By Claus Vistesen: Copenhagen
Even though the big news of last week undoubtedly is represented by the one trillion session in London, the smaller than expected nudge from the gents at Kaiserstrasse and the emerging talk of a market bottom and impending recovery, I am going to wonkishly stay on the topic with respect to my latest long piece on the land of the rising sun and its economic woes. One issue which I dealt with was the skewed nature of Japan's growth path dependent on exports as well as the derivative issue of how to raise consumption in Japan or put more broadly; how to spur domestic demand in a sustainable way? My answer to this question is more or less implicit in the analysis linked above, but before we get to that let me present two alternative suggestions or, as it were, arguments. One in the form of a piece by the Economist fresh off of the newest print edition and one more wonkish and academic by economist and investment adviser Cesar Molinas.
As for the Economist, they are not quite convinced that the story of Japan is also a story about export dependency and thus that this has something to do with demographics. That does not surprise me since the Economist's has, on several, occasions attempted to debunk this argument. Here I won't take directly issue with this claim but rather indirectly by scrutinising the following argument by the Economist;
The OECD predicts that public-sector debt will approach 200% of GDP in 2010, so the scope for further fiscal stimulus will be limited. Nor can Japan rely on exports for future growth; to the extent that it had enjoyed an export bubble, foreign demand will not return to its previous level. Japan needs to spur domestic spending.
One possible option, which the government is exploring, is to unlock the vast financial assets of the elderly. Japanese households’ stash of savings is equivalent to more than five times their disposable income, the highest of any G7 economy, and three-fifths of it is held by people over 60 years old. Gifts to children are taxed like ordinary income, but if this tax were reduced, increased transfers could boost consumption and housing investment since the young have a much higher propensity to consume. In theory, this could give a much bigger boost to the economy than any likely fiscal stimulus.
Of course, one reason why the elderly are cautious about running down their assets is concern about the mismanaged pension system and future nursing care. Services for the elderly should be among Japan’s fastest growing industries and create lots of new jobs, but they are held back by regulations which restrict competition and supply. Deregulation of services would not only help to improve the living standards of an ageing population, but by helping to unlock savings might also drag the economy out of deep recession.
The key to notice here is that the Economist talks about unlocking the savings of Japan and thus about making those large coffers of assets, primarily held by the mature parts of the population, work. What is Particularly interesting here is the idea to move money from the wealthy old generations to the young and further to implement tax incentives to optimize the effect from this. This sounds intuitively right and seems a sound policy proposal. But there is a big difference between transfers in kind (bequests) and investments (see Molinas' article).The Economist seems to be talking about cutting taxes for transfers in kind which would increase consumption in the sense that that the propensity to consume is higher amongst younger generations. In principal I am not in disagreement here although one has to wonder whether in fact those ever smaller younger generations really do have such a high propensity to consume. Basic ricardian equivalence and life cycle theory suggest that these transfers would be saved just as much by the young as by the old in the sense that as the young cohorts grow ever smaller relative to the burden they have to support through the tax system they also need to start saving earlier (and more) for their own retirement However, the most important point is that the Economist's suggestion effectively amounts to rapid dissaving and, in fact, even more rapid dissaving than if the elderly cohorts were to spend their wealth themselves. Note that this would effectively be dissaving and thus effectively not a good thing for Japan in the sense that it is not easy to see how Japan would replenish these savings. Moreover, as I have argued time and time again societies do not dissave they same way as their microagents do since this would effectively amount to a society/economy having an end point. Rather, they need to make those savings work.
Enter the article by Molinas.
Now, I could say a lot of interesting things about Molinas' piece and especially about how to operationalize demographics (and deflation) through the use of that illusive subjective discount rate. Essentially, this would allow us to approach the issue through the use of representative agent models and even though this may create a host of issues on its own and essentially be inappropriate, it means that we can start with a model well grounded in traditional neo-classical methodology. This may not be a virtue in itself, and for some not at all, but it is a place to start and an important one in the context of economic modelling.
Anyway, and moving on to the issue at hand there is an important twist in the way Molinas approaches the issue of lack of domestic demand (and thus deflation). Let us look at the following;
Taxation may be the best instrument for fighting deflation in the long run. At the core of deflation lies the problem of elder generations keeping their wealth away from entrepreneurial undertaking. A severe inheritance tax combined with a generous gift tax may reshape the battlefield of the war against deflation in a very favourable way, moving the focus inside households. Aging societies should try hard to mobilise their wealth. The best way of doing so may be establishing strong tax incentives for elders to transfer wealth to the younger generations while they are still alive.
It is important to note the distinction, albeit timid, with the Economist here.
Molinas' suggestion is consequently different in one key aspect. What Molinas suggests is that the eldery be more inclined to invest in the younger generations and that this this is pushed through e.g taxation on stashed savings. Basically, Molinas talks about mobilising the wealth and that this is invested in the (assumed) portfolio of profitable projects held by the younger cohorts. Like the Economist, Molinas talks about using taxation (or the lack thereof) as a weapon and actually my guess is that when Molinas talks about a more generous gift tax he is talking about the same thing as the Economist is.
Now,I am of course molding the arguments of the Economist and Molinas to fit my own agenda here but I still think that a clear message can be taken from these two pieces. Whether it be through transfers in kind or through investment Japan should attempt to channel the vast sum of wealth towards its younger generations in order to make the money work in stead of just sitting in deposits and under the mattress.
At this point, I am intrigued, very intrigued. Consequently and while these two contributions sound plausible they miss some crucial points. As for the Economist, I have already highlighted the fact that Japan is going to fight dissaving simply because they have to. This may sound rather unjust to simply wave off the argument like this. But we should also think about the fact that for Japan as an economy these savings are best mobilised if they are invested to earn a corresponding return [1]. In short, we will see dissaving but it won't solve any of Japan's problems to transfer older cohorts' wealth to younger generations for them to spend.
Moving on to Molinas he goes for the capitalist solution as it were; go forth and invest in the Japanese entrepreneur! This is a very appealing proposal, but tell me something; where are these entrepreneurs again, how many are they and what is the capacity for the young generation to absorb all those savings with the aim of delivering a return that can help Japan generate the income it needs to increase domestic demand and subsequently rid itself of the dreaded deflation.
I am almost done now and in order to move forward on this it is important to realize one major point about the arguments presented above. They are both made in the context of a closed economy. Whether it is in the form of transfers in kind or investment flows both the Economist and Molinas argue within the boundaries of Japan moving money from the elder to the younger cohorts. In doing so however they miss, or neglect, the fact that ageing as a demographic process manifests itself through changes in the age structure of society and thus that the kind of transfer they are talking about are not viable simply because the mismatch between generations is too great (and will grow larger as we move forward). Moreover, and even though it would in principle be possible for Japan to do as proposed above, it would not be rational let along fruitful from the point of view of fighting the slump in domestic demand.
So where do we go from here?
The crucial link to incorporate here is to allow Japan the possibility to trade with the rest of the world. Then I don't think it is implausible to imagine that Japan indeed will fight dissaving through investing its stock of savings, but that this has to be through a leakage. Quite simply, Japan can increase consumption by investing its wealth abroad for a higher return than at home as well as by maintaining a structural excess investment surplus towards the rest of world by letting domestic capex and production decisions respond to foreign in stead of domestic demand (at least on the margin). This finally means that the way Japan as an economy can fight off dissaving and attempt to battle deflation is to rely on the ability to keep a structural surplus towards the rest of the world.
Once we have established this point we can start to look at the real issue at hand here. What happens when everybody gets as old as Japan is now? Think global imbalances and the discussion we are having right at this moment about how to find a batch of economies with the ability to run a sustainable deficit to counter others' need to run a surplus. Basically, there are externalities at work here and essentially market failures. These are produced, in part, by ageing and since we know for sure that one country after the other will venture down Japan's road in terms of demographic structure we would be wise to give these points more than a scant thought as we move forward.
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[1] Here we could of course also open the can of worms in the form of Japan's public debt and how, at least part, of those well earned savings need to be put aside in order to finance the deficit spending by the government which again is only set to worsen as Japan gets older (and on and on we go).
