Tax Analysts Blog

Japan's Earthquake & America's Debt

Posted on Mar 21, 2011

"What happens if China stops buying our debt?"

For years that question has been tossed around Washington DC as a kind of doomsday scenario. As everyone knows by now, our national debt is on an unsustainable trajectory. The foregoing 'China issue' is identified as a possible trigger for all sorts of chaos including austerity measures and big tax hikes.

The reasoning goes something like this: (1) America spends far more than it collects in taxes, and our government must finance the difference. (2) The only reason we can afford to do this is that the bond market is not demanding high yields when we sell treasuries. Thankfully, our cost of borrowing is relatively cheap -- for now. (3) Should the bond market changes its mind, the party is over.

U.S. interest rates are artificially low thanks to the continued willingness of foreign central banks -- especially those of China, Japan, and South Korea -- to purchase our debt. They do so not out of kindness, but to keep their own currencies low and support their export sectors. The arrangement is an odd sort of co-dependency.

The folks who worry about these things have long presumed it would be China that might burst our bubble due to conflicting national interests (say, a clash over Taiwan). That's why U.S. diplomats go to great lengths not to upset Beijing too much. Essentially the Chinese hold our mortgage.

So does Japan, but nobody worries about their government creating problems for us. Japan has been a staunch U.S. ally for decades. Our political, economic, and military interests are closely aligned. No, Japan would never stop buying U.S. debt to spite us. But their hand could be forced due to recent events outside the world of geo-politics. The horrendous earthquake near Honshu and the resulting tsunami will require Japan to undertake the mother of all reconstruction efforts. The rebuilding of Japan's infrastructure will require massive boatloads of cash. Where will Tokyo get the money?

It's doubtful Japan would raise taxes; that's the last thing you want to do when your economy is slipping into recession. They could indulge in more deficit spending, but the country already has one of the highest debt levels in the world. It's more likely they will divert cash from other expenditures -- like buying other countries' debt. Alarmingly, Japan could be tempted to sell portions of the U.S. debt it's already holding. Think of it as a national liquidation sale. When you're desperate for cash, the first thing you do is sell off assets you no longer need.

Doing so would flood the bond market with U.S. treasuries that nobody necessarily wants. If other central banks don't pick up the slack, the U.S. might be forced to offer higher yields. How would America, then, cover the increased costs of carrying its debt? Would Congress take an axe to entitlement spending? Would it raise taxes? Neither move would be popular, but what's the option -- print more money?

Connecting the dots, one can see how Japan's natural disasters might cause the kind of economic problems once associated with a feared breakdown of the U.S.-China relationship. It's the same fiscal squeeze, but with a different triggering event.

Hopefully none of this will transpire. Earlier this week, U.S. Treasury Secretary Timothy Geithner tried to calm fears of a Japanese sell-off. Still, one thing is worth noting: Washington has control over many federal expenditures -- the cost of servicing debt is not one of them.

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