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Last September, when the Economic Outlook asked the question, "Is Japan Recovering?" it concluded: "If the Bank of Japan undertakes another round of aggressive unsterilized intervention and deflation moves toward price stability while the Japanese government avoids the temptation for further tax increases, markets will move from asking whether Japan is recovering to why it is recovering so vigorously."

The good news is that the Japanese economy has recovered briskly, with growth averaging a 6.7-percent annual rate over the last quarter of 2003 and the first quarter of this year. Meanwhile, the closely watched Corporate Goods Price Index has jumped from a low of minus 2.0 percent inflation in the middle of last year to a 2.7 percent annualized rate over the past three months ending in May. Broader price indices like the CGPI have stabilized close to zero inflation. Japanese policymakers have avoided major tax increases, while heavy foreign exchange intervention has been allowed to boost liquidity and the Bank of Japan has wisely set a goal of sustained modestly rising prices.

With all the goods news comes one problem: the interest rate on Japan's government bonds--of which there is ample supply--is rising rapidly. From an extraordinary low in the spring of 2003 of less than 0.5 percent, yields on ten-year notes have risen over a choppy path to about 1.8 percent in mid-June of this year. This is a normal byproduct of reflation and recovery, but the fact that Japan's fiscal situation includes a very large deficit and a very large stock of government debt outstanding makes the rate rise problematic. Debt-service costs will begin to increase as Japan's old bonds with lower interest rates mature and are replaced with higher yielding bonds. The additional interest cost will add to Japan's already large deficit. On the good side, if the Japanese economy grows rapidly enough, increased revenues will compensate for the increased debt-service cost. As its economy recovers, Japan really has no choice but to tolerate higher interest rates.

Japan Stops Killing Its Recoveries

For now, it is useful to examine a little more closely how the Japanese recovery came about. There are several causes, each of them necessary but not, taken separately, sufficient for Japan to have experienced a growth surge.

First, and perhaps most important, is to recognize what Japan did not do. After two episodes of recovery-cide over the last seven years, Japan elected not to kill this recovery in the name of fiscal orthodoxy, as it did with the April 1997 tax increases, or by prematurely fighting inflation fears, as occurred with the Bank of Japan's disastrous August 2000 rate increase. It took Japan almost a decade to realize that after speculative stock and land bubbles had burst, the key to recovery was neither tax increases nor higher interest rates. Those are the same lessons U.S. policymakers had to learn after 1929 at a higher cost to the U.S. and global economies than Japan's misadventures of the last decade.

Japan's move toward a sustainable recovery on the third try is due in no small part to avoiding mistakes on fiscal and monetary measures. Two key policymakers, each supported by Prime Minister Junichiro Koizumi, were responsible for executing the recovery policies in the fiscal and monetary spheres.

Heizo Takenaka, the cabinet minister in charge of fiscal policy and resolving the banking crisis, has, with the courageous backing of Prime Minister Koizumi, navigated around the treacherous shoals of fiscal orthodoxy to avoid ill-timed tax increases. He has managed this even as budget deficits have run at 8 percent of GDP and the ratio of government debt to GDP has risen to 140 percent.

On the monetary front, the head of Japan's central bank since April 2003, Toshihiko Fukui, wisely shifted last fall to a policy of quantitative easing at zero interest rates to flood Japan's financial markets with liquidity. At a time when Japan's banking system had become virtually inoperative, the Bank of Japan essentially became Japan's banking system, buying government notes and providing a large liquidity boost for the economy.

The recovery of Japan's stock market virtually coincides with the start of Governor Fukui's term, having risen from a low of about 7,700 last April by 50 percent to a level of about 11,500 in mid-June. True, Japan's stock market has come off its highs of around 12,200 reached earlier this year, but this move reflects a general, modest sell-off in global equity markets in the face of rising interest rates.

Outside and Inside Help for Recovery

Japan's avoidance of policy mistakes was a necessary but not a sufficient condition for the strong recovery of the economy starting last summer. Japan's striking recovery was strongly aided from the outside by rapid export growth and, more surprisingly, from the inside by a rebound in consumer spending that started in the third quarter of last year. The strong export growth is tied to the booming Chinese economy, as well as to the U.S. growth surge that began in the second half of last year. Japan specializes in the production of energy-saving capital equipment, and China is an excellent customer for such products, as is the United States in a period of rising energy prices. Growth of net exports accounted for over 25 percent of Japan's real growth between the third quarter of last year and the first quarter of this year, while personal consumption growth contributed approximately a third of the total growth during that same period.

The jump in personal spending by Japan's households over the past nine months was critical for Japan's recovery and not widely anticipated. Public spending growth has actually slowed, providing a modest drag on the economy over the same period. Japan's stronger consumption spending may reflect demographic factors, as well as improved optimism among Japanese households as job losses have ceased and been modestly reversed. More and more of Japan's elderly population now has a post-war mentality not quite so wed to the "work, save, and invest" mindset that has characterized Japan's elderly population in the past. While some questions remain as to the sustainability of stronger consumption growth in Japan, the increase is encouraging and may also reflect some response to success on the part of the Bank of Japan in erasing deflationary expectations and reducing the attractiveness of cash holdings. Japan is still burdened with substantial excess capacity, and sustainable growth of domestic demand would provide a strong boost to Japan's producers.

Managing Higher Interest Rates

The rise in interest rates that has accompanied Japan's recovery is both inevitable and problematic for Japan's policymakers. Japan still has tax receipts of only about ¥40 trillion (a little under $400 billion) and total government outlays of about ¥80 trillion. Of the ¥40 trillion deficit, about 8 percent of GDP must be borrowed. Recently, Japan's Ministry of Finance estimated that a one percentage point rise in interest rates (that has already occurred over the past year), would increase Japan's debt servicing cost by ¥3.3 trillion, about $30 billion over three years and by a larger amount in future years as new borrowing at higher interest rates occurs.

Over the longer run, the Japanese government's support for the Japanese bond market will atrophy simply because the aging population will mean that by the 2008 fiscal year, Japan's public pension funds will actually be net sellers of Japanese government bonds in order to meet payments to retirees. Consequently, Japan's rapidly aging population will put considerable strain on government finances in the coming decade.

The reality is that, if Japan continues on the sustainable recovery path, yields on its ten-year bonds will move from the current 1.8 percent to a longer-run level over 3 percent. Specifically, the average real yield on Japan's ten-year government notes prior to its long episode of deflation was about 3 percent. Therefore, with a very low level of expected inflation, the yields ought to settle between 3 and 3.5 percent.

Japan's bond market provides the Bank of Japan with a useful measure of its progress in the all-important battle to erase expectations of deflation. A reversal, begun last summer, of the pattern of expectations of accelerating deflation has helped bank balance sheets and the stock market and probably helps to explain stronger consumption growth.

Expected inflation cannot be directly observed, but it roughly measures the difference between observable market interest rates and the expected real rate of return on low-risk government bonds. For Japan, as for most advanced economies, the expected real return on ten-year government bonds is about 3.2 percent, give or take 0.25 percent. When yields on Japan's government ten-year notes fell to a low of about 0.5 percent last spring, the implied level of expected inflation was minus 2.7 percent, or 0.5 percent minus 3.2 percent. Now, with ten-year yields at about 1.8 percent, the implied level of expected inflation has dropped sharply to minus 1.4 percent or (1.8 - 3.2 = -1.4). The Bank of Japan understands that rising market interest rates in Japan, while painful, are ultimately a good sign that deflation is being squeezed toward zero. When interest rates on Japan's ten-year government notes move above 3 percent, that will signal the end of Japan's nearly decade-long battle with deflation.

Policy Options

As Japan's economy grows and inflation atrophies, its long-run fiscal goal needs to be to stabilize and then reduce its high (140 percent) ratio of government debt to GDP. There are three ways to accomplish this, with two of them detrimental to long-term growth prospects. Taxes can be increased, inflation can be boosted above expected levels, or sustainable growth above the real interest rate can be achieved. Boosting taxes jeopardizes a higher level of sustainable growth and puts a drag on the economy so that is not a desirable path. Engineering a surprise inflation is a classic way that governments have reduced the real burden of debt, but the solution is only temporary, and it dissipates all the benefits of expectations of stable prices for which Japan has paid so dearly.

Japan's best option is a combination of tax reform and continued structural reform that increases the efficiency of the economy and permits a higher real growth rate without higher inflation. Japan's growth surge over the past nine months has already caused the debt-to-GDP ratio to stop rising and actually to drop a modest amount, but sustained higher growth will be necessary to make a significant dent in it. There is no time to lose in making progress toward such a goal in view of heavy demands emerging on Japan's government-sponsored pension and healthcare systems. No less than the ability to fulfill the promise implicit in those systems is at stake. Fortunately, Japan's policymakers show every sign of understanding the gravity of the debt and deficit problem.

Japan's return to higher growth probably will not be sustained at the 6 percent-plus level we have seen over the past two quarters. But sustained growth at 3 to 4 percent would be a substantial accomplishment that would help Japan to deal with its significant debt problems even though achieving it with zero inflation means that Japan's interest rates must rise back to normal levels. The best hope is that a return to sustained growth in Japan will boost the value of other assets, such as stocks, by enough to offset the wealth losses implicit in higher interest rates on Japan's substantial public debt. Some have suggested that a 10 percent increase in the stock market produces enough wealth gains to offset a 1 percentage point increase in the interest rate paid on Japan's outstanding government debt. With a 50 percent increase from its lows in Japan's stock market over the past year, a substantial down payment on the possible wealth losses for Japan's bond holders has been made. However, the concentration of government bond holdings in the hands of Japanese banks and insurance companies, not to mention the Bank of Japan itself, presents some transitional problems to which Japanese policymakers are sensitive.

Japan's move onto a sustainable recovery path, while it carries with it the problems of transition, is unambiguously good news. With the world's second-largest economy providing a boost to global growth rather than a drag, future expansions everywhere should be more durable. Coupled with China's strong and volatile economy, a less volatile, steadily growing Japan can play a large role in stabilizing the broader Asian economy, which has become the most dynamic region in the global economy.

John H. Makin is a resident scholar at AEI.