Salvador Dali or M.C. Escher?

This question leaps to the mind navigating the ruins of Japanese cities like Tagajo. Skylines now look as if Dali’s surrealist brush had a hand in rendering things so out of place. Escher’s mind seems at work, too. Interlocking shapes that shouldn’t exist in the three-dimensional world litter cityscapes that before March 11’s earthquake and tsunami were pretty run of the mill.

The mess one confronts in the northeast ― flattened buildings, fleets of destroyed Toyotas at ports, ships sitting in the middle of streets, the search for bodies ― graphically demonstrates why Standard & Poor’s is so worried about Japan. Concerned about the magnitude of the reconstruction bill, S&P cut Japan’s rating outlook.

So is Japan on the verge of a debt crisis? No, and that may just be the problem.

Rising stocks and bond prices show traders aren’t buying the despair about Japan’s finances. They are focusing on the nation’s $15 trillion of household savings, the government’s latitude to raise taxes and the fact that about 95 percent of public debt is held domestically.

Yet Japan’s day of reckoning will arrive at some point, and the longer it’s delayed, the worse it will be. This is an ideal moment for the bond vigilantes, who from time to time take matters into their own hands and boost yields, to teach Japan a lesson. Nothing of the sort is happening.

On Wednesday, the day S&P threatened to downgrade Japan, credit-default swaps protecting government debt for five years returned to their pre-March 11 trading range. The message to politicians: By all means, continue borrowing with abandon.

It’s not unlike what’s afoot in the U.S. Negativity about America’s budget deficit has investors like Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., abandoning Treasuries. Bond dealers disagree, as evidenced by the 3.32 percent yield on the 10-year note. Broadly speaking, the bond market doesn’t seem worried about the U.S.

Looked at through this lens, traders are even less perturbed by Japan’s debt load; 10-year yields are a paltry 1.2 percent. One explanation for why markets are ignoring S&P is that credit rating companies, wrong on just about every major crisis of the last 15 years, have lost all credibility in Asia.

The more worrisome one is that markets are complacent. It’s hard not to draw this conclusion when you trek around the Sendai region, which was inundated by the tsunami. From my vantage point, the initial $300 billion reconstruction estimates are fanciful. So, too, might be S&P’s suggestion that the price tag would, at the high end, be $613 billion. It may cost far more.

The challenges that held Japan back before the quake are more acute now. The one most evident in the tsunami zone is how an aging and shrinking population symbolizes the decline of economic life in rural areas. The question isn’t just how to rebuild, but whether to even bother in some places.

There’s also the question of when to start. Economic logic tells you to begin right away. After a 1995 quake, the city of Kobe acted fast and vibrant growth followed. Such thinking is callous and borderline immoral to the likes of Shintaro Takegawa.

Takegawa, 57, is a Sendai truck driver whose company lost more than 90 percent of its fleet when the oceans poured into the city center. He was intrigued to see a wandering foreigner in his midst and offered me a ride back to the train station, a few kilometers from Sendai’s main port.

“There is a big hurry to rebuild, but we have to have respect for the dead and the missing ― more than 25,000 people,” Takegawa explains. “Why can’t we wait a few months?”

This sentiment is common in Japan’s northeast. I heard it, for example, from police officers in the city of Natori, which was literally wiped off the map last month. My Bloomberg News colleagues who have traveled extensively around Tohoku since March 11 routinely encounter it, too. It underscores the challenges facing a nation anxious to dispatch construction crews.

The nuclear crisis in Fukushima is another wild card. This week, electronics maker Sharp Corp. became the latest company to delay making forecasts for this year, citing difficulty in estimating the financial toll of the last several weeks.

Japan is in bizarre economic territory. Bank of Japan Governor Masaaki Shirakawa isn’t exaggerating when he says the economy faces “strong downward pressure.” That dynamic, coupled with the cost of rebuilding Tohoku, means issuing lots of new debt.

You would think that with Japan’s debt-to-gross domestic product ratio ― already 200 percent ― set to widen, traders would be wary. You would think a nation with a shrinking population would be chastened by markets for over-borrowing and forced to find another way to boost growth.

No, traders are saying all is well and giving Japan the green light to sell bonds. One can only imagine the market surrealism that will begin once that light turns yellow or, worse, red. 

By William Pesek 

William Pesek is a Bloomberg News columnist. The opinions expressed are his own. ― Ed.

(Bloomberg)