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.Reuse content