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Betting on the Tortoise in Japan

CAMBRIDGE – In April 2014, Japan’s consumption-tax rate is set to rise from 5% to 8% in an effort to address the long-term problem of high public debt. But will the resulting loss in purchasing power bring an end to the Japanese economy’s fragile recovery, as many fear?

The question is reminiscent of April 1997. Larry Summers, who was then Deputy Secretary of the United States Treasury, repeatedly warned the Japanese government that if it proceeded with a scheduled consumption-tax hike, Japan’s economy would slide back into recession. I was in the US government at the time. As the date drew near, I asked Summers why he persisted in offering Japan’s leaders this unwanted advice, given that they were clearly locked in politically. Summers told me that he knew he was unlikely to change anyone’s mind, but that he wanted to be sure that Japanese officials recognized their mistake when they went ahead with the increase. Sadly, his prediction proved correct.

Today, Japan’s fiscal problems resemble those of the US and many other countries. The economy is weak, but the Bank of Japan (BOJ) cannot make monetary policy much more expansionary than it already is. And, while fiscal stimulus is called for in the short run, the long-term outlook for Japan’s public finances is deeply troublesome, owing to the huge debts run up in the past.

What is required is easy fiscal policy today, together with plans to achieve fiscal rectitude in the long run. The difficulty with this Augustinian approach – “Lord, make me chaste, but not yet” – is that promises of future discipline usually are not credible. Politicians often say that they will achieve budget surpluses in the future, but seldom do so.

Given this, governments should provide specific fiscal-consolidation mechanisms that are visibly likely to take effect when the time comes. Raising the retirement age for future pension benefits qualifies as such a mechanism. Legislating phony sunset provisions for current tax cuts, as the US did during the George W. Bush years, does not.

For Japan, I like a proposal by Koichi Hamada (a Yale economics professor who is an adviser to Prime Minister Shinzo Abe) and others: the planned jump in the consumption-tax rate should be replaced with a gradual pre-announced path of increases, with the rate rising, say, one percentage point per year for five years. Because a gradual path establishes long-run fiscal discipline, it would not crash the bond market, as an outright cancellation of the tax increase might. At the same time, it spares an already-weak economy damaging fiscal contraction in the short run. Indeed, the expectation that tax-included prices will rise in the future can stimulate households to buy cars, appliances, and other consumer goods today.

Such a gradual path has positive implications for monetary policy, too. In normal times, central banks want to reduce inflation. The problem is that pre-announced hikes in tax rates or administered prices can have the undesirable effect of building annual price increases into public perceptions, undermining the central bank’s inflation-fighting efforts.

But these are not normal times. Inflation and interest rates in Japan lately have been even lower than in the US. The most important component of “Abenomics” this year has been the BOJ’s efforts to ease monetary conditions further, despite zero interest rates, and thus end the threat of deflation. Under these circumstances, inflation expectations are not a cause for concern. On the contrary, positive expected inflation would reduce the real (inflation-adjusted) interest rate – not a bad thing under current conditions.

There are useful analogies for policies in other countries. The US could legislate a pre-announced path of slow but steady increases in energy or carbon taxes (accompanied by immediate short-term offsets, such as a reduction in the distortionary payroll tax or an end to the damaging spending sequester). As in Japan, such measures would enhance long-run fiscal sustainability without weakening demand at a time when the economy has not yet fully recovered from the Great Recession.

In addition, the environmental and national-security arguments in favor of discouraging fossil-fuel consumption work better if the increase in energy prices is phased in gradually. That way, people have sufficient time to make effective decisions about automobiles, home heating systems, power plants, research into new technologies, and so forth.

Similar lessons are relevant in emerging-market economies. Countries like India and Indonesia are now facing possible financial crises, in part owing to large budget deficits, a major component of which has long been food and energy subsidies. Keeping domestic prices for food and energy artificially low has proved to be not only ruinously expensive, but also very ineffective in achieving the declared goal of helping to alleviate poverty.

Some leaders in these countries are aware of the need to reduce these subsidies. A credible, pre-announced phase-out path would provide much-needed reassurance to skittish global investors, without imposing immediate hardship on the poor. At the same time, the ability to plan ahead in anticipation of the price increases would allow more effective responses, as farmers plant different crops, manufacturers switch to more energy-efficient equipment, and so forth.

Governments worldwide face a similar imperative: maintain policy credibility without undermining economic recovery. Bold measures like those envisaged by Abenomics may help. But slow and steady wins the race.