Japan’s downgrade: A peek at America’s future?

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Let’s take a look at a country with mounting national debt, big fiscal deficits, low growth, and no solid plan for dealing with those problems due to incessant political bickering. In this case I’m talking about Japan, but many of you could have rightly assumed I was talking about the U.S. That’s why what happened today to Japan could very well be in America’s future, with serious consequences for the global economy.

Standard & Poor’s on Thursday downgraded Japan’s long-term credit rating. Granted, the rating is still very, very strong, but the action does indicate how investors are growing nervous about the deteriorating state of government finances even in those economies considered to be the bedrock of the global economy.

Japan has been heading here for a while. Its government debt to GDP ratio, at around 200%, is already the highest of any industrialized country. Its economy has been in a slow-motion economic crisis for two decades, yet policymakers have proven incapable of undertaking the sort of reforms necessary to get growth going again. And despite talk of a hike in the consumption tax and other measures to shore up state finances, the latest budget, passed in December, is anything but austere, with borrowing expected to exceed tax revenues. Thus giant budget deficits are expected to continue. S&P noted all this in its statement on the downgrade:

The downgrade reflects our appraisal that Japan’s government debt ratios–already among the highest for rated sovereigns–will continue to rise further than we envisaged before the global economic recession hit the country and will peak only in the mid-2020s. Specifically, we expect general government fiscal deficits to fall only modestly from an estimated 9.1% of GDP in fiscal 2010 (ending March 31, 2011) to 8.0% in fiscal 2013. In the medium term, we do not forecast the government achieving a primary balance before 2020 unless a significant fiscal consolidation program is implemented beforehand.

Nor are the underlying dynamics within the population and economy going to help Japan get out of its fiscal mess:

Japan’s fast-aging population challenges both its fiscal and economic outlooks. The nation’s total social security related expenses now make up 31% of the government’s fiscal 2011 budget, and this ratio will rise absent reforms beyond those enacted in 2004. An aging and shrinking labor force contributes to our modest medium-term growth estimate of around 1%.

S&P, however, has little faith that the current administration running Japan can implement a serious program that could reverse the deteriorating trend in national finances:

In our opinion, the Democratic Party of Japan-led government lacks a coherent strategy to address these negative aspects of the country’s debt dynamics, in part due to the coalition having lost its majority in the upper house of parliament last summer. We think there is a low chance that the government’s announced 2011 reviews of the nation’s social security and consumption tax systems will lead to material improvements to the intertemporal solvency of the state… Thus, notwithstanding the still strong domestic demand for government debt and corresponding low real interest rates, we expect Japan’s fiscal flexibility to diminish.

To be clear here, Japan is not Greece or Ireland. S&P’s downgrade doesn’t mean Japan is spiraling into a debt crisis. Japan is still a creditor nation with giant foreign exchange reserves and high national savings. But at the same time, the downgrade shows the slippery slope all of the developed world finds itself on. As debt mounts and aging populations put more strain on government budgets, there is a rising possibility that investors will eventually lose confidence in countries like France, the U.K. or Japan in the same way they have with Greece, Ireland and Portugal. This isn’t going to happen tomorrow, but it will happen unless governments fix their finances, and in an intelligent way that supports long-term growth.

The U.S. is right in the middle of this problem. Anything you can say about Japan you can say about the U.S. – and more. Unlike Japan, the U.S. is not a creditor nation, nor does the populace save enough. Despite talk of a more conservative approach to spending, the U.S. has no credible plan for reining in its deficits and debt. And this does concern investors. Moody’s already warned this month that if U.S. debt continues to rise, there would be pressure to downgrade the American sovereign credit rating. If that happened, and if investors began to worry about the quality of U.S. government securities, then……Well, let’s not even think about it.