Japan: Don't Sqeeze Me Too Tight

Japan economic specialist Richard Katz, writing in today's Financial Times, questions the advisability of turning the fiscal pressure screw in Japan. It's difficult to see how a country suffering deflation (or the imminent threat of it ) can benefit from further fiscal tightening. If in doubt ask the Germans.

It is not easy for a rich country to get itself into as much economic trouble as Japan has. In the postwar era, only Switzerland has stagnated as badly for as long. While the root cause is structural defects, policy blunders have repeatedly made a bad situation worse. They are at it again. Once more, the Ministry of Finance wants to raise taxes in a time of economic weakness. Last week, MoF officials and some business leaders discussed raising the 5 per cent consumption tax by 1 percentage point in 2004 and then another percentage point each year until it reaches 16 per cent. This comes on top of a permanent increase in government fees, equal to 0.5 per cent of gross domestic product, beginning in April that outweighs temporary tax cuts now being considered. In short, Tokyo exhorts consumers to spend more even as it takes away their means of doing so.

The last time Tokyo raised the consumption tax - from 3 per cent to 5 per cent, in 1997 - it triggered Japan's worst postwar recession to that point, caused the ruling Liberal Democratic party to lose the 1998 upper house elections and toppled the prime minister. Since then, GDP has grown a miserable 0.3 per cent a year and private domestic demand is still below the pre-tax peak. Why does the MoF propose to repeat the fiasco? The MoF argues that unless Japan begins closing its fiscal deficit - 7-8 per cent of GDP each year since 1998 - government debt will spiral out of control. Already, the debt-to-GDP ratio has soared from 80 per cent in 1995 to a projected 150 per cent this year. This trajectory, argues the MoF, will ultimately make mounting social security costs unpayable and could lead to financial calamity.The MoF reasoning is flawed. To be sure, Japan cannot keep expanding the debt-to-GDP ratio for ever. Nor can fiscal stimulus alone restore economic vibrancy. But the time is wrong for a contractionary fiscal stance - a cure worse than the disease.
Source: Financial Times
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Katz is obviously right about the likely negative impact of an increased consumption tax in Japan. He is also right in pointing out that, thanks to ultra-low interest rates, government interest payments today add up to 2 per cent of GDP, compared with 3 per cent in the late 1980s. Whatsmore, for some years to come, the burden will continue to lessen since the average interest rate currently paid on outstanding bonds is 2.2 per cent, which is far above the 0.9 per cent rate on 10-year bonds in the secondary market. So as old high-interest bonds mature and are replaced with new low-interest ones, the average interest burden will continue to fall. Where Katz goes astray, in my opinion, is in not seeing the impact of this on debt dynamics. As government debt continues to rise the cost of eventually raising interest rates becomes horrendous. Thus there will be no incentive to work to produce inflation since the impact on interest rates will be likely to hit government financing so hard that the most probable effect would be to send Japan straight back into recession! At the same time doing nothing, and continuing to sit back and watch the deflation process at work (even if at a rate of only 1% or 2% per annum) will see the debt/GDP ratio moving steadily upwards until it finally becomes unsustainable, even if the cost of servicing the debt remains small. When will people finally wake up and realise that it is the demographic processes itself which lies behind all this, and that if Japan does nothing about its demographic problem (eg opening the doors to immigration) then there will continue to be be no end in sight.