Chronic deflation: A phenomenon that cannot be explained theoretically
With the government of Prime Minister Shinzo Abe coming into office, Japan is set to pursue economic policy that calls for bold monetary easing to end deflation. The policy is predicated on the perception that once Japan successfully exits from deflation by setting an explicit inflation target and taking bold monetary easing measures, the economy will grow and jobs will be created. This assumption, however, does not necessarily hold. We must acknowledge the basic fact that economic theory has been unable to explain the cause or mechanism of the continuous price falls for more than a decade (long-term deflation) in Japan. The government and the Bank of Japan (BOJ) have been trying hard and have yet to end the deflation. The money supply has been raised to a level significantly higher than that prior to the economic bubble of the late 1980s, but prices are not going up. This indicates that there has been a chronic decline in the velocity of money. So why is this happening? Anxiety about retirement or the future in general can be cited as hypothetic causes, but we have yet to find any definite answer that can be explained by economic theory. If anxiety about retirement is the cause of the deflation, fiscal consolidation and social security system reform would be more important, and the government should be pursuing them instead of monetary easing. In any event, as the cause of Japan's long-term deflation remains unknown, there is no finding a definitive cure at this moment. We must remind ourselves of the common-sense fact that monetary easing is nothing more than a stopgap measure so as not to have excessive expectations.
The hypothesis that the economy begins to grow once the deflation is over also requires rigorous scrutiny. Economic growth over the medium- to long-term horizon is determined by changes in population and productivity, whereas inflation and deflation have only a nominal—if any—impact (neutrality of money).
An extreme easing of monetary policy by the BOJ would surely drive down the value of the yen, push up stock prices, and give a boost to the economy over a short period of time. This, however, would neither raise long-term economic growth nor increase tax revenue to the point sufficient to solve the nation's fiscal problem. Meanwhile, Japan is facing a series of serious challenges such as those indicated below:
Fiscal gap of a size equal to about 30% of consumption
It has long been pointed out that Japan is in a serious fiscal crisis. However, we rarely see comprehensive cost figures, such as the percentage to which the consumption tax rate will need to be raised eventually. Up until only a few years ago, Japan was considered to be better off than Italy in terms of government net debt, which is defined as total financial liabilities minus total financial assets of the government. However, Japan's fiscal condition has been deteriorating at an accelerated pace and what was considered common sense a few years ago is no longer applicable today. In the past couple of years, some overseas researchers have performed simulation analyses to examine the fiscal sustainability of Japan. According to their findings (Hansen and Imrohoroglu 2012; Braun and Joines 2012), Japan would have to find additional revenue equivalent to an approximately 30 percentage point hike in the consumption tax rate in order to restore fiscal sustainability. This fiscal gap must be filled by increasing taxes, reducing social security and other expenditures, and/or creating inflation.
Given the current reality of Japanese politics, this problem seems unsolvable. For instance, a fiscal consolidation plan proposed by Braun and Joines calls for eventually stabilizing the consumption tax rate at 17% but would take 150 years to be completed. Furthermore, before reaching that final goal, the consumption tax rate would have to be raised to about 32% and maintained for several decades, and social security expenditures would have to be cut significantly—all of these measures would be effective on the premise that Japan achieves 2% inflation.
The seriousness of the crisis we face can be seen in the fact that only such unrealistic policy prescriptions can be derived by analyzing data in a straightforward manner. Creating a bit of inflation will not solve the problem (2% inflation, even if realized, would have an impact of curbing the necessary consumption tax rate hike by only about five percentage points). The above figures derived from simulations must be acknowledged and shared by all of those involved as the starting point for discussing future economic and social security policies.
In other words, a drastic cut in social security expenditures (pension benefits and medical expenditures) should be discussed in the sphere of political decision making, and political leaders should realize that Japan cannot afford to postpone its planned tax hike. (The government should raise taxes first and, if the resulting impact on the economy is expected to be too severe, implement stimulus measures. Considering the current state of Japan, raising taxes after the economy gets better is just like putting the cart before the horse.)
[An example of comprehensive fiscal reform policy] (From Braun and Joines 2012)
In addition to 1) achieving 2% inflation, 2) raising copayments charged to elderly patients to 20% of the cost of the medical services provided, 3) accepting a drop in the pension replacement rate to 30%, and (4) reducing the operating expenses (purchases) of the government by 1%, the consumption tax rate should be adjusted as shown in the below chart:
Long-term growth strategy: Technological innovation in an aging society
The theory of directed technical changes (or induced technological innovation) provides hints for considering growth strategy for the coming years. The idea was advocated by Yujiro Hayami in the 1970s and formulated into theory by Daron Acemoglu in the late 1990s. The concept is that changes in the market environment and/or in the distribution of resources determine what technical changes will be profitable in the future. The direction of past technical changes can be explained by this theory to a considerable extent. Looking to the future of Japan, the biggest change in the market or resource environment is population aging. Technologies in alignment with this trend of demographic aging—i.e., gerontechnology—will be no doubt in great demand in the coming years. Since population aging is taking place across the world, there will be enormous demand overseas. It will be not at all surprising if those producing various systems and equipment utilizing gerontechnology grow into the leading export industry by the mid-21st century. We should recall that automobiles, which used to be expensive toys for rich people in the late 19th century, became the leading export item of Japan in the latter half of the 20th century.
Philosophy of policy visions
Grand social experiments with communism and social welfare states have taught us two lessons. From the experiment with communism in the Eastern bloc, we learned that governments are not necessarily wiser than the private sector. We were significantly overestimating the ability of governments and expected them to be more efficient than markets in distributing resources. It has been fully demonstrated that bureaucrats and governments are not much different from the private sector in their abilities and morals, and, depending on circumstances, they may engage in more egregious moral hazard.
Meanwhile, what we are beginning to learn from the experiment with welfare states in the Western bloc is that governments are incapable of making long-term commitments. We used to believe that governments, unlike the private sector, would be able to make ultra-long-term commitments, for instance, to maintaining certain institutional systems. It is based on the premise of such strong confidence in governments that social security systems have been built and maintained. However, in the face of various problems associated with age-old social security systems, including the scandal over missing pension records in Japan, governments' ability of making long-term commitments is now being seriously questioned. Both the sovereign problems in Europe and the fiscal problems in Japan can be defined as a phenomenon in which markets are being shaken up amid growing doubt over the governments' ability to make commitments to maintaining the social security system over an ultra-long term period. In considering economic policy for the future, we must base our discussion on the premise that: 1) the government is no better than the private sector whether in abilities or morals and 2) the government is just as incapable as the private sector of making long-term commitments and cannot promise what the policy decisions made today will bring in the remote future. Going forward, a change of government will likely become a recurring event in Japan. In order to restore people's confidence in the fiscal management and social security system in the light of that prospect, institutional systems should be designed in a way to allow flexibility, premised on the fact that the government cannot make commitments into the remote future. Political leaders—whether they belong to the ruling or opposition parties—need to come up with new ideas toward achieving that end.
