Japan Reaches for Stimulus. The Bond Vigilantes Will Pounce.

Sanae Takaichi became Japan’s first female prime minister on Oct. 21. (Chung Sung-Jun/Getty Images)

About the author: Desmond Lachman is a senior fellow at the American Enterprise Institute. He was previously the chief emerging market economic strategist at Salomon Smith Barney and deputy director in the International Monetary Fund’s policy development department.

All isn’t well in the Japanese economy. The Japanese yen is sinking. Long-term interest rates are rising close to their highest levels in more than 20 years. The government is drowning in debt, and inflation is above the Bank of Japan’s 2% inflation target.

Yet Sanae Takaichi, Japan’s new prime minister, thinks now is a good time to unleash a large fiscal stimulus and ease monetary policy.

Takaichi is expected to finalize this week a fiscal stimulus package of roughly $110 billion, worth more than 2% of the country’s gross domestic product. Making matters worse, she is also suggesting that the Bank of Japan maintains an accommodative monetary policy.

Takaichi, a hard-line conservative, ran this fall on the promise to increase spending to spur domestic manufacturing investment. But her policy approach risks exacerbating Japan’s public debt problem, accelerating the yen’s decline, and spiking long-term Japanese interest rates. That, in turn, could reverse capital flows from the rest of the world to Japan and renew trade tensions with the U.S.

It would be a gross understatement to say that Japan has a major public debt problem. At around 240% of GDP, Japan’s public debt ratio is more than double that of the U.S. Its consolidated budget deficit is more than 6% of GDP.

To get its public debt on a meaningful downward path, Japan would need to run consistent primary budget surpluses—surpluses excluding interest payments—while getting on a more rapid economic growth path. Without major economic policy changes, this looks like a remote possibility. Japan is currently running a 2.5% of GDP primary budget deficit, and its rapidly aging population makes it improbable that its economy can grow faster than its average rate of less than 1% over the past decade.

The last thing that an economy like Japan needs is a large fiscal stimulus that would widen the budget deficit. This is especially the case at a time when the economy is at close to full employment and when inflation is running above target. Yet that is the very thing that Takaichi is proposing.

Markets appear to have taken note of her irresponsibility. The 10-year and 20-year Japanese government bond yields have risen to 1.7% and 2.7%, respectively. Those are close to their highest rates this century.

As the prospective cost of rolling over Japan’s large debt mountain increases, the country risks tipping into a vicious cycle: Investors will demand yet higher yields on Japanese government bonds, making Japan’s public debt even less sustainable.

Markets have also ramped up pressure on the yen. Since it became apparent that Takaichi would become prime minister in October, the yen has sharply depreciated to its present level of around 154 to the dollar. That is its lowest level in nine months.

Further currency depreciation could put the Bank of Japan’s inflation target out of reach. It is estimated that a sustained 10% yen depreciation would add 0.5-1.0 percentage points to inflation.

Unfortunately, Japan’s economic size makes it unlikely that its problems will stay in Japan. One way we could get spillover effects to the rest of the world economy would be if higher long-term Japanese government bond yields give rise to the repatriation of Japanese capital. In recent decades, the outflow of Japanese capital has helped lift world financial markets.

And a weaker Japanese yen, coupled with Japan’s sizable external current-account deficit, could invite the Trump administration to impose additional punitive import tariffs on Japan. The administration just recently agreed to lower tariffs from 25% to 15% after negotiations with now-former Prime Minister Shigeru Ishiba. Japan’s economy is already feeling the impact of those pared back tariffs. Japanese government data released Monday showed its economy contracted for the first time in six quarters due to tariffs.

Takaichi should be working to minimize economic headwinds. That inevitably means she needs to stay on top of her country’s fickle trade relationship with the U.S. Her fiscal irresponsibility isn’t a wise first step.

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