Japanese government bonds arithmetic

The commentariat is getting up in arms at every little move up of Japanese Government Bond (JGB) yields, claiming that this augurs a failure of Abenomics.

They seem to be falling for a very basic money illusion type of error.

What is the status quo?

About 0-1% deflation, and long term yields at about +1%. That is the cost to the Japanese treasury to finance itself is 1-2% in real terms, which if I recall is in line with rates on index linked JGBs, as it should be. This is spot on the “normal” historical rate for developed countries for the past few decades. All business as usual and nothing to see here.

Where are we going?

The new monetary policy is to do what it takes to get 2% inflation. If they succeed the new bond yields required to maintain the steady state and “normal” rates — 1-2% real — will be about 3%, to get no change to the funding position of the Japanese treasury.

In fact, you could argue that the central bank has failed if rates stay below 2% as this is consistent with unchanged inflation expectations aka continuing deflation. Indeed whenever the rate on bonds is below the inflation rate, the existing debt stock shrinks every year in real terms (% of GDP) so if it was the case the Japanese debt would (slowly) disappear even if they never net repay a single yen.

Incidentally, if they achieve inflation and a matching adjustment to rates, the price of long dated legacy issuance sinks below par, which the government can arbitrage (via the central bank) if it wishes to make a profit and reduce the nominal debt to GDP ratio. So you get a win-win situation: funding costs unchanged with the real cost of legacy debt reduced, in addition to removing the brake effect of deflation on the economy.

(And I’m here skipping the fact that the Japanese government has no material funding requirement at all as a currency issuer, and could comfortably fund the kind of deficit they now have in perpetuity through monetary channels — the arithmetic exposed here works even if you believe in accounting for government finance in household/corporate terms.)

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