Economics
Japan

Martin Feldstein on Japan’s Economic Quandary

Burgess COMMENTARY
I have followed global economics for something more than 50 years, and do not understand why there is such a preoccupation with economic growth. I understand that it is easier for corporate profits to grow in a growing economy, but corporate profits are not the most important indicator of socio-enviro-economic system health. Rather, the health and prosperity of the population is more important, but pretty much ignored by the big name economists of the modern era. The preoccupation with GDP growth and modest inflation as the optimum economic performance may suit those with wealth, but more than 99% of the world's population has little wealth and their quality of life should be the dominant metric. When this thinking is applied to Japan, the economic state of Japan and its people is in a far better state than most other countries in the world. Peter Burgess ... TureValueMetrics.org
Peter Burgess

Japan’s Economic Quandary

CAMBRIDGE – 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 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. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

COMMENTS

Peter Burgess I have followed global economics for something more than 50 years, and do not understand why there is such a preoccupation with economic growth. I understand that it is easier for corporate profits to grow in a growing economy, but corporate profits are not the most important indicator of socio-enviro-economic system health. Rather, the health and prosperity of the population is more important, but pretty much ignored by the big name economists of the modern era. The preoccupation with GDP growth and modest inflation as the optimum economic performance may suit those with wealth, but more than 99% of the world's population has little wealth and their quality of life should be the dominant metric. When this thinking is applied to Japan, the economic state of Japan and its people is in a far better state than most other countries in the world. Peter Burgess ... TureValueMetrics.org

Procyon Mukherjee MAY 2, 2016 This is similar to the 'problems of prosperity' that Buffet mentioned in the annual share holder meeting. The earliest businesses needed way too little capital and now they need tons of capital and that impacts compounding of growth in equity. When that happens in an economy we edge towards deflation. Reply Comment

Richard Solomon MAY 1, 2016 Abe's fiscal stimuli and structural reforms have been empty gestures, at best. If he is serious about getting the economy going again, he needs to take concerted and ongoing action. Eg, eliminate the tax breaks for married women with children to stay home. Lower corporate tax rates for those companies which hire and promote substantially more women into permanent, full time jobs. Build many more daycare facilities so married women can ensure that their preschool aged shildren will be cared for when they work. Invest and spend much more money on developing renewable fuels as a source of electricity production in the country. The BOJ cannot do much more than it has. It is up to Abe to pick up and carry the ball! READ LESS Reply Comment

John Doyle MAY 1, 2016 This business about the Government Debt is all false. It's very far from being a problem for Japan. 'Government debt' is a misnomer. It's like saying your savings account at your bank is a bank debt. Not to you it isn't. And not to Japan is it either. Governments sell bonds to investors and then just sit on the money, paying interest. At maturity the transaction is reversed and the investors get their money back, the same money as invested. The government has no need to spend investors' money. It has access to all it needs at no cost. So government debt is s sign of wealth, not the contrary. And why would one want to reduce the budget deficit? The fiscal space, the Output gap is huge. There is tons of room to move. Instead we see someone applying leeches to cure enemia! READ LESS Reply Comment

John Brian Shannon APR 29, 2016 Hi Martin, As every economist knows, if the fundamentals of an economy are sound, any conceivable shock to the economy will quickly dissipate and normal economic flows will resume. Unfortunately, Prime Minister Shinzo Abe inherited an economy where the fundamentals were not sound, and more than one parameter was out of alignment. Which is a different way of saying the Japanese economy was designed to fail -- and to do so on his watch. The unexpected shock of the Fukushima-Daiichi meltdown and the subsequent shuttering of Japan's entire nuclear power plant fleet didn't help. Some 29% of Japan's electricity was produced by those (cheap to operate) nuclear power plants. Many of those n-plants are now undergoing decommissioning, or are still offline. Mr. Abe's Three Arrow policies were necessary, timely, and for what they are, effective. In retrospect, there was no other way for Japan to proceed. The country's economy would have imploded had the Prime Minister not acted so appropriately. However, I suspect that even Shinzo Abe knew that it would take more than Three Arrows to reset Japan's economy. But they are a great start to putting Japan's economic fundamentals where they need to be. It will take two more 'Arrows' in order to return Japan to a balanced state -- the 'steady state' where a fundamentally sound economy can withstand moderate political or economic shocks -- whether external or internal. Arrow #4 must surely be an inheritance tax of some significance. Japan's diminishing population pyramid means that domestic demand will continue to taper for many years. With falling tax revenue due to a shrinking population, the government needs money to operate -- providing the same level of infrastructure to a falling population. In Japan's case (similar case in Germany) a moderate-to-high inheritance tax will allow the government to maintain spending in the face of falling income tax and other tax revenues. Arrow #5 must be raising corporate taxes. Consumers will not accept the twin assault of higher inheritance taxes AND yet another VAT increase. That will only result in widespread public disaffection and the result will be Prime Minister Abe being voted out of office after doing so much good work. If consumers (voters) are expected to shoulder a higher tax burden, then corporations must also pay their fair share. If that means that corporate dividends for wealthy investors are a few cents lower, well, that's just too bad. (You understand the Japanese voter sentiment that I'm trying to explain in polite terms?) _____ By raising inheritance taxes and corporate taxes, the government should be able to return to a zero-deficit condition within two years. At that point the Japanese economy will again be in a 'steady state' where it can flourish as a fully functioning economy. A final note; Even though I'm a fan of massive stimulus: At the early onset of economic downturns massive government intervention works very well, but continuing to massively stimulate an economy for longer than 5 years (at the most) results in reaching a point of diminishing returns by the 6th or 7th year. That is why, in order for government intervention to be most effective, it must be massive, it must be early, and it must continue for 5 years or less. (Less is better) Other economic levers must also be applied. We can't expect stimulus to solve fundamental problems with the economy. If the economy hasn't got it's fundamentals in order, massive stimulus only warps the equation -- but in fairness -- it gives the country's leaders a few short years to get those fundamentals in order. _____ Therefore, my prescription for Japan's ailing economy is 'take two more arrows' and get that deficit down to zero, and do all of it within 2-3 years. Prime Minister Shinzo Abe has the credibility and the political energy to get it done. Leaving it for the next Japanese Prime Minister isn't really an option as the economy will continue to deteriorate in the meantime, now that the point of diminishing returns in regards to massive stimulus has, or is about to be reached. Thank you again for publicly posting your thoughts at Project Syndicate! As always, very best regards, JBS READ LESS Comment

John Brian Shannon APR 30, 2016 I've re-written my comment and posted it at: https://johnbrianshannon.com/2016/04/29/3-out-of-5-arrows-japans-abenomics/ If you would like to read it. Cheers, JBS Reply Comment

Marc Laventurier APR 29, 2016 Capitalism as Kabuki. In the States, it's a big-sky morality play wherein the 'native americans' and other livestock will suffer the tragedy implicit in the farce of pretending that immediate private profits constitute growth that will cover the public debt forming a narrowing canyon stretching into the sunset. Reply Comment

Steve Hurst APR 29, 2016 Why is the near automatic answer to recommend raising taxation the solution to growth problems when disposable income is the issue Comment

Robert O'Regan APR 29, 2016 It is a liquidity trap that has no simple solution, like raising taxes. Fiscal policy is best; international factors are working against Abe.