Martin Feldstein :
The Japanese economy is a paradoxical mixture of prosperity and failure. And, in a significant way, its prosperity makes its failures difficult to address.
Japan’s affluence is palpable to anyone who visits Tokyo. The standard of living is high, with per capita income in 2015 (in terms of purchasing power parity) amounting to $38,000, close to the $41,000 average in France and Britain. The unemployment rate, at 3.3%, is substantially lower than the US rate of 5% and the eurozone rate of about 10%.
But Japan’s economy has now slipped into deflation, with consumer prices lower in March than a year ago, while real GDP is declining. Despite near-zero borrowing costs, the fiscal deficit is running at nearly 7% of GDP, and government debt exceeds 230% of GDP. The population and the labor force are shrinking, implying even higher debt ratios in the future.
When Prime Minister Shinzo Abe took office in December 2012, he announced a strategy – comprising three “arrows” – to overcome the economy’s combination of slow growth and low inflation: very easy monetary policy, a short-term fiscal stimulus, and structural reforms to labor and product markets. But the government’s economic policies (so-called Abenomics) have not fixed Japan’s problems and are unlikely to do so in the future.
After Abe appointed Haruhiko Kuroda as the new head of the Bank of Japan (BOJ) and charged him with getting the inflation rate to 2%, Kuroda loosened monetary policy immediately and dramatically, by slashing interest rates and launching large-scale purchases of long-term government bonds. This caused a sharp fall in the value of the yen and sent the interest rate on ten-year bonds toward zero. The more competitive exchange rate raised the profits of Japanese exporters, but not their output, while the weaker yen also raised import prices, reducing the real incomes of most Japanese households.
In January, the BOJ went further and introduced negative deposit rates on commercial banks’ mandatory reserves, which markets interpreted as a confusing act of desperation. That had the adverse effect of weakening household and business demand. And, despite the BOJ’s easing, global financial conditions soon caused a rise in the value of the yen, which rose nearly 10% relative to the dollar.
This week, the BOJ surprised markets by making no policy change at its meeting, contrary to the widespread expectation of a significant further easing of monetary conditions. Markets reacted sharply, with the yen strengthening by 2% against the dollar and the Japanese stock market falling 3%.
Abe began his fiscal policy with a substantial spending program, focused primarily on repairing and replacing infrastructure affected by the 2011 earthquake. But he also raised the value-added tax (VAT) from 5% to 8% to address the enormous deficit and growing national debt. The result was an economic downturn, with two quarters of declining GDP. The level of real GDP now is no higher than it was in 2008.
The third arrow of Abenomics – structural policies aimed at boosting potential growth – has barely been launched. The good news is that there has been some increase in female labor-force participation and in the number of tourists visiting Japan. And a variety of reforms are intended to overhaul the highly protected agricultural sector, though substantial change depends on ratification of the Trans-Pacific Partnership trade agreement (and even then the changes would be phased in only over several decades).
Japan’s declining population and shrinking labor force is a major long-term challenge – reflected in Abe’s call for more women to work outside the home. Although a system of temporary permits allows foreign workers to be employed in Japan for up to three years, the country will not seek to ameliorate adverse demographic trends by opening itself to permanent immigration.
Reluctance to expand the number of foreign workers and to change work customs to encourage more married women to join the labor force may reflect the relative affluence that Japan currently enjoys. The Japanese public may prefer to maintain its current lifestyle and cultural homogeneity, even though doing so is preventing more rapid economic growth.
Japan’s biggest immediate problem, however, is the budget deficit and government debt. If the BOJ succeeds in achieving a 2% inflation rate, the deficit will rise rapidly, as the interest rate on government debt would increase from the current zero level. Failure to implement the spending cuts and revenue increases needed to reduce the budget deficit would undermine confidence in the economy’s prospects and increase speculation that the government would eventually resort to some form of debt repudiation.
Abe thus faces a dilemma in deciding whether to raise the VAT further, from 8% to 10%, as planned. Doing so is undoubtedly hard at a time when GDP has declined and CPI inflation has turned negative. And yet failure to raise the VAT or to cut government spending means continued large deficits and soaring government debt.
Abe has said he would offset the immediate contractionary effect of the VAT hike with a short-term fiscal stimulus in the form of higher government spending. That might allow the necessary permanent reduction of the deficit without causing a repeat of the economic downturn that accompanied the last VAT increase.
Another strategy that might help sustain aggregate demand would be to phase in the VAT increase at an annual rate of 1% for three or four years. This would give consumers an incentive to increase spending, especially on large ticket items, before each increment raises prices.
There is no way to avoid shrinking the budget deficit without jeopardizing debt sustainability – and probably sooner rather than later. If Abe can get public finances under control, Japan will be in a much stronger position to face its other economic challenges.
(Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984).
Courtesy: Project Syndicate.
