Abe’s Taxing Fall

Japan’s economic dilemma is this: The country needs to find a way to kick-start an economy that has been moribund for much of the last two decades while simultaneously regaining control of its public debt, which in gross terms is the highest in the world at a level well beyond twice GDP.

The solution to the dilemma is – in theory at least – quite simple: Recognize that Japan’s economic malaise is structural, not cyclical, and use structural reforms to correct it. When that is done, use a mix of austerity and inflation to tame the debt, much of which the government anyway owes itself.

Abenomics – the branding given to the economic policies of Japanese Prime Minister Shinzo Abe – is at least partially based on this understanding, but the devil is in the execution. Attempts at meaningful structural reform very quickly run into a wall of special interests, from farmers to doctors, so powerful that they defeat even a ruling party that for nearly two years has governed with virtually no organized political opposition.

Japan’s structural problem is also not hard to pinpoint. Its population is in decline, which is a drag on demand, and by extension borrowing and investment. Fixing this would take a mix of increased immigration, better support for working women, and a productivity boost. Alas, opening Japan’s doors to large-scale immigration remains a political non-starter. And while much lip-service is now being paid to improving the lot of working women, meaningful progress is elusive. The best short-term hope is for a breakthrough on productivity. The proxy for this is the Trans-Pacific Partnership, which would open Japan’s huge and ineffective service sector to international competition that would encourage productivity gains. Unfortunately, with Abe’s negotiators beholden to Japan’s tiny but very vocal farm sector, talks on the trade bloc have stumbled.

Without that kind of meaningful structural reform, Abenomics is left with the countercyclical tools of fiscal spending and monetary easing. Even Abe doesn’t pretend that his fiscal spending is anything new, but his team has done a masterful job of convincing pundits and ordinary citizens that aggressive monetary easing to tame deflation will somehow get the Japanese economy back on its feet. It won’t. (Monetary policy also has implications for Japan’s debt, of which more in a moment.) Deflation in Japan is simply a symptom of its structural weakness in demand. Flooding the economy with cash may produce stock and real estate mini-bubbles, to the delight of foreign investors, but it won’t prompt non-existent consumers to spend or companies already struggling with overcapacity to invest.

With only feeble economic kick-start policies, then, the economy is simply not able to withstand any attempt at austerity. In its wisdom, the Japanese government has – until very recently – believed that the best tool for increasing government revenue in a demand-weak economy is to tax spending, via a consumption tax, even as consumers were being asked to contend with both a weaker currency and an inflation target.

That belief was badly shaken when the consumption tax was raised from 5 to 8 percent on April 1 of this year, and snuffed out whatever growth momentum Abe’s government had hitherto managed to achieve. In fact, the setback has been more severe than it was the last time the tax was raised, in April 1997, when the economy also had to contend with the Asian Financial Crisis and domestic financial sector failures.

Under the current consumption tax legislation, which to be fair was introduced by the previous Democratic Party of Japan government, but which has been adopted by Abe’s Liberal Democratic Party, the prime minister was to decide by the end of this year whether to raise the consumption tax again, to 10 percent, in 2015. Both the Ministry of Finance and the International Monetary Fund want him to do it, while the Japan Center for Economic Research predicts a sovereign bond default if the consumption tax is not raised to 19 percent (although sovereign currency issuers tend to inflate, not default). 

But with two quarters of contraction, Japan is back in recession. With that contraction, political and public enthusiasm for another tax hike has disappeared. Hence the snap election, scheduled for December 14, which Abe hopes will give him a mandate to delay the next tax hike and, more importantly, take on the entrenched interests – many of which are in his own party – opposed to his reform agenda.

The consumption tax debate doesn’t resolve the nation’s basic dilemma, leaving Japan with three possible end games. First the pressure for reform will intensify to the point that the country undertakes the radical structural reforms it needs to return to growth robust enough to withstand higher taxes. Second, the Japanese government will opt for a more innovative approach to austerity, one that looks to tax idle money (savings) rather than spending, for instance in the form of a balance-sheet tax. Third, Japan will monetize its debt; in other words, the Bank of Japan will fund the government.

Most likely that Japan will muddle through with a mix of the first and third options. A steady drip of structural reforms – always too little, too late – will combine with the one area where the Japanese government has been prepared to innovate: monetary policy. 

Normally, debt monetization would raise the specter of hyperinflation, wiping out public debt and the public’s savings. But Japan’s is an interesting case: It has deflation by default. This suggests that it might be possible to at least partially monetize Japan’s debt without significant inflation. Indeed, this is already happening. The Bank of Japan has been able to push the envelope on bond purchases into the realm of effective monetization with no discernable impact on yields, notably again at the very end of October.
In an interesting piece on the excellent Project Syndicate site, Adair Turner, a former chairman of the U.K. Financial Services Authority, predicts that a chunk of Japan’s debt will be permanently monetized (noting that the Bank of Japan could potentially reduce the total public debt by around 60 percent of GDP), and argues that in Japan’s case this may well not matter.

Whatever the outcome, it is clear that Japan is treading new territory in economic management. When it is done, post-industrial economics will not look the same. Japan is an outlier in many respects, but other industrialized countries face similar demographic destinies. They would do well to watch and take note.