Japan – errant fiscal rule is sure to backfire

The Prime Minister’s Office of Japan has now released the transcript of the – Policy Speech by Prime Minister TAKAICHI Sanae to the 219th Session of the Diet (October 24, 2025). This was here first major speech after taking on the office of Prime Minister and allows us to see some detail beyond the rather general statements she had made previously about being supportive of fiscal expansion. The detail does not build much confidence.

After her introduction, the PM discussed – Basic policy on economic and fiscal initiatives – where she said that “Fostering a robust economy will be absolutely essential” and that ‘fiscal spending’ is enabled by the state of the economy.

More specifically, she said:

In order to build a robust economy, we will strategically employ fiscal policies as we endeavor to raise incomes, transform people’s mindsets regarding consumption, and boost tax revenues without raising tax rates as business earnings increase

Note “raise incomes” through growth which will also generate tax revenue and ensure “economic recovery”.

So this is a GDP growth mindset.

With this in mind, she then outlined what appeared to be her ‘fiscal rule’:

… we will curb the rate of growth of Japan’s outstanding debt balance so as not to exceed the rate of economic growth and lower Japan’s ratio of outstanding government debt to GDP. This will bring about the sustainability of public finances and ensure trust from the markets.

Ms. Takaichi is proposing a general mantra of “responsible and proactive public finances”.

However, tying available fiscal space to movements in the public debt ratio is unsound and doesn’t suggest ‘responsible’ fical management at all.

Remember that the Japanese government (by which I mean the consolidated central bank and finance ministry) issues its own currency, the yen.

No other institution has that right or responsibility.

The Government can issue (that is spend) as much as it wants in nominal terms up to infinity minus one yen (given that infinity is “boundless, limitless, endless, or larger than any natural number” (Source).

Of course, how many nominal yen it should spend is dictated by the context the Government finds itself in at any point in time, which will be continually shifting in accordance with non-government spending and saving plans and outcomes.

The question that has to be asked to understand how much the Government should be net spending into the economy is this: What is the purpose of fiscal policy?

The answer is not to deliver some public debt ratio or some fiscal deficit size, which is what a mainstream economist would assert.

That makes no sense in functional terms.

The functional purpose of fiscal policy is to ensure that the nation can expand its well-being and that includes maintaining low levels of labour underutilisation and achieving environmental sustainability.

In Japan’s case it means a lot more than that including ensuring that the housing stock is retrofitted to become more energy efficient.

It means reducing the over-use of plastics in packaging.

It means eliminating domestic gas as the principle energy source in cooking and heating.

It means investing in regional infrastructure to help achieve decentralised population shifts – more about which later.

And a whole lot more.

In that sense, any proposal that suggests the scope for fiscal expansion must be contained within the debt-issuance is tied to the GDP growth rate is exactly opposite to what a sound fiscal strategy would suggest.

Let’s assign some specific parameters to Ms Takaichi’s ‘fiscal rule’ to organise our thoughts.

Here is a simulation I did where nominal GDP growth is between 1 and 6 per cent and the change in the nomimal debt for Japan grows at the nominal GDP growth rate.

The Table shows the nominal change in trillion yen over the period from June-quarter 2025 to June-quarter 2026 of the outstanding nominal government debt.

The Ministry of Finance publishes – Central Government Debt – data.

Given that the debt issuance is equal to the fiscal deficit, the change in the nominal debt represents the available nominal fiscal space according to the fiscal rule Ms Takaichi is propounding.

In the June-quarter 2025, inflation was running at around 3 per cent.

Real GDP growth is the nominal rate less the inflation rate and the final column in the Table shows the growth rate given an assumed inflation rate of 3 per cent.

In the June-quarter 2025, it was 1.7 per cent on an annual basis and nominal GDP was growing at 4.71 per cent per annum.

To interpret the columns, the first column is the nominal GDP growth rate and I simulated the case for 1 per cent to 6 per cent per annum.

Applying Ms Takaichi’s fiscal rule gives a change in the nominal public debt outstanding in the second column for each assumed nominal GDP growth rate.

The final column shows the real output growth rate for each assumed nominal GDP growth rate on the basis that inflation is stable at its June-quarter 2025 level (3 per cent).

Nominal GDP growth rate (% pa)	Change in Nominal Debt (trillion yen)	Real GDP growth (% pa)
6	79.9	3
5	66.6	2
4	53.3	1
3	39.9	0
2	26.6	-1
1	13.3	-2

So, if the economy was growing at 3 per cent (6 per cent nominal), then the nominal debt would rise by around 80 trillion yen, and according to the rule, that would be the increase in the fiscal deficit that was within the scope of the rule.

However, if the nominal economy only grew by 3 per cent (zero real growth), then the rule would allow the fiscal deficit to rise by only 40 trillion yen.

The rule is strongly pro-cyclical, the planned fiscal deficit rises with overall economic activity.

The Table makes it clear what an application of this fiscal rule would lead to.

The proposal would reduce the ‘allowable’ debt issuance when the GDP growth rate was faltering (lower).

Given that under current institutional arrangements, the size of the debt issuance is directly related to the size of the fiscal deficit in each period, this means that the government would be required to cut the discretionary deficit when the GDP growth rate was falling.

Normally, we would expect the government to seek to stimulate the economy with increased net public spending (that is, a higher deficit) when GDP growth is declining, not the other way around.

So while fiscal policy should fill the non-government output gap to ensure production is at levels consistent with full employment, that task requires a counter-cyclical response.

Think about this – when real GDP growth is declining, unemployment and underemployment rise.

According to Ms. Takaichi the “new fiscal discipline” would see the government run a lower fiscal deficit, which would exacerbate the already deteriorating labour market situation.

For this reason, I cannot fathom why they think this “new fiscal discipline” rule is justified.

The other point to note is that the figures in the Table do not take into account interest rate movements, which adds another layer of complexity to the matter.

At present, the servicing of the national debt constitutes 24.5 per cent (about) of total government spending (28,217.9 billion yen).

That is income for the non-government sector, although as I note below a majority of the outstanding Japanese government bonds are held by the Bank of Japan anyway.

Further, rhe Bank of Japan publishes quarterly estimates of the – Output Gap and Potential Growth Rate.

Their latest data for the June-quarter 2025, estimated the output gap was -0.32 per cent and the potential GDP growth rate was 0.66 per cent per annum.

I have already written about why these estimates are likely to significantly understate the true idle capacity.

Please read this recent blog post – Japan challenges – is there really a labour shortage? – Part 5 (October 23, 2025) if you want to refresh your memories.

In real terms, the gap suggests that the potential output (based on June-quarter 2025 data) is 1,799.9 billion yen higher than the actual level recorded if the gap was to be closed.

We have to make some assumptions to translate that into nominal GDP, but at the current inflation rate, that would mean nominal GDP would be 2,032.4 billion yen higher (or 2.03 trillion yen).

So on those figures there is not much scope for expansion anyway.

But more recent analysis in these blog posts suggests otherwise.

1. Japan challenges – is there really a labour shortage? – Part 5 (October 23, 2025).

2. Japan challenges – is there really a labour shortage? – Part 6 (October 27, 2025).

The Ministry of Finance regularly publishes its – Japanese Public Finance Fact Sheet (April, 2025) (April being the latest edition).

It was all about fiscal consolidation – meaning austerity.

The current fiscal deficit is around 4.5 per cent of nominal GDP.

If you do the arithmetic, increasing the deficit by the amount implied by the rule at a 3 per cent nominal growth rate, would significantly add to this injection of net government spending.

Is there real resource space for that?

In other words, linking fiscal space to these financial parameters is nonsensical.

The available fiscal space is the extent to which there is idle capacity (productive resources) that can be reduced by government spending that brings the idle resources back into productive use.

One cannot assess that situation by merely looking at movements in the public debt ratio and as noted above focusing exclusively on the movements in that ratio can easily lead to policy choices that are damaging.

We have seen that many times in the past.

Finally, the implication that bond issuance is only credible if it follows a rule such as that proposed by Ms Takaichi is unsupported by reality.

For a currencly issuing government, bond issuance is always ‘feasible’.

There is never a shortage of private institutional investors who want to purchase JGBs.

The so-called bid-to-cover ratio which is the number of yen bids for government debt at each auction is always multiples of the available debt on issue.

The queue to buy JGBs is always long and the markets cannot get enough of it.

In a recent 30-year JGB auction, the bid-to-cover ratio was 3.31 which means there were 3.3 times the demand relative to supply.

The most recent 12-month average for these long-term instruments is around 3.38.

For the 10-year bond, the bid-to-cover ratio was 3 for the most recent auction.

There has also been strong demand across all the maturities which has pushed down yields over the last month.

Furthermore, as noted above, one must always remember that the Bank of Japan currently owns 51.7 per cent of all outstanding JGBs and 46 per cent of outstanding JGBs plus T-bills.

In other words, the government (the consolidated central bank and finance ministry) owns more than half of its own debt, which makes claims that it can somehow run out of money ludicrous.

One pocket of government sells the other pocket some debt, which then receives interest payments, that are sent back to the other pocket as dividends.

The reality is hysterical.

And if there was ever a problem that the ‘markets’ stopped wanting to purchase the debt, the government could alter the arrangements and stop issuing it altogether.

Its spending capacity would remain as it is today because it issues the currency and is the only body that issues it.

So all the talk of calibrating fiscal space in terms of public debt movements is ridiculous.

Conclusion

The new Japanese government under Ms Takaichi should stop talking about fiscal rules that are only specified in terms of nominal financial aggregates.

It should rather articulate the real challenges facing the nation and allocated funds accordingly within real resource constraints.

That is enough for today!

(c) Copyright 2025 William Mitchell. All Rights Reserved.