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This paper reviews the literature on the sustainability of Japanese government debt/deficit. First, we offer an overview of the approaches and the key findings on the sustainability analysis. Second, we introduce the arguments of Hoshi and Ito [1] , which they predict that foreign investors’ share of JGBs could exceed beyond domestic ownership. Finally, we discuss the coordination problem in the JGB market based on the findings of Onji <i> et al </i>. [2] that examine how government withdrawal from the JGBs could roil the market.

Over the last two decades, Japan has been overwhelmed by enormous government debt and significant budget deficits. The central government of Japan has been running budget deficits since the early 1990s and by the end of FY 2016, government debt outstanding accumulated to over 800 trillion yen (approximately USD 8 trillion). As a result, the general government’s (central and local) gross debt-to-GDP ratio was as high as 230% in 2014 (see ^{1} Reflecting this public financial condition, both media and practitioners are skeptical about the Japanese government’s solvency.

Researchers also have employed various methods to examine the fiscal sustainability of the Japanese government, or whether the government satisfies the intertemporal government budget constraints, giving rise to several strands within the literature, each focusing on a specific method. While specialization has enabled refinement, the technicality of discussion has not been necessarily conducive for a policy audience. Our first goal in this paper is to offer an overview of the approaches and the key findings.

Incidentally, there seem to be no symptoms of a sovereign risk in Japan, following the period of deflation and lower rate of yields on Japanese government bonds (JGBs). Some economists attribute this to the fact that domestic investors share the larger part of the JGB issuance, as shown in

Further, a sovereign debt crisis could have occurred even if a country is solvent. Some theoretic analyses on debt and currency crises clarify this. For example, Morris and Shin [

before the bond becomes worthless. A lack of coordination can lead each debt holder to sell out preemptively, thereby creating a crisis. We discuss this argument based on the findings of Onji et al. [

Section 2 surveys the studies that examine the sustainability of government deficit by focusing on three approaches: the track record of government budget, relevance with economic growth, and the predictions of tax and social security burden to national income or GDP. Sections 3 summarizes the arguments of Hoshi and Ito [

In a simple case, the “sustainability” of government budget deficit relates to whether or not the No-Ponzi Game (NPG) condition, equivalent to the intertemporal government budget constraint (IBC), holds. We explain this using Miyazaki [

The government’s one-period budget constraint is written as follows.

Δ B t = G t + r t B t − 1 − R t , (1)

where B t is government debt, R t is government revenue, G t non-interest spending, and r B t − 1 interest payment on debt. To put it simply, it is assumed that interest rate r t is stationary around its mean r. Based on this assumption, we define the following: G t * = G t + ( r − r t ) B t − 1 . This expression is used to rewrite Equation (1) as follows.

G t * + ( 1 + r ) B t − 1 = R t + B t . (2)

Rewriting Equation (2) for subsequent periods and expressing debt yields:

B t = 1 ( 1 + r ) S t + j + 1 + 1 ( 1 + r ) B t + j + 1 . (3)

where S t + j + 1 = R t + j + 1 − G t + j + 1 * . Then, solving the resulting equations recursively, it yields the following intertemporal budget constraint as follows.

B t = ∑ j = 0 ∞ 1 ( 1 + r ) j + 1 S t + j + 1 + lim j → ∞ 1 ( 1 + r ) j + 1 B t + j + 1 . (4)

By taking conditional expectations, we can write Equation (4) as:

B t = ∑ j = 0 ∞ 1 ( 1 + r ) j + 1 E t [ S t + j + 1 ] + lim j → ∞ 1 ( 1 + r ) j + 1 E t [ B t + j + 1 ] . (5)

Equation (5) demonstrates that initial debt equals the expected present value of future budget surpluses if and only if discounted future debt converge to zero. That is:

B t = ∑ j = 0 ∞ 1 ( 1 + r ) j + 1 E t [ S t + j + 1 ] (6)

must be equivalent to the following:

lim j → ∞ 1 ( 1 + r ) j + 1 E t [ B t + j + 1 ] = 0 (7)

Equation (6) is known as the IBC and Equation (7) as the NPG condition. Intuitively, Equation (6) means that if a government can run sufficient surpluses to repair the initial debt outstanding, then such a government is solvent as it satisfies the NPG condition. The arguments developed in Section 2.1 directly relate to this problem. Further, this is also a basis of all frameworks presented in Sections 2.2 and 2.3.

The approach to examine the sustainability of government deficit is threefold; analyzing the time series properties of the fiscal variables, the relevance with economic growth of the possibility of a “deficit gamble” and the calculation of fiscal surplus to restore sustainability, and the predictions of future tax and social security burden.^{2}

The earliest approach in checking the sustainability of government deficit is to see whether the government has been acting prudently by reducing debt when the levels are high. The idea is that the researcher checks the government’s record of accomplishment by employing the time series data on public debt and budget surplus to ascertain if the government can pay off the debt eventually. While it is difficult to examine how the budget deficit affects the welfare of economic agents and the financial market, this approach is informative in that researchers can clarify whether or not the government’s intertemporal budget constraint holds through an econometric investigation of government budget data. There are two approaches, as elaborated in Bohn [

The ad hoc approach enables us to examine whether or not fiscal policy is on a path such that the present value of expected future primary surplus equals the initial debt as shown in Equation (6). Typically, researchers examine the cointegration relationship between government revenues ( R t ) and total government expenditure (the sum of non-interest spending ( G t ) and interest payment on the debt ( r B t − 1 ).

Following Miyazaki [

Δ B t = ∑ j = 0 ∞ 1 ( 1 + r ) j + 1 Δ S t + j + 1 + lim j → ∞ 1 ( 1 + r ) j + 1 Δ B t + j + 1 . (8)

Given Δ B t = B t − B t − 1 , and using Equation (1), we can rewrite Equation (8) as follows.

G t + r B t − 1 − R t = ∑ j = 0 ∞ 1 ( 1 + r ) j + 1 Δ S t + j + 1 + lim j → ∞ 1 ( 1 + r ) j + 1 Δ B t + j + 1 . (9)

Given the NPG condition, this equation can be written as shown in Equation (10).

G t + r B t − 1 − R t = ∑ j = 0 ∞ 1 ( 1 + r ) j + 1 Δ S t + j + 1 (10)

To test whether or not Equation (10) holds, we test the stationarity of ( G t + r B t − 1 − R t ) by imposing R t , G t , and B t − 1 are cointegrated vector ( 1 , − 1 , − r ) (or the primary surplus and debt are cointegrated with a cointegrating vector ( 1 , − r ) ). If we can confirm stationarity among these variables, we can consider the budget deficit or debt as sustainable.^{3}

Many papers published during the decade from the mid-1980s to the mid- 1990s such as Trehan and Walsh [^{4}

Incidentally, a default may not be plausible if the government is running a budget surplus despite subsequent accumulation of government debt. The ad hoc approach cannot capture this. Bohn [^{5} Bohn [

s t = ρ d t * + μ t + ε t , (11)

where s t is the ratio of primary surplus to GDP, d t * is the ratio of initial debt outstanding to GDP, μ t is other determinants of the primary surplus, and ε t is disturbance. If ρ is estimated to be positive and statistically significant, we estimate that the budget deficit is sustainable because the government can generate a budget surplus to repay the initial debt. d t * is replaced by the privately held debt-to-GDP ratio at the start of the year in the original econometric analysis by Bohn [

How can we rate the Japanese government based on these approaches? Earlier studies [

Recent studies, in contrast, are more pessimistic. For an ad hoc approach, Ono [^{6}

Why is this change in results? One relevant indicator that possibly explains this is Japan’s social security expenditure increase due to a rapidly aging popula-

tion. As shown in

Incidentally, a record of the past fiscal policy does not provide information about the government’s future budgeting path. Therefore, it is necessary to conduct a simulation for future government debt or deficit under the framework assumed in economic growth. Two approaches that complement the time series analysis we have seen so far are considered: examination of the possibility of a “deficit gamble,” and forecasting the budget surplus to restore sustainability into the future.

First, we explain a simple framework for “deficit gamble.” Here we rewrite Equation (1) as follows.

B t = ( 1 + r t ) B t − 1 − ( R t − G t ) . (11)

By assuming that the primary balance ( R t − G t ) is equal to zero, we rewrite Equation (11) in per GDP terms:

b t = 1 + r t ( 1 + y ^ ) b t − 1 , (12)

where b t is the debt-to-GDP ratio and y ^ is the GDP growth rate. Equation (12) implies that the debt-to-GDP ratio grows by 1 + r t ( 1 + y ^ ) . Please note that 1 + r t ( 1 + y ^ ) = 1 + r − y t ^ . If the economy grows sufficiently faster than the interest rate

of government bonds, this may reduce the debt-to-GDP, even if the government generates budget deficits.

Ball et al. [

as a stochastic process in the US to examine the likelihood of a successful “deficit gamble.” Oguro [

The other framework is to predict the level of budget surplus to make the government budget sustainable using certain micro-foundation macroeconomic models.

First, Hosono and Sakuragawa [

Whereas studies presented in Section 2.2 calculate the size of the budget surplus to restore sustainability in the government budget, they do not clarify how nations should bear the burden. In Section 2.3, we introduce some researches that examine this.

A Blanchard-type [

Broda and Weinstain [

In contrast to these earlier studies, latter studies paint a dismal picture. Doi et al. [

One limitation with the Blanchard-type simulation is the need to impose assumptions on a number of variables such as the growth rate of an economy. In principle, the sensitivity of predictions to such assumptions can be validated as they can sometimes make the conclusion drawn from the analysis doubtful. An alternative framework is to model an economy to endogenize important variables, using some micro-foundation macroeconomic models.

Here we introduce two research studies. First, Ihori et al. [

The simulation based on some theoretical models also implies that future generations in Japan will bear the burden of fiscal debt as compared to the past generation in order to maintain the sustainability of government deficit.

Studies introduced in Section 2 do not use the open economy model and exclude the effects of foreign factors.

Recent research by Hoshi and Ito [

The findings of Hoshi and Ito [^{7} However, note that although Hoshi and Ito [

The Japanese government had exerted direct control over the allocation of JGBs. Until 1964, no government bonds were issued, in line with recommendations of the Dodge line. As early as 1953, public corporations issued bonds at artificially low rates. The bond market did not clear because the government organized a syndicate of banks, which purchased public corporation bonds. The Bank of Japan repurchased the bonds after one year. However, the government gradually lost its influence though the 1980s and the syndicate was formally abolished in 2006. The Trust Fund Bureau (TFB) played an important role in alleviating the coordination problem in recent years.^{8}

However, in 1998, the Japanese Finance Minister announced that the TFB funding would not be used to buy JGBs (78% reduction from previous year). Onji et al. [

There is no doubt that the block public holding historically mitigates a potential coordination problem among investors, as shown by Morris and Shin [

Reflecting the unprecedented debt accumulation over the past two decades, many researchers are concerned about the sustainability of government deficit and the possibility of a sovereign debt crisis developing in Japan. This paper reviews the related studies through a threefold approach: sustainability problem, relations with foreign investors, and coordination problem in the JGB market.

Researchers concerned with sustainability unanimously agree that the Japanese government will have to generate sufficient fiscal surplus for achieving sustainability. Moreover, when the share of foreign investors increases, as indicated by Tokuoka [

However, there is yet some scope for researchers to examine the underlying fiscal problems in Japan. First, there have been many studies focusing on the general government, but very few examine the relationship with monetary policy. Among the studies introduced in our paper, Doi et al. [^{9} In light of the Bank of Japan’s move of bulk buying of JGBs after 2012, researchers should pay more attention to the interaction between monetary and fiscal policy. Second, very few predictions have been made by employing theoretical models on the relationship between home bias and JGB holdings. Hoshi and Ito’s [

The authors would like to thank two anonymous referees, Seo-Young Cho, Shigeyuki Hamori, Bernd Hayo, Kentaro Iwatsubo, Yuji Kawano, Akihiro Kawase, Shigeto Kitano, Eiichi Miyagawa, Katsuyoshi Nakazawa, Yoshiki Ogawa, Masayuki Tamaoka, Hajime Yamada, Setsuo Yamaki, and participants of the workshop held in Kobe University and Toyo University. The Japan Society for the Promotion of Science (Grant-in-Aid for Scientific Research #16H03637 & #17K03764) has supported this work financially. The usual disclaimer applies.

Miyazaki, T. and Onji, K. (2017) The Sustainability of Japan’s Government Debt: A Review. Theoretical Economics Letters, 7, 1632-1645. https://doi.org/10.4236/tel.2017.76110