Japan's best fiscal bet is to leave deflation behind
By R.A. | LONDON
IT HAS been a tumultuous couple of weeks for Japanese policy makers. First, the Bank of Japan dramatically scaled up its quantitative easing programme in response to weak growth and inflation figures. Then, new data revealed that the Japanese economy shrank at a 1.6% annual pace in the third quarter, when growth had been expected. That decline was the second quarterly contraction in a row, putting Japan in a technical recession. And today Shinzo Abe, the prime minister, called snap elections with an eye toward building a mandate to postpone an imminent rise in Japan's consumption tax. The consumption tax rise is part of a strategy designed to get Japan's government debt under control; Japanese government debt is now above 240% of GDP and the government continues to run deficits of around 8% of GDP per year. But the first part of the deficit-reduction strategy, an initial rise in the consumption tax which took place earlier this year, seems to have been a significant contributor to the Japanese economic slowdown.
Japan's travails suggest a couple of key questions. First, what is going on with the economy that a consumption tax increase throws it back into recession? it may seem odd that an increase in the consumption tax from 5% to 8% could derail what had been until the second quarter of this year a relatively robust looking recovery. I'm not sure how surprised we ought to be, however. Given a general growth slowdown across the world few economies can count on external demand to carry their recoveries forward (as Japan did in the mid 2000s). The economies that are growing strongly now—America and Britain—are very clearly not relying on rising net exports. Instead domestic demand is left to bear the load. In Japan, that means the mobilisation of its significant private savings toward consumption and investment.
And that, in turn, means beating deflation. Higher inflation would mean that Japanese households should expect the gentle erosion of their savings, unless those piles of yen are put to good use. Deflation, by contrast, allows Japanese households to earn a positive return on their savings even when interest rates are stuck at zero.
But re-establishing consistently positive inflation is a confidence game. If households believe they will spend, firms will hire, and prices will rise. If households doubt the government's commitment to generating more inflation then the game is lost. The initial consumption tax rise certainly had a powerful effect on consumption choices; real GDP grew at a 6.7% annual pace in the first quarter as people brought purchases forward before the onset of the tax increase, then fell at a 7.3% pace in the second quarter. But the persistence of the negative effect probably reflects a loss of confidence that the battle against deflation will be won. The increase in the tax rate on consumption is clearly contractionary, and that is not the sort of action a government takes when it is fully committed to getting inflation and interest rates up.
Second, should we be concerned that Japan is not addressing its fiscal issues? This really is the critical question.
One answer to it is that a determination to raise taxes and/or cut spending is not exactly at the heart of the issue. Rather, the big problem has been the inability to manage growth in nominal output.
It is very hard to reduce the debt to GDP ratio in an economy in which the denominator refuses to grow.
Another answer is that there may come a time to worry about debt, but now is not it. The normal mechanisms through which markets concerned about debt register their displeasure (and inhibit growth) simply aren't a problem in Japan. Interest rates have rarely been lower. Too-low inflation is the matter. As Paul Krugman has said, a loss of market confidence in Japan's fiscal situation would not necessarily be a bad thing; if capital outflows led to a lower yen and higher inflation, that would be a welcome outcome for the Bank of Japan. And a serious debt panic need not be a concern so long as markets have faith that Japan could address its fiscal issues when push comes to shove. Given the readiness with which Japan moved forward on the initial tax rise, despite rock-bottom interest rates, it stands to reason that any meaningful uptick in government borrowing costs would prompt further fiscal consolidation. So for now fiscal concerns ought clearly to be second fiddle to growth-boosting policies.
And still another answer is that while Japan was once a very dirty shirt indeed, it is looking less dirty by the day. Among big bond issuers euro-area economies are moving up the league tables. Those euro-area economies do not have their own central bank, and the central bank they do have is not nearly as eager as the Bank of Japan is to buy government bonds. If liquid rich-world bonds are a scarce and precious resource, then the troubles within the euro zone are good news for Japan. And another sign that it ought to worry a bit less about its fiscal shortfalls.
But let's also be clear about the nature of Japan's debt problem. Its ratio of gross government debt to GDP is over 240%, which sounds perfectly awful. But if one nets out the value of debt held by different branches of Japanese government, then the ratio falls to less than 140%. The Bank of Japan alone holds about 20% of outstanding Japanese government bonds and is buying more each year than the government, spendthrift that it is, can issue. And despite all that interest rates and inflation are as low as low can be. Japan is rapidly moving toward a world in which it can simply net out the obligations everyone insisted it would need to bear. That is debt monetisation, the harbinger, if ever there was one, of hyperinflation. And yet hyperinflation is about the last thing Japan has to worry about.
It's ironic, in a way: by dealing a blow to the economy and reinforcing deflationary pressures the consumption tax rise, which was intended as a step to deal responsibly with Japan's accumulated debt, may have cleared the way for the relentlessly acquisitive Bank of Japan, and to monetisation. Of course, this wouldn't represent a free lunch. If one believes that Japan would have functioned as a more or less normal economy over the last decade or two had it not been stuck at the zero lower bound, then its experience at the deflationary trap has cost the economy trillions of dollars worth of output, and individual Japanese workers untold jobs and wage increases.
But at this point, the debate over what Japan should do about its debt is somewhat absurd. No amount of fiscal rectitude is going to get Japan out of its long-term rut. And so long as Japan is in its long-term rut government debt will build and will find its way onto the balance sheet of the Bank of Japan. It is hard to see how tax increases that undermine the effort to beat deflation serve anyone's purpose. They are paving the road, it should be clear, to something even less familiar and more bizarre than Japan's current straits: the monetisation of a massive amount of government debt with no inflationary consequences.
