Japan Faces Spending Constraints Amidst Soaring Public Debt

Japan, which holds the highest public debt among major economies, is encountering increasing difficulties in maintaining its traditional spending levels.

For years, debt-fueled government expenditure, supported by low interest rates, has been a key tool to address national issues. Struggling farmers and depopulated rural areas received substantial payments from the central government. Pandemic relief efforts evolved into increased defense spending and subsidies aimed at helping consumers cope with rising inflation.

Spending continued to rise even as additional Social Security funds were required to support Japan’s growing elderly population. The nation’s public debt has surged to nearly $9 trillion—more than twice the size of its economy.

With a fiercely contested summer election approaching, Japan’s ruling party faces mounting pressure to increase borrowing further. Small businesses affected by U.S. tariffs are requesting public aid, while households burdened by rising prices demand tax cuts.

However, as the Bank of Japan moves away from years of negative interest rates that facilitated government borrowing, spending limits are tightening.

Recently, the Japanese public debt market has mirrored growing concerns about the country’s fiscal health. Yields on long-term bonds, which serve as a gauge of investor confidence in the government’s repayment ability, hit record highs at one point last week. Additionally, weaker-than-expected demand at a 40-year bond auction on Wednesday unsettled investors.

Prime Minister Shigeru Ishiba recently warned at a government meeting about the “terror” of rising interest rates, even drawing parallels between Japan’s budget situation and Greece’s 2009 debt crisis.

Most economists and officials agree that Japan is not on the brink of a financial collapse. A vast majority of its debt is held domestically by the Bank of Japan and national financial institutions, reducing the risk of a sudden capital flight. Still, doubts are growing about how long Japan can sustain its current spending pace.

Excessive borrowing typically risks pushing economies into a dangerous spiral: bondholders become increasingly wary of the government’s ability to meet obligations, driving interest rates up. These rising rates then spread throughout the economy, restricting a nation’s borrowing capacity.

“Warning lights are flashing, and any one of them could turn red at any moment,” said Koji Yano, former administrative vice minister of Japan’s Ministry of Finance. He emphasized the real risk of rising borrowing costs and expressed concern that Japan’s debt could face a significant downgrade, akin to the recent credit rating cut for the United States.

The July Upper House elections will test Ishiba’s Liberal Democratic Party, which has effectively dominated Japanese politics for nearly seven decades. Some analysts attribute the party’s sustained control partly to its ability to use spending to quell populist opposition seen in other advanced democracies.

However, the longstanding pressures remain. Japan’s aging population strains Social Security budgets, and rural economies continue to decline. Meanwhile, pensions are still being funded, and subsidies flow from the national government to smaller municipalities to support local industries and maintain infrastructure such as roads and schools.

“There has long been a commitment to providing a uniform level of services nationwide and to absorb the costs associated with that,” said Tobias Harris, founder of Japan Foresight, a political risk advisory firm. He noted that such policies have helped ease public discontent.

More recently, Japan has seen early signs of populist unrest. After decades of stagnation, the resurgence of inflation over the past three years has squeezed Japanese consumers, especially non-regular workers whose wages lag behind those of permanent employees.

Unlike parts of Europe and North America where populism often gains rural supporters, “Japanese populism is more of an urban phenomenon,” Harris explained. Among some executives and non-regular workers, there is a sense of frustration toward government spending, especially when they feel they are the ones generating fiscal surpluses and managing their own quality-of-life issues.

This public frustration has recently escalated into protests targeting efforts to rein in Japan’s deficits.

Over the past year, demonstrators have gathered outside the Ministry of Finance building in central Tokyo. These protests, occasionally drawing around 1,000 participants, are notable in a country unaccustomed to large-scale public dissent. Protesters’ signs call for abolishing national consumption taxes and dismantling the Ministry of Finance, an institution long seen as the enforcer of fiscal discipline in Japan.

Ahead of the elections, several opposition parties have proposed rolling back tax increases implemented in 2019 aimed at reducing Japan’s deficit.

For years, the cost of servicing Japan’s enormous debt remained manageable, partly due to the Bank of Japan’s large-scale purchases of public debt. However, since last year, the central bank has scaled back these purchases, and weak private sector demand has caused long-term bond yields to surge.

Prime Minister Ishiba opposes cutting the consumption tax, but within his party, he faces opposition from fiscal expansionists who argue that public deficits are largely irrelevant for countries able to finance themselves directly through their central banks.

Sanae Takaichi, a politician who narrowly lost to Ishiba in the party leadership race last September, has urged the Liberal Democratic Party to propose its own tax cut plan. She criticized Ishiba for effectively conceding the election by refusing to campaign on a consumption tax reduction.

In the current environment, discussions about lowering taxes raise concerns for Yano, the former finance official.

In 2021, while still in office, Yano sparked controversy with an article in a magazine labeling the Liberal Democratic Party’s spending plans as “disastrous,” likening Japan to a ship heading toward an iceberg. His unusually public criticism angered party members, including Takaichi, who called his remarks “outrageous.”

With a debt-to-GDP ratio exceeding 200% over the past five years, creditors will eventually say “enough,” Yano warned. “It’s like a stew heating up before boiling over. Interest rates will soar.”

By comparison, the U.S. federal debt approaches 100% of GDP, and a tax cut bill under consideration in Congress could raise that to about 130%, partially prompting Moody’s recent downgrade of the U.S. government’s credit rating.

Less fiscally hawkish officials and economists agree that Japan must reduce spending, but they differ on the timing.

Leif Eskesen, chief economist at investment group CLSA, said a “Greece-like scenario” remains highly unlikely in the near term. The economic uncertainty caused by U.S. tariffs also makes this an inopportune moment for Tokyo to push for major cuts in public spending.

Looking ahead, Eskesen noted that Japan’s potential economic growth remains moderate, pension and healthcare costs will continue rising, and increasing interest rates will make debt financing more expensive. “Japan is going to have to start seriously implementing the promised fiscal consolidation,” he said.