Why is the public debt situation in Italy worse than in Japan?
By Scott Sumner
Japan’s public debt is much higher than in Italy, as a share of GDP (roughly 240% vs. 130%, though sources differ). The difference in net debt is not nearly as large, but still significant. And yet Italy must pay a substantial risk premium on its public debt (third largest in the world), whereas Japan (with the second largest public debt) pays roughly zero interest rates on borrowed funds.
In previous posts I’ve discussed one difference; Japan borrows in its own currency whereas Italy borrows in euros. Thus buyers of Italian debt face a positive default risk, whereas buyers of Japanese debt face a near-zero default risk.
But this doesn’t fully explain the difference. While the ability to print money allows a country to avoid outright default, the side effect is often inflation. If investors feared that the authorities would be forced to pay its bills by printing money, then inflation expectations would rise and this would increase nominal interest rates on long-term bonds (via the Fisher effect.)
Having the ability to print one’s own currency does not, in and of itself, insure low interest rates on public debt, as the US learned in the 1970s and early 1980s. Turkey paid rates of over 50% per year during the 1990s. So why are Japanese interest rates so low? In other words, why don’t investors fear Japanese inflation?
I suspect that one important difference is that Japan has substantial “fiscal space”, while Italy does not. Italy’s government currently spends about 49% of GDP, whereas in Japan government spending is roughly 39% of GDP. (BTW, 10% of GDP is a lot.) Japan actually has a slightly larger budget deficit, as the difference in taxes is even greater. But investors understand that Japan still has lots of room to raise tax revenues, if they are needed in the future.
After taking office in 2013, the Abe government wisely raised the national sales tax from 5% to 8%. Another increase to 10% is scheduled to occur later this year (although it could be delayed.) In contrast, Italy already has a 22% VAT, higher than in France, Germany, or the UK. A few Nordic countries have slightly higher rates, but they have less of a problem with tax evasion than Italy. Investors understand that Italy will have difficulty raising tax rates much further, before falling onto the down slope of the Laffer Curve. Hence the elevated default risk for Italian debt.
I don’t usually comment on twitter attacks, but Dilip directed me to a tweet that criticized an earlier post I did, which made some of the same points, but more briefly. Someone named Pavlina Tcherneva took me to task for supposedly not understanding that Japan borrows in its own currency whereas Italy does not. Apparently, on twitter one does not actually have to read a post before calling it “embarrassing”, as I clearly made that point in the post she referenced:
MMTers would say that Krugman doesn’t understand the distinction between Italy using the euro and Japan having its own currency (with zero default risk.) In fact, it’s the MMTers that don’t understand that having your own currency doesn’t guarantee low rates if investors believe that the only way you’ll be able to handle your debt is via inflation.
FWIW, I suspect one difference is that Japan has far lower government spending than Italy, and thus more room (fiscal space) to raise taxes before relying on money creation.
Her other criticism was that I was wrong in claiming that Japan had more fiscal space, which I supported by pointing to its lower level of government spending. For some reason she refuted my government spending claim by pointing to comparative government public debt data, not the government spending data I clearly referred to. And then she added, “check your data”. I gather this sort of snark is business as usual on twitter.
Again, fiscal space is about the ability to finance future government spending. To the extent that the current stock of debt matters, it’s already picked up by the interest component of current government spending. Japan’s not likely to default because there’s no reason for a developed economy spending 39% of GDP to default on its public debt. I’m not certain Italy will default either, but the risk is clearly greater with government spending at 49% of GDP. Italy has less room to maneuver and a far less responsible government, at least in terms of its public finances.