Tuesday, November 29, 2011

Italy and Japan

Consider the following differences between Italy and Japan. Italy has a history of lower budget deficits, as well as forecast budget deficits for the next few years that are dramatically lower than those forecast for Japan:

(All data is from the OECD; figures for 2011 and 2012 are forecasts.)

Italy's debt to GDP ratio has remained roughly constant over the past 15 years, while Japan's has climbed steadily higher:

Both countries have had relatively poor economic growth over the past decade, with little difference between them:

And yet, despite all of this, yields on Japanese 10-year government bonds hover around 1.0%, while yesterday the Italian government was forced to pay nearly 8.0% to borrow money for 10 years. Given how much worse Japan's public finances look when compared to Italy's, it seems unlikely to me that investors are demanding higher interest rates from Italy simply because they are worried about excessive budget deficits or debt.

So what explains the dramatic disparity in investor willingness to lend to Italy compared to Japan? There are three crucial differences between Italy and Japan that, when put together, create a coherent story about what lies at the heart of this crisis:

1. Japan has the ability to create its own currency, while Italy does not.
2. Japan has been running current account surpluses, while Italy has had a current account deficit for the past several years.
3. Japan can borrow at 1.0% while Italy must pay much more to borrow.

Item #1 on this list has helped to cause the crisis for the reasons noted by Paul DeGrauwe: by giving up its own currency, Italy lost the important backstop on its government borrowing costs that countries that can borrow in their own currency have. This was a key prerequisite for this crisis to take hold.

Item #2 on this list is important because at its heart, this crisis can be seen as a balance of payments problem. Italy (along with the rest of southern Europe) has been dependent on capital flows from northern Europe to meet its borrowing needs, as reflected by the large current account deficits Italy has experienced in recent years. But private capital flows are notoriously fickle, and when they stop, a balance of payments crisis can ensue. What we're seeing in southern Europe right now is a variation of that.

Item #3, you'll notice, is simultaneously cause and effect. This is the self-fulfilling downward spiral that Italy has become trapped in. Once the necessary conditions were established by item #1, and once Italy became vulnerable to a stop in private capital flows thanks to item #2, the dynamics inherent to self-fulfilling crises took hold -- and events have mercilessly followed that unforgiving logic to the point in which Italy finds itself today.

On the other hand, government deficits in Italy had little to do with getting it into this mess. Which is why all of the stern talk in Europe about setting up firm and credible ways to discipline countries into being fiscally responsible will do nothing to end the crisis in the short run, and nothing to prevent it from happening again in the long run.

UPDATE: I should have mentioned that item #1 goes hand-in-hand with one additional ingredient to Italy's current predicament: the lack of a flexible exchange rate that could adjust in response to the stop in private capital flows. Such an exchange rate adjustment would improve Italy's external competitiveness and reduce its relative income, which in turn would help Italy bring its current account back toward balance. Again, the point is that this crisis is primarily a balance of payments problem, not a budget deficit problem.


  1. Kernow Castellan11:23 AM

    There is another big difference - Japan's population is schrinking, as a result, their GDP-per-person has outgrown Germany in the last 10 years. 

  2. Anonymous1:47 PM

    Between 2000 and 2010 Japan's population grew by 0.2%, while Italy's grew by 3.6% and Germany's grew by 0.8%.  Not very large differences over a ten year period.

  3. Nice post Kash, congrats...I think that Japan funds its fiscal deficits domestically...that should be some additional help. Moreover a look at World Bank data could tell us that while domestic credit to private sector is contracting, during the last decade, total domestic credit is increasing. I'm wondering whether that means that the public sector is crowding out the private sector. Any comment would much appreciated...cheers

  4. KeithOK4:00 PM

    I'm not sure why this would be such a big advantage.  You have fewer people to pay back the debt in the future.

  5. KernowCastellan5:51 PM

    True. But the markets like the obviously strong track record of a country that has a very strong GDP-per-capita growth. It shows long-term stability, and a culture of continual productivity gains, which results in a strong balance-of-trade. See the recent Economist artilcle on this - http://www.economist.com/node/21538745

    Italy (and the rest of Club Med) do not have such a culture, and to expect that to change anytime soon is madness. Anyone who has spent a lazy afternoon in the town square watching the governement employees 'working' will recognise this.

  6. And no.1 is by far the most important. You can't improve no.2 without the ability of the currency to reflect the current state of the economy and to act as an appropriate risk transfer. Forget this internal devaluation malarkey. Making people unemployed and poorer within their own country is far different to a currency depreciation that actually makes them more competitive and isn't a job destroyer. Living in a country like Australia, I can appreciate the shock absorber characteristics of a freely floating sovereign currency, as can the rest of the population (whether they know it or not).

    Italy's major problem is the fact that it's entire debt is in a foreign currency, the Euro. The country must generate Euros to make every payment. There is no resorting to creating currency. The ability does not exist for them. And the powers that be think it's a terrific idea, through austerity, to deprive the country of the ability to even generate the required amount of Euros! I guess that's what happens when you cede your ability to respond adequately to aggregate demand shocks....

  7. The Japanese Government has a yen deficit, but the Japanese Gestalt has a vast Yen Surplus.
    The Italian government and the Italian gestalt have a euro deficit.

    Japan will explode violently once its ageing population tips the export/import ratio into imports, but until then, the state could probably abolish tax and run 20-30% of GDP deficits without breaking out of 1.5%

  8. I don't think that crowding out is the right way to think about it, because there is plenty of savings sloshing around in Japan's economy to fund increased private sector borrowing.  But the fact that Japan runs current account surpluses does indeed mean that it is good at funding its fiscal deficits domestically.  Interestingly, Italy is also unusually good at funding its own fiscal deficits domestically, despite the current account deficit.

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