1. Consolidate
Taxes now take about 28 percent of Japan’s GDP, so if Japan raised the consumption tax by 12 to 32 percentage points, it could whip the debt. But this may be politically impossible, because of the economic pain involved. When Prime Minister Shinzo Abe recently succeeded in raising the tax from 5 percent to 8 percent, Japan’s economy experienced a severe contraction. That echoes a similar experience in 1997. Why exactly Japan’s economy is so vulnerable to tax increases isn't clear -- after all, the U.S. recently carried out a similar tax hike with far less pain. But whatever the reason, the pain associated with tax increases means that getting to a sustainable level of taxes looks politically unlikely as well.
So if my friends in Japan are wrong, and consolidation isn't in the cards, that leaves monetization of debt as the only option to avoid a sovereign default. The Bank of Japan will be asked to pick up more and more of the burden of buying Japanese government bonds. Printed money will replace corporate savings and household pension funds as the chief source of demand for bonds. This is alreadyhappening.
2. Monetize
What will be the result of debt monetization? That depends on whether it leads to inflation. Without inflation, interest rates will simply go lower and lower, and the government will be able to roll over its debt more and more cheaply. In other words, the situation that has prevailed for the past two decades will continue. But if inflation strikes, it could rise high enough to hurt growth, and therefore tax revenue, severely. That would mean game over -- Japan’s government would be forced to default (or to hyperinflate, which amounts to a messier version of the same thing).
3. Default
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The fact is, no one really knows what causes high-inflation episodes to begin. The Japanese central bank is embarking on a road that no country has ever traveled before -- a bold experiment to test the hypothesis that debt monetization can sustain an infinite ratio of government debt to GDP. It is being forced to do this by the dysfunctional nature of the Japanese political system, combined with Japan’s unfavorable demographics. I, for one, am interested to see where it goes.
