Asymmetrical Information - Megan McArdle

09.27.12

How Long Until Japan Meets its Demographic Doom?

Japan has been running up debts and pension obligations at a furious pace. Can its shrinking workforce possibly make good?

Yesterday, I blogged about why I might have been wrong about social security privatization.  Today, I'll add some nuance to that.  I was wrong about social security privatization, and yet, that doesn't mean that I've hopped on the "Social Security is the most awesome thing that ever happened" bandwagon.  Social Security has real issues compared to private savings: most notably, that it encourages people to retire early, and to have fewer children.  The existence of social security substantially undercuts the demographic increase needed to make the security system solvent.  That raises the risk of a catastrophic adjustment, in which people who have relied on Social Security rather than saving, or working longer, suddenly find themselves under-pensioned and unemployable.

I have written about the difficulties that such demographic shifts present: when fixed obligations meet a falling workforce, the effects can be dire indeed. In this month’s Atlantic, Peter Boone and Simon Johnson paint a catastrophic picture of what such a demographic shift looks like in Japan:

About half of the Japanese government’s annual budget now goes to pensions and interest payments. As the government has spent more and more to support its growing elderly population, Japanese savers have willingly financed ever-increasing public-sector debts.

Elderly people hold their savings in the form of cash and bank deposits. The banks, in turn, hold a great deal of government debt. The Bank of Japan (the country’s central bank) also buys government bonds—this is how it provides liquid reserves to commercial banks and cash to households. Similarly, Japan’s private pension plans—many promising a defined benefit—own a great deal of government bonds, to back their future payments. Few foreigners hold Japanese government debt—95 percent of it is in the hands of locals.

Given Japan’s demographic decline, it would make sense to invest national savings abroad, in countries where populations are younger and still growing, and returns on capital are surely higher. These other nations should be able to pay back loans when they are richer and older, supplying some of the funds needed to meet Japan’s pension promises and other obligations. This is the strategy that Singapore and Norway, for example, have undertaken in recent decades.

Instead, the Japanese government is using private savings to fund current spending, such as pensions and wage payments. With projected annual budget deficits between 7 and 10 percent of GDP, Japanese savers are essentially tendering their savings in return for newly issued government debt, which is not backed by hard assets. It is backed only by an aging, shrinking population of taxpayers.

Japan’s taxpayers are already rebelling against small tax increases needed to limit escalating deficits. This leaves little room for hope that future taxpayers will accept the larger tax increases needed to repay debts.

Japan’s demographic decline will be hard to reverse—and even in the best-case scenario, the positive effects of a reversal would not be felt for decades. The economy, roughly speaking, is as healthy as it is likely to become. Yet the government seems incapable of steering away from the cliff, a characteristic that should strike no one as uniquely Japanese—just look at how the Euro­pean leadership has behaved over the past half decade, or how you can polarize American politicians with the phrase debt ceiling.

For about a decade now, people have been pointing to Japan as proof that the US can safely issue more debt. After all, they say, Japan has twice as much and they’re doing fine! However, it seems like we must be getting close to the point where Japan is very much not fine, if for no other reason than it is dependent on domestic savers for financing, and those savers are going to need that money back to spend on retirement.

We’re not nearly there; Japan’s demographic decline is among the fastest in the world. But we will have the same problem to a lesser degree. And of course, as Boone and Johnson point out, to some extent we will have Japan’s problem: if they have a crisis, the waves are likely to wash over our shores as well.