|No.61 February 4, 2003|
|The Risk Premium Warning on Japanese Government Bonds|
The phenomenon of diminished international confidence in the creditworthiness of JGBs has been observed in the past. For example, in the period after 1932, when Japan started issuing JGBs in large quantities and the Bank of Japan (BoJ) began underwriting this process, yields on sterling-denominated JGBs soared above the yields on comparable gilts issued by the British government. These market warnings went unheeded, and the country pursued a "Financial Fortress Japan" seclusion policy that focused on isolating the country from overseas financial markets to keep interest rates low and thereby enable the continued issuance of a high volume of JGBs.
Today, the ratio of outstanding government debt to GDP has reached a level comparable to that recorded in the latter stages of WWII in Japan and the United States. The pace of the rise in outstanding debt, however, exceeds that recorded during the Takahashi regime in Japan (1932-36) as well as during the New Deal in the United States--both periods of unrestrained classical Keynesian fiscal expansion.
Under the policy of quantitative monetary easing that the BoJ has been implementing since March 2001, the influence of zero interest rates has been gradually extending to the market for long-term government bonds, paradoxically restricting the inflation expectations that should naturally be incorporated into long-term interest rates. For this reason, there is concern that the markets may demand an even greater JGB risk premium if such non-orthodox methods as JGB underwriting by the BoJ under an inflation targeting policy--as many currently advocate--are pursued.
One suggested solution is the adoption of a non-Ricardian fiscal policy, which would couple higher spending to stimulate the economy with promises not to raise taxes in the future. Yet, the high level of existing debt and the rapid aging of Japan's population both suggest that such a policy has a low probability of success. Conversely, the dangers of possible non-Keynesian effects (suppression of economic growth due to higher long-term interest rates) cannot be ignored if investors start to demand a higher JGB risk premium than currently exists.