CONVENTIONAL WISDOM ON JAPAN IS WRONG / THE FINANCIAL TIMES COMMENT & ANALYSIS

Conventional wisdom on Japan is wrong

Solving its economic problems means doing something about private sector surpluses

Martin Wolf



Why is Japan finding it so difficult to raise inflation to its 2 per cent target? Why has its monetary policy become so extreme? Why is Japan’s public debt so remarkably high? The answer is that the country shares challenges confronted by other high-income economies, but in extreme form. This does not mean its situation is disastrous. It means that conventional wisdom is misleading.

Despite the efforts of the Bank of Japan, year-on-year inflation (without fresh food and energy) is only 0.2 per cent. Yet nearly five years have passed since, in concert with the government, the BoJ declared its intention to hit a target of 2 per cent inflation. Then, in April 2013, it announced “quantitative and qualitative easing”, which unleashed a huge expansion of its balance sheet. In January 2016, it announced a modestly negative rate on new bank reserves. In September 2016, it announced “yield curve control”. It has even said that it would continue to buy assets until inflation “exceeds the price stability target of 2 per cent and stays above the target in a stable manner”. That is a commitment to future irresponsibility.

Yet even all this has failed. This is not because these measures — supported by expansionary supplementary budgets — have failed to stimulate the economy. The rate of unemployment has fallen to 2.8 per cent, a level last seen in 1994. The Organisation for Economic Co-operation and Development has forecast growth at 1.5 per cent this year, up from 1 per cent in 2016, and it expects growth of 1.2 per cent and 1 per cent, in 2018 and 2019 respectively, both slightly above potential. Moreover, gross domestic product per head grew at close to the average rate of OECD members between 2012 and 2016. (See charts.)

Yet the anchoring of inflation expectations appears so strong — at about zero in Japan — that wages and prices remain sticky. Does this matter? In an inescapably slow-growing economy, such as Japan, near-zero inflation does limit the effectiveness of monetary policy in a downturn, since it makes it harder to deliver negative real interest rates. Yet recent experience suggests monetary policy still works. The failure to raise inflation appears no disaster.

Two more important challenges exist. On one of these, current orthodoxy is right. On the other, it is wrong.

Where orthodoxy is right is on productivity. Given Japan’s demography and currently low unemployment, raising productivity is essential, though increasing participation of women and older people also matters. Fortunately, Japan enjoys room for productivity improvement: its average productivity per hour is among the lowest of the high-income countries; big business is far more productive than smaller firms; and manufacturing vastly more productive than services.

Where orthodoxy is wrong is on public deficits and debt. It is true that gross debt is 240 per cent of GDP and net debt about 120 per cent. Without elimination of the structural primary fiscal deficit (now close to 4 per cent of GDP), debt ratios are likely to rise still further in future. It is not surprising that official institutions — the OECD, the International Monetary Fund and the Ministry of Finance — agree on structural tightening. Yet there are two objections. 

The first is that the BoJ holds more than 40 per cent of all Japanese government bonds. It can continue to hold this debt forever, should it need to do so. It can also continue to pay no interest on commercial bank reserves if it wished. It need only change required reserves. More fundamentally, the Japanese public is the creditor: it is not hard to see ways for the government to manage its liabilities to the public. When the government ceases to run primary deficits, it could, for example, convert its debts into irredeemable low-yielding bonds.

The more important point is that the government’s persistent deficits are simply the mirror image of the private sector’s huge and persistent financial surpluses. There is no point in discussing how the government will eliminate the former without indicating what is likely to happen to the latter.

One possibility is for Japan to run far larger current account surpluses. In 2015, for example, that would have required a current account surplus almost twice as big, at close to 6 per cent of GDP. Foreigners would surely not have liked that. The alternative is for the Japanese private sector to invest more or consume more (or both). The problem with the first option is that Japan’s private sector already has an exceptionally high investment rate, especially for a high-income country with structurally low growth. The difficulty with the latter is that Japan’s household savings rate is already close to zero. Consumption will only rise if household income does.

The solution is not to tax consumption, as respectable opinion suggests. The solution is to tax savings. Uninvested and undistributed profits need to be turned into consumption. That could be done by “expensing” investment, while (quite logically) eliminating depreciation allowances.

Conversion of uninvested and undistributed corporate profits into private consumption would eliminate the private sector surpluses and so the need for offsetting public sector deficits. In the absence of such policies, efforts to close the fiscal deficits are likely to fail, since, as has happened so often before, they are likely to tip the economy back into recession. In the absence of some such reform, the Japanese private sector is doomed to lend to the government the money it cannot currently use, in the sure and certain knowledge that it will never get back in full what it has lent.

Fiscal tightening is the respectable solution to Japan’s soaring public debt. On its own, however, it cannot work.