NEW YORK: When even Paul Krugman is worried about the national debt, you know you have a problem. The country in question isn’t Greece or the US, but Japan.

With low unemployment and high labour force participation, Japan has essentially no idle resources. The scope for boosting the economy with fiscal stimulus or easy money is almost nil. But Japan continues to run an enormous budget deficit every year.

In 2014, the government had a deficit of 7.7 per cent of gross domestic product, with a primary deficit of just under 6pc.

Things are looking somewhat better for 2015. A hike in the consumption tax in 2014 has swelled revenues. Government coffers have also been boosted by increased profits at Japanese companies — which is then subject to the country’s high corporate tax rate. As a result, the primary deficit is projected to be only about 3.3pc in 2015.

But 3.3pc is still way too high. In the long run, any deficit that stays higher than the rate of nominal GDP growth is unsustainable. Japan’s nominal GDP growth is now about zero. Its long-term potential real GDP growth is no more than 1pc (due to shrinking population), and the Bank of Japan has not managed to increase core inflation to the 2pc target despite Herculean efforts.

Even if interest rates stay at zero forever — allowing the country to eventually refinance all its debt in order to bring interest payments down to zero — borrowing 3.3pc of GDP every year is just too much. And if interest rates rise, deficits would explode.

The government, of course, knows this, and has pledged to cut the primary deficit to 1pc by 2018 and to zero by 2020.

But its projections rely on unrealistically fast growth assumptions; it would require Japan to expand well above its long-term potential rate. As in the US, Japanese administrations are in the habit of over-optimism. The Ministry of Finance, full of sober-minded bureaucrats, projects that under more realistic growth assumptions, the primary deficit will shrink only to 2.2pc. Even that improvement would require tax hikes, spending cuts or some combination of the two.

A primary deficit of 2.2pc would be at the very edge of long-term sustainability. If we assume a 1pc real potential growth rate and 1.5pc inflation, then a 2.2pc deficit will be just barely under the maximum sustainable level of 2.5pc.

By arrangement with The Washington Post

Published in Dawn, November 29th, 2015