The election result in Japan was historic. For the first time since World War II, one party secured a two-thirds majority in parliament. Prime Minister Takaichi can now implement her plans without the compromises that have so often paralyzed Japanese politics. The stock markets responded positively: prices rose and records were broken. This is the first effect of the coming reflation on Japan’s financial markets.
Takaichi owes her historic victory to a combination of factors. Her personal popularity played the leading role: with approval ratings around 70 percent and a fresh image in Japan’s male-dominated political landscape, she managed to mobilize returning LDP voters, independent voters, and young voters alike. The so-called “surprise effect” of the snap election gave her a structural advantage: the opposition had only sixteen days to organize, the shortest campaign period since World War II. The newly formed centrist opposition party collapsed completely and lost two-thirds of its seats.
Chinese pressure also backfired: Beijing’s economic retaliatory measures following Takaichi’s remarks about Taiwan actually strengthened her image as a strong leader who does not bow to the “regional bully.” Finally, her close relationship with Trump, who openly supported her, played a role, as did a broader shift to the right in Japanese public opinion.
Not a debt crisis, but a growth crisis
Japan has a government debt of more than 240 percent of GDP, the highest among developed economies. Yet this is no reason for panic. The structure of Japan’s debt differs significantly from that of Europe or the United States. More than 90 percent is held by Japanese institutions and households. The central bank owns about half of all government bonds. Japan therefore owes debt to itself, not to foreign parties that can flee at the first sign of unrest.
The lost decades were therefore not a debt crisis, but a growth crisis. A shrinking labor force and persistent deflation following the bursting of the dual bubble in real estate and equities in the early 1990s kept the economy trapped for decades. The denominator in the debt ratio simply did not grow, causing even small deficits to push the debt ratio higher.
Reflation as a solution
The solution to Japan’s debt problem is simple in theory, but requires patience and political courage. The first step is extending the maturity of government bonds. The longer the average maturity, the less sensitive the debt burden is to rising interest rates. Japan has already made significant progress here: the average duration of Japanese government bonds is 9.6 years.
Step two is achieving moderate inflation as an ally. This is called reflation, or in less flattering terms: financial repression. The economy then grows faster than the interest rate on the debt. As a result, the debt ratio declines automatically, without austerity or defaults. This is exactly what is now happening in Japan. For the first time in a generation, the country is experiencing higher inflation and higher nominal growth. The central bank can gradually raise interest rates without choking off growth.
Japan is not entering unfamiliar territory with reflation. The United States applied the same strategy after World War II. Government debt then exceeded 100 percent of GDP. Within three decades, it fell to 30 percent, not through austerity but through economic growth and moderate inflation that was higher than interest rates. Bondholders lost more than half of their purchasing power during that period. In the Netherlands, the loss was even greater: up to two-thirds of purchasing power evaporated in the same period. The United Kingdom followed a similar path. After the war, London carried a debt of more than 200 percent of GDP. Through decades of financial repression, in which interest rates remained artificially low while inflation did its work, that mountain of debt slowly melted away.
Inflating away debt
Countries with debt in their own currency and their own central bank can inflate away their debt, provided they have the patience and political will. It is painful for savers and bondholders, but it works. For bondholders, reflation is unfavorable. They receive returns that lag behind nominal growth. Their purchasing power gradually declines. This is a time-tested method of addressing a debt crisis: the government repays debt with money that is worth less.
But for shareholders, reflation is attractive. Higher nominal growth translates into stronger corporate profits. Sectors such as energy, commodities, infrastructure, and real estate benefit the most. When real interest rates remain low for an extended period, bubbles often emerge. Cheap money pushes investors toward riskier assets.
Stable political relations and a strong relationship with Washington reinforce the positive picture. But with such an overwhelming mandate, Takaichi can no longer make excuses. Voters who handed her such a large victory will have little patience if results fail to materialize. Thanks to reflation, Japan is transforming from a country that disappointed investors into an economy with genuine opportunities.
Japan stands at the beginning of a new economic cycle. After three decades of stagnation, deflation, and disappointing returns, the country finally has the ingredients for a turnaround: stable political leadership with a historic mandate, structurally higher inflation that reduces the debt burden, and targeted investments in strategic sectors. For investors who avoided Japan for decades, this is a moment to take another look.
Han Dieperink is chief investment officer at Auréus Vermogensbeheer. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co.