Tax cuts are not a simple solution for Japan

Gavyn Davies on why fiscal easing does not always boost economies

ECONOMISTS, especially macroeconomists, frequently complain that their work is handicapped by a lack of laboratory experiments. This is why it is so fascinating to study what is going on in Japan - a laboratory experiment in how much damage an egregiously misguided macroeconomic strategy can do to a developed economy.

Last week, this column argued that Japan now stands at a crossroads, with the US urging the Hashimoto government to adopt a further easing in fiscal policy, while the Bank of Japan is apparently flirting with the notion of opening the monetary floodgates. There are no apologies for returning to this topic this week, since the entire world economic outlook could hinge on which of these policy options is chosen.

The US recommends fiscal action because it would boost Japanese domestic demand, and alleviate the Asian crisis without devaluing the yen. But influential voices are now arguing that fiscal stimulus is not sufficient, and that it may become necessary, as a last resort, for the central bank to take to the printing presses.

Paul Krugman of MIT is one such voice, as his insightful new article on Japan's Trap (posted on his personal website, http://web.mit.edu/krugman/www/) explains in detail. He reckons that real interest rates are simply too high to allow private sector spending to rebound, and says that this will remain the case until the central bank generates the expectation of future inflation by announcing a permanent increase in monetary growth. But if the printing presses really were switched on, the consequent devalution of the yen would push China and the rest of Asia into much deeper trouble.

Japan's problem has many dimensions, but at present the key elements are severe debt deflation, along with a liquidity trap which prevents interest rates from falling. What does this combination imply? As recession deepens, and prices fall, the real burden of debt increases, crippling an already-weakened banking sector. The appropriate response from the central bank is obviously to reduce real interest rates, but this cannot be done since nominal interest rates cannot go below zero. In fact, real interest rates - perversely - rise as inflation goes negative.

The traditional analysis of liquidity traps, which dates back to Keynes and Hicks in the late 1930s, emphatically suggests that an easing in budgetary policy, not monetary policy, is the correct way out of this problem. In fact, increases in the money supply are usually thought to be entirely pointless when a liquidity trap exists, because the demand for money becomes infinite. Nominal interest rates on bonds are driven to such low levels (not necessarily zero but probably pretty close) that money absolutely dominates bonds as a medium for savings. If the central bank attempts to pump more money into the system by buying bonds, the money is simply accepted by the private sector with interest rates remaining unchanged at very low levels. Nothing else changes.

Not only is it pointless to attempt to use monetary policy, but budgetary expansion can become extremely powerful in a liquidity trap, assuming that it can affect aggregate demand. This is because interest rates do not rise as demand increases, so there is no crowding out of the extra budgetary spending through tighter monetary conditions. Overall, then, the traditional theory seems to support the case for fiscal, not monetary, medicine in Japan today.

Unfortunately, however, there are genuine reasons for doubting whether this traditional analysis holds. This is because fiscal expansion might not even get as far as increasing aggregate demand in the first place, so the absence of any crowding out through rising interest rates becomes irrelevant.

Here we come to another building block of macroeconomics, the theorem of Ricardian equivalence. This states that, under certain very restrictive assumptions, tax cuts will not stimulate demand. This is because rational consumers will observe that the build-up in public debt necessary to finance the original tax cuts must imply that higher taxes will be needed to service the debt in future. Since households are no better off in the long run, there is no reason why they should raise their spending in the first place.

Usually, full Ricardian equivalence can be safely discarded as a curiosum of the textbooks, but that is not necessarily the case in Japan today. The extremely severe nature of the public sector debt problem, the high profile it has been accorded in political debate, and the imminence of demographic ageing, all imply that consumers may be very sceptical about whether tax cuts can be safely afforded by the government.

Even if they are described by politicians as "permanent", such tax cuts may therefore be viewed by households as very temporary, and might therefore have relatively little effect on spending. This perception is likely to be strengthened by the existence of the Fiscal Structural Reform Law, which insists that the budget deficit must be reduced to under 3 per cent of GDP by 2005. This means that tax payers can anticipate a fiscal tightening of over 4 per cent of GDP in the first five years of the next century - quite a dampener on consumer confidence - even in the absence of more tax cuts in the next 18 months.

As the table shows, the Japanese government is already running a deficit of about 7 per cent of GDP, excluding the (temporary) surplus in the social security budget. The ratio of gross public debt to GDP is close to 90 per cent, and although the net debt ratio looks comfortable at only 23 per cent, this is because the social security system temporarily holds financial assets which will quickly disappear as the population ages. The full severity of Japan's fiscal problem is demonstrated by the figures at the bottom of the table which show that, on present policies, the budget deficit and debt ratios will truly explode in the first third of the next century.

This, of course, is why the the Ministry of Finance has been reluctant to "go for broke" with a massive fiscal easing. From 1992-96, the cumulative fiscal stimulus was about 3.7 per cent of GDP, and according to the OECD this managed to boost the level of GDP at the end of the period by only 1.2 per cent of GDP. In other words, the long-run multiplier from the fiscal boost to final spending was less than one third, which is extremely mediocre by normal international standards.

Notwithstanding these genuine reasons for doubting whether tax cuts will work in present circumstances, there is a strong case for having one more attempt at a huge fiscal package this summer. To have any chance of success, these tax cuts must be described as permanent (which means amending the Fiscal Structural Reform Act); they must be much larger than anything so far contemplated; and they must involve cuts in marginal tax rates at the upper end of the income scale which are not offset by increased taxes lower down. None of these requirements will be easy to achieve. Indeed, the past record of the Hashimoto government suggests that such decisive action is only a remote possibility.

If so, Japan may soon face Krugman's trap, in which the last resort policy of massive and permanent monetisation may begin to look like a gamble worth taking.

Suggested Topics
Start your day with The Independent, sign up for daily news emails
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Guru Careers: Software Developer / C# Developer

£40-50K: Guru Careers: We are seeking an experienced Software / C# Developer w...

Neil Pavier: Management Accountant

£45,000 - £55,000: Neil Pavier: Are you looking for your next opportunity for ...

Sheridan Maine: Commercial Accountant

£45,000 - £55,000: Sheridan Maine: Are you a newly qualified ACA/ACCA/ACMA qua...

Laura Norton: Project Accountant

£50,000 - £60,000: Laura Norton: Are you looking for an opportunity within a w...

Day In a Page

Sun, sex and an anthropological study: One British academic's summer of hell in Magaluf

Sun, sex and an anthropological study

One academic’s summer of hell in Magaluf
From Shakespeare to Rising Damp... to Vicious

Frances de la Tour's 50-year triumph

'Rising Damp' brought De la Tour such recognition that she could be forgiven if she'd never been able to move on. But at 70, she continues to flourish - and to beguile
'That Whitsun, I was late getting away...'

Ian McMillan on the Whitsun Weddings

This weekend is Whitsun, and while the festival may no longer resonate, Larkin's best-loved poem, lives on - along with the train journey at the heart of it
Kathryn Williams explores the works and influences of Sylvia Plath in a new light

Songs from the bell jar

Kathryn Williams explores the works and influences of Sylvia Plath
How one man's day in high heels showed him that Cannes must change its 'no flats' policy

One man's day in high heels

...showed him that Cannes must change its 'flats' policy
Is a quiet crusade to reform executive pay bearing fruit?

Is a quiet crusade to reform executive pay bearing fruit?

Dominic Rossi of Fidelity says his pressure on business to control rewards is working. But why aren’t other fund managers helping?
The King David Hotel gives precious work to Palestinians - unless peace talks are on

King David Hotel: Palestinians not included

The King David is special to Jerusalem. Nick Kochan checked in and discovered it has some special arrangements, too
More people moving from Australia to New Zealand than in the other direction for first time in 24 years

End of the Aussie brain drain

More people moving from Australia to New Zealand than in the other direction for first time in 24 years
Meditation is touted as a cure for mental instability but can it actually be bad for you?

Can meditation be bad for you?

Researching a mass murder, Dr Miguel Farias discovered that, far from bringing inner peace, meditation can leave devotees in pieces
Eurovision 2015: Australians will be cheering on their first-ever entrant this Saturday

Australia's first-ever Eurovision entrant

Australia, a nation of kitsch-worshippers, has always loved the Eurovision Song Contest. Maggie Alderson says it'll fit in fine
Letterman's final Late Show: Laughter, but no tears, as David takes his bow after 33 years

Laughter, but no tears, as Letterman takes his bow after 33 years

Veteran talkshow host steps down to plaudits from four presidents
Ivor Novello Awards 2015: Hozier wins with anti-Catholic song 'Take Me To Church' as John Whittingdale leads praise for Black Sabbath

Hozier's 'blasphemous' song takes Novello award

Singer joins Ed Sheeran and Clean Bandit in celebration of the best in British and Irish music
Tequila gold rush: The spirit has gone from a cheap shot to a multi-billion pound product

Join the tequila gold rush

The spirit has gone from a cheap shot to a multi-billion pound product
12 best statement wallpapers

12 best statement wallpapers

Make an impact and transform a room with a conversation-starting pattern
Paul Scholes column: Does David De Gea really want to leave Manchester United to fight it out for the No 1 spot at Real Madrid?

Paul Scholes column

Does David De Gea really want to leave Manchester United to fight it out for the No 1 spot at Real Madrid?