Economic Policy Priorities in 2010
February 3, 2010
Exports to Western markets have significantly declined following the global economic crisis of 2008, preventing the Japanese economy from staging a recovery fueled by external demand, especially in the light of an appreciating yen. This has created a need to stimulate economic activity with fiscal outlays. Over the long term, the government should map out a vision for a shift in the industrial structure to one centered on environment-related industries to create new wealth.
The global economic crisis of 2008 vastly transformed the conditions confronting the Japanese economy. Since the collapse of Lehman Brothers, investment and consumption in the United States fell sharply, resulting in a rapid decline in Japan’s exports. The Japanese economy, which had been relying on exports to fuel a recovery since 2002, suffered a major blow, and its growth rate since the Lehman shock has been the lowest among the major industrial countries. The rapid appreciation of the yen has hindered a return to export growth, moreover, and domestic demand remains sluggish. There has been a noticeable decline in price levels, prompting the government to declare in November 2009 that Japan had fallen into deflation.
The yen moved back down slightly in late December and early January—a trend accelerated by newly appointed Finance Minister Naoto Kan’s statement welcoming the weaker yen. The Japanese economy has yet to fundamentally shake off the Lehman shock, however, as exports remain weak and the yen comparatively high.
Looking abroad, the recovery in the United States remains languid, and prospects of a return to brisk demand are unlikely. Not a few economists project a recovery in the US economy later this year, but many US and European banks are straddled with huge nonperforming assets, which are likely to take years to write off. Many American consumers are having second thoughts about securitizing their homes and spending borrowed funds, so consumption is not likely to return to pre-Lehman levels anytime soon. Chances of a prolonged financial and macroeconomic slump are high in North America and Europe, and Japanese exports to those markets are unlikely to recover quickly. Driving global economic growth henceforth will be emerging economies like China and India, and intense competition will emerge among Japan, the United States, and Europe for shares of those markets.
Short- and Long-term Issues
A broad range of issues pertaining to the Japanese economy requires policy attention. For the sake of clarity, I will classify them into short-term and long-term issues.
In the short run, a key concern is making up for the shortfall in external demand. This will require additional fiscal outlays in the form of government investment and consumption, as well as rejuvenating exports via a cheaper yen. A weaker yen may be achieved either through monetary relaxation to boost the money supply—thereby halting deflation—or intervening in the currency market to drive down the yen’s value.
If we assume that demand in Western markets will remain sluggish in comparison to those in the emerging economies, a longer-term strategy would be needed to either cultivate new markets in and structurally shift the focus of exports to the latter or achieve economic growth on the strength of domestic consumption and investment, without relying on exports. The latter will require reforms in pensions, health insurance, and other social security systems to allay people’s anxieties about the future and encourage greater consumption. A key issue in achieving growth led by domestic demand will be expanding the population, such as by easing the burden of raising children.
Another important long-term issue for Japan is restoring fiscal health. Should government debt continue to swell, the economy could very likely be derailed by instability in interest rates or a shrinking of government services. Net government debt today (total debt minus financial assets) is estimated at around 70% of gross domestic product. If current trends continue, though, net liabilities could exceed 100% of GDP in the not too distant future. Japan’s finances will continue to be in an extremely unstable condition—rarely seen among major industrial countries—for many years to come.
The Direction of the New Administration’s Policies
Since the change of government last year, the administration of Prime Minister Yukio Hatoyama has strongly indicated its intention to tackle long-term issues, such as achieving domestic-demand-led growth and fiscal rehabilitation, but it has seemed less enthusiastic about taking short-term steps to boost government demand and expand exports through a weaker yen. It has reined in public works, such as by scrapping the Yanba Dam construction project in Gunma Prefecture and slashing government programs through a public review of budgetary outlays. These are steps more or less in the right direction as far as meeting the longer-term goals are concerned, but they have a dampening effect on economic activity in the short run. Pushing forward with the review of government programs to trim the budget while at the same time formulating a supplementary budget of fiscal stimulus measures is like stepping simultaneously on the axle and brakes. This has led to confusion about the basic direction of the Hatoyama administration’s economic policy.
Conventional wisdom dictates that the administration address short-term concerns like rising unemployment with expansionary fiscal and monetary measures, while implementing longer-term institutional reforms (of subsidy programs and taxes) to encourage domestic consumption and restore fiscal health. The administration has certainly been consistent about seeking a structural shift to a domestic-demand-led economy, as symbolized by the child allowance and other measures to shift the policy focus “from concrete to people.” But this has tied its hands in meeting short-term needs, since it cannot too aggressively boost spending. It does not want to be seen as pursuing seemingly contradictory policies of short-term expansion and long-term austerity, and so it has not openly advocated an expansion of government spending over the short term, instead calling the public’s attention to its long-term austerity goals. Emphasizing long-term fiscal rehabilitation goals is politically understandable, but since the administration is being forced to adopt an expansionist fiscal policy in the face of a stagnant economy anyway, it should be upfront with the public and come forward with at least a general explanation about how much fiscal stimulus it intends to provide over the short term. Even after the fiscal 2010 budget is passed, there may be a need to adopt a supplementary budget right away, perhaps in the spring before the House of Councillors election. It should indicate its basic ideas on how far it intends to bolster economic activity, either through higher spending or tax cuts.
As the administration remains shy (no doubt, for political reasons) about expounding its economic policy, there are growing expectations surrounding monetary measures by the Bank of Japan. After the government made its deflation announcement in November last year, many economic commentators voiced the need for much bolder monetary relaxation. But it should be remembered that the short-term challenge for Japan is the decline in exports to shrinking Western markets following the Lehman shock, coupled with the appreciation of the yen, which is further retarding a recovery in exports. Deflation (or a price collapse) is the result of the fact that even as external demand is falling, domestic demand is not growing either, leading to a situation in which aggregate demand (domestic demand plus exports) is deficient vis-à-vis aggregate supply. I do not believe, though, that the economy is in a deflationary spiral—a vicious circle in which deflation leads to a contraction in demand, triggering further deflation. (Incidentally, there is neither theoretical nor empirical consensus at the academic level on whether a deflationary spiral is a realistic threat for the Japanese economy.)
The reason for the heightened expectations about further monetary easing is because it would presumably lead to a weaker yen. Such expectations are only natural, given that the problems facing the economy today are a drop in external demand and a strong yen. But there are other ways of inducing a devaluation, such as intervention in foreign exchange markets and an expansionary fiscal policy (which would increase government debt, undermining confidence in the yen and resulting in a weaker currency). The latter policy options are available not to the BOJ but to the administration. Many took issue with Naoto Kan’s statement, made soon after being named finance minister in January, that a weaker yen was desirable; whether or not the remark was appropriate is open to debate, but there is no denying that a cheaper yen—either through monetary relaxation or market intervention—would give an immediate boost to a recovery.
But Japan must also consider its relations with other countries. In the late 1990s and early 2000s, when Western economies were registering robust growth, Japan alone was in recession. Thus there was room for accepting a weak yen. But today, when Western countries are also confronting recession, attempts to boost exports with a cheaper yen means depriving those countries the same export opportunities and hindering their prospects for growth. The United States has openly indicated its desire to increase exports to China and other markets to fuel a recovery, and it may harbor hopes to keep the yen strong against the dollar. If Japan adopts policies to drive the yen down by a significant margin—through monetary measures or market intervention—this will clash directly with US interests. And if it persists without coordinating its efforts with those of other industrial countries, they will no doubt counter with measures to induce a weaker dollar or euro, inviting beggar-thy-neighbor policies of seeking export growth at the expense of other states. The pursuit of a lower yen, even if it escalates into a full-fledged confrontation with Western countries, is not a viable option for Japan. The margin of depreciation will thus need to be rather limited, and policies to achieve a dramatic decline in the yen’s value will remain off-limits.
If a substantially weaker yen is not possible, then achieving growth through higher exports will be difficult. The only other way of boosting aggregate demand, then, is with fiscal approaches.
In addition to addressing employment needs and providing welfare for low-income groups to allay people’s anxieties about the economy, such approaches also need a long-term dimension, clarifying the directions that promise to lead to growth.
One key direction will likely be the environmental field.
International negotiations on global warming countermeasures will continue to take twists and turns. But one thing is certain: Shifting the structure of the Japanese and world economy to lessen its reliance on fossil fuels and giving renewable energy sources a central place will be in Japan’s long-term interests.
According to a world energy outlook by the International Energy Agency, fossil fuel prices will continue rising over the long term. An oil-dependent economy, therefore, will mean paying higher prices to oil-producing states—even if oil reserves do not dry up. Building a new industrial structure free of reliance on oil, on the other hand, will require hefty investments, leading to a bigger burden for taxpayers. But since the use of fossil fuels can be curtailed, there will be savings in oil payments to foreign countries. Creating an industrial structure that is not reliant on fossil fuels will, without fail, bring long-term benefits for both Japanese companies and individuals.
The government, for its part, must make large investments to promote research into and development of environment-friendly technologies in creating a new industrial and social structure. This will result in the creation of job opportunities as well from public works projects and in the environment-related industries, helping narrow the gap between supply and demand and helping stimulate economic activity. A new structure can also help propel sustained economic growth.
Given the desirability of such a structural shift, the problem is securing fiscal revenues. For the time being, at least, the government will have no choice but to secure funds by increasing its debt. This could mean having to significantly increase taxes in the future (in such forms as an environment tax, a higher consumption tax, or a one-time levy of a tax on assets). Failing that, a very high rate of inflation will result, which would effectively result in a decline of real government debt. (Inflation, from an economics viewpoint, is a tax on money, so it would essentially have the same effect as a tax hike.)
Fiscal adjustments of this sort would probably be unavoidable as the economy shifts to a new structure.
The essence of our financial assets lies in the capital equipment built to meet the needs of the old (existing) industrial structure. Should the economy shift to a new structure, the existing plants and equipment would become obsolete and lose their value. Logically speaking, the value of the financial assets of our generation would also plummet. But the creation of new environment-friendly industries would engender new wealth, the proprietors of which would be people of future generations. This is akin to the shift from the agrarian society of the nineteenth century to an industrial one of the twentieth century. Farmland once commanded high asset values, but with industrialization, its importance declined, as did its monetary value. Increasing in value, on the other hand, were new assets in the form of factories and equipment. A similar pattern will likely emerge when the fossil-fuel-reliant industrial society of the twentieth century is replaced by that of the twenty-first century built around renewable energy sources.
Households and investors do not directly own the old capital equipment of the twentieth century, however; their assets are held in the form of financial instruments like bank deposits. Even if the value of the loan assets (collateralized with twentieth-century capital equipment) held by banks dissipates, deposits will not automatically depreciate, for they are protected by government guarantees. Adjusting the value of such household assets to the lower value of banks’ loan assets may require a large asset tax or inflation. This should be seen as part of an unavoidable process of depreciating the now overvalued wealth wrought by underproductive equipment.
A new industrial structure centered on environment-related industries will generate substantial new wealth, and this could help to avoid a fiscal collapse. What the government must do now is to outline a long-term vision for a structural shift in the economy and society and to formulate appropriate fiscal policies to achieve such a vision.