In 1988, Michael Lewis wrote a story about what would happen if Tokyo was destroyed by an earthquake. To write the story, he went to Tokyo and sniffed around to find the answer. Amazingly, the Japanese government was also investigating the same thing. One Japanese economist told Lewis that Japan would have to sell its overseas assets to pay for the reconstruction. As a result, America would suffer a 5% increase in interest rates, a collapse in economic growth and asset prices.
Of course, the theoretical earthquake that hit Tokyo would have resulted in $1 trillion in damages, far more than the damages caused by the Tohoku earthquake. Nevertheless, the Tohoku earthquake did a considerable amount of damage and reconstruction would still cost hundreds of billions of dollars. That money has to come from somewhere.
“I wouldn’t be shocked if the Japanese government, to cover the losses, will need to sell off at least some of their 800-and-something billion dollars in U.S. treasury bonds,” said Lewis. “And I wonder: if the Japanese become big net sellers of our bonds, who will step in to buy them?”
Japan has been buying U.S. Treasury bonds for a very long time. In fact, in May of 1984, as part of the Yen-Dollar Accord, Japan agreed to use its trade surplus money to finance the U.S. budget deficit by buying Treasuries. If Japan chose to reduce its purchases of Treasuries or if it chose to actually sell its Treasuries, America would have to find someway to reduce its budget deficit. And you thought the debt ceiling fiasco was much ado about nothing.
In the ensuing months, Japan and America would fight it out over who had to increase taxes and reduce government spending in order to pay for the reconstruction.