Defying gravity: can Japanese sovereign debt continue to increase without a crisis?

Japan has the highest debt to GDP ratio among advanced countries, and many studies find that the current fiscal regime of Japan is not sustainable. Yet, the Japanese government bond continues to enjoy low and stable interest rates. The most plausible explanation for such an apparent anomaly is that the bonds are predominantly held by the Japanese residents, who are willing to absorb increasing amount of Japanese Government Bonds (JGB) without requiring high yields. Even if the Japanese residents continue to invest their new saving into the government bonds, however, Japan's fiscal situation is not sustainable, which this paper shows through simulations under various scenarios. In all of the scenarios that assume the fiscal policy stance of the Japanese government does not change in the future, we find that the amount of government debt will exceed the private sector financial assets available for the government debt purchase in the next 10 years or so. The paper also shows that sufficiently large tax increases and/or expenditure cuts in the future would put the government debt on a sustainable path. Thus, if the market believes that Japan will embark on such fiscal consolidation in the next 10 years, at most, the low JGB yields are justifiable. If and when the expectation changes, however, a fiscal crisis can be triggered even before the government debt hits the ceiling of the private sector financial assets.— Takeo Hoshi and Takatoshi Ito