The Japanese Fiscal Crisis

My thoughts are the outcrop of reading Megan McArdle’s article “Japan and the Limits of Keynesianism” and following her links.  The post war Japan economy experienced strong economic growth culminating in the 1980’s.  Real estate and stock prices tripled.  Like China today, Americans both marveled and feared its strength but weaknesses of an underdeveloped financial sector unraveled the Japanese mystic.

In late 1989, the Japanese Finance Ministry raised interest rates and asset prices collapsed, beginning Japan’s “Lost Decade.”  The financial weaknesses of many highly indebted, poorly run corporations were exposed but they were sheltered from the winds of creative destruction by a government that deemed them and the backs that loaned to them as too big to fail.    The government responded with Keynesian deficit spending to try to kick start the economy, but with little positive effect.  The private sector financial crisis turned into a government sector fiscal crisis. 

How bad is the Japanese fiscal crisis?  They have the highest debt-to-GDP ratio in the developed world and over half the current budget is debt financed.  Megan quotes views of two other writers, Felix Salmon and Matt Iglesias, and then gives her own.Salmon implicitly assumes that cutting deficits is the proper policy and cannels one of my biggest fears.

The lesson here, I think, is that it’s very, very hard for a government to enact a serious fiscal adjustment unless and until the bond market forces its hand. The Brits are trying, of course — and we’ll see whether or not the coalition government can succeed. But as we saw with George W Bush, the fiscal rectitude of one administration can be more than wiped out during the course of the next.

Even now, with the attention of the world more concentrated on sovereign fiscal issues than ever, the Japanese government can still contrive to raise agricultural subsidies by 40% and send child-care payments soaring, including payments to families who don’t need the money. It’s even getting rid of highway tolls. Oh, and it’s cutting the corporate tax rate.

From a bond-market perspective, this basically just means an ever-greater supply of JGBs: we’re still a very long way from any real credit risk, given the political power of the owners of those bonds. But as a lesson in fiscal political economy, Japan is much more worrisome. Everybody agrees that the budget must be cut and the country put onto a sustainable fiscal course. But no one is capable of doing that, and instead they go in the opposite direction entirely. It’s the see-no-evil easy choice to make. And I suspect that we’ll see continue to see similar choices being made in other highly-indebted countries around the world. Including the US.

Matt Iglesias pushes for increased immigration and printing money.

Normally, though, we expect human beings and the organizations they run to respond to incentives. If people cease wanting to buy Japanese debt, then the Japanese government will find ways to issue less debt. But demand for Japanese debt is high, so why wouldn’t the government keep issuing more?

That’s not to say these endless debts are optimal policy for Japan. What they ought to be doing is trying to have more economic growth. Finance their government with a bit less debt and a bit more printing of yen. That’ll create elevated inflation expectations and spur growth. More immigrants wouldn’t hurt either. I think the real mystery is why unconstrained governments are so reluctant to really put the pedal to the metal.

I agree that pushing immigration could help Japan’s aging population with the infusion of a little young blood.  The population is declining and the median woman is 46 years old.  I hope that he is correct in assuming that the government will solve the budget puzzle when Japanese stop buying debt and don’t agree with his “helicopter drop” plan to print money.  Having spent a couple years in Argentina during an inflationary binge, I have little confidence that inflation will produce growth, even in a deep recession.  It will lower long run growth.  I do believe that Japan pushed the pedal to the metal, but instead of unleashing 400 horse power of policy muscle, found instead 120 horses pulling an economy with four flat tires. 

McArdle focused on the limits of Keynesian fiscal policy.

Japan has simply reached the limits of Keynesian policy in an economy which has never managed to jolt itself back up to a healthy rate of growth.  Demographics is obviously a big contributor to that slow growth, and there are a whole host of secondary factors one could nominate, but whatever the reason, they have now had two decades of anemic growth, which they have fitfully attempted to address with stimulus.  Maybe not enough stimulus, maybe badly designed, but they've certainly tried to follow the basic Keynesian playbook:  borrow money and spend it when times are bad, in the hopes that you can bring back growth.

But for Japan, at least, the growth has not materialized.  Few economists would advise undertaking a fiscal adjustment, on the scale that Japan requires, in the face of the current crisis.  The problem is, there hasn't been a good time for retrenchment in 20 years.  I can't blame the politicians for trying to restore some semblance of normal growth in the run-up to elections.  But at some point, they're going to have to cut back, whether or not it's a good time. 

All the authors offered insights into policy that our policymakers should consider to avoid a lost decade.