The Japanese government, despite being in serious economic straits, financed 90 percent of the rebuilding. I expect the recovery from the most recent disaster will be just as rapid. Despite the earthquake being 700 times more powerful than the one that turned Haiti into a basket case last year, most Japanese buildings withstood the shaking. Still, recovery costs will likely run as much as half a trillion dollars, and once again the Japanese government will have to assume the bulk of the expense. It will find doing so much harder than in 1995.

In the years since the Kobe earthquake, Japan’s government has run huge annual budget deficits in hopes of sparking the economy out of a prolonged downturn. Despite deficits as high as 10 percent of GDP, the turnaround has not materialized. Up until now, Japan has gotten away with this because almost all of its debt is financed at home. This has allowed it to keep bond yields at an average of 1.39 percent for the past decade. But as Japan’s debt soared over 200 percent of GDP, the market has begun worrying about Japan’s ability to see itself clear of impending fiscal disaster. In January, Standard & Poor’s cut Japan’s credit rating one notch, followed by Moody’s Investor Services, doing so in late February. Neither organization is hitting the panic button yet, but both are maintaining a negative outlook.

At a time when Japan already is close to reaching its debt limits, it will have to dig deep to find significantly more funds to finance recovery. Some commentators are already saying that this additional spending will actually have a positive impact on the economy and GDP. In the short-term this may be the case, but it is actually a classic example of the “broken window fallacy.” Every penny that the government spends on the recovery has to be borrowed or taxed away from the productive economy, where it would have been spent on increasing prosperity. Instead, Japan will now spend trillions of yen just to get back to where it was a week ago.

Worse, this new surge in deficit spending pushes Japan closer to the day of reckoning. No country can avoid the iron laws of economics forever, no matter how clever it is in placing its debt. No one knows exactly where the tipping point is, but when it is reached the onset of a new financial crisis will be rapid and devastating. For the moment though, Japan probably still has the financial wherewithal to weather this crisis. But as a result of its fiscal recklessness during the “lost decade,” doing so is placing the country’s entire financial system at risk. Moreover, even if Japan recovers without destroying the yen, it will be substantially less able to handle any future crisis. A nation’s capability to raise debt in times of emergency is a blessing that any country should be loath to squander. What creditor is going to run the risk of propping up Japan when its debt reaches 300 or 400 percent of GDP? There is, of course, an obvious lesson here for U.S. policymakers. How much harder will it be for the United States to react to a disaster once our debt makes it difficult to raise new funds except at exorbitant cost?

What other near-term effects can be expected? Based on evidence from past disasters, the impact on Japan’s GDP is likely to be minimal. Which is hard to credit as good news, as the Japanese economy was still contracting in the fourth quarter of last year. But even this ongoing contraction may be a blessing in disguise, since it has created significant spare capacity throughout the economy. Unused production facilities are therefore available and can be brought immediately online to limit the earthquake’s impact. In purely economic terms, though, Japan got lucky in regards to the earthquake’s location. The hardest hit area around Sendai accounts for not much more than 2 percent of GDP and is likely to bounce back rapidly. There are some car-part factories in the area, so some disruption in the global supply chain is expected. However, other plants will rapidly pick up the slack, and, despite many Japanese firms’ dependence on just-in-time manufacturing, there should be a rapid return to normalcy. Moreover, as Japan’s economy is export-oriented, it is unlikely to see any slackening in demand for its products.

There remains one major concern for which Kobe provides no precedent: Japanese authorities are battling to ward off meltdowns in two of the six nuclear reactors at the Fukushimia Daiichi power plant. In order to do so, they are flooding the reactors with sea water, which will probably render them unusable for an extended period. Officials are already stating that there will be rolling blackouts starting Monday that may extend several weeks. While the possibility of a serious energy shortfall cannot be ignored, I believe the effects of losing this reactor complex will be minimal. Japan has 54 operating nuclear reactors, producing 49 of the 279 gigawatts (GW) of power it uses daily. The loss of the Fukushimia Daiichi complex will take offline at most 5 GW of power. Luckily, Japan still has a few aging oil-fired plants that are mainly used to meet peak-demand requirements. These facilities can be called on to make up most of the loss from the closed nuclear reactors. In brief, the closing of a nuclear power plant will require some adaption, but it is not a crisis — unless government mishandling turns it into one.

Still none of this is good news for an already struggling Japanese economy. If I owned any Japanese equities, I would be a seller. The Nikkei was already down nearly 8 percent by the weekend, and Nikkei futures are showing a continued fall for Monday. Continuing to use the market’s reaction to the Kobe earthquake as a guide indicates that the Nikkei is set on a glide path lower for at least the next several months. Furthermore, the shutting down of several oil refineries has temporarily reversed the rising price of oil on global markets. Unfortunately, this effect is going to be short-lived, as Japan’s oil demand will increase as damage is repaired and other refineries pick up the slack. Moreover, any price reductions caused by demand destruction in Japan will be overwhelmed by the ongoing crises in the Middle East.

One can also expect Japanese investors, particularly insurance companies, to start bringing home a lot of yen to help pay for repairs and to add liquidity to the nation’s financial system. This was already evident on Friday, when the long depressed yen gained 1.5 percent against the dollar and 1 percent against the Swiss franc. Further yen repatriation can easily impact the U.S. bond market. Japan is the third-largest purchaser of U.S. government debt and may exit the market for awhile in order to conserve funds to pay for recovery. When a market player the size of Japan exits, even for a short period, it will have an effect. Expect the U.S. government to have to pay somewhat higher interest on new debt for an unspecified period.

The yen’s rise may be arrested by investors looking to unload it as worries about Japan’s prospects grow and some begin to doubt its safe-haven status. Moreover, if the yen does begin a precipitous rise, one can expect the Bank of Japan (BOJ) to intervene. The BOJ, for the first time in 15 years, entered the currency markets in September in a failed effort to halt the yen’s appreciation. It did so again Monday morning, with an $86 billion intervention, probably the first of several it will take to stabilize the market. It has already announced that it is cutting next week’s two-day meeting to one day. It is a fair assumption that, as it has no room to lower interest rates, the BOJ will flood the market with a multi-trillion yen intervention.

In the end, Japan will likely see its way through this crisis without melting down, although that is not a certainty. It would have been easier and considerably less risky if Japan’s leaders had not been so financially irresponsible for so long. If the irresponsibility continues, it is near certainty that some future crisis will leave a wrecked economy in its wake.

There are a lot of lessons here for Washington.

— Jim Lacey is the professor of strategic studies at the Marine War College and author of the forthcoming The First Clash.


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