by Adam S. Posen, Peterson Institute for International Economics
Adam Posen, senior fellow, summarizes the main conclusions and recommendations of his Restoring Japan’s Economic Growth, published by the Institute in September 1998, and assesses the subsequent initiatives of the Japanese government.
© Institute for International Economics. All rights reserved.
As ever in Japanese economic policy, the reality is in the implementation. The banking reform bills passed by the Japanese Diet in mid-October and the fiscal stimulus package contained in the FY1999 budget proposed by the Obuchi government address the two major barriers to a restoration of confidence in Japan: financial fragility and lack of domestic demand. Combined with the Bank of Japan's efforts already underway to stop deflation, these initiatives could bring about a sustained recovery in Japan (and provide a floor under developments in the rest of Asia)—if they are properly carried out.1
The legislative program is in itself a healthy correction of an ongoing mistake in Japanese policy—resigned acceptance of economic stagnation. From 1992 to the present, the Japanese government claimed to be undertaking significant public investment and stimulus packages while consciously spending only one-third of the amount commonly estimated. In the midst of the 1990s recession, Japanese fiscal policy was, in fact, often contractionary because of misplaced budgetary priorities. Cleanup of the banking sector was repeatedly postponed, first with claims that the problems were small and would fix themselves and then with fears that the problems were too large to be tackled without making matters worse.
On both fronts, however, poor economic performance was always the result of policy choice. A rapid return to the growth of which Japan remains capable was, and still is, attainable through responsible policies. As I argued in Restoring Japan's Economic Growth, sizable fiscal stimulus in the form of permanent tax cuts, financial cleanup through sorting out banks on the basis of solvency, and monetary expansion anchored by an announced positive inflation target would constitute such a program. Now that the Japanese government will have a legislative mandate to engage in that type of fiscal expansion and banking reform, the how-tos for successfully implementing that mandate should be set out.2
How to Expand Fiscal Policy
When true fiscal stimulus was undertaken in Japan, as occurred in September 1995 when a 1.6 percent of GDP public investment program was combined with a temporary consumption tax cut equivalent to 1.2 percent of GDP, substantial economic growth of 3.9 percent ensued in the following year. When consumption taxes were raised from 3 percent back up to 5 percent in April 1997, and public investment was cut in 1996 and 1997, the economy contracted. The folly of this stop-go policy has been compounded by the small size of all prior stimulus packages, except that of September 1995.
Size matters for fiscal policy because, unless an economy is stimulated above its rate of potential growth, unemployment will continue to rise and capacity utilization will continue to drop. Confidence, and with it consumption and investment, will erode further. For this reason, a small fiscal stimulus package may be a waste of money, whereas a sufficiently large fiscal package will lead to sustained growth. The Obuchi government is thus correct to think in terms of passing a stimulus program larger than a minimum threshold in order to have the visible impact necessary to restore confidence.
How much is large enough? Fiscal stimulus of 4 percent of GDP (20 trillion yen) is the number to shoot for. Japan's potential rate of growth remains at least 2 percent a year. Given an expected contraction in the Japanese economy of 1.5-2.0 percent of GDP in 1998 and the need for fiscal stimulus to make up the difference between that and potential, the content of the package should be about as great as the sum of those two numbers.
There will be a multiplier effect on fiscal expansion greater than one, as there clearly was for the September 1995 package. At least initially, however, the multiplier will be lower than usual, given the current lack of confidence and the banks' weakness, which is the reason for stimulus to almost equal the output gap in size. There is no reason not to err on the side of too much stimulus, because the Japanese economy is hardly in danger of overheating.
A temporarily dampened multiplier on fiscal policy should not lead to misplaced fears that a large tax cut would be saved rather than spent, offsetting the stimulus. There has never been an instance anywhere of a large, credibly lasting, tax cut that did not filter out into the real economy, not in the United States in the 1970s (before deregulation and improvements in productivity growth), not even in prereform Latin American economies in the 1980s—economies which had financial or confidence problems arguably worse than today's Japan.
This consistency of response makes economic sense because, by transferring present and future income out of the government's hands and into the private sector's, there is an increase in wealth and a decrease in uncertainty for individuals. Both of these stimulate spending no matter what those individuals' beliefs are about the state of the economy. In addition, the evidence from Japan and elsewhere is clear that a primary determinant of short-run savings behavior is recent economic growth in the savers' country, which means that as fiscal expansion improves growth, spending is encouraged and investment is crowded in.3
It is true that interest rates on Japanese government bonds have risen in recent weeks in response to the stimulus announcements. Some perspective must be maintained on the limited importance of this development. Japanese interest rates still could hardly be lower and even in real terms remain lower than almost any government has paid to borrow this century. The idea that the world's largest creditor nation—with the lowest net public debt in the G-7, absolutely no government debt issued in foreign currency and essentially no debt (less than 1 percent of GDP) held by foreign creditors—will become a default or even an inflation risk is patently absurd. The few percent of GDP in additional debt issued to support appropriate fiscal stimulus today will make no difference to the aging Japanese society's social security burdens tomorrow.4
The proposed FY1999 budget comes close to, but is still short, of the ideal number, containing about 15 trillion yen (or 3 percent of GDP) in actual stimulative content, once the usual deductions for previously promised spending and for irrelevant programs is made. It is in the form of the stimulus, however, that there remains significant room for improvement. As proposed, half of the stimulus will come through new public spending and half will consist of personal and business income tax cuts for FY1999.
The entire fiscal stimulus in Japan should instead take the form of permanent tax cuts. Any form of tax cut is better than the wasteful public works spending repeatedly undertaken in Japan. In general, permanent tax cuts reduce distortions in the economy, induce future cuts in public spending (as the Reagan deficits did in the United States), and provide a clear signal of commitment from the government. With tax cuts, unlike public spending, there is no way for bureaucratic resistance or implementation delays to impede the full disbursement of the money—factors of indisputable importance to the failure of Japanese stimulus packages in the 1990s.
The type of tax cut is less important than its size (and that it is not public works). There is clear reason, however, to prefer tax cuts that are permanent and that are structurally neutral if not positive. Permanent tax cuts, which are taken into account in multiyear planning, are more likely than temporary cuts to be spent and to reduce uncertainty.
Income tax cuts or housing tax cuts (combined with appropriate deregulation5 ) would be best because they would remove gross inefficiencies and inequities while stimulating. At present, only 50 percent of Japanese households pay income tax, and there is enormous pent-up demand for housing in Japan. Such cuts would go directly to those Japanese households whose increased discretionary saving is the source of the downturn. Meanwhile, consumption taxes cannot credibly remain low for an extended period because they are the most efficient way to collect taxes, especially in an aging society.
The goal of any expansionary fiscal policy should be sustained growth. Not even fervent advocates of fiscal stimulus for Japan believe that government support for aggregate demand could or should continue indefinitely. This is precisely why the new fiscal stimulus must be sufficiently visible, sizable, and rapid so as to improve private-sector expectations and induce a sustained upswing in private-sector demand. Further credibility gaps between stated expansionary intent and actual impact will impose a heavy cost—an exact repeat of the 1996 cycle of temporary stimulus, uncertain expansion, and then fiscal contraction could be devastating to confidence.
How to Solve the Credit Crunch
The Japanese government's statements greeting the first few private banks' acceptance of public capital made it seem that the plan to recapitalize Japan's banks would be far less conditional than desirable. The events of recent weeks, especially the commendably expeditious closure of Nippon Credit Bank by the Financial Supervision Agency, demonstrate that proper implementation of financial cleanup may in fact be underway. As I predicted when the financial reform bills first passed the Diet in October, the cleanup appears ready to succeed despite widespread political intent to maintain business as usual.6
This prospect for success arises because the pressures on the Japanese banking system from both international markets and Japanese savers have increased and changed in severity in recent months. Savers are increasingly looking for alternatives to domestic Japanese banks and finding them in insurance companies, postal savings, foreign banks, and even cash; foreign banks have moved from charging Japanese banks a premium to do business, to refusing to act as counterparties with those banks. As a result, there is increased incentive for the better or too-big-to-fail Japanese banks to differentiate themselves from their weaker brethren and decreased ability of the weaker Japanese banks to withstand the market discipline.
This healthy separation does not make a successful cleanup inevitable. Concerted efforts by Japanese politicians to maintain some form of convoy system could derail the process. Though some members of the government may genuinely believe that widespread and unconditional injection of public capital is necessary, they are mistaken that capital alonewill ease the credit crunch without additional reform efforts. In fact, only a credible bank reform program—including forced bank closures, management replacement, bad loan selloffs, and improved disclosure and supervision—will restore credit flows while minimizing disruption.
Repeated invocation of the “hard landing” scenario has promoted the myth that, if Japan were to truly clean up its financial sector problems, the credit crunch would radically deepen. The reality is different. Japan is not the first economy of the Organization for Economic Cooperation and Development (OECD) to have a banking crisis and asset price decline—in fact, almost every industrial democracy experienced something similar in the last 12 years. While none of their financial problems were allowed to grow and fester to the extent that Japan's was, we did learn some basic lessons that apply to Japan as well.
First, although no one should expect to clean up a country's banking problems overnight, or even over a couple of years, you limit the cleanup's ongoing drag if you put a transparent process in place for deciding which banks to close and how to dispose of bad loans. It is not as though one day the Japanese government announces "there is 75 trillion yen in bad loans, and 125 million Japanese citizens, so each of you will write a check for 600,000 yen." The public gets to spread out the cost over several years, and the ultimate bill meaningfully shrinks from the initial estimate of bad loans, because as the economy improves, some money is received for bad loans sold off, and banks make better loans with improved incentives. This only works, however, with a process justifying the conviction that supervision is decent for new loans, that banks getting public capital are truly solvent, and that a liquid market for distressed assets like real estate is created.
Second, cleaning up a financial mess in the right way is not entirely contractionary for an economy. There are compensating effects that expand credit as well. Although forcing banks to meet capital standards, and closing some banks, will contract credit, the removal of uncertainty about the system as a whole will allow surviving banks to borrow more easily on interbank markets, will encourage good borrowers with low risks to come back into the credit market, and will improve the ability of banks to sort out bad from good lending opportunities. It also encourages individual savers to put more of their money back into the private banks, thereby reducing the cost of funds and the uncertainty of cash flows for those banks, further improving the flow of credit.
These two points taken together mean the contractionary effect of proper financial cleanup should not be thought of as imposing a "100 trillion yen hit", or anything close to that number, on the Japanese economy all at once. Improper or partial financial cleanup ignores both lessons—it simply spends public money that will eventually add to the bill due, and it foregoes the expansionary effects of reform by leaving market uncertainty undiminished.
That is why the financial cleanup must be carried through in line with the market pressures for a differentiation among Japanese banks. A lenient public capital injection alone will be ineffective in alleviating the Japanese credit crunch. Neither Japanese depositors nor Japanese banks' counterparties in financial markets will believe that the public money is being well spent rather than gambled on high-risk loans or paid out to shareholders. Neither will be able to verify whether banks truly are solvent. The pointlessness of less-than-credible claims of solvency can be seen in the rising pressures upon the Japanese financial system in the last year despite repeated statements that its banks (including the now nationalized LTCB) already met the Basle Capital Adequacy standards.
Without proper cleanup, the ongoing distrust by depositors and interbank lenders will deprive the Japanese banks of liquidity, and that part of the new capital that is not squandered will be inevitably eroded. Even in the initial period before the capital disappears again, good and new borrowers will be unable to arrange loans in an environment where their potential collateral is constrained by the lack of disposal of assets underlying bad loans. Add the ongoing risk of runs on Japanese banks, and interbank markets refusing to roll over their short-term paper (not just charging a Japan premium), given the ongoing lack of transparency, and nothing has changed from the previous situation despite the injection of public funds.
The bank recapitalization legislation passed by the Diet in October can form the basis for a successful financial reform in Japan. The bill as written contains the key elements required, including the needed commitment of public funds, but also the admission that some banks must close, distinctions between banks on the basis of solvency, the bolstering of an institution for the disposal of bad loans and distressed assets, and the separation of banking supervision from the Ministry of Finance. The law itself is not significantly more vague than the initial pieces of legislation that began successful financial cleanups in other OECD economies in the past decade. It is only some parts of the Japanese government's apparent intent to implement the laws with excessive regard for current bank shareholders and management, and therefore without regard for moral hazard, that might make a failure out of a success.
Recovering Some Optimism
Japan can make a rapid return to sustainable growth, and there is good reason to believe that the legislation of Fall 1998 and the FY1999 budget could make that return possible. It is heartening that, after years of ill-advised austerity by its predecessors, the Obuchi government has committed itself to passing a large fiscal stimulus package. As the Japanese Diet moves to pass the 1999 budget, it should increase the size of the stimulus to a full 20 trillion yen and, more importantly, mandate implementation of the stimulus through permanent income tax cuts. This would be a structurally sound manner of expansion that would avoid confidence destroying administrative delays.
On the financial side, the law is in place. What remains is the cleanup. Even if lenient implementation of solvency standards or political pressure to keep banks open and lending is genuinely intended to aid the Japanese economy, it will not actually do so. Luckily, market discipline in the form of continued depositors' and foreign financial firms' withdrawal of funds seems to be forcing the Obuchi government to truly solve the credit crunch in the only manner possible. Doing so will hurt less than people think. The remaining short-run contractionary effects of the financial cleanup are an additional reason why sizable fiscal stimulus must be undertaken at this time.
The fact that an optimistic outlook for the Japanese economy is attainable through proper implementation of fiscal and financial policies is a double-edged sword. As seen in the healthy pressures on the Japanese financial system, there remains the real risk of an outright collapse in financial and consumer confidence in Japan. Such a collapse would likely prompt capital flight, and thereby put the Japanese government in a dilemma with no easy solution—the policies necessary to restore confidence in the yen in such a situation (i.e., raising interest rates, contracting deficits) would be the exact opposite of the policies necessary to restore financial stability.7
A Japanese-led capital outflow from Asia and the yen decline accompanying it would harm the growth of Japan's already hard-hit neighbors.8 It would also further enlarge trade imbalances between Asia and the United States and Western Europe, putting additional pressure on political support for the open world economy. Thus, a failure to properly and rapidly implement the appropriate policies for restoring Japan's economic growth could provoke exactly the crisis that the Japanese government—and the world economy—must avoid.
1. Japanese fiscal expansion would play a central role in a “Concerted Asian Recovery Program” as advocated by C. Fred Bergsten, “APEC to the Rescue,” The Economist, 7 November 1998. Given its size and high level of development, Japan is the only economy in the region which can undertake fiscal expansion independently and still have significant benefits domestically as well as positive spillovers on its neighbors.
2. For a discussion of an appropriate monetary policy for Japan, see Adam S. Posen, “Japan Needs an Inflation Target,” Asian Wall Street Journal, 30 July 1998, and Restoring Japan's Economic Growth, chapter 5.
3. Restoring Japan's Economic Growth, chapter 3, discusses these relationships between private saving, public spending, and growth.
4. Like every wealthy aging country, Japan cannot meet its future social security obligations through any acceptable level of taxation. To close the shortfall, Japan must increase some combination of its birthrate, its retirement age, its immigration, or its participation of women in the workforce.
5. For more on the housing problem in Japan, see Takatoshi Ito, The Japanese Economy (Cambridge: MIT Press, 1994), chapter 14, and Bela Balassa and Marcus Noland, Japan in the World Economy (IIE, 1988), chapter 4.
7. I discuss this disaster scenario in chapter 4 of Restoring Japan's Economic Growth.
8. Marcus Noland, Sherman Robinson, and Zhi Wang, The Global Economic Effects of the Japanese Crisis, IIE Working Paper 98-6.