Why Japan Is Doomed to Insolvency

 | Mar 19, 2013 | 3:57 PM EDT
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There is a great deal of confusion about the sovereign solvency of Japan. I've written about the issue from time to time, and I mentioned it in last week's column, "Heading Toward Insolvency," in a brief discussion of the trajectory of U.S. sovereign debt. 

Some people say that Japan is beyond the terminal point and cannot now reverse the trajectory toward, and eventual acknowledgment of, sovereign insolvency. Others respond that because Japan issues its own currency, it can't become insolvent, and more broadly, any country issuing its own currency can't become insolvent.

This is just plain wrong. Period.

There are rules, regulations and international accounting procedures that apply to sovereign debt just as they do to corporate or individual debt, and a country's ability to issue its own currency does not void them.

When a sovereign needs capital for fiscal spending, it can raise the money through taxes or borrow it through the issuance of debt securities.

When a country borrows money by way of issuing debt securities, those securities require interest payments to be made. Those interest payments can also be borrowed or raised through taxes.

This process includes a country borrowing money from its central bank. The central bank can issue new currency at essentially no cost to itself and lend the new currency to the sovereign government to spend.

Even though the central bank holds the debt, the country still must pay interest. Those interest payments must be made, even though the central bank then rebates most of that interest back to the central government.

The circular transmission of the government borrowing money from the central bank at interest and the central bank returning that interest to the government treasury is the genesis of the erroneous conclusion that a country that operates this way can't become insolvent.

A country undertaking this circular transmission of money in the absence of or as a replacement for tax revenue would eventually arrive at a point where its currency is issued and depreciated to a point of worthlessness and all economic activity ceases.

The requirement to borrow at interest is one of the principal underpinnings of the global debt markets and capital markets overall. It provides the fundamental means by which all asset classes are valued relative to each other, country to country, company to company, and debt to equity, commodities, currencies and real estate.

Without this fundamental accounting, the global capital markets break down, because the means by which value is relatively measured ceases to exist.

It doesn't have to be that way, but it is. A country cannot simply state that it is no longer going to borrow at interest or that it is going to fix its interest rates or currency value or issue currency by charter without first defaulting on its current debt and on the current accounting standards.

If a country doesn't want to default, its economy and resulting sovereign tax revenue must increase at a faster rate than the country is depreciating its currency and issuing sovereign debt.

But there is a limit to the servicing of sovereign debt by way of taxes that, once exceeded, cannot be reversed within the accounting rules and economic principles by which the world operates.

Once servicing existing debt exceeds 25% of tax revenue, the only way a sovereign can increase its economy and resulting tax revenue faster than debt service is if it has a large underutilization of existing capacity that can be made productive with fiscal stimulus resulting in a positive multiplier.

This is not the case in Japan, and the country has run out of the time necessary to produce the capacity by way of immigration reform and fiscal spending necessary to grow the economy fast enough to reverse the insolvency trajectory.

No matter what economic policies are followed now, Japan is terminally insolvent. Increasing or decreasing taxes or fiscal spending will require more currency depreciation and increased levels of debt service.

Japan is now in a terminal vicious spiral, and the only immediately politically viable policy available is to postpone the inevitable as long as possible.

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