
Japan’s public debt is much higher than in Italy, as a share of GDP (roughly 240% vs. 130%, though sources differ). The difference in net debt is not nearly as large, but still significant. And yet Italy must pay a substantial risk premium on its public debt (third largest in the world), whereas Japan (with the second largest public debt) pays roughly zero interest rates on borrowed funds.
In previous posts I’ve discussed one difference; Japan borrows in its own currency whereas Italy borrows in euros. Thus buyers of Italian debt face a positive default risk, whereas buyers of Japanese debt face a near-zero default risk.
But this doesn’t fully explain the difference. While the ability to print money allows a country to avoid outright default, the side effect is often inflation. If investors feared that the authorities would be forced to pay its bills by printing money, then inflation expectations would rise and this would increase nominal interest rates on long-term bonds (via the Fisher effect.)
Having the ability to print one’s own currency does not, in and of itself, insure low interest rates on public debt, as the US learned in the 1970s and early 1980s. Turkey paid rates of over 50% per year during the 1990s. So why are Japanese interest rates so low? In other words, why don’t investors fear Japanese inflation?
I suspect that one important difference is that Japan has substantial “fiscal space”, while Italy does not. Italy’s government currently spends about 49% of GDP, whereas in Japan government spending is roughly 39% of GDP. (BTW, 10% of GDP is a lot.) Japan actually has a slightly larger budget deficit, as the difference in taxes is even greater. But investors understand that Japan still has lots of room to raise tax revenues, if they are needed in the future.
After taking office in 2013, the Abe government wisely raised the national sales tax from 5% to 8%. Another increase to 10% is scheduled to occur later this year (although it could be delayed.) In contrast, Italy already has a 22% VAT, higher than in France, Germany, or the UK. A few Nordic countries have slightly higher rates, but they have less of a problem with tax evasion than Italy. Investors understand that Italy will have difficulty raising tax rates much further, before falling onto the down slope of the Laffer Curve. Hence the elevated default risk for Italian debt.
I don’t usually comment on twitter attacks, but Dilip directed me to a tweet that criticized an earlier post I did, which made some of the same points, but more briefly. Someone named Pavlina Tcherneva took me to task for supposedly not understanding that Japan borrows in its own currency whereas Italy does not. Apparently, on twitter one does not actually have to read a post before calling it “embarrassing”, as I clearly made that point in the post she referenced:
MMTers would say that Krugman doesn’t understand the distinction between Italy using the euro and Japan having its own currency (with zero default risk.) In fact, it’s the MMTers that don’t understand that having your own currency doesn’t guarantee low rates if investors believe that the only way you’ll be able to handle your debt is via inflation.
FWIW, I suspect one difference is that Japan has far lower government spending than Italy, and thus more room (fiscal space) to raise taxes before relying on money creation.
Her other criticism was that I was wrong in claiming that Japan had more fiscal space, which I supported by pointing to its lower level of government spending. For some reason she refuted my government spending claim by pointing to comparative government public debt data, not the government spending data I clearly referred to. And then she added, “check your data”. I gather this sort of snark is business as usual on twitter.
Again, fiscal space is about the ability to finance future government spending. To the extent that the current stock of debt matters, it’s already picked up by the interest component of current government spending. Japan’s not likely to default because there’s no reason for a developed economy spending 39% of GDP to default on its public debt. I’m not certain Italy will default either, but the risk is clearly greater with government spending at 49% of GDP. Italy has less room to maneuver and a far less responsible government, at least in terms of its public finances.
READER COMMENTS
Mark Z
Mar 21 2019 at 7:08pm
I would think that having your own currency, with which you could effectively default by inflation at will, would drive a country’s interest rates up, not down. Being on the Euro constrains Italy’s ability to do this, and should put creditors more – not less – at ease.
Maybe the argument is that, since Italy is tied to the Euro, it’s more likely to formally default than Japan, but bond holders lose either way whether the country formally defaults or just inflates the debt away. I’m not sure I’d be willing to lend at a lower rate to someone who can effectively change the terms of the load at will merely on the basis that ‘at least I can be more certain they’ll give me something back.’ I think this point actually works against Italy.
C
Mar 22 2019 at 2:29pm
That’s a really reasonable point. I suppose if you’re a country that borrows in something other then it’s own currency then default becomes more likely because inflating isn’t an available option. To a lender the difference between defaulting and inflating wouldn’t seem to be that great or that’s what I’d think; maybe the people lending have a more nuanced view.
Benjamin Cole
Mar 21 2019 at 8:41pm
I agree with this post, and I cannot understand why people lend to France or Italy or even Greece again for such small amounts of interest. I suspect most European nations cannot raise taxes anymore.
I guess it is true what Ben Bernanke says, that there is a global glut of capital. Cap rates on industrial properties along the West Coast are down to 3%.
Many nations can borrow at 0%. A few nations are paid to borrow.
If in the future more nations are paid to borrow money…The topic of government finance will have to be addressed anew.
BC
Mar 22 2019 at 2:03am
“I cannot understand why people lend to France or Italy or even Greece again”
What haircut did private Greek bondholders end up taking after all of the bailouts? Wikipedia says private banks took 50% haircut but the haircut was “effectively reduced due to bank recapitalisation and other resulting needs”. I also don’t know how private European “private banks” really are. Maybe, people lend to Greece with an expectation of IMF/ECB/German bailouts that effectively create a floor on default recovery rates. Sovereigns can be too-big-to-fail too.
ChrisA
Mar 22 2019 at 9:44am
At the end of the day the ECB will be forced to bail out France or Italy to keep the EU show on the road. This is why their bond yields are so low. If the ECB allow Italy for instance to default, the fall out in Europe would be enormous.
Lorenzo from Oz
Mar 22 2019 at 6:28pm
Japan is more like a Protestant country. Italy is a Catholic country. Yes, dominant religion does appear to affect interest rates on public debt.
https://www.bbc.com/news/magazine-18789154
As different religions come with different attitudes to time, this is not nearly as weird as folk might think.
https://www.youtube.com/watch?v=A3oIiH7BLmg
Lorenzo from Oz
Mar 22 2019 at 6:36pm
Japan is more like a Protestant country. Italy is a Catholic country. https://www.bbc.com/news/magazine-18789154
As different religions are associated with different attitudes to time, that dominant religion can affect interest rates is rather less surprising than it sounds.
Lorenzo from Oz
Mar 22 2019 at 6:37pm
A rather fun video from psychologist Philip Zimbardo on attitudes to time.https://www.youtube.com/watch?v=A3oIiH7BLmg
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