Satyajit Das: Lessons from Japan’s Massive Debt Hangover

Yves here. Since the US and many Western economies have gone on a borrowing spree, it would seem prudent to look for ideas on how to manage the debt overhang. Satyajit Das looks at Japan which has preserved high standards of living and scores well on social indicators.

Das explains why Japan’s experience is not terribly generalizable to ours. Japan has a very high domestic savings rate. It also remained an export powerhouse even if its domestic economy was suffering. And an intriguing observation: Japan’s much decried demographic decline was actually an advantage in managing its debt burden.

Some observations:

1. Right after the 2008 meltdown, Japanese officials said with unusual directness that the biggest mistake they made in their crisis was not writing off bad debt quickly. There are too many connected creditors in the West for that to be very likely.

2. Das correctly finger the Bank of Japan interest rate drop in response to the Plaza Accords sending the yen to the moon as playing a big role in pumping up its asset bubble. But I first started dealing with Japan even before then, and people who should have known better were talking themselves into believing nose-bleed asset valuations: “Oh, the capital flows are so great that prices will never go down.”

The importance of focusing on the BoJ action is that (contrary to claims of soi-disant experts like Jeffrey Sachs whose remarks demonstrate ignorance of how Japan operated then) the Plaza Accords did not hurt the economy. There was a teeny blip downward, not even a recession but a mild reduction in growth for less than a full year, and growth was back on its old trend line.

What made the BoJ rate reduction toxic, and is STILL not well understood, is that around that time, the US forced a very rapid deregulation on Japanese banks, who were so behind Western state of the art that they did not even know how to do asset-liability management (not making this up, I wrote the primer for Sumitomo Bank, then Japan’s answer to Citibank and considered to be its most sophisticated financial firm). And what did they start doing? Zaitech, as in derivatives! The resulting great increase in leverage and train wreck were inevitable.

By Satyajit Das, a former banker and author of numerous works on derivatives and several general titles: Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives  (2006 and 2010), Extreme Money: The Masters of the Universe and the Cult of Risk (2011), A Banquet of Consequences RELOADED (2021) and Fortune’s Fool: Australia’s Choices (2022). His latest book is on ecotourism and man’s relationship with wild animals – Wild Quests (2024). First published on 28 May 2025in the New Indian Express print edition.

With a recession looming, the global economy is looking into the abyss. Policymakers looking to resuscitate economic activity, combat falling asset prices and deflation would do well to critically examine Japan’s trajectory which illustrates the problems of traditional approaches, especially their risks.

Japanese post-war success was based around low costs, manufacturing competence and an undervalued currency. When the 1985 Plaza Accord forced revaluation of the yen adversely affecting exports and growth, the authorities cut interest rates, fuelling a debt funded real estate and stock price boom.  The ‘bubble’ economy collapsed in 1990 triggering a balance sheet recession as heavily indebted households and businesses cut back on consumption and investment to reduce debt.

Over two decades, Japanese policymakers repeatedly lowered interest rates, injected liquidity and unleashed waves of government spending to resuscitate the economy. The policies alleviated the slowdown but did not restore growth levels or create needed inflation to boost nominal asset prices and reduce real debt levels. Japan’s potential growth rates fell reflecting misallocation of capital which reduced returns on investment. Excessive manufacturing capacity and low domestic demand increased reliance on exports and balance of payments surpluses to align production and demand. Government financed infrastructure investment only provided a short term boost in economic activity.

Low interest rates and abundant liquidity allowed excessively high debt levels. Weak businesses survived in a zombie-like state, operating only to pay loan interest. Banks avoided writing off loan assets, tying up capital reducing credit availability for productive enterprises, especially small and medium enterprises. Low returns reduced income for savers, decreasing consumption and encouraging additional saving for retirement.

The increasing reliance on government spending financed by debt led to a steady deterioration in public finances as the government ran large deficits.  The policies acted as a palliative allowing essential reforms to be deferred.

Policymakers borrowing from Japan’s playbook misunderstand the country’s circumstances.  When its bubble economy collapsed, Japan was relative rich and technologically advanced. The country entered the crisis with modest government debt. It had high domestic savings and a high home investment bias which allowed the government to finance its spending domestically, assisted by the central bank’s quantitative easing programs.

In the 1990s, Japan’s benefitted from favourable external conditions. Strong global economic growth allowed exports to partially offset the lack of domestic demand. A weaker yen was helpful in creating economy activity.

Contrary to commonly held views, Japan’s demographics were helpful. Its aging population was an advantage because it meant fewer new entrants into the workforce keeping unemployment low. A falling population supported per capita income and disinflation or deflation ameliorated the erosion of living standards. There were problems of a shrinking workforce and lower tax base but Japan’s welfare system (aged and healthcare costs) is less generous than those in many countries.

The social and political background were favourable. Shaped by the hardships of World War II and the immediate post war period, Japanese culture is characterised by strong national consciousness, stoicism and selflessness, particularly among older citizens. There was acceptance of the need for economic sacrifices. Japan is de facto a one party state, where the ruling LDP is able to pursue its policies with little political opposition. This allowed the country to pursue consistent policies to manage its problems with limited opposition.

Most of these conditions do not exist in other countries should they seek to copy Japan’s approach. The backdrop is vastly different. The problems are now global in scope. The world now faces unsustainable debt levels. There are trade and currency wars which are likely to escalate. There is a deteriorating geopolitical security environment, an expensive and slow energy transition and resource scarcity. In essence, one lesson from Japan’s experience is that it is better to enter a crisis first as there are greater options.

Despite its advantages, Japan has never fully recovered its full economic and financial standing. The period since the collapse are known as the  ‘lost decades’. There are social costs – elderly poverty encouraging some to commit crimes for the security of jails and a cohort of dispirited young who have opted out of society.

Now, Japan may be illustrating the terminal phase of this process where the side effects and distortions of the initially effective policies become toxic and damaging.  The endgame begins with inflation. Beginning in 2020, the supply shocks from the pandemic and geopolitical events combined with the longstanding loose monetary policies has created price pressures. Japan’s inflation rate, while lower than elsewhere, rose to around 3 percent. Despite tentative steps, Japanese authorities are reluctant to normalise policy settings. They fear the impact of higher interest costs especially for the government and highly indebted businesses. There is the risk of falls in asset values which support high debt levels.

This creates currency weakness. The differential between the Japan’s low rates and those in most advanced economies caused the yen to fall from around 100 to the dollar to over 160 (with a recent small recovery). The devaluation feeds inflationary pressures through higher import prices especially for raw materials, food and energy. It feeds capital flight, limits policy options and flexibility to respond to new crises. In August 2024, a modest 0.25 percent rise in rates was responsible partially  for large falls in stock prices and volatility as the infamous yen carry trade (yen borrowings funding higher yielding asset) was unwound. It points to how difficult and painful reversal of the policies in place for decades may be.

An additional factor is the effect of higher inflation on government debt servicing costs. Japan’s government bond rates – particularly at the long end – have risen significantly. The 10-year rate is around 1.50 percent. The 30-year rate is now around 3 percent below recent highs of around 3.17 percent. These rates, not seen for decades, combined with its large stock of government debt (around 240 percent of GDP) means interest costs now consume more tax revenues although remain modest by global standards. As most of the debt is held domestically, the economic pressure is less obvious but limits policy flexibility.

The real lesson from Japan is that expansionary monetary and fiscal policy purchases time for reducing debt levels and structural reforms of industrial structure, productivity, corporate governance, labour markets and public finance. You cannot cover up underlying economic weaknesses with increasing borrowing, government spending and low rates forever.

Recent events in Japan may be an unpleasant foretaste of what is lies ahead for many economies. Policymakers elsewhere might benefit from reviewing its experience to understand how crushing debt, inability to adjust interest rates, dysfunctional financial markets and currency pressures work to lock nations into stagnation and decline. It might help them avoid a similar fate. But no one learns anything either from history or from the experience of others as we choose to believe that we know better and it will never happen to us!

 

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