Japan Defies Inflation Expectations with High Debt, Low Inflation

The conventional wisdom that high government debt causes inflation has been challenged by Japan's economic experience. Despite having nearly double the US' government debt as a share of its economy, and with the yen losing half its value against the dollar since 2021, Japan's headline CPI is only at 1.9% and core is at 1.7%, both below the current US rates.

Japan imports most of its energy and food in dollars, which has led to higher import prices in yen terms. However, a significant portion of this increase can be attributed to the yen's depreciation, rather than inflationary pressures.

The government debt in Japan is not free money injected into the economy but rather a claim on capital today that will need to be serviced and rolled over in the future. This 'crowding-out effect' means that capital is being misallocated towards funding the deficit instead of productive investments, limiting economic growth and inflation.

Total Factor Productivity (TFP), which measures output beyond what labor and capital add, has been flatlining around 1% in Japan, contributing to its stagnant real GDP growth. The country's aging population, strict immigration laws, and declining population have all contributed to the negative impact on economic output.