What Abenomics tells us about the great bond bubble Shinzo Abe: "Three arrows." Abenomics is working. Or is it? Japan is going for broke with Shinzo Abe's ""three arrows"" plan to reverse more than two decades of economic decline. In an effort finally to rid the country of deflation, the Japanese Prime Minister has pledged to double the country's monetary base, to engage in further fiscal stimulus (as if Japan needs more bridges to nowhere), and to shower his country with structural reform (which it certainly does need). Early signs seem quite promising. Data released yesterday show that Japan grew at an annualised rate of more than 4 per cent in the first quarter, while the much weaker yen helped to double April's current account surplus from a year earlier. Bank lending is rising and consumer confidence is improving. First set to Abe. Unfortunately, there is still plenty of scope for things to go seriously wrong. There are three major concerns with Abenomics. The chief one is that by destabilising markets and raising bond yields, it threatens finally to tip the Japanese government into bankruptcy. A second is the effects on trade. Already Korea, which competes directly with Japan in many export markets, is screaming blue murder over the extent of Japan's currency depreciation. For America, it's a bit different. Given that it has been a pioneer in the application of ""unconventional monetary policy"," the US is less inclined to complain and, in any case, it welcomes anything that might give the world economy a boost. Yet even in America, there are rumblings, particularly in the still recovering auto industry. And finally, it is not at all clear that Prime Minister Abe can deliver the structural reform the plan needs to work effectively. Without it, the time bought through monetary and fiscal accommodation will count for nothing in the long run. And what's been announced to date has been distinctly underwhelming. Many of the reforms needed to make the economy grow again - in particular, removal of barriers to population growth, inward investment and trade - are red line issues for much of the Japanese population. Yet it is the first of these concerns I wish to focus on, because of its obvious read across to heavily indebted western economies. The breakthrough in Abenomics is the realisation that, unless Japan can get some inflation back into the economy, the government is on a path to certain bankruptcy. The same point was recognised some while back in the US and Britain. Without inflation, the debt burden gets steadily worse. The eurozone, fast following Japan into deflation, has yet to reach this moment of epiphany. Net general government debt in Japan has already risen to a breathtaking 200 per cent of GDP. Even acknowledging the fact that the overwhelming bulk of this debt is domestically owned, there is a sense in which the Japanese lend to the government, rather than pay it the required level of taxation - it has plainly reached completely unsustainable levels, and is only affordable as things stand because of extraordinarily low interest rates. The other side of the coin is that levels of indebtedness among households and companies have fallen to relatively low levels. Banks are also less leveraged than many Western counterparts. For Japan, the problem of excessive private sector debts is largely over, but that's another story. In any case, any significant rise in rates and the government would be in difficulty. The trouble with Abenomics is that, by raising inflationary expectations, the Prime Minister threatens to deliver just such an outcome. This is one of the reasons the Bank of Japan has been so loathe to act in the past. If it stimulates the economy too much, it might trigger a fiscal crisis. Chris Watling of Longview Economics has crunched the numbers, and they are pretty terrifying. At an average interest rate of 1 per cent, interest on central government debt consumes around 20 per cent of central government revenues. It follows that if rates rise to 2 per cent, the debt interest bill doubles to 40 per cent and so on until at 5 per cent, the normalised level for Western economies, the costs reach 100 per cent of tax revenues. Obviously, this wouldn't happen overnight, since the average maturity of outstanding debt is more than seven years and it would therefore be a long time before all the stock of debt had to be refinanced at the higher rates. All the same, on the face of it, the risks of triggering a fiscal meltdown are high. Except that they aren't if Japan can restore some growth. Rising sovereign bond yields are sometimes a sign of deteriorating credit risk but most of the time they merely indicate a stronger economy and therefore rising inflationary expectations.If a country is moving from deflation to inflation, then nominal interest rates can rise quite a long way before there is any significant rise in real interest rates. Inflation will also erode the real value of existing debt. As Longview Economics points out, rising nominal yields won't much matter if the Bank of Japan can improve the trend growth rate, since government tax revenues will rise naturally with inflation to pay for the extra interest costs. If it can't, then debt dynamics become unsustainable quite quickly, and all bets are off. None the less, right now, yields are more a reflection of optimism than pessimism. The same is true of Britain and the US. Unlike Japan, neither country has yet had a deflationary problem; in Britain, rather the reverse. That may be because both countries acted early to the banking crisis by cranking up the central bank printing presses. The Bank of England has expanded its balance sheet particularly aggressively. This has been very bad for pension funds and cash savers but it has enabled the Government to smooth the fiscal adjustment in a way that otherwise would not have been possible, and it may therefore have supported demand at a higher level than otherwise. UK gilt yields have risen a little of late in response to the better economic news but from an extraordinarily low level and they still point to no rise in base rate for some years to come. What this means, in effect, is that growth and inflation would have to be much stronger than anticipated for bond prices at these levels to be a bubble. If on the other hand you think the economy is about to sink back into recession and eventually deflation, then there is room for gilt yields to fall even further. Relatively high inflation and no growth, or stagflation, is another possibility, but for the moment this is not a mainstream view. In any case, Japan, the US and Britain are at different stages of the cycle, causing bond yields to rise for slightly different reasons. In the US and in Britain, it is because markets fear renewed growth will bring about the end of money printing; in Japan it is because money printing may bring about some growth. What might reasonably be concluded from all this? So far, sovereign bonds have behaved in textbook fashion, defying those who thought them a bubble even at much lower prices. But these are largely uncharted waters and, although the theory looks reasonable enough, the practice will undoubtedly produce some totally unanticipated outcomes. In the meantime, markets will remain volatile.