Executive Fellow, Economic Research Center
Prime Minister Kan’s concern
The mention of a 10% consumption tax is the highlight of the upper house election manifesto announced by Prime Minister Naoto Kan on June 17. It appears that Prime Minister Kan diligently studied fiscal policy and economics during his tenure as finance minister and now understands the danger of failing to tackle fiscal deficits. This explains why the Democratic Party of Japan (DPJ), which had hitherto been cautious on the subject, suddenly began to lean towards a tax hike. Prime Minister Kan was also likely affected by international conferences where he got a good look at the problems facing Greece and other European countries. According to the Nikkei Shimbun, Prime Minister Kan has expressed that, regarding the necessity for tax hikes, “absent efforts towards fiscal reform, even how we use chopsticks will be controlled by institutions such as the International Monetary Fund (IMF).” He has also made similar comments in stump speeches.
These comments, however, are farfetched. It is important to first understand exactly what the IMF does; a search on Wikipedia reveals the following.
“The IMF aims to promote international trade, maintain high employment levels and national income in member countries, and stabilize exchange rates by providing loans to member countries facing severe balance of payment problems. …To stabilize exchange rates, the IMF provides loans to countries with balance of payment difficulties and monitors the rates and exchange policy in each country. …Since 1979, loans have been provided on the condition that “countries with political climates that might hinder the effect of loans” must “improve policy.” The demands levied on subject countries at this time are called “Structural Adjustment Programs.” Many hold that these IMF “Structural Adjustment Programs” have caused various economic problems (such as unemployment) and social disruption in African, South American, Asian, and other developing countries.”
No place for the IMF in Japan
This is the role of the IMF. Prime Minister Kan likely meant he wanted to avoid such Structural Adjustment Programs being forced upon Japan. As we have seen, however, the IMF only enters the picture when the balance of payments deteriorates, and has no voice in countries free of such problems. Along with China and Germany, Japan enjoys the highest balance of payment surplus in the world, and the yen is presently the strongest currency. In fact, the country Mr. Kan now leads is the least likely to become obliged to the IMF. In contrast, Greece has long been saddled with a deep current account deficit, and has covered this with external debt. But the situation has become unsustainable, and Greece has emerged as precisely the kind of country that requires IMF support.
Prime Minister Kan is not the only one harboring this misconception: many others including certain economists seriously think that Japan is in the same, if not worse, boat as Greece because of its higher GDP ratio of outstanding government debt.
In terms of debt, the countries are indeed similar. The economic effects of external and internal debt, however, are completely different. The Greek government has borrowed euro-denominated cash primarily from non-Greek European banks amounting to nearly the equivalent of its GDP. It must pay back this debt by raising taxes, slashing civil servant jobs, and cutting social security. Because the money is paid back to other countries, Greek citizens suffer lower incomes and deteriorating lifestyles, inciting them to protest and strike. Japan has issued more government bonds than Greece, but it pays the money back to Japanese citizens because all bonds are held domestically. Japanese citizens therefore see no reduction in the money they can spend on themselves in the future. The problems facing Japan and Greece are different in nature, as are their respective responses; Greece is not a useful reference for Japan.
Japan’s first problem: How long can it maintain current account surpluses?
Japan has two problems that it must take seriously. First, is there enough money—in other words, national savings—to continue absorbing government bonds? Put differently, how long can it maintain current account surpluses? The aging of society and stagnating income have rapidly pushed household savings down since 2000, a trend that should only accelerate with the approaching retirement of the baby-boomer generation. On the other hand, money has flowed into the pool of savings from corporate coffers, and interest and dividends from overseas assets—known as balance on income—are increasing; Japan’s current account is unlikely to swing to deficit. Many private think-tanks and banks estimate that the current account surplus can be maintained until about 2020, and potentially much longer if the recent export-driven growth continues. Unless fiscal balance is achieved before the current account falls into deficit over the long-run, Japan will eventually become dependent on external debt and end up facing a problem similar as Greece.
Japan’s second problem: unexpected sell-off of government bonds
The second problem is the possibility that even with savings Japanese investors will eschew government bonds. The already-ballooned Japanese bonds may be unattractive from the perspective of diversified investment. An unexpected event such as a rumor could also trigger a sell-off of existing bonds, leading to a drop in price, hike in the interest rate, and credit uneasiness among the banks holding a surfeit of bonds. Excluding extreme cases such as war, in my knowledge there is no precedent of a government bond sell-off on the market in a country with current account surpluses. So while this is simply a mental exercise, it remains a fact that investors could at any time unload Japanese government bonds in favor of stocks or securities. Foreign hedge funds could in fact be orchestrating such a scenario. Yet, even in this case Japan would not request help from overseas governments or the IMF to pay back debt. Japanese government bonds are denominated in yen, so in the end the Bank of Japan could buy the debt. Greece, on the other hand, is a member of the euro zone and has no such sovereignty over its currency; the central bank buying government debt is not an option.
Inflation emerges when the central bank buys government bonds. The level of inflation depends on the destination of the returned money. The asset price of securities such as stocks and real estate should rise sharply, but the money could also flow overseas, leaving the impact on domestic prices less significant. Given that the domestic excess capacity is still considerable, however, the kind of hyperinflation seen after war is unlikely to emerge. Inflation would depreciate the value of existing bonds, easing the real burden on governments. History is rife with examples of governments reducing debt through inflation. But inflation also raises interest rates, making it difficult to issue new bonds. Before that, it is necessary to pave the road towards fiscal balance.
Crisis even when fiscal policy is sound
Such dramatic market shifts are impossible to predict; even credit rating agencies often miss them. Spain is facing a growing problem, but it was a star of Europe with a fiscal surplus as recently as 2007. On top of the global recession that followed the Lehman shock, Spain saw its private sector slump from the collapse of the housing bubble and subsequent economic slowdown, drop in tax revenue, rise in social security spending, and, in the end, high fiscal deficit.
The 1997 Asian currency crisis, still fresh in Japanese memory, was also not the product of fiscal deficits. Thailand, South Korea, Indonesia, and the Philippines all enjoyed fiscal surpluses up until the eve of the crisis. The massive inflow of overseas short-term money into the private sector followed by its sudden outflow invited instability (see Graph 1). In turn, a sluggish private economy erodes tax revenue and widens deficits. It is therefore a mistake to think that sound finances make governments impervious. The troubled Asian countries shared the following characteristics: the overall balance of the country—in other words, the current account—was in deficit; foreign currency-denominated loans were relied on to cover these deficits; and a fixed exchange rate had been adopted before the crisis. None of these traits are evident in Japan today.
Rush to rebalance on a global-scale
Financial products that securitized sub-prime loans proliferated around the world in 2007, leading to the Lehman shock and a rapid downturn in the global economy. The crisis can be attributed to home mortgages and other excessive debt in the private sector. The sovereign debt crisis in Greece came to light just as signs of recovery were emerging in late 2009. Though the massive amount of debt belongs to the Greek government, it was made possible by over-saving in Germany and Holland.
The global economic crisis that began three years ago is a signal that the coexistence of such excessive savings and debt has reached its limit. The global economy should adjust its trajectory in the opposite direction and pursue a “rebalance.” The US and Southern European countries should endeavor to curb consumption and increase savings while expanding exports. Japan, China, and Germany should create environments favorable to consumption and investment in the private sector. If, for example, corporate governance is made to function effectively, corporate over-savings could be distributed to investors and workers in the form of dividends or wage increases, helping to stimulate depressed consumption. There is no hope for fiscal balance absent such improvement in the economy as a whole. The G8 and G20 summits to be held in Canada at the end of June will likely raise such issues. In this meeting of leaders, discussion will focus not only on public finance but also the overall economy, such as employment and business. It will be interesting to see what lessons Prime Minister Kan will bring back with him.