With Japan’s central bank having recently increased interest rates to their highest level in three decades, and Sri Lanka navigating a fragile post-crisis recovery under an International Monetary Fund programme, the contrast between the two economies could not be more striking.
Nevertheless, their fiscal challenges reveal a common underlying issue. Japan and Sri Lanka occupy divergent positions on the global economic spectrum. The former is characterised by wealth, stability and the capacity to sustain public debt levels that would be unsustainable for most nations, whereas the latter experienced a severe economic collapse in 2022, defaulting on its debt and facing shortages, inflation, and a profound recession. However, beneath these differences lies a shared story. Both countries employed fiscal policy not primarily as a means to transform the economy, but to avoid making challenging political decisions. Although the tools and outcomes varied, the fundamental failure was consistent.
This is not a story about categorising countries as good or bad based on their policies, nor is it a debate between Keynesian economics and austerity. Instead, it examines how governments utilise financial resources to postpone conflict, and what happens when postponement becomes a permanent strategy.
Throwing money at problems
Fiscal policy fundamentally determines the allocation of tax burdens, the distribution of financial support, and the responsibility for economic adjustments during periods of change. Ideally, it functions to mitigate economic shocks and foster long-term growth. However, in practice, it is often employed to avoid confrontation. Japan exemplifies this through its extended demand management strategy.
For several decades, the Japanese government has operated with substantial deficits, facilitated by extremely low interest rates and a central bank willing to absorb government bonds. Japan’s gross public debt now surpasses 230 per cent of GDP, yet the nation has largely avoided a sovereign crisis, largely because nearly 90 per cent of this debt is domestically held, primarily by banks, pension funds, and the central bank. The domestic holding and denomination of Japan’s debt in its own currency have enabled the country to borrow without provoking a crisis. This fiscal latitude has allowed policymakers to safeguard influential groups and preserve social stability.
Sri Lanka adopted a similar approach but employed different mechanisms. Instead of relying on inexpensive domestic borrowing, it utilised subsidies, tax reductions without corresponding revenue, and foreign borrowing. These strategies were also intended to keep voters satisfied and postpone reforms, particularly concerning taxation and state expenditure. The distinction lies not in intent but in capacity.
In both instances, fiscal policy served as a substitute for political compromise, with governments opting to obscure distributional tensions rather than address them. The illusion was that this approach could continue indefinitely.
When strength becomes a trap
Japan’s economic experience illustrates how economic strength can become a constraint rather than an advantage. Due to its wealth, trustworthiness, and robust institutional framework, the country has been able to postpone necessary adjustments for an extended period. There has been no critical juncture compelling policymakers to confront uncomfortable trade-offs.
Consequently, the nation has experienced a form of managed stagnation, characterised by weak growth, modest productivity gains, and uneven innovation. Despite numerous economic stimuli over several decades, Japan’s average real GDP growth has remained below 1 per cent since the mid-1990s. This trend highlights the role of fiscal stability in maintaining social peace, albeit without restoring economic dynamism. The aging population has exerted additional pressure on public finances, yet significant reforms in pensions, labour markets and protected sectors have encountered political resistance. Each group benefiting from the existing conditions possesses sufficient influence to obstruct change, and fiscal policy has been employed to mitigate the repercussions.
While no significant disruptions occur, neither does substantial improvement. Japan has managed to avoid collapse, yet it has also not achieved renewal. This situation echoes what Joseph Schumpeter had famously warned regarding the suppression of “creative destruction” – the process by which inefficient firms, outdated technologies, and protected interests must be displaced to facilitate growth and renewal.
As I argued in my earlier column, economies that prioritise political stability by protecting incumbents often sacrifice long-term gains for short-term tranquillity. Japan’s extended fiscal accommodation has mitigated disruption and preserved social peace, but in doing so, it has also subdued the very forces that drive productivity, renewal, and economic dynamism. Stability has become an end in itself, even as the economy gradually loses its dynamism. This situation does not reflect a failure of competence but rather a failure of incentives.
When a State can perpetually borrow to maintain stability, the urgency to reform disappears. Strength permits delay, and delay gradually erodes vitality.
When weakness forces a reckoning
Sri Lanka’s economic trajectory has been notably more severe and conspicuous. Unlike Japan, Sri Lanka lacked substantial economic buffers. By 2021, Sri Lanka’s tax revenue had declined to less than 9 per cent of GDP, representing one of the lowest ratios worldwide. This situation rendered the state reliant on borrowing and particularly vulnerable when external financing dried up. The nation’s debt was increasingly external, its foreign exchange reserves were minimal, and its currency was susceptible to fluctuations. When confidence evaporated, the economic adjustment was abrupt and severe.
Imports plummeted, inflation escalated, and economic output experienced a significant decline. The social repercussions were profound. Nevertheless, this very collapse necessitated reforms that had been postponed for years. Taxation had to be increased, subsidies required re-evaluation, and debt restructuring became imperative. Although external oversight was unpopular, it enforced a discipline that domestic political mechanisms had failed to establish.
The inherent weaknesses eventually made avoidance impossible. A political framework sustained by borrowing and concessions could no longer be maintained. Despite the painful nature of the crisis, it prompted a re-evaluation of the State’s funding mechanisms and its responsibilities.
This does not imply that economic collapse is desirable. The human cost is real and severe. However, it does illuminate an uncomfortable truth about the adaptability of economic systems. Markets and institutions often force adjustments only when political entities are unwilling to do so voluntarily.
Also read: With MGNREGA dismantled, Modi govt now has to prepare for upheaval in rural economy
The real lesson for policymakers
The inclination to regard Japan as a model of stability and Sri Lanka as a warning of mismanagement overlooks a critical insight. Both nations prove what happens when a fiscal policy is employed to avoid distributional conflicts. The difference is one of timing and manifestation of these failures. Japan shows the consequences of indefinite postponement because it can be afforded, while Sri Lanka shows what happens when it cannot. One ends in stagnation, the other in crisis; neither should be considered successful.
The significant lesson is that economic sustainability is not just about debt ratios or deficits. It fundamentally involves the political willingness to confront who bears the costs, who reaps the benefits, and who must adapt when circumstances evolve. While fiscal measures can provide temporary relief, they cannot substitute for this essential discourse.
For robust nations with extensive financial markets, the danger lies in complacency, where the absence of crisis may lead to inertia. Conversely, for less resilient countries, the challenge is to establish institutions that facilitate reform without precipitating collapse. In both scenarios, the objective should be the same: to develop mechanisms that enforce early, gradual, and equitable adjustments, rather than delayed and tumultuous ones.
Capitalism does not reward virtue or punish excess in a moral context; it rewards adaptability. Japan averted collapse but struggled to adapt, whereas Sri Lanka collapsed because it could no longer postpone adaptation. Both nations shared the misconception that financial resources could indefinitely replace political action.
Dismantling this misconception is the true mandate of economic leadership. Without addressing it, even the strongest economies risk gradual decline, while the weakest are left waiting for the next crisis to accomplish what politics has failed to achieve.
Bidisha Bhattacharya is an Associate Fellow, Chintan Research Foundation. She tweets @Bidishabh. Views are personal.
(Edited by Ratan Priya)