As a former senior official at the Bank of Japan, and now chief economist at JP Morgan in Tokyo, Masaaki Kanno has the rare ability to view Japan’s financial situation from both the inside and the outside. Based on what he’s seen, he’s worried. Japan is not only mired in a downward creep of falling prices, Kanno says, but the government’s debt is more than twice the annual gross domestic product of the whole country and is likely to get bigger in the coming years.

“The government should let people know how bad deflation is,” Kanno said during a panel discussion featuring some of Japan’s brightest financial minds at the FCCJ on March 29.

“Japanese journalists don’t want to tell the truth to the Japanese public,” he said. “The current public pension system will not be sustained. Why don’t Japanese press reporters ask what the BOJ should do to solve the problem? I’m hoping that the foreign press will write about this.”

In the view of Kanno and other economists, Japan could become like Greece in the long term if it doesn’t rein in its massive debt. The Hatoyama government’s budget, announced in early April to kick off the fiscal year, promises to spend a record trillion dollars this year on building a European-style welfare state, by issuing an unprecedented ¥44.3 trillion of new bonds this year.

This has Kanno and others increasingly worried about a “JGB asset bubble” in Japanese government bonds, which are fueling a public debt that is the highest among advanced economies. Japan’s debt, mostly owed to creditors within Japan, is more than 200 percent of annual Gross Domestic Product, compared to 113 percent in Greece, 50 percent in Spain and 69 percent in the U.S., according to New York-based investment research group ISI. “I’m actually envious of the Greek situation,” says Kanno. “They have market pressure forcing them to take action sooner than later. In Japan, even if the government tries to cut spending, social security costs will likely grow ¥1 trillion every year. The government deficit is likely to grow forever, in a sense.”

“I think the debt is unsustainable, even if it’s stable at the moment,” Richard Jerram, head of Asian Economics for Macquarie Capital Securities, said during the discussion. “You just keep piling up more and more debt, and nothing changes to solve the problem. If you have persistent deflation for the next five to 10 years, the public finances are going to crash.”

Yet the government seems to be going in the opposite direction, toward more spending and even bigger deficits. Prime Minister Yukio Hatoyama has pledged to transfer funds from “concrete to households” by giving out ¥13,000 a month per child and introducing free tuition at public high schools starting this spring. He said the government won’t release a fiscal discipline strategy until June. “When thinking about the long-term fiscal framework, vague discussions alone won’t do,” Hatoyama told reporters in early April. “We need to show where we are heading two, three years ahead on fiscal reconstruction, possibly through some numerical form.”

Citing Hatoyama’s lack of clear strategy, Standard & Poor’s cut its outlook for Japan’s sovereign rating in January, and other agencies are reportedly threatening downgrades if Japan issues more debt. The Nikkei reported in April that the government may have to cancel spending plans or issue more bonds because it could face a shortage of ¥7 trillion in funds over the next two years to pay for social programs.

Asian Development Bank President Haruhiko Kuroda also has a dual insider-outsider perspective. He, too, thinks Japan’s debt is “very serious,” even though most debt is held within Japan, not overseas, and Japan continues to enjoy a current-account surplus. “The Greek problem is largely an external debt problem. That does not mean that the Japanese debt situation is benign and can be left indefinitely,” Kuroda said during a press conference at the FCCJ on March 17. “Given the aging population and health-care and pension costs which could continue to rise, Japan will have to deal with how to fund expenditure on social programs in coming decades. Solving it is absolutely necessary. It’s unsustainable domestically.”

The root problem, all agree, is that Japan’s economy is not likely to grow enough to bolster the tax base needed to pay for increasing social welfare costs. Deflation is not helping the situation, because it indicates that domestic consumer demand is still too weak to drive economic expansion. Prices in Japan have been falling for 12 straight months, according to the Ministry of Internal Affairs and Communications’ Statistics Bureau. Land prices in some suburban areas are roughly half what they were 20 years ago. Although Finance Minister Naoto Kan and Bank of Japan board members are promising to stem the price slide, many financial analysts are warning that further “de-flay” could delay any economic recovery.

Kanno says deflation is leading to a rise in banks and individuals choosing what they wrongly assume are “risk-free assets” in JGBs, which yield more than bank deposits. While 94 percent of the government’s debt is currently held by domestic investors, they won’t be able to fund the government forever, as tax revenue flattens amid higher demands for welfare spending. “People forget about the credit crisis and the risk of JGBs. The JGB bubble will eventually burst someday. Japan’s fiscal problem is a flow problem. Will domestic investors finance the deficit forever?” Kanno asks. He says that within three to five years the government deficit will exceed tax revenue, and debt-servicing costs will likely rise. “All the best policies are going to have short-term pain to get the best long-term results,” Kanno says. “Without taking these risks, Japan will fall into a trap (from) which we can’t find an exit.”

Waseda University professor Eisuke Sakakibara, speaking at the March 29 panel discussion, says Japan at least has a large accumulation of household savings –about 300 percent of GDP – to rely on for now. While also worried about the debt, he remains in favor of spending to spur economic growth. “The current government should overhaul the previous government’s policies,” says Sakakibara. “The government should be following the European Union states, not the United States, and create a welfare state in Japan.”

Yet Sakakibara, known as “Mr. Yen” when he was vice minister of finance in the 1990s, raised eyebrows at the FCCJ by saying Japan’s deflation is not necessarily a bad thing. “We aren’t in a deflationary spiral. I do not think mild deflation in Japan is a bad thing. We should enjoy mild deflation, rather than ponder it as a disease.”

Sakakibara says deflation is due to economic integration, as intraregional trade in East Asia reaches 57 percent of all the region’s trade. “If you import cheap goods from China, then naturally prices will come down, compared to the conventional prices we’re used to in Japan. It’s very difficult to avoid deflation by monetary policies, when it’s because of structural changes. Relatively slow deflation is something given.”

Kanno and Jerram disagreed, saying deflation will further dampen economic growth and lead to an eternally climbing debt-to-GDP ratio.

“Deflation is a bad thing. People don’t want to spend money, that is the big problem,” says Kanno. “Now deflation and the economy are affecting each other. It’s not easy to see what is the egg and what is the chicken. Without ending deflation, the government’s target of 3 percent growth is impossible.”

“Deflation corrodes the health of your economy long term,” says Jerram. “Non-manufacturing companies are more pessimistic than they were a year ago. Deflation means it’s impossible to fix the fiscal problems in the economy without some nominal growth.”

The problem, says Jerram, is that the government is more focused on fulfilling spending promises than budget cuts. “The government has too many other things to worry about, such as political scandals and U.S. relations. The government is trying to pretend to deliver on election promises – some of which are good, some of which are silly – but actually doing nothing. I think the government doesn’t understand it well enough. To be fair to them, they just took office six months ago, and they’re starting to see how bad things are. You need to tell the public that the last 10 to 15 years have been a terrible mistake.”

The question is, will the Japanese media tell the public? ❶