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【Japan's way out may be to spendーBy Brian Reading】
Financial Times; Sep 16 2002
Most commentators argue that Japan's problems are structural. They blame high personal savings. They say fiscal reflation has failed leaving a legacy of soaring debts. Japanese public finances so the argument goes are unsustainable as Standard & Poor's asserted in April when it dropped Japan's sovereign credit rating to equal that of Botswana. Failing fiscal consolidation a debt trap is inevitable.
The trouble is that the facts do not fit the theory. Japan's problems lie with companies not consumers. Fiscal policy has been immensely successful. Continued profligacy better directed may be the solution to Japan's problems.
Supply-side constraints did not cause Japan's post-bubble stagnation. Japan suffers excess capacity. Actual gross domestic product growth is below potential. But consumers are not to blame: the personal savings ratio has fallen. Slow consumption growth is a consequence not a cause of slow income growth. True the savings rate may rise again when incomes grow once more. But the rise in savings will absorb only a part of the income increase and consumer spending will accelerate.
Japan's economy collapsed because bubble-bloated private investment collapsed. During the bubble days the corporate sector ran a record financial deficit - the excess of investment spending over its own savings (retained earnings) - financed by borrowing. This reached 4 per cent of GDP in 1989. Companies ran up record debts.
When the bubble burst retrenchment was essential for survival. Investment was slashed plants closed pay and bonuses were cut and jobs were shed. This is a normal reaction in times of hardship and as history has shown the collapse of investment and consumption can often lead to depression. Yet in Japan it led only to stagnation.
By 2001 Japanese companies had turned the 4 per cent deficit in 1989 into a 5 per cent surplus. On a national accounts basis Japanese companies are now extremely profitable: corporate retained earnings have reached 20 per cent of GDP. But operating profits have disappeared down a black hole of bad loans stock losses and pension fund top-ups. As a result the bottom line of Japanese company accounts is abysmal.
To compensate for the huge retraction of corporate investment the government started spending lavishly turning a budget surplus of 2 per cent of GDP into a huge deficit of 7 per cent. In other words the government filled the yawning hole in aggregate demand left by the retreat of the indebted corporate sector.
Budget balances can deteriorate cyclically because of recession or structurally through tax cuts and spending increases to prevent one. The Organisation for Economic Co-operation and Development estimates that only ? per cent of the 1989-2001 Japanese budget deterioration was cyclical. The remaining 8.5 per cent was structural. It is true that massive fiscal easing failed to prevent stagnation. But it did save Japan from outright depression.
Corporate investment has fallen but not far enough. Corporate balance sheets have improved but remain unhealthy. Corporate retrenchment will continue until balance sheet health is restored. Failing a massively increased current account surplus continued big-budget deficits are inevitable. Yet deficits are so big that the danger is surely a debt trap.
Paradoxically fiscal consolidation on its own increases the danger of such a debt trap. When a government cuts its deficit it reduces the rise in public sector debt. But it also reduces the rate at which nominal GDP is growing. If GDP growth slows more than debt growth the debt ratio rises. That is exactly what would happen in Japan.
To make consolidation work monetary easing must offset fiscal tightening to sustain GDP growth. But with near-zero short-term interest rates Japan has virtually no scope for making the necessary cuts. One possibility would be to increase the money supply instead of cutting interest rates. The Bank of Japan or commercial banks could finance the budget deficit boosting money supply. But this worthwhile option continues to be strongly resisted by the Japanese authorities.
Alternatively consolidation could work through the mechanism known as "Ricardian equivalence" - whereby individuals might save less today in the belief that a healthier fiscal position means they will be taxed less in the future. Again this is highly improbable. Except in inflationary times high debt ratios have never been cut by fiscal tightening. Instead faster growth is the solution to debt problems. Take the example of Britain which reduced debts of 300 per cent of GDP in 1947 to less than 60 per cent in 2001. Budget deficits pushed up debts but growth and inflation reduced their burden. By contrast fiscal consolidation in the early 1930s caused Britain's debt ratio to soar.
In the case of Japan profligacy may offer a way out increasing GDP growth more than debt. True this is not without risk: while interest rates cannot fall they can rise. The Bank of Japan might hold fire on short-term rates but markets could push up long-term rates. Even so they would not rise a great deal immediately since much outstanding government debt is long term.
Fundamentally Japan has surplus savings which the government mops up at negligible cost. It pays 1.4 per cent of GDP servicing its 140 per cent debt an interest cost of 1 per cent - the highest debt and nearly lowest interest rate among the OECD countries. When surplus savings are reduced the government would have to pay more for its borrowing. But lower savings would boost GDP growth meaning that the government would not have to borrow as much.
Japan can afford big budget deficits and build up bigger debts until corporate balance sheets are again healthy and private investment stops falling. Resumed GDP growth would enable budget deficits to be cut while monetary policy would remain relaxed. But when - as now - prices are falling and money easing is ruled out premature fiscal consolidation is a disastrous proposition.
The writer is director of Lombard Street Research
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