When Japan's debt bubble bursts – watch out

Investors are understandably scared of the sovereign debt crisis unfolding in Europe, but they are ignoring a more definite and significantly larger sovereign debt catastrophe that is about to hit the world's third-largest economy: Japan.

The prelude to Japan's current crisis began in the early 1990s when its housing and stock market bubbles popped, leading to recession.

For the next 20 years, using flashy names like Fiscal Structural Reform Act, and Emergency Employment Measures, and Policy Measures of Economic Rebirth, the government cut taxes, increased spending, and borrowed money to finance itself. Once or twice the government found fiscal religion and raised taxes; however, the economy stuttered and taxes again were lowered and the stimulus story continued.

Today, 20 years into endless stimuli, the Japanese economy is beset by the same rot it was then, except that its debt has tripled – the ratio of debt to gross domestic product (GDP) stands at almost 200 percent, double those of the United States and Germany, and second only to Zimbabwe.

Washington should take heed, because the current US course is disturbingly similar to Japan's. There are several key lessons from Japan's decline, but the most important one is this: We must stop looking for government to be the source of sustainable growth.

Population declines spell trouble

A country that has ballooning debt needs to have an expanding economy to help the country outgrow its debt burden. Economic growth is driven by two factors, productivity and population growth. Though the Japanese economy may continue to reap the benefits of productivity, population growth is not in the cards.

Japan has one of the oldest societies in the developed world; every fourth Japanese person is over 65 years of age, and the population is shrinking. Due to cultural mores, workers are largely compensated not on merit but on seniority. Thus, young adults marry later in life, and have kids later.

This helps explain why the Japanese birthrate is one of the lowest in the world, a meager 1.37 per woman, well below the 2.1 figure needed to sustain a population. In addition, Japanese are xenophobic – there is little or no immigration into Japan. Though its debt is ballooning, GDP is unlikely to grow (it's more likely to decline) and thus debt-to-GDP and debt per capita will only rise.

Though debt has tripled over the past two decades, government spending on interest payments has not changed; in fact it even declined a little in the mid-2000s. This happened because the government's average interest rate paid on its debt declined from more than 6 percent in the 1990s to 1.4 percent in 2009.

This is about to change. Historically, more than 90 percent of Japanese government-issued debt was consumed internally by its citizens, directly or through its pension system. In the 1990s, the savings rate was very high, pushing the mid-teens, but as people get older, they retire and start drawing down their savings and pensions. Today, the Japanese savings rate is approaching zero, and will probably go negative in the not-so-distant future.

The Japanese economy operates on the (soon-to-be-proved-false) assumption that the government will always be able to borrow at low interest rates. As internal demand for debt evaporates – and it's approaching this level already – the Japanese government will have to start hocking its debt outside Japan.

When it does, it will face a rude shock in the form of higher interest payments. Japanese 10-year Treasuries now yielding 1.0 percent will not stand a chance against US or German bonds of the same maturities that yield 2.89 percent and 2.59 percent, respectively.

Interest-rate dilemma

To attract investors, Japan will have to offer much higher rates. Though they have their own fiscal problems, the US and Germany still have much lower indebtedness and superior demographic growth profiles.

Japan's stimulative, low-interest policy put the country in its debt trap: It cannot afford higher interest rates, and low interest rates are no longer stimulative to the economy.

In 2009, over a quarter of its tax revenue went toward interest payments. If the cost of its borrowing were to double (which it may soon), the increase in the cost of debt would equal the Japanese budgets for education and science and defense combined. Higher interest rates will probably trigger debt downgrades, which will drive borrowing costs up even more.

Higher taxes and the austerity measures that will undoubtedly follow, combined with higher interest rates, will slow down the economy further and drive Japan toward insolvency.

Unlike European countries that socialized their currencies and cannot on their own print euros, Japan has complete control over its printing press. Also, unlike Greece, which, due to its small size, could be bailed out by Germany and other European friends (and a bit of help from the ever-willing International Monetary Fund), Japan is too big to be bailed out.

Defaulting on its own debt, especially when the majority of it is owned by its own citizens, is a political impossibility. This is why governments that have control over their currencies don't default – they print. And print they will, in Japan! Decades of deflation will turn into hyperinflation, which will destroy the purchasing power of citizens' savings and collapse the yen.

Consequences for America

The consequences of what is slowly but surely unraveling in Japan is important to US investors, as it will not stay in Japan but will spill into the US and rest of the world.

Along with China, Japan is the one of the largest holders of US government debt, and its demand for our fine paper will decline. Most likely, Japan will start selling Treasuries. And to make things worse, Japan will start competing with the US, not just in cars and electronics, but for buyers of sovereign government debt. Japan will export inflation, inflation will rise globally, and so will interest rates.

Had I written a similar article five years ago, I would have been "wrong," as today the Japanese economy is still ticking. Timing bubbles – and Japan is in the late stages of an enormous debt bubble – is very difficult, as bubbles tend to last longer than rational observers expect. But every year that the Japanese bubble doesn't burst and debt swells, the eventual pop just grows more catastrophic.

Japan is past the point of no return; its fiscal and demographic problems were created over decades and will take decades to be resolved. In the meantime, its citizens will pay the painful price. Japan is proof that a country cannot borrow itself to prosperity. The US and other developed nations still have a chance to make the politically difficult but right decision to cut government spending and stop looking for government to be the source of sustainable growth, which it never is.

Vitaliy N. Katsenelson is a portfolio manager/director of research at Investment Management Associates in Denver. He is the author of "Active Value Investing: Making Money in Range-Bound Markets." A version of this article originally appeared in Institutional Investor magazine.