Japan Defies Conventional Wisdom on Debt and Inflation

The conventional wisdom is that government debt causes inflation. However, Japan's experience contradicts this narrative. Despite having one of the highest levels of debt in the world, as a share of its economy, Japan has maintained relatively low inflation.

From 1995 to present, Japan's Consumer Price Index (CPI) averaged just 0.50%, with deflation marking 13 out of 31 years. Since the pandemic, CPI has been above its 2% target, but still lower than in the US. The Bank of Japan (BOJ) has slowly raised its policy rate to 1.25%, a departure from zero and negative rates that prevailed for much of the period.

Japan's high debt levels are often cited as a reason why it should be experiencing runaway inflation, but this narrative is flawed. Government debt isn't free money injected into the economy; instead, it's a claim on capital today and in the future. When government debt is serviced and rolled over, it takes away from the capital that could have been lent to businesses.

According to Reinhart and Rogoff's research, when government debt exceeds 90% of GDP, each additional dollar of debt-financed spending buys progressively less growth. Japan is a real-world test case for this theory, with its high debt levels crowding out private investment. Japanese corporations sit on large cash hoards rather than deploying them domestically.