What happens when an economy runs out of fiscal space? The presumption is embodied in the image of “hitting the wall”. Under this assumption, public debt exceeds a certain limit and financial confidence collapses. As a result, interest rates rise, the currency falls and panic ensues. At times this scenario holds true – for economies with sizeable foreign-denominated public debt or for economies that create political breakdowns.

Japan demonstrates a different reality about the problems of excessive debt – one that Shinzo Abe, its new prime minister, should keep in mind as he launches a fiscal stimulus package. Japanese public debt has ballooned for 20 years, rising from 60 per cent to 220 per cent of gross domestic product (though the true figure net of government holdings may be 130 per cent). During that time Japan has been in recession, recovery and back in recession, but interest rates on Japanese government bonds have remained below 2 per cent for the past 13 years. While the debt accumulated, the yen appreciated from Y130 to Y78 to the dollar, before reversing to Y89 over the past few months.

Japan was able to get away with such unremittingly high deficits without an overt crisis for four reasons. First, Japan’s banks were induced to buy huge amounts of government bonds on a recurrent basis. Second, Japan’s households accepted the persistently low returns on their savings caused by such bank purchases. Third, market pressures were limited by the combination of few foreign holders