Monday, November 24, 2014

Japan’s Fiscal Crisis Comes of Age

TOKYO – Has Japan’s political paralysis finally lifted? The recent agreement, after a long debate, between the government and leading opposition parties to double the consumption tax – from 5% to 8% in 2014, and then to 10% in 2015 – suggests that it has. But there is a real risk that the government will mistake this measure for the end of the reform process. In fact, it is – or should be – only the beginning.

By virtually any measure, official Japanese debt is the highest in the world. The total outstanding volume of Japanese Government Bonds (JGBs) is an almost unfathomable $9 trillion, only just below the $10.5 trillion in outstanding debt for the full 17-country eurozone, which has more than triple the population.

So grim has Japan’s fiscal position become that bond issuance has exceeded tax revenue since 2009. Taxes cover less than half of government spending. And last year’s earthquake, tsunami, and nuclear disaster only made a grim fiscal picture worse by requiring huge new spending on reconstruction. Japan issued a record ¥55.8 trillion ($693.5 billion), or 12% of nominal GDP, in government bonds during the last fiscal year.

Of course, Japan’s fiscal problems have been mounting for decades. Annual tax revenue has fallen 30% since the country’s property bubble burst in 1989, owing to slow growth and deflation, with tax cuts implemented as stimulus measures during the 1990’s recession playing a subsidiary role.

The only reason that Japan has been able to sustain its fiscal position is that 93% of its debt is domestically held (with the Bank of Japan now buying close to one-third of the JGBs issued each year). Indeed, in contrast to the foreign capital flight that has so damaged Europe, willing foreign buyers of JGBs are currently plentiful, pushing interest rates to their lowest levels ever.

Moreover, Japan’s private sector – its households and companies – sits atop a mountain of savings, which is mostly used to purchase JGBs. Because the government can still borrow mainly from the Japanese people, its balance sheet remains stable. But, given Japan’s aging population, how long can that continue?

Most leading Japanese economists believe that the situation cannot be sustained, given that the large number of households formed by pensioners is increasingly drawing down savings. The share of those aged 65 or over has nearly doubled over the past two decades, to 23%, compared to 13% for the United States and 16% for Europe. If this trend continues, as seems likely, the captured market that JGBs have had for decades will begin to shrink dangerously. At that point, foreign purchasers are unlikely to pick up the slack.

In reaching the agreement to raise the consumption tax, the opposition Liberal Democratic Party insisted that the main squeeze on the budget deficit – the amount spent on social-security benefits for Japan’s retirees – begin to be addressed. But the agreement actually does nothing to fix that problem.

The large number of elderly and retired people means that spending on health care and social security now consumes 29.2% of the budget, a one-third increase since 2000. To meet these demands, Japan’s government has been slashing spending on education and research, the two areas in which the country’s post-war economic rise was forged. And the old jibe that Japan cannot resist building bridges to nowhere if the government is paying rings less true nowadays. Public works and pork-barrel spending fell to 5.1% of the budget this year, from 13% in 2000.

Of course, the tax system will also need to be addressed. Just as Japan’s deficit is monumental by any measure, Japanese income earners are clearly under-taxed. Even after the proposed doubling of the consumption tax, the rate will remain half the 20% (or more) that almost all European countries levy. Overall tax revenue is roughly 27% of GDP, putting Japan in 28th place among the 35 OECD countries.

The government must not overestimate how much revenue can be gained by the consumption-tax increase, and thus how much of the budget hole can be closed. Moreover, it has so far shrugged off any concern that the tax increase might have a chilling effect on consumption, and thus on economic growth.

Hiromichi Shirakawa, the chief economist at Credit Suisse AG in Tokyo, suggests that the revenue increase from the consumption-tax hike will soon begin to evaporate – and disappear completely in 5-7 years. If he is right, the increase will turn out to be little more than a finger in the dyke of Japan’s budget problems.

Despite its two decades of economic malaise, Japan remains the world’s third-largest economy, and will grow by about 2% this year and 1.5% in 2013. Given the economic doldrums in which the world finds itself, that may not seem so bad. But, if Japan is ever to address its fiscal dilemma effectively, it will need to sustain faster growth than that.

Such growth presupposes a credible strategy to pare the deficit, which means a plan that recognizes the reality of the growing cohort of pensioners. Japanese authorities will also need to launch bold liberalizing reforms to unshackle the many areas of the economy that are shielded from competition. These reforms must aim to boost greater workforce participation by women; induce corporations to invest more at home; and increase competition in cosseted sectors of the economy.

If any country has the political tools to undertake a program of comprehensive reform, it is Japan. The unity with which the Japanese population met last year’s disaster demonstrated once again that, when called upon, the national spirit can work miracles. And Japan’s “greatest generation” – the men and women who rebuilt a war-shattered country into an economic powerhouse – should not be deemed unwilling to sacrifice for the greater good. After all, they saved their country once; they are more than capable of doing it again.

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    1. CommentedProcyon Mukherjee

      A very interesting dialogue that this article had brought up and one is reminded of Bernanke’s 1999 Paper, “Japanese Monetary Policy: A Case of self-induced paralysis”, as the word paralysis does feature in the discourse in a number of areas. First of all Bernanke, himself is proved wrong if I take his conclusion at the end of the paper, where he prescribed a Rooseveltian resolve to make sweeping changes in the banking system that would do exemplary monetary easing and secondly by devaluing the currency; both these initiatives means precious little now as we have interest rates near zero with hardly any further possibility of monetary easing or devaluing of the currency.

      The current perspective is an ageing population with high savings rates and even higher propensity to save than to consume and a consumption tax would further aggravate the savings over spending. This is an ultra-defensive strategy biased towards savings over consumption and essentially could act more towards the backstop for the $9 Trillion debt that is carried by the bulk of the population. This is not a budget- hole healing action at all.

      But still as some comments point out, Japan is far more resilient to shocks than the EU, which is plagued with debt spiral of the Southern nations with one creditor country Germany, that is unwilling to change its stance by stimulating its domestic economy through cessation of the wage freeze. It is a far more complicated problem to deal with.

      Procyon Mukherjee

    2. CommentedMichael Heng

      The economic problems facing Japan are both economic and cultural-political in nature. As Ms Kolke has correctly suggested, the human power shortage arising from ageing can be solved, at least in the short and middle term, by having more women participation. Those who are fit to work should be encouraged to remain longer in the work force, perhaps with re-designed work environment and flexible hours.
      Japan's problem also shows up the inadequacy in economic research. Why can't a country have a strong economy with negative growth when its population is decreasing? Why can't you run an economy with deflation? It is like trying to say that one does not know how to drive a car when it is not picking up speed.

    3. Commentedfernando fajardo

      I can see from Ms. Koike's article that the Japanese government deficit is largely financed by borrowing from its own people who happen to save a lot because they consume less and pay lower taxes. If the consumption tax is increased, the Japanes people will now have to consume lesser still and cut down their savings. Lower consumption will be bad for the Japanese economy while lower saving also mean that the Japanese people will have lesser money this time to lend to the government for it to spend. So unless the Japanes government will have other sources of money to spend in addition to what it collects in taxes and the little volume of money that it could now borrow from the people after the additional consumption tax, the Japanese economy will remained depressed.

    4. Commentedparthasarathy Shakkottai

      What is the problem? Japan is monetarily sovereign and can deficit spend as much as required. Japan is not an Euro country which has all the problems of a common currency with no federal bank. Koo explains all this deleveraging during Japan's lost decade in "The world in balance sheet recession:
      causes, cure, and politics
      Richard C. Koo (Nomura Research Institute, Tokyo)"
      which is a proof of MMT.

    5. CommentedMargaret Bowker

      Yes, hopefully, Yuriko Koike is right and Japan's political paralysis has lifted and this positive process will continue. The agreement between the government and leading opposition parties on the consumption tax was a significant example of effective politics. Clearly it was a very difficult issue, but perhaps continuity will be seen as possible.

        CommentedYoshimichi Moriyama

        Economics is a difficult discipline, perhaps like any other social science, if it is not ideology but science at all. I must confess my ignorance first.

        Japan has been in stagnant economy, long enough to come of age. It raised its consumption tax in 1997, nipping an incipient recovery in the bud and starting deflation all over again.

        As Mr. Richard Koo writes in the essay mentioned by Parthasarathy above, raising taxes can be harmful in deflation. Economics knows how to fight inflation but it does not know how to deal with deflation. This is the embarrassing situation of "You can pull at a string but cannot push at it." Prof. Stiglitz says there is no instance of a big economy's recovery by means of austerity.

        Even conceding that the 3% consumpton tax raise was necessary at this time of the economy, Japanese politicians took such a long time and made such a big fuss as if they were going to raise 1,000%. Such a long time and such a big fuss not because they had wisdom to see danger in a tax hike at this time of deep deflation -I wish they had such intelligence -but because they were afraid of getting their clients angry.

        Now politicians are already competing to earmark the expected revenues from the tax hike you mentioned for such uses as construction works the social value of which is dubious. They are trying to look after the vested interests.

        Our population is dwidling and rapidly aging. Our use of land, for example, is notoriously inefficient, which is the cause of high-cost agriculture and high prices for housing. This is one big reason why we have repeatedly failed to expand domestic demand in spite of one dose after another of economic stimulation pills. The fact that Ms. Koike wrote this Japan's Financial Crisis is a good testimony to the gravity of the problem.

    6. CommentedBill Hocter

      Ms. Koike-if you could bring a country with a declining population to greater than 2% sustained economic growth (requiring greater than 2-3% productivity growth), your talents were wasted in defense and national security. You should have been Prime Minister!

    7. CommentedYoshimichi Moriyama

      In my comment below, bubbles and bust is bubbles and busted, and Put One and Two is Put One and Two together, of course.

    8. CommentedYoshimichi Moriyama

      Japan's greatest generation - the men and women who rebuilt a war-shattered country into an economic powerhouse - is gone and no more. The generation which made the estate bubbles, bust them and has been fumbling for the past two decades, is a new, pampered generation.

      Here is a question of easy arithmatic. One: The Japanese do not try to act on their enviornments; they simply react to them (Ms. Chie Nakane, an anthropology professor of Tokyo Uniberstiy). Two: The Japanese dislike logics and philosophy; they love short poems the scope of which precludes extended narratives or developing complex ideas and, concentrating on immediate things, elicits emotional responses (Hajime Nakamura, H. Paul Varley and others).

      Put One and Two. What do you get?

      The answer is: Josephe Grew, U.S. ambassador to Japan until the outbreak of the Pacific War, wrote in his diary that the Japanese turn tail before difficult problems instead of facing up to them. One Japanese decision after another leading to the war was characterized by "drift" or "a long evolutionary process . A whole series of decisions of limited scope were taken, each building on the other and pushing the nation that much closer to war (Nobutaka Ike, Japanese Politics)."

      I can hardly share in Ms. Koike's optimistic ignorance or ignorant optimism as far as Japan's fiscal problem is concerned.