Issues Facing the Japanese Economy in 2012 (January 2012)
Lessons for Japan from the European Economic Crisis
Vice Chairman and Vice President, RIETI
Structure of the European economic crisis
It had been expected that the Japanese economy in 2011 would continue its recovery from the impact of the global economic crisis, and the government initially predicted 1.5% real growth in gross domestic product (GDP) for the current fiscal year ending March 31. The past 12 months, however, turned out to be an extremely difficult year. Domestically, we were faced with an unexpected economic crisis triggered by the Great East Japan Earthquake. The Japanese economy was also affected by shockwaves from overseas crises such as the floods in Thailand, a country in which a number of Japanese companies have manufacturing bases, and the ongoing European economic crisis brought on by the Greek debt problem. Supported by post-quake reconstruction demand, Japan is expected to see relatively strong growth in 2012, 2.0% in real terms according to the latest Economic Outlook released by the Organisation for Economic Cooperation and Development (OECD). However, economic conditions in Europe continue to shed uncertainty, posing a significant downward risk for the Japanese economy.
Extensive analysis has been made on the eurozone crisis. It is thus unnecessary to rehearse in detail, but let me briefly explain how and why this has happened. While the eurozone countries are united under a single currency and hence a single monetary policy, they are not so in terms of fiscal management. Therefore, changes in the value of the currency cannot serve as an automatic stabilizer for adjusting fluctuations in economic and fiscal performance that differs across countries. This is the structural factor underlying the eurozone crisis. Had all the eurozone countries kept to the Stability and Growth Pact (SGP) that calls for keeping fiscal deficit within 3% of GDP and government debt at or below 60% of GDP, the crisis might have been contained. However, the SGP failed to serve as a brake due partly to the influence of the global economic crisis that followed Lehman Brothers' downfall.
Where business cycles are synchronized across regions, a centralized monetary policy is an effective economic stabilizer for regional economies; the monetary authorities can tighten reins when the risk of inflation is on the rise and ease the grip during recessions. However, when the degree of cross-regional synchronization is low, a policy choice that is appropriate for one region may have a negative impact on another.
Apart from the integration of goods, services, and labor markets, there are many conditions that must be fulfilled to be an optimal currency area (OCA), one of which being a high degree of cross-border business cycle correlations. Even before the crisis, it had been pointed out that cross-country business cycle correlations in Europe are low relative to cross-state correlations in the United States (Clark and Wincoop, 2001). And even within the United States, some empirical studies have shown that a significant number of states do not fulfill the OCA criteria with their business cycles weakly correlated with the national business cycle, and that the U.S. monetary policy has been significantly exacerbating business cycles in these state economies (Beckworth, 2010). Following the global economic crisis, there emerged significant business cycle differences within the eurozone, namely, between low growth economies--such as Greece, Portugal, and Spain--and Germany, a high growth economy. This served one of the factors leading to the ongoing crisis.
Eurozone economies benefited greatly from the monetary union in the form of increased trade and investments. This time around, they are suffering hardships brought on as institutional defects of the monetary union surfaced.
Fiscal decentralization and business cycles
As is well known, Japan's fiscal situation is more serious than that of Greece or Italy, with its public debt to GDP ratio at about 200%, the highest among advanced economies. However, it is unlikely that a crisis similar to the one in the eurozone will occur in Japan. Because its currency and monetary policy covers the same geographic area, a significant loss of confidence in its fiscal sustainability will lead to a rapid depreciation of the yen. Of course, this is not desirable. But foreign exchange fluctuations will play an adjustment role to some extent.
Does this mean that the eurozone crisis has no implications to the Japanese economic and fiscal policies? The answer is "No." In the past 10 years or so, Japan has moved toward decentralization from the central to local governments. Theoretically, decentralization is regarded in a positive light as it leads to the provision of public goods and services in a way that better suits the needs of people in respective regions. However, experiences of some advanced countries show that the decentralization of spending responsibilities has outpaced that of revenue powers, and hence, decentralization tends to cause an increase in the overall fiscal deficit (Eyraud and Lusinyan, 2011).
If local governments--whether prefectural or regional--are given fiscal spending and revenue authority particularly with a high degree of borrowing autonomy, Japan would be structurally fraught with the risk of facing the same problem as that of the eurozone. Prefectural business cycles are, all in all, highly correlated in Japan (Artis and Okubo, 2011), and we have so far not seen a situation where monetary policy changes made by the Bank of Japan exacerbates business cycles in certain areas. Going forward, however, business cycle differences across different prefectures or regions may increase as a result of further declines in the population mobility rate due to the progressive aging of the population, a shift to a more service-oriented industrial structure, and interregional differences in the extent of linkage with overseas economies.
Lessons for Japan: Importance of local fiscal discipline
Outlining the historical experience of five federal states with their fiscal systems, Bordo et al. (2011) argue that the United States, Canada, and Germany--those that have maintained relatively strict fiscal discipline over the local governments--are cases of "successful" fiscal unions in terms of economic performance measured by inflation and public debt performance, whereas Argentina and Brazil--where fiscal discipline over the local governments has been somewhat loose--are examples of "less successful" ones. They point out that the presence of a no-bail-out clause as a means to impose fiscal discipline on local governments has been instrumental in avoiding disintegration of the monetary union. Feldstein (2011) also notes that the United States is distinctly different from the eurozone in that it has a centralized fiscal system and that each state is bound by the balanced-budget rule under its state constitution.
Japan also has put in place its own set of institutional mechanisms for imposing fiscal discipline, namely, the threshold fiscal performance standards for prompting early corrective actions and the rules requiring underperforming local governments to formulate and implement fiscal construction plans, as required under the Act on Assurance of Sound Financial Status of Local Governments. However, if Japan is to further promote decentralization including a proposed shift to a Doshusei regional bloc system, it is necessary to strengthen fiscal discipline at the subnational level and to ensure that the central government maintains its coordinating role to address cross-regional fiscal inequality. Japan is a country prone to natural disasters, and the risk of a devastating earthquake hitting the Tokyo metropolitan area or the Tokai region has been pointed out. Given these circumstances, it is extremely important that the central government serves as an insurance mechanism. This is one of the lessons we should learn from the eurozone crisis from the institutional point of view.
- Artis, Michael and Toshihiro Okubo (2011), "The Intranational Business Cycle in Japan," Oxford Economic Papers, Vol. 63, No. 1, pp. 111-133.
- Beckworth, David (2010), "One Nation under the Fed? The Assymmetric Effects of US Monetary Policy and its Implications for the United States as an Optimal Currency Area," Journal of Macroeconomics, Vol. 32, No. 3, pp. 732-746.
- Bordo, Michael D., Agnieszka Markiewicz, and Lars Jonung (2011), "A Fiscal Union for the Euro: Some Lessons from History," NBER Working Paper, No. 17380.
- Clark, Todd E. and Eric van Wincoop (2001), "Borders and Business Cycles," Journal of International Economics, Vol. 55, No. 1, pp. 59-85.
- Eyraud, Luc and Lusine Lusinyan (2011), "Decentralizing Spending More than Revenue: Does It Hurt Fiscal Performance?" IMF Working Paper, No. 11/26.
- Feldstein, Martin S. (2011), "The Euro and European Economic Conditions," NBER Working Paper, No. 17617.
December 28, 2011
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