Japan’s Lesson on Government Debt Levels

In case you missed it, the U.S. government’s total public debt outstanding surpassed $35 trillion on July 26, 2024. This amounts to over $102,350 for every person in the country, based on the population of 341,963,408 in 2024. On average, this would be more than $255,875 per household, assuming each household has 2.5 members. These figures may seem daunting, especially when top executives from financial institutions who oversee high-priced deals express concern about them.

One recent example is Oliver Baete, the CEO of the major German finance company Allianz, who highlighted this in an interview when discussing market volatility.

Germany’s Allianz, one of Europe’s biggest financial firms and investors, warned on Thursday about high public debt levels and the risk of sovereign bonds.

Chief executive Oliver Baete said public debt levels were “really scary”, and called out the United States by name.

“Investment in sovereign risk, particularly domestic, is seen to be risk-free. Nothing could be more wrong than that. It’s not risk-free”, Baete told journalists.

Firms like Allianz that deal with billions in sovereign debt issued by national governments have a direct stake in knowing the inherent risks of that debt. For large financial institutions, a failure to recognize those risks could very well lead to the threat of collapse of national economies.

Japan’s Fiscal Earthquake

In the last week, Japan discovered those risks are very real the hard way. That country’s central bank was forced to abandon its plans to increase interest rates to fight inflation after its stock market experienced its worst day since 2008. The market value of its largest banks plunged as their solvency came into question, which proved to have global repercussions.

Those repercussions were fueled by sovereign debt issued by Japan’s government. Here’s how Deutsche Bank, another financial institution with a global footprint, described the risks fueled by that nation’s debt could pose in October 2023:

Japan’s government is engaged in a massive US$20 trillion “carry trade”—the funding of loans and foreign assets by borrowing low-cost yen—that could bring unexpected risks if the central bank tightens policy, Deutsche Bank analysts warn.

Using research by the San Francisco Federal Reserve and International Monetary Fund, Deutsche’s head of currency research George Saravelos analysed a consolidated balance sheet of the Japanese government including the government-run pension fund GPIF, the Bank of Japan (BOJ), and state-owned banks, showing the asset-liability mix of its US$20 trillion debt.

That debt, Deutsche Bank found, amounts to an enormous “trade” invested abroad at high interest rates and funded by low-rate, short-term borrowing in yen.

A Dire Prediction that Started Coming True

Deutsche Bank then went a step further. Its analysts predicted what would happen after rising inflation might finally force the Bank of Japan to raise interest rates.

“If the central bank raises rates the government will have to start paying money to all the banks and the carry trade’s profitability will quickly start unwinding,” Deutsche analysts said.

That would mean higher interest payments on bank reserves and a fall in government bond values, as well as a decline in the government’s asset values in a higher interest rate environment.

The analysts also expect that an appreciation of the yen as domestic interest rates rise could potentially trigger a drop in the value of both foreign and domestic assets.

The effects would not be limited to the government, they said, with older and wealthier households in Japan suffering a fall in their assets’ values and a hit to their pension entitlements if the government’s finances are impaired.

Fast forward to August 2024, all these things started to come to pass.

As the predicted scenario started to unfold, it’s no wonder the Bank of Japan was willing to sacrifice its credibility in fighting inflation so quickly.

Because of their quick reversal, the potential for the larger financial crisis predicted by Deutsche Bank’s analysts appears to have been averted—at least for now. Instead, Japan will have to deal with the challenge of rising inflation, which its central bank cannot currently afford to tackle. Given the current circumstances, they don’t have that option and won’t for years.

This leads to a different kind of fiscal crisis, which will have its own impact on Japan’s population. Regardless, this turn of events settled a major question about whether a nation like Japan or the U.S. could manage such a large national debt.

The lesson learned? A large national debt that desperately needs interest rates to be kept low to keep the nation’s economy from falling apart is a bad policy choice for politicians. It is even worse for the people. Everybody loses.