A wind of austerity blowing from London has brought an unseasonal chill to the barbecues, strawberries and Pimm’s parties that mark the British summer. The first coalition government since Winston Churchill’s in World War II is sending shivers down everyone’s spine with grim talk of deep spending cuts and protracted economic gloom.

David Cameron, the young British prime minister, has been warning of “inevitably painful times that lie ahead of us” as the Conservative-Liberal government tackles a government debt problem “even worse than we thought.”

Meanwhile in Japan, where spine-tingling ghost stories tend to be as much a feature of the traditional summer as yukata, unagi and furin bells, warnings of fiscal doom from new Prime Minister Naoto Kan are even more frightening.

“The state of Japan’s public finances is now dire, being the worst of any developed country,” Kan told the Diet in his policy speech. “As seen in the instability in the eurozone which originated in Greece, we risk fiscal collapse if we neglect mounting public debt and lose confidence in the bond markets.”

Conventional wisdom certainly supports Kan. By IMF reckoning, Japan’s gross public debt already is more than double the size of its GDP. That’s far worse than Greece (115%), not to mention the U.S. (83.2%), Germany (72.5%) or the U.K. (68%). Surely Japan’s public debt is a source of high anxiety?

Most knowledgeable economists, if they are being honest, will answer “no.” Instead, they believe the Japanese government’s real priority should be to end deflation and restore positive nominal growth. Accomplish that, and the public-debt problem will be greatly eased. Cut public spending or raise taxes prematurely while there is still insufficient private demand and too much idle capacity, and you consign the Japanese patient to an even lengthier stay in hospital.

According to Kan, the “dire” state of Japan’s public finances is “owing to a large number of expensive public-works projects and tax cuts, chiefly in the 1990s, as well as the steep increase in social security costs as a result of our rapidly ageing society.”

Of course, it is very much in the interest of Kan’s Democratic Party to finger waste by the Liberal Democrats -- think of all those lovely “roads and bridges to nowhere” -- after ousting them from power last year, just as Cameron is blaming profligacy by the U.K.’s last Labour government, ignoring the fact that the recent huge jump in U.K. debt stems largely from bailing out the banks.

The other side of Japan’s debt equation gets scant acknowledgment by Kan. It is the halving of government revenue since the bursting of the late-1980s asset bubble.

“Japan is not living beyond its means; it’s living below its means,” Peter Tasker, a co-founder of fund manager Arcus Investments, told me. “The real driver of the deficits has not been spending by the government but less tax.”

You would not think it by reading news reports, but in absolute terms, Japan’s public debt is still dwarfed by that of the U.S., to the tune of trillions of dollars. What has ballooned, after two decades of economic stagnation, has been the share of public debt to Japan’s GDP. Meanwhile, the American economy has powered ahead.

On other international gauges, Japan’s public finances hardly rank as “dire.” The ratio of Japan’s budget deficit to GDP is below that of the U.S. or the U.K., while the share of tax in the economy, at 27.9%, is one of the smallest of any industrialized country, offering plenty of scope, like the U.S. (28.3%), to increase tax revenue when growth permits.

Crucially, Japan has run a current-account surplus -- apart from brief lurches into the red last year and during the 1990s -- for almost three decades. In April, thanks largely to booming exports to China and the rest of Asia, about ¥40 billion flowed into Japan each and every day.

This helps explain why 94% of Japanese government bonds (JGBs) are bought by local investors, and why the interest the government has to pay on these bonds can be kept so low. Greece, in contrast, has a large current-account deficit that it has to fund, and 70% of its government debt is held by foreigners. The U.K., too, is dependent on foreign buyers for 28% of its government securities, or “gilts.”

“As things stand now, it is very hard to foresee a collapse in confidence leading to capital flight from Japan,” Tasker said. “You would need the gross amount of savings to fall, most likely from mass unemployment as a result of a real depression. Otherwise, the private sector will stay in Japan and continue to finance the deficit. Japan is not like Greece. It’s not politically fractious and explosive. It doesn’t have one class of very wealthy people, with all the money, who might take fright and take it all overseas. Japan’s wealth is much more evenly distributed.”

“The state of Japan is a scandal, an outrage, a reproach,” wrote Paul Krugman, the Nobel economics laureate. “Sixty years after Keynes, a great nation -- a country with a stable and effective government, a massive net creditor, subject to none of the constraints that lesser economies face -- is operating far below its productive capacity, simply because its consumers and investors do not spend enough. That should not happen; in allowing it to happen, and to continue year after year, Japan’s economic officials have subtracted value from their nation and the world as a whole on a truly heroic scale.”

Krugman’s remedy for pulling Japan out of its slump is for the Bank of Japan to deliberately create inflation by directly purchasing public and private assets on a massive scale; in effect, by printing money. The Bank of Japan, however, has strongly resisted adopting an inflation target set by the central government -- a policy nowadays followed by the central banks of the U.K., Canada, Australia, New Zealand, South Korea, Brazil and Mexico -- citing its hard-won independence.

Hopes that Kan’s new administration would force a change of heart were dealt a blow by the new finance minister, Yoshihiko Noda, who praised the Bank of Japan for handling monetary policy in “an appropriate, flexible manner.”

That’s certainly not how foreign economists see it.

“Since the BoJ got its independence in 1998, we’ve had 12 years now of almost continuous deflation. The mandate of the BoJ is to promote the healthy development of the Japanese economy through price stability. Well, continuous deflation for 12 years is not price stability. The BoJ has not done its job,” Robert Feldman, managing director of research at Morgan Stanley MUFG Securities, told me.

The other obstacle to reform is the Ministry of Finance, which is responsible for managing public finances. In selling JGBs to finance the deficits, the MoF has benefitted greatly from falling prices, which have made the meagre nominal yields on government debt seem attractive in real terms. Not only the state-run Japan Post Bank, but also Japan’s private banks invest most of their available cash in JGBs. In effect, the Japanese banking system acts as a gigantic government bond fund.

Stephen Church, a research partner at Japaninvest, believes the ministry has a vested interest in prolonging deflation as it keeps a tight lid on the interest burden of servicing government debt.

“The prime causes for the debt problem and its intractability lie at the feet of the Ministry of Finance and the Bank of Japan, who are imposing perverse policies which are ruining the Japanese economy,” Church says.

Kan has resorted to some macho posturing in order to distance himself from the hapless Hatoyama. His cabinet, he says, should show the courage and resolve of the Kiheitai, a militia from Kan’s home region which helped to overthrow the Tokugawa shogunate.

The truth is far less dramatic. Restoring Japan’s economy to health would not require any clash of arms or bloodshed. The measures that need to be taken have all been tried and tested elsewhere, and declared safe and sensible.

Once a healthy rate of inflation is attained, and Japanese start spending freely again, the government can start to raise taxes and reduce expenditure. It can also sell off hundreds of trillions of yen in public assets. The Ministry of Finance still owns one-third of NTT, i.e., 530 million shares, and half of JT Group (the old Japan Tobacco) -- another 5 million shares. Then there are all the water and sewerage works and transport companies still owned by local governments that could go on the block. The only loss in all this would be to the pride and reputation of some recalcitrant elite bureaucrats. And let’s face it, few tears would be shed. ❶