Naoto Kan's Big Problem Is Japan's Massive Debt

Japan's former finance minister, Naoto Kan, has become the nation's fifth prime minister in just four years—and the predictable cycle of high expectations followed by mild cynicism has begun anew. How long he will remain in office is anyone's guess, but one thing is certain: trying to solve government finances could be for this premier the same kind of career killer that the Futenma base-relocation issue was for the last one.

The inescapable math of an aging society that has been promised huge retirement and welfare benefits, which are not fully covered by taxes, could make Kan's tenure a true test of government and party leadership. Japan's gross debt-to-GDP ratio is second only to Zimbabwe, at almost 200 percent. Even if double counting the debt (what government agencies owe each other) were deducted, net debt is still 113 percent of GDP. That's about the same ratio as Greece, which ignited a continentwide financial meltdown earlier this year.

No one can predict if or when the Japanese bond market will collapse, of course, but rating agencies, the Organization for Economic Cooperation and Development, and the International Monetary Fund have all publicly expressed concern. Aging populations exacerbate pension costs and pay fewer taxes. In Greece, the 65-and-over population is projected to increase from 18 percent of the total in 2005 to 25 percent in 2030. For Japan, the swell is worse, from 19.9 percent to 30 percent.

Until recently, Japan's debt—the total of all annual budget deficits—was allowed to build thanks to the country's unique market conditions. With 95 percent of the national debt held by Japanese, increased government borrowing from its own citizens was arguably nothing more than a domestic transfer—a shift of funds from the right hand (taxes to pay off the debt) to the left hand (interest income for bond holders). As long as interest rates remained artificially low and competing investment opportunities in the private sector limited, the government could manage the bond market without depending on the kindness of foreign lenders. It could tap into the country's savings surplus until the economy recovered.

Except for one unforeseen glitch: the economy never recovered. Throughout two "lost decades," Japan applied small Band-Aids to festering fiscal wounds that drained the country of its dynamism and prolonged the recession. In lieu of major tax cuts or aggressive spending that could have stimulated economic growth, the Japanese government and the Liberal Democratic Party (LDP) opted for incremental tax hikes, increases on insurance premiums on social welfare, and minor cuts in benefits.

Today, the government has maneuvered itself into a cul-de-sac. The three largest expenditures—social security, debt servicing, and tax transfers to local governments—have grown from 30 percent of the national budget and 1 percent of GDP in 1960, to staggering heights: 70 percent of the national budget, and 13 percent of GDP. Any attempt now to cut welfare benefits drastically, raise taxes sharply, or reduce its legal obligations to financially strained local economies like Osaka and Akita would, at least in the short term, throw the economy deeper into recession. Ironically, that would make delivering these promised benefits all the more difficult.

The Hashimoto cabinet's failed attempt in 1997 to restore fiscal balance illustrates the dilemma. To avoid further debt financing, the government raised the consumption tax levied on goods and services (similar to a sales tax) from 3 percent to 5 percent. Within six months, Japan plunged into a deep recession. Tax and stamp revenues perversely fell 12 percent, forcing the government to issue even more bonds. Government bond sales rose 103 percent over the two-year period.

If only Kan could halt deflation, which raises the real cost of debt, the vicious cycle would finally end. Highly leveraged companies would stop worrying about minimizing corporate debt and resume economic growth by investing in new projects. The stock market would rise. Unemployment would fall, and Kan would have proven himself to be a decisive leader. But to achieve this, Kan needs to persuade the Bank of Japan to print more money—something he failed to achieve as finance minister. This leaves Kan no other choice but to adopt LDP-style political theater: Reconvene previously abolished party-policy councils. Discuss raising the consumption tax (again). And talk, talk, talk. Welcome to the new government.

Scalise is research fellow at the Institute of Contemporary Asian Studies, Temple University, Japan Campus.