What's wrong with Japan?

Standard & Poor downgraded its rating of Japanese government bonds (JGBs) from AA- to A+ on concern about Japan's economic prospects [Source].

If you can remember a time when Americans were afraid of the Japanese taking over the U.S., you might wonder how Japan got into such a precarious financial situation.

This YouTube video was a bit fast for me, but here's how I understand the situation, with assistance from this blog:

1. Based on years of poor economic performance (the "Lost Decade"), Japan's central bank has low interest rates.
2. Japanese savings deposits and government bonds also have very low rates.
3. That's OK, because deflation creates higher effective actual returns.
4. These years of poor economic performance have caused the Japanese government to invest heavily in Keynesian-style economic stimulus.
5. Years of direct economic stimulus (Japan's "bridges to nowhere") have driven up Japan's government debt above 200% of GDP (like a guy earning $30,000 a year who buys a $60,000 car).
6. To sustain this, domestic banks are mandated by law to invest in "safe" investments, which means JGBs.
7. Because stock markets are dominated by keiretsu companies who care little about minority shareholders, consumers don't have an effective alternative.
8. Japanese are also concerned about exchange rate risk, so that keeps them captive to the internal market.

The situation is stable and sustainable to the extent that the government holds households captive for their savings and the country's demographics don't change.

However, issues with the system's stability include:

1. If the economy does well, BOJ will have to tighten monetary policy, raising interest rates and thereby increasing government expenditures to service its debt. Right now even that measly percentage of debt consumes 23% of the national budget.
2. Inflation targeted at 2% (to induce spending) will cause a negative effective return on JGBs if interest rates stay the same.
3. If domestic investors are not happy with a negative return, they may flee the domestic market.
4. If outside investors are not happy funding the difference, bond rates will have to go up.
5. As the population ages, the quantity of savings in the bank will decline.
6. Special interest groups (farmers and construction industry) prevent cuts in spending. Households that are just breaking even oppose a tax hike.
7. Government has a disincentive to reform the stock market or corporate governance practices.

The result is that the government's forced borrowing prevents private sector lending, which retards economic growth. Low/negative investment returns acts as a stealth tax on savers. Sadly, the Japanese economy is in a structural depression, and it seems it will only get worse.