Kenneth Rogoff thinks interest-rate hikes are inevitable and could pose a significant threat to the global economy

Could Japan become the world’s next great growth story? Billionaire and legendary investor Warren Buffett seems to think so. And the International Monetary Fund expects the Japanese economy to grow by 1.4% in 2023 – an impressive figure for a country whose population has steadily declined for the past 14 years.

But the Japanese economy could also be a ticking time bomb. Its labour market is tight, inflation remains stubbornly high despite the introduction of petrol subsidies, and the yen’s real exchange rate has reached a three-decade low. After decades of maintaining near-zero interest rates, it is unclear whether the Bank of Japan can raise them without sparking a systemic financial crisis.

While the BOJ’s new governor, Kazuo Ueda, has said that the Bank will maintain its ultra-loose monetary policy, he also acknowledged the global economy’s “very high uncertainty.” Given the forces driving up inflation and interest rates worldwide, it is increasingly clear that Japanese monetary policy can no longer be conducted in isolation.

Over the years, many investors have bet against the BOJ, shorting Japanese bonds on the assumption that the zero-interest-rate policy could not last. Time and again, the speculators were crushed. Now, however, the “widow-maker trade” might actually pay off.

The BOJ’s reluctance to increase its short-term policy rates is understandable, given that Japan’s gross government debt currently stands at 260% of GDP, or 235% of GDP after netting out US$1.25 trillion in foreign-exchange reserves. Should the Bank be compelled to raise its short-term policy interest rates by 3% – about half as much as the US Federal Reserve has – the government’s debt-servicing costs would explode.

Moreover, a sharp interest-rate increase would put enormous pressure on the Japanese banking sector, particularly if long-term rates were to rise as well. This is precisely what happened in the United States in March when the Fed’s monetary tightening triggered a chain reaction that led to the collapse of Silicon Valley Bank and several other financial institutions.

Hiking interest rates in an environment of near-zero interest rates, when investors expect rates to remain ultra-low forever, will be challenging, no matter how the BOJ frames its actions. But if inflation remains persistently high, policymakers will be forced to act. After all, markets will inevitably push up rates across the yield curve.

Over the past two years, as real interest rates have soared worldwide, they have declined in Japan, despite the rise in inflation. This is not sustainable in the long run, given the country’s deep integration into global financial markets.

As one of the first industrialised countries to grapple with population decline and a systemic financial crisis, Japan has served as the world’s macroeconomic laboratory for more than two decades. While some pundits cite Japan as evidence that enormous government debts do not matter, the fact is that they do. Like other highly indebted countries such as Greece and Italy, Japan has experienced extremely low average growth over the past three decades. In the early 1990s, Japanese GDP per capita reached 75% of US levels; it has since declined to less than 60%, even though the US experienced only modest growth during this period.

In addition to its debt problems, Japan’s economy is caught in the middle of the escalating rivalry between the US and China. Over the past few decades, as Ulrike Schaede notes in her insightful book The Business Reinvention of Japan, Japanese firms have found a high-value niche within the Asian supply chain. While the country’s most profitable companies may not be household names, primarily because many of them provide intermediate products to businesses rather than final products to consumers, they operate in high-tech sectors with huge markups.

But much of this economic reinvention has been based on taking advantage of China’s rapid growth. Now that the Chinese growth engine is sputtering, and with heightened geopolitical tensions threatening to make things worse, it is unclear whether this unique strategy can last.

At the same time, much like Europe, Japan faces the urgent need to boost defense spending. Alarmed by China’s growing assertiveness, especially in light of Russia’s invasion of Ukraine, the Japanese government has unveiled plans to double military spending to 2% of GDP in the next five years. With such spending likely to increase further in the long term, Japan will no longer be able to maintain low taxes by free-riding on the US defense budget.

To be sure, as the world’s third-largest economy (after the US and China), Japan has many tools to tackle its demographic and economic challenges. For example, it could confront outdated corporate social norms that discourage women from having children. It could also use public-policy tools, such as welcoming more immigrants.

But policies to stem decline will only bring forward the need for interest-rate normalisation. The most severe financial crises often happen where they are least expected. A resurgent Japan is good for the global economy, but resurgent Japanese interest rates could be a major risk.

*J Kenneth Rogoff, a former chief economist of the International Monetary Fund, is Professor of Economics and Public Policy at Harvard University.. Copyright: Project Syndicate, 2023, and published here with permission.