Tuesday, July 19, 2011
Reader Dilip pointed me to Paul Krugman's article over the weekend, Italy Versus Japan. In it, Krugman (via commenters) asks why Italian debt is trading at 5.7% on the 10yr, while that in Japan is trading at 1.1% (as of July 19, 2011).
The answer's pretty simple: just 7% of Japan's public debt is held outside its borders. Furthermore, near all of it is denominated in yen, a fiat currency that is funded by the Japanese government itself. On the other hand, Italy has quite a large share of external public debt, 43% of total public sector debt, and the sovereign has conceded monetary policy to the currency union. Simply put: Italy's constrained, Japan is not - and interest rates reflect this.
On a similar note, I often hear that 'Italy is very similar to Japan' in my business. The point is that while the government debt is high, the private sector balance is elevated, so that accounting requires the government to run large deficits and accumulate debt. This is true of both economies; but Japan's private sector surplus is multiple factors of that in Italy.
The sectoral balances in Japan and Italy
The Japanese private sector financial balance (the current account as a % of GDP less public sector net lending as a % of GDP) is seriously elevated, 11.7% of GDP in 2010 (mostly the business sector). Given that Japan runs current account surpluses, the level of deficit spending is somewhat less, 8.1% of GDP in 2010.
In stark contrast, Italy runs current account deficits, -3.3% of GDP in 2010, and the private sector financial balance is only slightly positive, +1.3% of GDP. This implies smaller but manageable public sector deficits on the order of 4.6% of 2010 GDP.
However, given that Italy does not have monetary sovereignty, the credit has become more 'risky' with rising current account deficits. Because for a given level of private sector saving, a higher current account deficit will by definition pressure government debt via increased public deficit spending. This dynamic will ultimately hinder the Italian sovereign's ability to refinance - we're seeing this now.
So while Italy does have a positive private sectoral balance, the economy's sectoral balance does not represent that in Japan. It's wrong to compare Italy to Japan.