Japanese Prime Minister Sanae Takaichi has unveiled an expansionary economic blueprint aimed at breaking Japan’s long-running cycle of stagnation through state-led investment, creating a delicate balancing act for the Bank of Japan as it tries to preserve market confidence and monetary stability, Helen Thomas writes.

A newly installed leader is promising to break with recent economic orthodoxy by using the state to stimulate investment, improve productivity and lift the economy’s long-term growth potential, while also reassuring markets that public debt will remain sustainable. Sound familiar? Despite the clear parallels with the UK, this is Japan, where Prime Minister Sanae Takaichi has set out her first annual economic blueprint, offering an unapologetically reflationary vision for an economy that has spent much of the past three decades trapped between anaemic growth and deflation.

An ageing population, persistent deflation and the world’s largest public debt burden have produced policy prescriptions that would have seemed extraordinary almost anywhere else, ranging from quantitative and qualitative easing to yield curve control and negative interest rates. Yet those unconventional policies were a prelude to what followed as other developed economies faced similar pressures. Japan may once again be pointing to what comes next.

The appeal of Takaichi’s agenda is obvious. Faster growth would create the possibility of financing higher public spending without resorting to tax rises or spending cuts. The difficulty is that markets are now far less willing to accept the argument that today’s borrowing will automatically generate tomorrow’s prosperity.

An early draft of the blueprint referred to the Bank of Japan being “expected to coordinate closely with the government”, language that quickly revived concerns about the independence of monetary policy given Takaichi’s earlier criticism of interest rate rises during her campaign for the Liberal Democratic Party leadership. The market reaction was swift, with renewed pressure on both the yen and Japanese government bonds as investors questioned whether the institutional separation between fiscal and monetary policy might gradually be eroded.

The final version of the document tried to ease those concerns by removing the contentious wording and adding a footnote referring to the statutory requirement to respect the Bank of Japan’s independence. That was an important reassurance, but it did little to change the overall direction of policy. In fact, the blueprint marks a clear departure from the more cautious fiscal language used by Takaichi’s predecessor. Last year’s emphasis on “fiscal consolidation” has disappeared entirely, replaced by a programme that explicitly prioritises long-term public investment and allows greater flexibility on achieving primary budget surpluses, provided the overall debt-to-GDP ratio is eventually put on a declining path.

That difference matters. A commitment to achieving a primary surplus places an immediate constraint on fiscal policy by requiring governments to finance current spending largely from current revenues. By contrast, targeting the debt-to-GDP ratio implicitly assumes that sufficiently strong economic growth will eventually offset the extra borrowing taken on today. The blueprint therefore rests on an optimistic assessment of the returns from state-led investment, envisaging public and private investment of ¥370 trillion across 17 strategic sectors by 2040, alongside a separate investment framework financed through “temporary” government bonds that will not be subject to conventional expenditure ceilings. The expectation is that these measures will raise Japan’s long-run growth rate to one per cent while materially improving productivity.

The widow-maker

Whether those ambitions are achievable is ultimately less important than the challenge they pose for the Bank of Japan. Under conventional macroeconomic theory, a more expansionary fiscal stance would normally require tighter monetary policy if inflationary pressures are to remain contained. But Japan is not operating under ordinary circumstances. Government debt already exceeds 230 per cent of GDP, while the central bank has only recently begun the long and delicate process of normalising monetary policy after years of extraordinary intervention in financial markets. Every increase in interest rates may be justified on macroeconomic grounds, but each one also raises debt-servicing costs and risks weakening a government bond market that has already undergone a significant repricing.

Few trades earned a more notorious reputation than betting against Japanese government bonds. The “widow-maker” reflected decades in which deflation, quantitative easing and strong domestic demand for government debt rendered Japan’s huge debt burden largely irrelevant to market pricing. That era is ending. Interest rates have risen to one per cent, inflation has returned and the ten-year yield is at a 30-year high. For the first time in decades, Japan’s debt dynamics are no longer being overwhelmed by monetary policy.

The yen tells a similar story. Decades of ultra-low interest rates have left Japan with one of the widest policy differentials against the United States, helping push the currency to its weakest levels in decades. Even the US Treasury has said in its latest semi-annual Currency Report that “[Japanese] Monetary policy normalisation would help anchor inflation expectations and reduce excessive exchange ​rate volatility”. Yet the same tightening that might support the yen could also unsettle the government bond market. The Bank of Japan therefore finds itself in the uncomfortable position of choosing between currency stability and financial stability just as the government adopts a more expansionary fiscal stance.

Britain is not Japan, but it cannot afford to dismiss Japan’s experience as unique. If anything, the UK’s greater reliance on overseas investors may leave it even more exposed to bond vigilantes. The broader dilemma is increasingly familiar: governments want faster growth without fiscal retrenchment, while central banks must preserve both price stability and market confidence. Japan has spent two decades testing the limits of unconventional monetary policy. It may now be testing the limits of fiscal activism instead.

Helen Thomas is founder and CEO of Blonde Money