Issues Facing the Japanese Economy in 2008

Economic and Fiscal Policy Agenda for 2008

TSURU Kotaro
Senior Fellow, RIETI

Fiscal 2007 growth rate estimates revised significantly downward

The enhancement of growth potential was the top priority issue for former Prime Minister Shinzo Abe's administration, embodied by his slogan "no fiscal consolidation without growth." During the past year, the government did indeed, over all other concerns, devote itself to improving the nation's growth potential. Nevertheless, the government's economic growth forecast for fiscal 2007 (ending March 2008), announced in December, showed significant downward revisions. The government now expects Japan's economy to expand 1.3% and 0.8% in real and nominal terms respectively; down from its earlier predictions of 2.0% and 2.2%. Of course, such revisions are not without reason. The latest amendments to the Building Standards Law, implemented last year and designed to ensure public safety and security, have inadvertently had a negative effect on the economy, resulting in a substantial decrease in housing starts. Also, the subprime loan problem and rising crude oil prices are deepening uncertainty over the future course of the Japanese economy. All these factors undoubtedly contributed to dampened growth estimates. Yet the degree of the latest downward revisions is relatively large, given the real GDP growth rates in fiscal 2005 and 2006 exceeded the government's initial estimates with the nominal rates revised downward by 0.3-0.4 percentage points.

Increasing growth potential is unquestionably important. However, any "illusion" that the government can freely control economic growth needs to be corrected. In this column one year ago ("Economic and Fiscal Policy Agenda for 2007"), I wrote as follows:

"The second distinctive feature of the Abe administration is its advocacy of a result- or performance-oriented approach. The Japanese economy is not a planned economy and the administration, by making economic growth the top policy goal in such a setting, has virtually made itself open to evaluation based solely on the 'result,' namely, its ability to achieve the intended growth ... Abe seems to have cut off his own escape route, rushing headlong toward consequentialism."

The factors underlying the latest downward revisions might not have been foreseeable, but the eventual outcome for the ongoing fiscal year must be taken earnestly and seriously.

Growth potential and fiscal reform

As a first step, the government under Prime Minister Yasuo Fukuda must once again fully recognize that increasing growth potential and restoring fiscal health are the "two wheels" to drive reform. In order to overcome deflationary pressures accompanying fiscal reform measures and push the reform process, the growth potential of the whole economy must be strengthened. Yet it is also impossible for fiscal reform to progress steadily by counting solely on economic growth. The two wheels are like the father and mother of a traditional, large family. The father, as the backbone and breadwinner of the family, must work hard in order to eventually rise to the top of the management ladder (as with setting an ambitious, real term, growth goal); while the mother, as the controller of the family budget, needs to efficiently and frugally manage household finances (like making steady progress with fiscal reform) so the family can get by even if the father advances only to a lower departmental management position. This analogy formed the core of the integrated reform of expenditures and revenues under the Basic Policies for Economy and Fiscal Management and Structural Reform 2006 (Basic Policies 2006). Important here is that the mother is not pessimistic about the father's career progress, but rather, she is working hard to support his career. She must exercise as much caution and restraint as possible in managing household finances because this is not an area that should be subject to risky behavior.

Examples from the United States and European countries do indeed show that adopting prudent assumptions for the economy is critical to the success of fiscal reform. In the Netherlands, for instance, in addition to the most likely growth scenario, the "prudent scenario" which deliberately underestimates economic growth is presented, and is used as the basis for formulating fiscal policy. Similarly, in Canada, the average of private-sector economic forecasts, instead of the usually optimistic government forecast, is used in budget planning. (Canada was even more prudent in the past, using figures based on private-sector forecasts but negatively biased by a certain percentage point margin.) The United Kingdom, along with high-growth and low-growth scenarios, presents a baseline scenario that assumes that government policy remains unchanged. In contrast, Japan's Course and Strategy, a package of medium-term government policies adopted in January 2007, presents four different prospects depending on differences in assumptions for the future growth rate and expenditure cuts. Japan applies no concept of a "baseline scenario" such as in the UK, but it should. In addition, it should consider establishing a separate, prudent set of assumptions for the economy as a basis for fiscal reform, following the global standard.

Another noteworthy implication of U.S. and European examples is that publishing long-term fiscal estimates, in addition to adopting prudent assumptions, is increasingly important in promoting fiscal reform. The UK, which until 2001 provided 30-year fiscal estimates, has extended the covered period to 50 years. Following suit, the European Union now publishes estimates for 45 years. These moves reflect the increasing importance of verifying the sustainability of fiscal policy from a super-long-term viewpoint amid a protracting reform process and concerns over population aging. Japan has made economic outlooks covering at least five consecutive years in each package of its medium-term policy, be it Reform and Perspectives or the Course and Strategy, while in some years trying to envision the economy beyond that period, albeit in a limited manner. However, the new Course and Strategy, to be adopted in late January, covers only the four-year period through fiscal 2011; under five years for the first time. This is largely attributable to delayed formulation of debt reduction measures. The government had earlier set a goal of ensuring a steady decrease in the ratio of debt to GDP by the mid-2010s but has been unable to finalize concrete measures to that end due partly to the ongoing political situation. However, even with this factor discounted, Japan, despite already lagging behind the U.S. and Europe, is obviously backpedalling on the publication of long-term estimates.

Three requirements for economic and fiscal policy

The government under Prime Minister Fukuda must restart economic and fiscal policy with both its wheels firmly on the rail. It must first and foremost fulfill three requirements.
1. Specify a long-term vision of the economy that incorporates perspectives of at least 10 years
2. Promote and disseminate the idea that the government and the private sector unite and make across-the-board efforts to increase growth potential, that is, increase growth capacity, not in nominal terms, but in real terms
3. Adopt, as a basis for implementing fiscal reform, a separate, prudent set of assumptions for the economy

January 8, 2008

January 21, 2008