September 3, 1998
|Contact:||Adam S. Posen||(202) 328-9000|
Washington, DC—Japanese stagnation in the 1990s is the result of mistaken policies of fiscal austerity and financial laissez-faire, rather than any increase in fundamental structural weaknesses or failures of "the Japanese model." In Restoring Japan's Economic Growth, Adam Posen documents that the actual fiscal stimulus undertaken by the Japanese government during 1992–97 was only one third of the amount commonly estimated and that Japanese policy was at times contractionary. When real stimulus was undertaken, as occurred only in 1995, substantial economic growth ensued. When taxes were raised in 1997, the economy contracted.
In short, fiscal policy works in Japan. But the Japanese government injected only 23 trillion yen (4.5 percent of GDP) of total stimulus into the economy from 1992 until this summer's package, far short of the usual estimates of 65–75 trillion yen. It took out 2 percent of GDP in contractionary fiscal policies in the same period. This stop-go policy has been compounded by all stimulus packages, except that of September 1995, being too small in size. Japan should therefore now adopt the following steps:
Fiscal stimulus of 4 percent of GDP prior to year-end 1998. Unless the economy is stimulated above potential growth of 2.0 to 2.5 percent per year, unemployment will continue to rise and capacity utilization will continue to drop. Confidence, and with it consumption and investment, will erode further. A small fiscal stimulus package may be a waste of money whereas a sufficiently large fiscal package will lead to sustained growth. Given an expected contraction in the Japanese economy of 1-1.5 percent of GDP in 1998, and a rate of potential growth of at least 2 percent, fiscal expansion should be greater than the sum of those numbers.
Fiscal stimulus should take the form of permanent tax cuts. Permanent tax cuts are more likely than temporary cuts to be spent and to affect consumer planning. Income tax cuts are better than consumption tax cuts because they get money to salarymen whose lack of consumption is the problem. Given the inequities of the Japanese tax code, income tax cuts constitute reform as well as stimulus.
Either form of permanent tax cut, however, is better than public works spending. Tax cuts reduce distortions in the economy, induce future cuts in public spending (as the Reagan deficits did), restore confidence, and provide a clear signal of commitment from the government.
Deficits should be funded by short-term government debt. Issuing short-term rather than long-term government debt, the government's traditional mode, has four advantages. It encourages long bond holders to shift into corporate investment. It offers cash hoarders a safe substitute for currency, thereby recycling savings. It forces the government to confront the issue of debt rollover in the near-term, when times are better. It adds liquidity, which is currently lacking, to the Japanese debt market.
While the Japanese economy does suffer from structural weaknesses, there was no sudden worsening of these problems that could cause the stagnation of the 1990s. Accordingly, Japan's primary economic goal should be to make up the shortfall between its current and potential rates of growth, still at least 2 percent a year. In the short run, growth can in fact be considerably faster than 2 percent annually until the large accumulation of unemployed workers and resources are re-employed. Japan need not wait for significant structural reform, beyond a resolute but finite banking system clean-up, to grow again. Structural weaknesses present opportunities for increasing potential growth in the future, not a constraint on the ability of Japanese policy to raise growth to its current potential.
In addition to fiscal stimulus, Dr. Posen outlines an effective and politically feasible program for Japanese economic recovery that includes monetary stabilization and financial reform. Its unifying principle is the restoration of domestic Japanese confidence, thereby ending the self-fulfilling contractionary trend towards excessive savings and capital flight.
Monetary policy, Posen argues, should be oriented to stabilize price expectations in the economy against both deflation and inflation. The Bank of Japan therefore should:
Announce an inflation target of 3 percent for 2000. Deflation is clearly harmful, especially when debt is held by a fragile financial system. Unanchored monetary expansion, however, will simply replace deflationary restraint with inflationary uncertainty. A positive inflation target, enough above zero to be clearly expansionary but finite and public so that it provides a floor on price expectations, offers most of the advantages of "turning on the presses" without incurring many of its risks.
Yen depreciation should not be a goal of policy. A decline in the value of the yen, like unanchored inflation, increases uncertainty and erodes wealth. Such loss of purchasing power encourages people to take money out of the economy and deters investment. In addition, it is less effective in stimulating the economy than domestic policies because its benefits are concentrated in particular (export-oriented) sectors. Depreciation also poses the risks of a competitive devaluation response by other countries and of a protectionist response to further increases in Japan's trade surplus.
Financial reform needs to follow the model of prior banking system clean-ups in the United States and other OECD economies in the 1980s and 1990s. Posen suggests the following guidelines:
At a bank closing in the near future, clarify the extent of deposit guarantees by directly paying off individual account holders to the limit but no higher and by not paying stock holders or counterparties;
Put new capital only into solvent banks;
Hire a new corps of supervisors and have them act with a sense of urgency to provide information identifying which banks merit saving;
Privatize the Postal Savings system, to stop the ongoing government-subsidized run on the Japanese private banking system.
The likely short-run contractionary effects of these necessary efforts to put the Japanese financial system on a sound footing are an additional reason why fiscal stimulus and monetary stabilization must accompany financial reform.
The risks to the Japanese economy are mounting. There is a threat of sizable capital flight and disintermediation, the first signs of which we are already seeing. The risks from declining confidence, financial fragility, and international tensions would then reinforce each other. Such an event would put Japan in a policy dilemma with no ready solution—those policies which would support the financial system (lower interest rates, public infusion of capital, easy monetary policy) would drive the yen further downward and vice versa. Policy inaction or gradualism, which appears prudent, may in reality be reckless when such downside risks are present.
The United States has an enormous interest in Japanese economic recovery—for its own economy and as a means to assist recovery from the Asian crisis. However, the US role is limited. Diplomatic pressure on the Japanese government has had only modest success. Economic brinkmanship by the United States, through threatening to let the yen fall or increase trade protection, would increase the risks to U.S. interests and be counter-productive. The only constructive option open to the U.S. government is positive engagement, offering political and economic support (e.g., coordinated currency market intervention) conditional on explicit timetables of Japanese policy change.
The author concludes that Japan's relative (and absolute) economic decline in the 1990s is due to mistaken policies of fiscal austerity and financial laissez-faire. The episode does not provide a verdict on the "Japanese model"—to the limited extent that such a concept is valid, it remains as much a combination of good and bad attributes as when Japanese performance was an example to be emulated. There are two lasting lessons for policymakers from this crucial episode: that counter-cyclical macroeconomic policies retain their importance, and that policymakers should be held accountable for short-run economic outcomes—as the Japanese public itself indicated in the upper-House elections of July 12.