A man who looked like he might know how Sonny Rollins was supposed to sound waited for the train with his hands over his ears

December 19, 2012 § Leave a comment


Japanese government bond (JGB) yields have stayed exceptionally low since the mid-1990s, as can be seen in Figure 25. Contrary to the conventional wisdom — for example, the International Monetary Fund, credit rating agencies and so forth — Japanese government bond yields have stayed low even as the country’s fiscal deficits remained elevated and the government’s net debt ratio rose. The reasons are simple: 1) Japan’s debt is issued in its own currency, 2) the Bank of Japan can control government bond yields though its balance sheet and communication tools, and 3) the demand for government debt remains strong, as the country’s domestic private financial institutions hold the bulk of it.

The fear that bond market vigilantes or increased levels of government debt would cause Japanese government bonds to sell off suddenly and yields to spike sharply have proven to be spurious. In countries with sovereign currencies such as Japan, changes in long-term interest rates are fairly tightly correlated with changes in short-term interest rates; thus, long-term interest rates generally stay low when short-term interest rates are low.

Moreover, when observed core inflation and inflationary expectations are low, both short-term and long-term interest rates tend to stay low. Long-term interest rates are also driven by persistence, implying that long-term interest rates tend to stay low once they become low and stay high once they turn high. In sum, it would take a major shift in economic prospects to inspire a turnaround in long-term interest rates.

International credit rating agencies such as Moody’s have downgraded Japan’s government debt many times since the late 1990s (see Figure 26) based on the view that increased ratios of government deficits and debt to GDP entail increased credit risk. However, the evolution of Japanese government bond yields reveals that the downgrades of Japan’s sovereign ratings by Moody’s and other credit rating agencies have had no effect on yields.

The rating agencies seem unwilling to acknowledge that the credit risk profile of a government that issues debt in its own currency — such as Japan and the U.S. federal government — is very different from the credit risk profile of a government that issues debt in a currency that it does not control — such as the peripheral countries of the euro zone and U.S. state and local governments. Importantly, a central bank issuing bonds in its own currency can keep yields low for as long as it deems appropriate.

The Bank of Japan can and does control — and, indeed, may even target — Japanese government bond yields as appropriate through its overnight policy rates and other balance sheet tools, including large-scale asset purchases. Moreover, given its ability to issue its own currency, the government of Japan retains the ability to always service its yen-denominated debts barring some extremely low-probability but high-impact catastrophe.

Following Woodford (2001), as cited in Tcherneva (2010), it can be stated that for any sovereign government that issues debts in its own currency, such as Japan, its debt is merely a promise to deliver more of its own liabilities in the future. That is to say, a Japanese government bond is simply a promise to pay yen — which are merely additional government liabilities that happen to be non-interest bearing — at various future dates. It could perhaps be argued that a higher ratio of public debt to nominal GDP might under certain circumstances lead to inflation and a depreciation of the Japanese yen, but there are no operational barriers to prevent the government of Japan from servicing its debt. As such, Japanese authorities are theoretically free from obsessing about fiscal consolidation, and the country’s fiscal policy should focus on promoting public well-being and economic prosperity.  read more

PHOTOGRAPH: Bernhard Handick

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