Caxton Global Economic Commentary

Is America the Next Japan?

In late January, Standard & Poor’s reduced its sovereign debt rating on Japanese government
debt from AA to AA-. Almost simultaneously, the U.S. Congressional Budget Office reported that
the U.S. budget deficit in 2011 would be $1.48 trillion or 9.8 percent of GDP, an increase of nearly
$300 billion from previous estimates. While the CBO announcement was not a huge surprise, in
light of the substantial additional tax cuts enacted by the Congress in December, it did lead some to
suggest (including the Moody’s debt rating service) that America could be headed for a “lost
decade” that includes crushing budget deficits and an ever-rising debt burden. Concerns over the
rising U.S. deficits and debt burden were underscored by George Soros at the Davos conclave when
he pointed specifically to a possible “crowding out” problem for the United States: if the economy
picks-up and prices begin to rise, U.S. interest rates will rise so rapidly that they will choke-off the
recovery.

America’s looming debt/deficit catastrophe has been a perennial feature of the pronouncement
of global soothsayers for nearly a decade. It has been conveniently forgotten that many of the
analysts who are credited with having foreseen the financial collapse of 2007-2008 had predicted
that it would arise because of a collapse in U.S. bond markets and a collapse in the dollar related to
the unwillingness of America’s creditors to continue to accumulate U.S. government notes and
bonds. The actual crisis, which saw the housing bubble translate into a systemic financial collapse,
created the reverse—a panicky rush into the “safety” of the U.S. dollar and Treasuries that, after the
Lehman crisis and the turmoil that followed, drove yields on Treasury notes down close to 2 percent.

The fact that history has not played out as expected, especially with regard to the implications
for the dollar and U.S. government debt, should not lead to complacency going forward. Still, it is
worth remembering that the experience after Japan’s real estate bubble burst in 1989, not to mention
the experience of the Great Depression, suggests that the behavior of deficits and government debt,
alarming as it may be, is not a reliable guide to the path of interest rates going forward. It is
necessary, after bubbles burst, to keep a close eye on the behavior of inflation and the possibility of
deflation. A drift toward deflation, like that occurring in the Great Depression and in Japan after
1997, can be more dangerous than a rapid run-up in government debt, especially if the real burden of
that debt accumulation is enhanced by deflation. Further, outright deflation usually means a fall in
nominal GDP growth and an attendant rise in the ratio of government debt-to-GDP.

It is also important to keep an eye on the behavior of total debt (government debt and private
sector debt), when evaluating the implications of a sharp run-up in government debt. For example,
few have pointed out that at the end of 2010, total U.S. debt was actually lower than it was in 2008.
Although the highly visible and much-bemoaned federal budget deficit grew sharply, from $0.458
trillion in 2008 to $1.413 trillion in 2009, and to $1.294 trillion in 2010, pushing the debt-to-GDP
ratio up sharply from just above 40 percent to 62 percent at the end of 2010, private borrowing fell
by so much that U.S. total borrowing actually fell during 2009 and 2010.

How bad is the U.S. government outlook going forward and how does it compare with Japan’s
debt prospects? Probably the best metric to employ when addressing this question is the ratio of net
government debt-to-GDP, which approximates the public’s holdings of government debt exclusive
of debt owned essentially by the government itself either in Japan’s postal savings system or in the
United States Social Security account. Gross debt measures are more alarming but using net debt
measures that compare across countries is probably the soundest way to proceed. Few of the
conclusions reached using net debt figures would be altered by using gross debt figures save for the
fact that the headline numbers would be more alarming for both countries, the United States and
Japan.

First, take a look at the last six years. Over that period, Japan’s net debt-to-GDP ratio rose at
about 6.5 percent a year…..a pretty alarming pace that means that the debt-to-GDP ratio doubles in
just eleven years. In Japan’s case, which started at an 82 percent debt-to-GDP ratio in 2004, that
would mean a truly alarming 165 percent debt-to-GDP ratio by 2015. That is a frightening number
that doesn’t represent a very controversial forecast. It isn’t very far from IMF projections of 153
percent. Even Greece’s debt-to-GDP ratio is not supposed to rise above 150 percent over the next
half decade. Of course the market’s treatment of Greek debt is substantially different from its
treatment of Japanese debt with interest rates on ten-year government bonds in Japan yielding about
1.2 percent while interest rates on ten-year Greek debt yield about 10.6 percent. Much of Greek debt
is externally held and the Greek government’s credibility regarding its ability to manage
expenditures and collect taxes is low.

What about the United States? Its debt-to-GDP ratio rose even faster than Japan’s between
2004 and 2010 at an annual rate of about 7.7 percent, implying a doubling of the ratio in just ten
years. Such rapid growth, that accelerated sharply after 2007, probably accounts for the enhanced-
relative to that occasioned by Japan-- rise in global concern over US debt and deficits Of course with
a debt-to-GDP ratio at about 42 percent in 2004, a doubling of its debt-to-GDP ratio over 6 years—
the Japanese pace after 2004-- would take it to 84 percent in 2015. That would leave the U.S. debt-
to-GDP ratio just above the debt-to-GDP ratio in Japan in 2004. That measure for Japan engendered
little of the hand-wringing that is associated with the current, sharp prospective rise of U.S.
government debt relative to GDP, perhaps because steady deterioration of Japan’s fiscal condition
had been underway for over a decade or perhaps because the growth in Japan’s debt-to-GDP ratio
had been slowing for a decade, prior to 2004. Beyond that, the uncertainties tied to the 2008
financial crisis were absent in 2004.

An analysis of the proximate determinants of the path of the debt-to-GDP ratio is revealing
both in terms of how to evaluate the significance of prospective changes in that level and how to
compare the experience of the United States and Japan. The percent change in the debt-to-GDP ratio
is determined by two components. First, the difference between the interest rate on outstanding debt
and the growth of nominal GDP. The larger that difference, the faster the debt-to-GDP ratio rises.
The second component of the percent change in the debt-to-GDP ratio is the primary deficit—
government spending minus tax revenues divided by the stock of debt. The sum of those two
percent numbers determines the growth rate (positive or negative) in the debt-to-GDP ratio.

Japan has been plagued both by larger primary deficits and by episodes of sharply negative
nominal GDP growth. Japan experienced very weak (about one percent nominal GDP growth from
2004 to 2007) and sharply negative nominal GDP growth thereafter until the start of 2010. Nominal
GDP growth is the sum of inflation and real output growth and Japan’s persistent deflation has
sharply weakened nominal GDP growth and thereby contributed to a persistent increase in its debt-
to-GDP ratio. In a sense, Japan’s fiscal failure has been two-fold. The government has failed to cut
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spending enough to reduce the primary deficit. (Tax cuts would probably be counterproductive as
they would slow nominal GDP growth even further.) Second, the Bank of Japan has failed to move
Japan out of deflation and thereby allowed persistently-negative nominal GDP growth to push up the
debt-to-GDP ratio and thereby push up the burden of debt. The average interest rate on Japan’s
outstanding debt (average maturity about 5 years) is only about 50 basis points, but the average
negative 4 percent growth rate of nominal GDP during 2008 and 2009 contributed mightily to the
rise in Japan’s debt-to-GDP ratio, boosting it by 2.8 percent in 2008 and by a record (since 1981) 7.2
percent in 2009.

Japan is in a debt trap because deflation boosts the real burden of debt while pushing up the
debt-to-GDP ratio. That rising burden, in turn, forces the government to continue trying to cut
government spending and even flirt with tax increases, both of which are counterproductive because
they further depress growth. Clearly, Japan’s debt dilemma is one of the reasons behind Chairman
Bernanke’s strongly stated determination to avoid a drift from disinflation into deflation in the
United States. In a real sense, Japan’s fiscal dilemma, which led to the most recent S&P downgrade,
is an answer to the question: “why is it important for governments with sharply rising debt burdens
to avoid deflation?”

In contrast to Japan, much of the sharp 20.8 percent rise in the debt-to-GDP ratio during the
2009 fiscal year (which began in October 2008, just after the Lehman crisis) was due to a large rise
in the primary deficit. While the drop in U.S. nominal GDP growth boosted the debt-to-GDP ratio
by 4.5 percent during 2009 (given an estimated 2.5 percent interest rate on outstanding debt), the
nominal GDP growth rebound in fiscal 2010 reduced the debt-to-GDP ratio by 0.8 percent. The
overall 11.4 percent rise in the U.S. debt-to-GDP ratio in 2010 was mitigated by stronger nominal
GDP growth, despite the large primary deficit. Japan’s persistently weak nominal GDP growth
contributed to the persistent rise in its debt-to-GDP ratio in 2010.

Going forward, while the U.S. debt burden problem is not as serious as Japan’s, when
measured by the outlook for the ratio of government debt-to-GDP, it is certainly time to take
decisive action to reduce prospective deficits over the coming five to ten years. The burden of
mitigating the rise in the debt-to-GDP ratio, however, should not fall entirely on adjustments to the
primary deficit…that is largely adjustments to reduce government spending while enacting revenue-
neutral tax rate reductions financed by a widespread elimination of tax preferences. A higher
nominal growth rate for the U.S. coupled with stable nominal interest rates would contribute
mightily to containing the implied rise in the U.S. debt-to-GDP ratio. The CBO’s recent report on
U.S. deficits and debt demonstrates the right approach. With a growth rate averaging about 3
percent from 2011 to 2016 and an inflation rate rising gradually from the current core inflation rate
of 0.6 percent to an average of 1.9 percent in 2013 to 2016, an average nominal growth rate
approaching five percent coupled with spending cuts and stabilization of tax revenues would mean a
debt-to-GDP ratio of about 75 percent in 2016. That is only modestly above the 70 percent level
projected for this year and still well below Japan’s 2004 level of 82 percent.

Achieving higher nominal growth and a more modest increase in the debt-to-GDP ratio
provides another benefit—the likelihood of lower nominal interest rates. Substantial empirical
research by Thomas Laubach, at the Federal Reserve Board of Governors, demonstrates that a 10
percentage-point reduction in the five-year forward debt-to-GDP ratio would, other things equal,
reduce the five-year forward yield on Treasury notes by about 50 basis points. That is substantial
progress toward reducing the debt-to-GDP ratio below levels currently expected and would provide
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a double bonus by reducing the nominal interest rate on outstanding Treasury debt and thereby
reinforcing a further drop in the debt-to-GDP ratio.

The other reason to press for a stabilization of the U.S. debt-to-GDP ratio going forward arises
from the extensive research conducted by Carmen Reinhart and Kenneth Rogoff in their widely-
cited book, “This Time is Different.” They show that a debt-to-GDP ratio above 90 percent sharply
increases the chance of a financial crisis associated with a rapid increase in sovereign debt. While
not a hard-and-fast rule, this result makes considerable sense. Examining the proximate
determinants of the debt-to-GDP ratio, if one allows for a negative impact on nominal GDP growth
arising from a reduction in the primary deficit, the higher the debt-to-GDP ratio, the more likely is
the paradoxical outcome whereby a reduction in the primary deficits aimed at reducing the debt-to-
GDP ratio actually boosts it because of a negative impact on nominal GDP growth. This is the
situation akin to that being faced by many Southern European countries where highly stringent fiscal
measures are so depressing growth that aiming for a smaller primary deficit actually results in a
higher debt-to-GDP ratio and thereby a debt trap. Japan too could be vulnerable to this debt trap,
given its tendency toward deflation-driven, negative GDP growth. The United States is far from this
point, but the extreme undesirability of getting into such a debt trap should help to prompt
aggressive and credible deficit reduction measures over the next five years by the Congress.

It is not too late for the U.S. to rescue itself from a debt/deficit trap like the one that arguably
has encompassed Japan and some distressed sovereign governments in Southern Europe. But it is
certainly not too soon to take credible measures to avoid that outcome. The Fed’s job is to avoid
deflation and to help sustain nominal GDP growth of around 5 percent while the job of Congress is
to reduce federal spending from about the 24.7 percent of GDP projected in 2011 down to 22 percent
in 2015. That would help to reduce the rise in the debt-to-GDP ratio, actually reduce interest rates
on outstanding debt, and help to make way for the rise in private borrowing that will accompany a
sustained U.S. economic recovery.

Dr. John H. Makin

Chief Economist, Caxton Associates, LP
February 7, 2011

The foregoing commentary expresses the views of Dr. John Makin, Caxton Associates LP’s Chief Economist, and may not represent
the views of Caxton’s portfolio managers. Therefore, one should not infer from the foregoing commentary what actual trading
positions or recommendations may be made by Caxton currently or in the future.