It doesn’t get much mainstream press these days, but Japan has a bit of a debt problem. The national debt will be an estimated 245% of the GDP, which seems simply unfathomable. In order to pay such a debt off, Japan spends something like 23% of its budget on interest payments. And Japan is currently running a budget deficit, meaning it is adding to that every year.

In other countries, natural inflation could be relied on to lessen the effect of the debt year by year (if there was a budget surplus). But of course, Japan has chronic deflation, which actually makes the debt worse. And there are also a whole host of other things on Japan’s plate too – like declining birth rate, retiring baby boomers, forced retirement at 60, chronic savers, etc…

This has led to a ton of speculation as to what will happen to Japan in the near future. And it has ranged from total economic collapse to some extra inflation. A lot of the top advisors have weighed in on the topic actually and judging from the comments people leave, it is a very hotly debated topic as to what exactly will happen. And as with all financial predictions, nobody has a clue how it will all play out.

The truth in these types of situations always lies somewhere in the middle or a combination of things in my opinion. After all, there is the very slight possibility that it all can be avoided somehow.

Kyle Bass is a hotshot fund manager who got lucky with the sub-prime crisis in the States. He is calmly letting everyone know that financial ruin will hit Japan sometime in the next 18 to 24 months. He placed a lot of bets on this, going so far as to buy his house in yen so that he can save money because he is betting the yen will devalue with the crash.

The reasoning behind this (in a very small nutshell) is that right now the Japanese government (and other governments) are spending more than they are taking in. To work this magic they sell government bonds at auction, print more money, or do some combination of both. These bonds are the national debt. And at the moment, a lot of those are owned domestically and continue to be purchased domestically in Japan.

This allows Japan to have a lot of control over its debt. It doesn’t have to worry about making investors nervous, because they all live in Japan and they want Japan to keep working and not go bankrupt. The problem is, the domestic money supply is drying up. When that happens foreign investors step in and the interest rates may go up on the bonds.

If the rates go too high, it is game over for Japan. The country will default and there will be a lot of economic problems as a result (in theory).

For a more detailed, animation-filled explanation of this please check out the following video:

Currently this is resulting in historically low interest rates. For example, if you want to take out a house loan at the moment, the variable rate is about 0.775%. Even for a 35 year fixed rate, it is 2.5% which is almost nothing. That’s because any increase in rates will cause Japan to default according to some sources.  Also, banks are in cut throat competition with each other to get customers, luring them in with cheap loans and making money off of other services.

But, actually, a lot of people believe that countries like America and Japan can’t default. Because, and again I’m paraphrasing here, a country can simply keep printing money. Of course, if you print too much money, you end up like Zimbabwe.

Now there are a couple of ways to solve some of these issues above. For example, Japan currently has a trade deficit at the moment, which makes things even worse. If they could increase trade, they could increase GDP and help them pay off their debts. The easiest way to do that would be to trade with their neighbors, like China. Unfortunately, China and Japan are currently having a hissy fit over Senkaku, a group of islands in the Pacific, which seem to have a lot of oil around them.

Japan could also privatize some of its national assets that it has lying around. This would make the properties more profitable in theory and give Japan some money to pay down the debt. The only problem is Shinzo Abe didn’t campaign with this idea and hasn’t really mentioned it at all.

The current plan on the table is a consumption tax hike from the current 5% to 8% in April of next year and then up to 10% in 2015. This will, in theory, close up the budget deficit a little bit and stabilize things, but nobody really likes the idea of a consumption tax and many fear it could slow down the economy.  Of course, now with the Olympics in the picture, there are a lot of people that are hopeful for a turn around, but no one seems to truly believe there will be a boom.

Japan has a lot more control over its financial situation than a lot of other countries do. This allows them to do things like order the Bank of Japan to buy up bonds to keep them a float for a little while longer. And since a lot of bonds are owned domestically it can do things like peg the interest rate of bonds so that interest rates don’t go up.

It seems inevitable that some kind of inflation needs to happen in order for things to get better. Higher inflation means the debt gets smaller relative to GDP and that means it will be more manageable. How much inflation is needed? A lot. Some estimate 6% per year in order to reverse the trend.

Japan can do this by devaluing the yen, which would increase exports, but there is one catch. Since a lot of manufacturing has been moved overseas, Japan now needs to import things it used to produce domestically. And of course, since oil is priced in dollars, fuel costs will rise as well.

What seems like the most likely scenario is a slow steady raise in inflation and weakening of the yen. As the yen gets weaker, exports will pick up and things will get better. Hopefully this process will be a slow one, but it will still be rather painful.

Higher inflation will of course cause its own set of problems, much like what is happening in the States now. The middle class will get hollowed out. Money will funnel its way to the rich, and things will get tougher for the retirees living off savings. In theory, wages should increase along with that, but nothing is for certain.

The general spirit of people in Japan though is kind of a ã—ょã†ãŒãªã„ attitude.  In other words, it can’t be helped so no need to protest it.  For example, a lot of people aren’t happy about the consumption tax, but it seems like most will just deal with it and go on.

It is very easy to start believing in doomsday scenarios. Half the videos on YouTube about the financial situation talk about global financial collapse and how the world is going to turn into Mad Max at any moment.

The truth though is that nobody really knows what in the world is going to happen. Everyone is kind of guessing. Personally, I’m trying to get as much money into assets as I can just to be safe. That is one of the reasons I’m scrambling to find a house at the moment. Granted housing and land in Japan aren’t exactly the best investments, but you have to live somewhere.   Also, I want to lock in these great interest rates in case something goes haywire.

But, what about you? What do you think of the financial crisis? Let me know in the comments below.

Since this article is about finance, I might as well just come out and say that I haven’t studied economics in any formal sense and I really have no idea what I am taking about. Please don’t make any financial decisions based on what I wrote. Do prudent research before making any investments. Never take investment advise from some guy with a blog about the JLPT.

And also, if I have made a mistake in my explanation of the situation, please by all means let me know in the comments.

Photo by IvanWalsh