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  Japan's Runaway Debt Train   (2001)

Imagine, if you can, an economic Hell in which the U.S. government was borrowing 40% of its annual budget, creating annual deficits of 900 billion dollars a year; where 65% of all tax revenues were gobbled up by interest payments on a mind-boggling $13 trillion public debt; and where there was no conductor in sight to stop this runaway debt train.

Welcome to Japan, where that Hell is reality.

Reports on Japan's weak economy and the mountains of bad debt in its banking system have been percolating for over a decade; every once in a while, a downgrade bubbles to the surface, and then the whole "crisis" sinks from view again, lost in the complacency of seemingly permanent malaise.

But after a decade of half-hearted attempts at reform and repeated stabs at "kick-starting" its moribund economy with pork-barrel spending, time is finally running out for Japan. For despite the endless hand-wringing about weak banks, Japan's real financial cancer lies in the public sector, run not by bankers but by politicians.

In fact, if Japan's bad bank debt magically vanished tomorrow, the root causes of the nation 's financial woes would remain untouched.

Japan's Public Spending Orgy

Japan's legendary work ethic has created a decade-long conundrum: how can one of the hardest-working people on Earth have one of its most troubled economies?

It comes down to this: losses and loans eventually have to paid by somebody. Sure, you can max out another credit card to make the interest payments on the last spending orgy, but at some point you run out of people willing to lend you money, and you find yourself owing far more than you can possibly pay off.

This is essentially where Japan's government finds itself: having borrowed itself into a deep hole to pay for ten "stimulus packages" (read construction pork-barrel spending) totalling over $1 trillion in the past eight years, it no longer has the ready ability to borrow enough to cover the estimated $1 trillion in bad debts held by banks, insurance companies and other institutions.

Instead, it finds itself caught in a vicious circle, borrowing more heavily every year just to finance yet more ineffective "stimulus" spending and ballooning interest payments, which in turn add another vast sum to the nation's debt load.

The numbers are truly stunning: Japan's swelling public debt of $6.3 trillion is 136% of the nation's GDP--over twice the relatively modest U.S. rate ($5.6 trillion in public debt, or about 56% of GDP)--surpassing even Italy, long the European Community's poster child of public indebtedness at 120% of GDP.

In stark contrast to the universal hand-wringing which arose when the U.S. national debt hit 70% of GDP in the late 80s, this record-breaking public debt has only recently created a ripple of concern around the world.

It's not just the size of Japan's current debt that worries observers; it's how fast it's growing. Government receipts totalled only $463 billion in 2000, while its expenditures were $830 billion.

The $367 billion difference--a staggering 40% of the budget--was borrowed, with the government issuing some 33 trillion yen of new bonds to fund the new debt. Deficit spending is now a mind-numbing 9% of the entire GDP.

This is the result of a decade of denial.

Pay Now or Pay Later

Our government faced a similar crisis in the late 80s when the under-regulated savings and loan industry blew up, creating an Everest-sized pile of bad debt and an army of angry depositors. In response, the Feds seized the S&L's assets, sold off what they could, and covered the depositors' losses--in effect, transferring $350 billion in private losses to the public ledger.

In other words, the taxpayers footed the bill. While it was painful medicine to swallow, it worked, restoring the sector's financial health and setting the stage for renewed growth.

But Japan's leaders have consistently downplayed the size and the severity of their nation's woes, insisting that tepid reforms and modest set-asides were taking care of the lingering bad debt and liquidity problems.

Their "solution"--ignore the debts debilitating the banking and insurance sectors and "grow" their way out of the resulting economic malaise by spreading unneeded pork-barrel bridges, runways and reclamation projects throughout the country--has failed miserably. Despite spending $1 trillion in "stimulus packages", Japan managed only an anemic 1.2% annual GDP growth in 1995-99, compared to the U.S. average of 4.1%. And now even that meager growth has slid to a halt.

The government revised the heady 2.4% rise in GDP it had estimated last summer--which had caused a short-lived spike up in the sinking Nikkei stock average--down to a 0.6% decline in the third quarter, effectively admitting that even this rise was largely illusory.

A Mount Fuji-Sized Pile of Debt

Let's say Japan's leadership finally decided to get serious about facing their debt hangover. Just how big is it?

Very big. In fact, the nation's debts defy description. Virtually every layer of Japan's public and private institutions is larded with stupendous and largely under-reported debts.

Despite the government's modest efforts at financial reform, grandiosely titled "the big bang," there is an enormous hoard of bad debt still hidden away in banks and insurance companies; Moody's analysts estimate this dead weight totals between 30% and 40% of GDP (non-performing bank loans alone are guesstimated at about $700 billion).

Although Japanese officialdom routinely poo-poo these high estimates, the Hyogo Bank bankruptcy is fairly typical. When the bank went belly up in 1995, it left bad debts 25 times higher than its previously declared totals.

So much for accurate estimates. While there's been talk of improved transparency for years, few independent analysts place any faith in government estimates of non-performing loans and asset valuations.

As of April, new disclosure laws will require companies to report stock and real estate assets at their current market value, rather than the absurdly unrealistic purchase prices left on the books since the 1989-90 Bubble; that should be viewed as an improvement, but many are looking on with fear.

For if already unsteady banks and insurance companies reveal that their asset base has dramatically weakened, the results are bound to be wrenching.

If that isn't enough, there's also the issue of corporate pension plans, which Goldman Sachs (Japan) estimates are underfunded to the tune of $725 billion.

Oh, and don't forget the local government spendthrifts, who have run up an astonishing $1.6 trillion debt on their own.

Certainly those vaunted Japanese corporations are healthy, right? Not quite; Mikuni & Company, Japan's only independent credit rating firm, gives two-thirds of Japan's 1000 largest bond issuers--the cream of Japan's corporate economy--a junk bond rating of BB or less.

Should the central government absorb this overhang of bad debt--and it is slowly taking over and liquidating the most obviously bankrupt banks and insurance companies, to the tune of $85 billion last year alone--it's estimated the public debt would quickly rise to 180% of GDP.

This is an astounding prospect. Deficit spending is almost 10% of the economy, the interest payments eat up half of tax revenues, there's trillions in outstanding bad debt hidden in government, bank and corporate books, a trillion-dollar stimulus has utterly failed, a no-growth economy staggers under a peacetime public debt larger than the world has ever seen--and still, there are few prospects for the fundamental policy changes so desperately needed.

Is this any way to run the world's second largest economy?

Political Stalemate

Of course not.

So why has the Japanese government been so resistant to change?

Look no farther than the current Prime Minister for an answer. Soon-to-be-sacked Yoshiro Mori is just the latest in a string of ineffective party hacks who are beholden to the ruling Liberal Democratic Party's subsidy-dependent, rural-dominated power structure.

The problems stemming from Japan's virtual one-party system--the LDP has, except for one brief period of voter revolt, held power since 1955--have been well-documented. For instance, it's commonly acknowledged that the position of prime minister has been awarded more for service to the LDP than for leadership abilities.

But there are deeper political problems in the Japanese system. Rural populations carries more political weight in the Diet than their numbers alone would dictate, creating an expensive patronage system of rural subsidies as politicians curry favor with farmers and maintain rural employment with pork-barrel spending.

And the intricate, collusive game of musical chairs between government and corporate debt--the bankrupt insurance companies own a ton of government bonds, which were sold to fund low-cost loans to failing companies, which can't be allowed to go belly up because the bonds would have to be written off--form a sclerotic mass in the body politic. The greatest resistance, however, may come from the "doken kokka," the so-called "construction state" of lenders, builders and politicians which feeds off the massive and mostly useless public works funded by the deficits. This "construction-industrial complex" employs six million workers and consumes 20% of the GDP, perhaps the greatest and most politically potent "make work" project since the Great Pyramids.

In short, there are powerful interests who benefit from the current stasis. Just how powerful was demonstrated earlier this month, when respected Finance Minister Miyazawa blurted out a very public warning that Japan's finances were nearing collapse. This brief outbreak of truth was so alarming that Miyazawa was forced to backpedal almost immediately.

So who will be left standing when the game comes to an end? Just don't let it be you. If you happen to have own funds which hold Japanese bonds or stocks, sell. Sell now, while complacency reigns, because when this boil bursts, there will be planet-wide pain. The next global financial crisis is on the horizon, and you need only look to the East to see the first red glow of the coming reckoning.

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Statistics are from the Organization for Economic Cooperation and Development (OECD) and the C.I.A. World Factbook.

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