Japan's policymakers have found a dangerous way to avoid confronting the nation's decade-old financial and economic crisis. The persistent deflation that is causing nonperforming loans on the balance sheets of banks and insurance companies to increase more rapidly than the loans can be written off has simultaneously created a growing demand for cash and government securities. This means that the Bank of Japan can print more money while the government issues more debt to pay its bills. As government liabilities outstanding increase, the future cost of the deflationary expedient being employed in Japan rises higher.

Japan's Debt Problem

The steady rise in the quantity of Japanese government debt means that its price will ultimately collapse. This could come about in two ways. If the Bank of Japan eventually increases liquidity fast enough to cause reflation, interest rates will rise and outstanding government securities bearing very low interest rates will fall in value. Alternatively, if the deflation continues and the government continues to employ the expedient of more rapid issuance of debt, the outstanding stock of debt will rise too rapidly to be absorbed by Japanese investors.

After Moody's, the bond-rating agency, downgraded Japan's debt by two classes to the level assigned to Botswana's, Japan's Finance Ministry angrily pointed out that most of Japan's debt is held by Japanese citizens and so the prospect of default to foreign bondholders does not apply. This is indeed correct but should offer little consolation to Japan's policymakers. It is true that most of Japan's debt is held domestically and therefore the concerns of global bondholders will not discipline the Japanese government as it issues ever more liabilities. However, the fact that Japan's debt is held domestically means that when the level of that debt becomes too large to be absorbed by Japanese investors, the burden of default will fall on the Japanese themselves. This is hardly a consoling thought as Japan's government debt rises above 140 percent of its GDP.

Just as Japan's financial markets have enjoyed their annual spring "rebound" on hopes that Japan's economy is about to recover, signs of trouble with respect to Japan's heavy reliance on debt have begun to emerge. As Japanese investors have begun to worry about the impact on prices of long-term bonds of a reflation or a sudden increase in supply of such bonds, the government has had to rely more heavily on the issuance of short-term bills to finance its large deficit. But three-month government bills have become virtually identical to cash in Japan because they carry such a low interest rate (a few hundredths of a percent) that they constitute a non-interest-bearing liability of the government--the definition of cash. In short, Japan's citizens have become less willing to make long-term loans to the government in view of its rapidly rising debt burden; they understand that such debt burdens cannot rise indefinitely without resorting to faster and faster money growth and sharp inflation.

So far this year, about 60 percent of Japanese government borrowing has been financed by short-term bills. The Bank of Japan has purchased 30 to 40 percent of that bill issuance, thus causing a rapid acceleration in the growth rate of Japan's monetary base--cash in the hands of the public and reserves held by the banking system. The acceleration in money base growth has produced no increase in broader money aggregates because Japan's banking system has been contracting its loans and investments, and is thereby ceasing to function as a financial intermediary.

As the year progresses, more and more of the Japanese government's financing of its deficits will be done in the form of bill issuance or issuance of long-term securities that are purchased by other government agencies and consequently not subjected to any market test.

Deposit Insurance Sharply Cut

Beyond the unsustainable growth rate of Japan's debt issuance, there is a ticking time bomb in Japan's financial system that will require the Bank of Japan to purchase even more government bills. As of March 31, 2003, government deposit insurance on demand deposits at banks will be virtually eliminated. (Deposit insurance on savings accounts was cut on March 31 of this year.)

The withdrawal of deposit insurance will result in accelerated withdrawals of funds from banks by increasingly nervous businesses and households. To meet that increasing demand for cash, Japan's banks will have to sell the government securities that they have purchased over the years. The Bank of Japan will be faced with a choice. Either it will buy the increasing supply of government securities being placed on the market, both by the government and by the banks trying to raise cash at par, by accelerating money printing, or it will refuse to do so and will watch a collapse in the value of government securities that will result in a run on the illiquid banks. Banks will not have the alternative of selling other assets like stocks, loans, or land unless, again, the Bank of Japan is prepared to purchase those assets at prices far above the value placed upon them by markets.

The underwriting of bank balance sheets by the Bank of Japan to stem a run on Japanese banks will be part of the process of effective nationalization of Japan's banking system. The process may be labeled many different things, but in the end characterizing this as nationalization is inescapable because the government or the Bank of Japan will, to avoid a run on its banking system, purchase the assets of the banks at far above their market value. Ultimately, the difference between the purchase price of those assets and their market value will have to be made up by printing more money, which would amount to an inflation tax that reduces the real value of government liabilities.

In sum, the deflation and the attendant liquidity trap in Japan that make it possible to avoid dealing with the serious balance sheet problems of Japan's financial intermediaries only exacerbate those problems and thereby increase the ultimate cost of creating a necessary condition for sustainable recovery in Japan: a viable and solvent system of financial intermediaries.

Another False Recovery

How, many will ask, can this gloomy picture of a still looming financial crisis in Japan be reconciled with the widely touted "recovery" of Japan's economy and stock market this spring? Beyond pointing out that such "recoveries" occur virtually every spring, only to be dashed in the second half of the year, it is, alas, unfortunately easy to reconcile the bad news about Japan's underlying financial health with the apparent good news about its economy and stock market.

First, the stock market. By early June, Japan's stock market had risen by more than 14 percent to above 12,000, making it by far the best performing stock market of 2002 among major industrial countries. Still it is fair to point out that this may not be much of an absolute accomplishment in view of the 12 percent drop in the U.S. equity market and the drop by about half that amount of European equity markets so far this year. In the year 2000, Japan's equity market had rallied by a similar percentage amount to nearly 21,000 on hopes that Japan was ending its ten-year slump. Unfortunately, part of the celebration included a decision in August 2000 by the Bank of Japan to start raising interest rates. Between May 2000 and February 2001, Japan's stock market plunged by nearly 40 percent to 12,000. Revived hope for another recovery in the spring of 2001, buoyed further by the election of Prime Minister Junichiro Koizumi and his reform agenda, pushed the stock market back up to 14,000 before its annual second-half swoon brought it down below 10,000 by September.

Thereafter, Japan's stock market rallied briefly to 11,000 in the fall before dropping again below 10,000 in January of this year as concerns about Japan's financial system intensified. Since then, the stock market, as mentioned already, rallied to about 12,000 by the end of May and has subsequently drifted downward.

The rally in the Japanese stock market in 2002, while impressive in comparison with the weakness in stock markets in Europe and the United States, represents a typical seasonal bounce that is decidedly unimpressive both in degree and in amount by the standards of past years. Japan's stock market has benefited this year from an export-led boost that has lifted the year-on-year growth rate of industrial production from a negative 11.3 percent in January to a negative 6.1 percent in April. Exports to Asia may continue to moderate the negative growth rate of Japan's industrial production, while hopes for a global economic recovery may continue to buoy hopes for Japan's equity market to rise.

As for the economy, the first-quarter growth rate of Japan's GDP was reported in early June at 5.7 percent, just above the U.S. first quarter growth rate of 5.6 percent. This year, however, even optimists about Japan's prospects were anxious to downplay the seemingly robust first-quarter growth numbers. This is the third consecutive year in which Japan's first-quarter growth figure was dangerously misleading. In the first quarter of 2000, Japan's first-quarter growth was originally reported to be above 10 percent at an annual rate and later revised down to "only" 8.2 percent. After another quarter of strong growth that year, Japan's economy contracted at a 2.9 percent annual rate in the third quarter and grew at only a 1.1 percent growth rate in the fourth quarter.

Again, in the first quarter of 2001, Japan's growth rate was reported at more than 4 percent, but that was followed by three quarters with negative annual growth rates of 4.9 percent, 2.2 percent, and 4.9 percent. This devastating collapse brought year-on-year GDP growth to minus 1.7 percent in the first quarter of this year, despite the 5.7 percent annual growth rate during the quarter.

To their credit, Japan's policymakers have begun to recognize how counterproductive it is to report such misleading growth numbers at the beginning of the year. There are two problems with Japan's growth figures. The first is deflation, which applies to all of its growth figures. In normal economies where prices are rising, the money value of output growth is reduced by subtracting the contribution of inflation. However, where prices are falling, as they are in Japan, calculating inflation-adjusted growth data by subtracting negative deflation makes real growth look larger while the nominal growth figures are shrinking. Nominal shrinkage of the economy is dangerous because, first, as noted above, the deflation it entails means that balance sheets are deteriorating rapidly and, second, it makes it difficult for producers to earn profits without further reducing costs and thereby contributing to additional deflation.

The other flaw with Japan's GDP statistics is simply that the initial estimate of its biggest portion--consumption--which accounts for about 55 percent of GDP, is badly distorted. That estimate is based on a narrowly defined survey, which tends to be upwardly biased. For example, the initial estimate of real consumption growth was an annualized increase of 6.6 percent. But the final estimate is based in turn on an estimate from the Ministry of Economy, Trade, and Industry, which says that real consumption spending for the first quarter was minus 3.8 percent (annualized). Unfortunately, the Japanese government has chosen to use misleading initial estimates of its GDP growth rates usually reported late in the second quarter of the year. This may be tied to the fact that the planning for the subsequent year's budget begins in June and a supportive set of GDP numbers makes it possible to make optimistic assumptions about revenue growth in subsequent years. Whatever the intentions, the persistent shortfall of revenue growth below government estimates during fiscal years is consistent with this explanation.

The Road to Sustained Recovery

The annual ritual of crisis and denial in Japan that has prolonged its economic stagnation is wearing thin. The fact that it is supported by a persistent and steadily accelerating deflation that is hollowing out the balance sheets of Japan's financial intermediaries has turned this ritual from an expedient way of avoiding confrontation of crisis to a dangerous process that threatens the financial integrity of the world's second-largest economy. Ultimately, geopolitical stability in Asia depends on a sustainable economic recovery in Japan. That, in turn, requires that the country's financial intermediaries shed their bad loans, shrink their number, and return to the normal business of mediating between borrowers and lenders in a manner that provides the necessary precondition for sustainable economic growth.

John H. Makin is resident scholar at the American Enterprise Institute.