Thanks to Rick Katz for the insights on what the banks are thinking as they look at their situation and the possibility of an increase in the JGB risk premium in the future.

I'm struck that if all of the banks try to do what Tokyo-Mitsubishi UFJ is planning (switch into 1-year bonds), Japan will lose much of its ability to "inflate away the debt", which is its secret weapon for dealing with debt that has reached over 200% of GDP and is headed much higher. It is possible to inflate away debt if much of the government's holdings are in 10-year bonds or longer, at low interest rates. If debt is in this form, an inflation rate of 5 or 10 percent a year will reduce the real value of these bonds gradually over 10 years, before the government is forced to go back to the market to refinance this debt at interest rates that will be much higher once everyone realizes the government has pushed the inflation button.

If all or most of the debt is in 1-year bonds, the government won't be able to inflate away its debt before interest rates rise and might be forced to default. Of course, if the banks keep their money in 10-year bonds and the government inflates, the BANKS will take the huge hit and they will go bust.

This analysis highlights for me how Japan having all of its debt denominated in yen and held by its own people (the banks) is not as reassuring as conventionally argued. Yes, it is likely to push off into the future the day when people panic and realize they have to charge a risk premium because the debt has become so massive the government can't pay it off. But when push comes to shove, either the government or the banks will be stuck. And if the banks are already positioning themselves for this game of hot potato by moving into 1-year bonds, doesn't that move forward the day of reckoning as the government realizes it needs to do something before it is stuck with the potato?

Perhaps this is why Noda is pushing so hard for the increase in the consumption tax. If he can pull this off and bring in enough revenue to shift the debt trajectory off this path, the banks will be reassured and won't begin shifting into one-year bonds. I can imagine the MOF guys laying this out for Noda. If you were the PM, wouldn't this influence your calculus, even if an election were on the horizon?

Len

Len Schoppa