Priorities for the Japanese Economy in 2015 (January 2015)

Seventy Years After the Defeat in World War II, Can Japan Avoid Another Defeat by Showing a Path to Fiscal Reconstruction?

OGURO Kazumasa
Consulting Fellow, RIETI

The year 2015 marks the 70th year since Japan's defeat in World War II. At noon on August 15, 1945, Emperor Showa read out the Imperial Rescript on the Termination of the War over the radio, announcing to the people of Japan his previous day's decision to accept the Potsdam Conference terms of unconditional surrender.

Up until just before the defeat, the government had continued to issue massive amounts of war bonds to finance its military operations. The so-called "war indemnity debt," money that the wartime government borrowed from and promised to repay to its people in the form of orders or contracts, accumulated. By around 1945, the overall government debt amounted to about 200% of Japan's gross domestic product (GDP). The scale of debt was obviously too huge for the postwar government to repay in full. Thus, immediately after the war, the government introduced the "war indemnity special tax," thereby effectively nullifying its obligations to pay the remaining war indemnities. More specifically, the government offset all of the remaining debt by imposing 100% tax on amounts paid in war indemnities. Furthermore, the government forced people to exchange the old yen currency with the new yen currency, froze bank deposits, and conducted a property investigation for the purpose of confiscation. Meanwhile, the Bank of Japan (BOJ) printed huge amounts of banknotes. As a result, inflation accelerated and war bonds literally turned into worthless pieces of paper.

Today, about 70 years later, Japan's government debt already surpasses 200% of GDP, exceeding the level shortly before the defeat in World War II. Although government debt in excess of 200% of GDP does not necessarily mean that the country is destined for a fiscal collapse, the probability of such an event is indisputably growing.

Figure: Changes in Japan's Government Debt as a Share of Nominal GDP, etc. since FY1890
Figure: Changes in Japan's Government Debt as a Share of Nominal GDP, etc. since FY1890
[Click to enlarge]
Note 1: The amount of government debt for each fiscal year is the amount of government bonds and borrowings outstanding as of each fiscal year end (March 31) based on data provided in Kokusai Tokei Nenpo (Annual Report on Government Bonds), etc. The amount for fiscal 2012 is the estimated amount of government debt as of March 31, 2013.
Note 2: Debt is measured against gross national expenditures provided in the so-called "Okawa-Takamatsu-Yamamoto estimates" (Choki Keizai Tokei: Kokumin Shotoku [Estimates of Long-Term Economic Statistics of Japan since 1868: National income] edited by Kazushi Okawa, Nobukiyo Takamatsu, and Yuzo Yamamoto) for the years through FY1929, against nominal gross national product (GNP) provided in Nihon Choki Tokei Soran [Historical Statistics of Japan] for the years from FY1930 through FY1954, and against nominal GDP provided in the Annual Report on National Accounts for FY1955 and thereafter. The figure for FY2012 is a forecast.

Fiscal collapse would mark another of Japan's defeat

Despite the snowballing of government debt, Japan has been able to maintain fiscal stability, owing significantly to the BOJ's massive purchases of government bonds under its quantitative and qualitative easing policy. However, as discussed in my recently published book, Zaisei Kiki no Shinso [Underneath the Fiscal Crisis] (NHK Publishing, Inc.), such unprecedented monetary easing policy has its limits, just as fiscal policy does. Although this is not an imminent possibility, it is no exaggeration to say that should Japan go into a fiscal catastrophe, it would mean "another defeat in war."

A big factor behind the snowballing of government debt is swelling social security costs amid the rapid aging of the Japanese population. Thus, the government has been pushing forward integrated reform of the social security and tax systems with a view to restoring its fiscal sustainability. Setting its goals of halving the primary deficit of central and local governments relative to GDP by FY2015 and turning the primary balance into a surplus by FY2020, Japan raised the consumption tax rate from 5% to 8% in April 2014, and another hike from 8% to 10% had been planned for in October 2015.

Prime Minister Shinzo Abe postponed the second hike by a year and a half because of growing concerns over a downside risk to economic growth. However, at the meeting of the Council on Economic and Fiscal Policy held in December 2014, he made it clear that the government will not give up on its goal of halving the primary deficit to GDP ratio in compiling the FY2015 budget.

Also, in a series of public debates—including those among party leaders—in the run-up to the latest House of Representatives elections, Prime Minister Abe pledged that his government would reexamine government expenditures and aim to achieve a primary surplus in FY2020 on the premise of raising the consumption tax rate from the current 8% to 10% in April 2017. Indeed, Japan is facing a dire fiscal reality. Yet, it must by all means pave the way toward fiscal reconstruction, carrying through a drastic social security reform.

Economic and Fiscal Projections for Medium to Long Term Analysis, a report prepared and released by the Cabinet Office every year in conjunction with the submission of the following year's budget bill to the Diet, is to provide a key framework for efforts toward fiscal reconstruction. However, there has been a significant departure from assumptions used in calculating such projections.

More specifically, the medium to long term projections released by the Cabinet Office in 2014 were based on the assumption that the consumption tax rate would be raised to 10% in October 2015 and Japan's GDP would achieve real growth of 1.2% in FY2014. This assumption no longer holds as the planned consumption tax hike has been postponed and the Japanese economy is likely to see negative growth in FY2014. For instance, according to the latest ESP forecast published on December 5, 2014 by the Japan Center for Economic Research, the general consensus is for Japan's real GDP to contract by 0.5% in FY2014.

Thus, the Cabinet Office's forthcoming medium and long term projections, to be released in January 2015, will be the first litmus test to assess the political will of the re-elected government of Prime Minister Abe toward achieving fiscal reconstruction.

Expectations of the new Abe government sticking to the goal of fiscal reconstruction

In their renowned book Democracy in Deficit: The Political Legacy of Lord Keynes, James M. Buchanan and Richard E. Wagner pointed out that a constitutional rule mandating a balanced budget is about the only way to maintain the budgetary balance and prevent the endless bloating of government under democracy because politicians in a real democratic society are ready to cut taxes but unable to raise them because of elections. The fact that Prime Minister Abe maintains his pledge about the fiscal reconstruction goals is appreciable.

As we enter the 70th year since our defeat in World War II, Japanese political leaders are being tested for their degree of commitment to fiscal and social security reform so as to save the country and its people from another defeat. I would like to place expectations on the initiative and efforts of the new Abe government.

December 26, 2014

January 13, 2015