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Tuesday, November 28, 2006

The Fiscal Position In Japan

Glancing through the OECD Japan Economic Survey 2006 section on the Japan's current fiscal position, I couldn't help having some inconvenient thoughts.

Now as explained here, societies with high median ages and large fiscal deficits (like Japan, Germany and Italy) really face a very special problem: they need to generate sufficient economic growth on a sustainable basis (and since with high median ages they have comparatively low propensity to consume from additional income, and a comparatively high propensity to save, this means export-driven growth) to create sufficient revenue for the exchequer to be able to balance income and expenses. None of the three usual suspects have been able to achieve this balance in recent years - and they have therefore seen their net financial position deteriorating - so it is clear that if they are going to be able to convince the financial markets that long term their position is sustainable, then they need to be able to change course, and demonstrate an ability to maintain the change. This, I take it, is what all the fuss about the 'sustainable recovery' is all about.

The curious thing is that despite all the fuss about the fact that this has been the longest boom since the Izanagi cycle of the late 1960s you tend to read comparatively little about this problem, or about the macro implications of addressing it.

The OECD estimate the current level of the debt/GDP ratio at around 170% of GDP. Now this number is highly contested, since they do have assets in a social security fund, but, otoh, if you count these, so the argument runs, then you also need to take into account implied liabilities, and from here on in there is a large accounting and political wrangle.

I am inclined to take the same view as the Standard and Poor's guy who was very un-impressed by recent attempts by the Greek and Italian governments to reclassify upwards their GDP values by incorporating estimates for the informal economy (an attempt we should note which did to some extent cut ice with Almunia at the EU Commission, I guess those who inherently want to be convinced are grateful to anyone who can offer them a reason why they should be). Basically the S&P's guy said that all this makes little difference since what matters with sustainability is revenue and expenditure, and how they balance. This is what determines the dynamic of the debt, and informal activity by definition doesn't pay tax.

So the same goes for Japan. What matters isn't really the exact number to be attached to the debt/GDP ratio (which in any event is large) but whether the relation of expenditure to revenue is moving towards a balanced path or whether they are spiraling out of control. In the context of population ageing this issue is huge, since obviously stagnant GDP opens the possibility that such debts may NEVER be payable, something which no-one yet seems to want to contemplate, but this doesn't mean that at some point or another markets won't wake up, and maybe with a jolt.

(Incidentally, just a little side dish at this point. We have had a series of red-herrings in the great ageing debate, and one of these is the issue of stock market meltdown. In fact this confusion comes from applying a time horizon which is far too long - so many studies focus mechanically on the 'magic number' of 2050 - and a rigid idea of the life cycle theory, whereby people dis-save as they get to the oldest-old ages. What we can see is that you need to look at a much shorter time horizon - I would say 2010 to 2020, wasn't Keynes's big 'discovery' the ability to distinguish between short, medium and long terms, something which despite the frequent use of the 'in the long run we are all dead' quip, few seem to think about. Sometimes I think that, in economic terms, we live in something of a fools age. The other point would be that before we reach the dis-saving age - if we ever reach it, in fact the oldest old seem to be very spendthrift, so somehow I have my doubts here - we go to an age of increased saving, this is what we are seeing in the older countries across the globe. People are being very mislead here by the savings decline in the US. So I think that rather than stock market melt down what we may see is a very low rate of return environment - remember I am talking 2010-2020 - and the real issue is about what the pension funds can realistically offer their clients if this environment holds).

So I think that at some point the markets will wake up, and this is one of the reasons that I have become so interested in Hungary, since this may well become the first case in history of a country which finds itself stuck on just such an unsustainable (or rather self-evidently unsustainable, since Japan and Italy, IMHO, are already on unsustainable courses, but no-one wants to recognize this) path. Hungary may become the case where this conclusion becomes hard to avoid. I say may, and I mean may, but since the *possibility* exists this certainly makes it worth following for this reason alone, apart from everything else that can be learnt there, and the pure technical fascination of the situation for anyone interested in macroeconomics, it is just such a classic case in some senses, but a classic case with a new, and potentially deadly, ageing twist.

The thing is that if people do start to wake up over Hungary, then eyes will turn to Italy, and if there is a crisis in Italy, then this will obviously lead to a reconsideration of what exactly is going on in Japan. I think I am tentatively outlining a scenario (or possible scenario) here.

So to close, just one or two details on Japan:

Limiting the growth of government spending is the priority in addressing the serious fiscal problem. The FY 2001 Structural Reform and Medium-Term Economic and Fiscal Perspectives set an objective of freezing public expenditure at 38% of GDP through FY 2006, and this target is likely to be achieved. Such spending restraint, which was achieved in part through cuts in public investment, aimed at the goal of a primary budget surplus for the combined central and local governments in the early 2010s. On a general government basis, the primary budget deficit has fallen from 6.7% of GDP in 2002 to an estimated 4% in 2006, with about half of the decline due to structural factors, and the rest accounted for by the economic expansion.


What we should note here are really two things. Firstly that despite everything Japan is still running a substantial fiscal deficit, and that really this deficit hasn't reduced hardly at all if you take into account the fact that half of the saving has come from increased revenue during the boom, and that the other half, which has been a real reduction, may well reverse if 'automatic stabilizers' are applied during the downturn.

Then there is this:

The Reference Projection for the FY 2005 Reform and Perspectives shows a primary budget balance for the combined central and local governments in 2011. However, a balance would not be adequate to stabilise the level of public debt relative to GDP in the long run if the nominal interest rate on government debt exceeds the growth rate of nominal output. While the economic expansion and an end to deflation may push the nominal growth rate above the interest rate in 2006, assuming that growth remains higher would not be prudent for setting a medium-term fiscal objective. Indeed, population ageing will tend to slow output growth while possibly increasing the interest rate. In sum, stabilising the public debt to GDP ratio is likely to require a primary budget surplus for the general government of between ½ and 1½ per cent of GDP.

The point about interest payments is important since of course if rates were to rise in Japan this would put even more pressure on the budget deficit, since the costs of the debt would rise for the Japanese government, which is another reason why some at the finance ministry may be urging the BoJ to exercise caution in raising rates. Indeed Japan may already be in some kind of trap here, given the continuing weakness of domestic consumption. Fortunately (from this point of view) rates are not likely to rise (IMHO) and I fully expect Japan to be back in Zirp either sometime in 2007 or in early 2008.