Confronting the Risk of a Fiscal Meltdown
February 3, 2012
A decade ago, Japanese economists were warning that the consumption tax might have to be raised as high as 15% to achieve fiscal sustainability over the long run. But since then the aging of Japan’s population has exceeded predictions, and the economy has foundered in the wake of the 2008 Wall Street meltdown.
Recently, analysts have begun to conclude that a consumption tax rate of 25% will be needed to restore Japan to fiscal health—assuming the government also makes substantial cuts in social-security spending. Without such cuts, the tax rate needed to avert a debt crisis could soar to 30% or higher.
Lest there be any misunderstanding, this is the consumption tax rate required to stabilize the ratio of debt to gross domestic product at a sustainable level, not to actually pay off the national debt. Even with a 25% consumption tax, the debt would continue to grow.
What’s more, the situation is deteriorating rapidly. According to a recent study by Takatoshi Ito of the University of Tokyo and Takeo Hoshi of the University of California, San Diego, the Japanese government can achieve fiscal sustainability if it raises taxes now, but if it waits another three years, the debt will explode, and the situation will be out of its control. Clearly, time is of the essence.
Some maintain that the debt problem can be solved without tax increases or spending cuts as long as economic growth picks up. But according to an analysis by Hitotsubashi University economist Kazumasa Oguro, a “natural” increase in revenue sufficient to restore government finances to good health would be possible only if growth in per capita gross domestic product reached an unrealistic 3.7% or if inflation soared 14%.  Needless to say, 14% inflation would be devastating for Japanese households.
What will happen if government finances continued to deteriorate? Eventually the government will default, financial institutions investing heavily in Japanese government bonds will fail, and a major recession will ensue. So far there are no quantitative studies estimating the impact of a fiscal crisis in Japan, but the examples of countries like Greece and Italy give us a fairly clear idea of what would happen if the markets lost confidence in the Japanese government’s ability to repay its debts.
Interest rates would soar, businesses would collapse, and the ranks of the jobless would swell. Senior citizens would see the value of their savings and other assets tumble in the face of rampant inflation, and many would doubtless fall below the poverty line.
If the administration of Prime Minister Yoshihiko Noda is unable to make any headway on the debt problem, we will have to await the next general election and the time required for a new government to settle in and win support for a plan of its own. This will mean another three or four years of inaction at the least.
Although Japan’s relatively large household savings rate has helped support its massive public debt to this point, few believe that the situation is sustainable for more than another seven or eight years. Without some progress toward fiscal reform over the next few years, the prospect of a Japanese bond market collapse will begin to loom very large.
In fact, for some, the biggest mystery is why Japanese government bond prices have not crashed already. The current situation is such that the smallest impetus could trigger a panic in the bond market, and one can only wonder what prevents such a crash from occurring. Yet despite this precarious situation, Prime Minister Noda has been unable to drum up political support for his proposed tax increases. What does the government need to do to rally the public behind painful fiscal reforms?
Sharing the Pain
To win such support, the administration needs to offer three things: a package of measures demonstrating the willingness of public servants to share in the sacrifice; a roadmap toward the government’s long-term goals for tax and welfare reform; and a detailed timetable showing how both reforms are to proceed concurrently.
Even before Noda came to power, the ruling Democratic Party of Japan had committed itself to a “unified” reform of the tax and welfare systems on the grounds that expenditures and revenues should be approached as part of an integrated package. Economically, the government was correct to stress this linkage, but to succeed politically, Noda needs to focus on a different kind of unity as well. If voters are to be called on to accept painful reforms, they need to know that their leaders and representatives are willing to share the pain.
To win voters’ support for fiscal reform, the government must demand sacrifices not only from ordinary people but also from the country’s public servants—including politicians, national and local civil servants, and employees of quasi-governmental organizations like national universities and the Bank of Japan. It can do this by including in its reform plan measures to reduce the number of seats in the National Diet, cut Diet members’ compensation, and reform the civil service system to reduce pay for local as well as national government employees.
Practically speaking, these measures will have a negligible effect on Japan’s massive deficit, but they will do much to marshal political support by conveying the message that those who make and implement painful policies are prepared to share in the sacrifice.
This is the same issue underlying the controversy that erupted over construction of civil-servant housing in Asaka (Saitama Prefecture) and Honancho (Tokyo). Suspension of these construction projects was one of the more popular decisions taken by the government since the DPJ came to power, but last fall Noda reversed that decision and announced that construction would be resumed.
Noda offered various economic rationales, but reviving the projects was an obvious political blunder, and the administration was obliged to backpedal in the face of strong opposition. This could have been avoided if the government had understood how deeply voters resent public servants who refuse to give up their own perks even while imposing sacrifices on ordinary voters.
A second requirement for gaining political acceptance of a tax and welfare reform plan is to issue a roadmap clearly setting forth the government’s long-term fiscal goals and the means of reaching them. Simply presenting a timetable for increasing the consumption tax to 10% is not enough,  particularly given the growing belief that a rate of around 25% will be required in the long run. Reform of the social security system, likewise, should start from clear-cut goals for overall cuts in social spending on the elderly, including the pension system, healthcare, and nursing care.
Finally, the government should draft and enlist the opposition parties’ support for a truly integrated reform timetable detailing measures that impact public servants (downsizing and pay cuts) as well as ordinary households (tax hikes and cuts in social security spending).
The government must realize that voters will not stand for a tax increase that is not accompanied by cuts in outlays for public employees. But it must also understand that simply trimming fat from around the edges of the budget will not get us to the goal of fiscal sustainability, and further that time is of the essence. That is why substantive tax and welfare reforms must be carried out concurrently with these largely symbolic reforms of the Diet and the civil service.
Toward a Global Expanding Equilibrium
Fiscal reform must demand sacrifices from both the private and public sectors, but a plan that does no more than this is a prescription for economic contraction. The government needs to put forward a vision and strategy for economic growth along with its plan for fiscal retrenchment.
The first element of this growth strategy should be to expand Japan’s role as a global investment superpower by making the most of growing demand in the emerging economies and other regions with prospects for rapid growth. With European banks pulling capital out of Asia, Japanese financial institutions have an opportunity to step in and meet the need for financing in the region’s emerging economies. In this way they can support rapid growth in those countries and aid the Japanese economy in the process.
Meanwhile, the yen’s unprecedented strength presents an opportunity for Japanese manufacturing and other industries to expand overseas. Direct investment and overseas production will initially boost Japanese exports, and the profits from such investment will benefit the domestic economy and create jobs at home. Subsequent losses of manufacturing jobs can be compensated for through deregulation aimed at creating jobs in Japan’s healthcare and eldercare markets.
Second, Japan should adopt a more strategic approach when providing assistance to alleviate the European debt crisis. Until now we have merely responded to requests from Europe and the United States in piecemeal fashion. This approach exposes Japan to asset risk, with no payoff to speak of. We would be far better off announcing our own initiative to provide financing on the order of 30 trillion yen to 50 trillion yen, provided the debt is fully guaranteed by the European Union. In addition to enhancing Japan’s international status, such financing would help stem the yen’s rise.
To provide it, the government would have to purchase large quantities of euro-denominated bonds (either common European bonds or instruments issued by the European Financial Stability Facility), and this would have the same effect as the massive selling of yen and buying of euros—which is how the Bank of Japan intervenes in currency markets to keep the yen from soaring further.
In short, by providing bailout funds for the EU in this manner, we can automatically address economic issues at home stemming from the yen’s excessive appreciation. Such a policy is sure to have a salutary effect on the Japanese economy.
The Need for Fiscal Risk Management
Over the long term, expanding the government’s holdings of overseas assets would also have a stabilizing effect on our government finances, as I explain in greater detail elsewhere.  A plunge in Japanese government bond prices would sharply weaken the yen. But if the government moves now—while bond prices remain strong—to float large issues of yen-denominated bonds and buy up the same amount in foreign assets (that is, assets denominated in a foreign currency), it will serve to blunt the yen’s historic rise and avert too precipitate a drop in the yen’s value later on.
Such a policy would function in the same manner as conventional government intervention to stem the yen’s rise by selling yen and buying another currency. Moreover, if the public sector expands its holdings of foreign assets now, government finances should benefit from the relative appreciation of foreign assets relative to yen-denominated assets farther down the road, when the yen begins to depreciate. In this way, the investment in foreign assets can serve as a hedge against a debt crisis.
Finally, our leaders must have a contingency fiscal plan to contain the damage in the event that the Japanese bond market really does crash. Of course, the government has a responsibility to manage its finances so as to avoid such a collapse. But that does not give it license to neglect contingency preparations on the grounds that the worst-case scenario is too awful to contemplate. We have seen the dangers of such thinking in the context of Japan’s nuclear energy policy, where a failure to prepare for a full-blown disaster (in the belief that such a disaster must never happen) allowed the damage to snowball to horrendous proportions.
Our government leaders and politicians have a duty to learn from this tragedy and draw up a contingency plan—including emergency tax increases and social-security spending cuts—to restore the market’s confidence with the least possible impact on Japanese households in the event of a fiscal meltdown.
 Kazumasa Oguro and Keiichiro Kobayashi, Nihon hatan o fusegu futatsu no puran (Two Plans for Preventing Japan’s Financial Collapse), Nikkei Premium Series, 2011.
 Noda announced on December 29, 2011, that the tax would be hiked to 8% in April 2014 and to 10% in October 2015.
 Ibid. 1