The surprise decision by ratings agency Standard & Poor’s to downgrade Japan’s credit rating for the first time in nine years should send a strong warning to the United States of the dangers of ballooning budget deficits. Unfortunately, it’s a lesson that the US is almost certain to ignore.

In the first place, the US is likely to take comfort in the fact that even though Japan has easily the worst debt problem in the developed world — the country’s gross debt is expected to exceed 200% of GDP this year — Japan has been spared the expense of higher interest rates. Indeed, the yield on Japanese 10-year bonds remains exceptionally low at around 1.25%. What’s more, the Japanese bond market largely shrugged off the news of the credit downgrade.

But to be complacent would be to ignore the huge difference between the US and Japan. The US depends heavily on foreign investors to finance its yawning budget deficits, whereas Japan is essentially self-funded, with Japanese buyers holding about 94% of the country’s debt.

Since the early 1990s when Japanese government finances first tipped into the red, Tokyo has been able to tap into the country’s $US17 trillion in savings. Most of this money is channelled through domestic institutional investors — Japanese banks, insurers and government pension funds — into low-risk Japanese bonds. This has afforded the Japanese government the luxury of being able to borrow at extremely low interest rates.

But this is all about to change. Japan’s rapidly ageing population will force government spending on pensions and health care to soar, putting government finances under acute strain. At the same time, the growing number of retirees will see the country’s savings pool diminish, and the shrinking workforce will mean lower tax revenues.

If Japan has to start relying on foreign investors to fund its budget deficit, it will be forced to offer substantially higher interest rates. This will cause the Japanese government’s debt servicing costs to soar.

It’s not as though Japan’s politicians are not fully aware of the country’s budgetary woes. In a recent interview with the Financial Times, Kaoru Yosano, the Japanese economy and fiscal policy minister, said that Japan was at a “critical point” where it risked losing investor confidence unless it could implement measures to tackle the ballooning national debt. “We face a dreadful dream that one day the long-term interest rate might rise,” he said.

But few have faith that Japan will be able to introduce measures such as spending cuts and tax rises that are needed to turn the situation around. In its latest report Standard & Poor’s noted the Japanese government lacked “a coherent strategy to address these negative aspects of the country’s debt dynamics”.

A similar criticism could be made of the United States. This week, US President Barack Obama attempted to demonstrate his commitment to fiscal health by calling for five-year freeze on non-defence spending by the US government in his State of the Union address. But critics were quick to point out that the spending freeze only applied to around 15% of the US government’s $3.5 trillion budget.

Meanwhile, the Congressional Budget Office left little doubt as to the size of the US budgetary woes in its latest report, which warned the country faced “daunting economic and budgetary challenges”.

The US is now facing its largest deficits since 1945. The CBO projects that the 2011 budget deficit will climb to just shy of $1.5 trillion, or 9.8% of GDP, up from the $1.3 trillion deficit in 2010.

As a result, bond market vigilantes are now warning that unless the US comes up with more convincing solutions than Obama’s half-hearted spending freeze, the US will itself confront the “dreadful dream” of rising long-term interest rates.

*This article was originally published at Business Spectator

Peter Fray

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