(Bloomberg View) — When even Paul Krugman is worried about the national debt, you know you have a problem. The country in question isn’t Greece or the United States, but Japan.
With low unemployment and high labor force participation, Japan has essentially no idle resources. The scope for boosting the economy with fiscal stimulus or easy money is almost nil. But Japan continues to run an enormous budget deficit every year. In 2014, the government had a deficit of 7.7 percent of gross domestic product (GDP), with a primary deficit — which excludes interest payments — of just under 6 percent.
Things are looking somewhat better for 2015. A hike in the consumption tax in 2014 has swelled revenues. Government coffers have also been boosted by increased profits at Japanese companies — which is then subject to the country’s high corporate tax rate. As a result, the primary deficit is projected to be only about 3.3 percent in 2015.
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But 3.3 percent is still way too high. In the long run, any deficit that stays higher than the rate of nominal GDP growth is unsustainable. Japan’s nominal GDP growth is now about zero. Its long-term potential real GDP growth is no more than 1 percent (due to shrinking population), and the Bank of Japan has not managed to increase core inflation to the 2 percent target despite Herculean efforts. Even if interest rates stay at zero forever — allowing the country to eventually refinance all its debt in order to bring interest payments down to zero — borrowing 3.3 percent of GDP every year is just too much. And if interest rates rise, deficits would explode.
The government, of course, knows this, and has pledged to cut the primary deficit to 1 percent by 2018 and to zero by 2020.
But its projections rely on unrealistically fast growth assumptions; it would require Japan to expand well above its long-term potential rate. As in the United States, Japanese administrations are in the habit of over-optimism. The Ministry of Finance, full of sober-minded bureaucrats, projects that under more realistic growth assumptions, the primary deficit will shrink only to 2.2 percent. Even that improvement would require tax hikes, spending cuts or some combination of the two.
A primary deficit of 2.2 percent would be at the very edge of long-term sustainability. If we assume a 1 percent real potential growth rate and 1.5 percent inflation, then a 2.2 percent deficit will be just barely under the maximum sustainable level of 2.5 percent.