Priorities for the Japanese Economy in 2020 (January 2020)

What Should Japan’s Economic and Fiscal Policy Be?

Program Director / Faculty Fellow, RIETI

The age of uncertainty

When you think comprehensively about Japan's macroeconomic policy, what direction would you recommend? In the current situation where negative interest rates and low inflation continue and public debts continue to increase above 240% of gross domestic product (GDP), the immediate goal of economic management would be to focus funding on redistribution of income to correct disparities and technological innovation to promote growth, based on the prerequisite of avoiding financial crises (unstable high inflation, rise of interest rates, etc.).

We have to begin with analyzing the current status, asking why negative interest rates and low inflation continue. It suggests that the natural interest rate at which aggregate demand is equal to aggregate supply might be negative. A possible reason for the negative natural interest rate is growing uncertainty, which urges people to increase savings in preparation for the worst scenario, resulting in the negative natural interest rate.

Extreme uncertainty prevailing in the world's politics and economy is roughly classified into two types. One is political instability (such as the rise of populism) increasing in Western developed countries, East Asia, and other areas in the world. Its major cause is thought to be income disparities that have been growing all over the world since the 1980s. Before around the 2000s, the expectation was that the "trickle-down effect" would naturally eliminate income disparities, but the real market mechanism was unable to overcome those disparities, which are being passed down from generation to generation, dividing society, and destabilizing global democracy.

The other uncertainty is about the future of key technologies of industry. Currently it is said that the Fourth Industrial Revolution is underway, represented by information technology (IT), artificial intelligence (AI), and fintech, which uses them. When key technologies change significantly, you cannot forecast what will happen and how society will be transformed. You can understand that Facebook's virtual currency Libra may drastically change monetary policies, but who knows what the world will be after that change? Investments in new technologies are full of uncertainty, while existing technologies become obsolete and investment opportunities for them shrink. As a result, investment demand surges for government bonds and currencies, which are safe assets, and negative interest rates occur.

It is important for growing disparities, which destabilize politics, to be swiftly corrected through income redistribution policy including social security for all generations. On the other hand, it will take at least two or three decades to eliminate uncertainty associated with changes in key technologies. During that period, investment demand may continue to be diverted by government bonds. With the amount of outstanding government bonds increasing progressively, won't confidence in the bonds collapse on a long term basis? If we can keep the nominal interest rate (r) zero or negative while maintaining the nominal economic growth rate (g) slightly above zero, then we will be able to maintain confidence in government bonds. That is because if r is less than g and the primary balance deficit does not exceed a certain level, the bond increase rate can be kept below the GDP increase rate g.

The "good equilibrium" scenario where the interest rate is below the growth rate

Although standard economics claims that r is larger than g on a long term basis, Professor Marcus Hagedorn of the University of Oslo showed in his 2018 paper the logical possibility of g being larger than r on a long term basis. And various overlapping generations (OLG) models and incomplete markets models had already shown as well that the steady state of r<g is theoretically possible, although they were not necessarily designed to explain the low interest rates around the world in recent years. Professor Hagedorn used a model in which households gain direct utility by owning government bonds. The reason why the bonds provide direct utility is that unlike private assets, they have high liquidity and collateral value in financial transactions. And the fundamental reason why government bonds have high liquidity and collateral value is that the outlook for the private sector is highly uncertain, while confidence in the government remains strong, with people thinking that fiscal reconstruction will be undertaken at some time in the future.

In the steady state of Hagedorn's model, real interest rates are also kept low. So, according to Fisher's equation, the zero interest policy (nominal interest rate r = 0) holds the inflation rate around zero, too. The Bank of Japan (BOJ)'s commitment to continuing the zero interest policy until its 2% inflation target is met may, contrary to its intent, be causing low interest rates and low inflation. Under the standard model, continued zero interest rates are supposed to cause inflation, but that has not happened so far. This fact suggests the steady state of r<g has been reached.

If that is the case, then we can think of the following "good equilibrium" scenario as what we should pursue. To begin with, if fiscal credibility (or the expectation of eventual fiscal reconstruction) is maintained, government bonds are seen as safe assets. So if the economic outlook for the private sector remains highly uncertain, government bonds have higher liquidity and collateral value than private assets. As a result, we can maintain the state of r<g. At this point, if the primary balance deficit can be kept below a certain level, we can reconstruct fiscal conditions because the amount of government bonds outstanding increases at a rate of around r and GDP increases at a growth rate of g, which means that the bond ratio (the ratio of government bonds outstanding to GDP) gradually decreases on a super-long-term basis. This is how the initial expectations for fiscal reconstruction are self-fulfilled.

Now it can be said that we are unexpectedly on track for this "good equilibrium" scenario, but it is not clear whether uncertainty in the private sector will remain high or whether fiscal credibility will continue. It is necessary to maintain fiscal credibility while preparing for a situation in which the interest rate surpasses the growth rate (r>g). To that end, the following two policies are required.

Policy packages required

The first policy goal is to reduce the primary balance deficit, or more correctly to realize a state in which the primary balance deficit does not keep increasing. If it falls within a finite range, under the condition of r<g, the bond ratio will converge to a certain value, stabilizing the fiscal situation.

Necessary conditions for r to be smaller than g in Japan's economy are that expectations for fiscal reconstruction are broadly shared in the market and that uncertainty in the private sector remains extremely high. Unless these conditions are met, interest rates will rise and r will become larger than g.

The second policy goal is to make contingency plans to prepare for that potential, unfavorable situation. Interest rate rises can take various forms. If interest rates rise after uncertainty in the private sector is eliminated and investments are stimulated (fundamental rise in interest rates), then the economy will grow, meaning that raising taxes and decreasing expenditures will be easy. With a large debt balance, however, there is still a possibility of critical fiscal conditions. If overseas factors (conflicts, economic crises, etc.) put upward pressure on interest rates, similar effects will also be observed since the BOJ's monetary easing is expected to drive the yen down and the economy up. If loss of fiscal credibility triggers capital flight from government bonds and the yen to the dollar, etc. (the rise in interest rates caused by loss of credibility), there will be great pressure to dump government bonds. The BOJ may respond by supplying more money to depress interest rates, which would make inflation uncontrollable. In this case, fiscal collapse would be more likely. To maintain credibility, we have to ensure that the market is convinced of the government's ability to resolve such crises. The purpose of contingency plans is to realize a situation (the "good equilibrium" scenario) where we don't have to implement such plans. But when the market knows that the government does not intend to implement contingency plans, confidence can no longer be sustained.

Contingency plans inspire confidence

We can learn from the 2002 Financial Revitalization Program (the so-called Takenaka Plan). At the time, there was an urgent need to establish confidence in the government's determination to completely write off all remaining bad debt. The major pillars of the Takenaka Plan included the full introduction of market valuation of banks' assets and the semi-forced implementation of public capital injections. When this plan was announced, doubts about the government's determination were wiped out and banks voluntarily began conducting massive capital increases, mergers and restructuring, in addition to writing off bad debt. Thus, the Takenaka Plan was not exercised on a large scale and proved effective by invoking voluntary responses of the market.

Similarly, contingency plans specifying how to respond to fiscal crises will greatly help establish confidence in the government's determination. Such plans need to provide for emergency measures in circumstances where government bonds are dumped, such as government bond market stabilization by the BOJ and selective suspension of expenditures (triage). They also need to explain structured methods of subsequently improving fiscal balance. In a situation where r>g, a study shows that we need to improve fiscal balance by 14% of GDP (about 70 trillion yen), meaning that drastic improvements are required. By preparing those contingency plans in advance, we must pursue a "good equilibrium," which will save us from implementing them.

Let me add one thing. Government officials have worried that making contingency plans will shock the market and give rise to financial crises. That's why publicly discussing contingency plans has been considered taboo. But in the current state of r<g, we don't have to be too sensitive to market responses. When g remains larger than r, reasonable expectations develop for the amount of government bonds outstanding to gradually decrease. Even if the government announces a contingency plan at this time, the market will quickly stop flustering and conclude that it is good news because it will improve fiscal credibility.

The same concern was presented years ago regarding bad debt write-off. People said the government's intervention would cause fear in the market. But we should remember that the Takenaka Plan resulted in financial stabilization, rather than banking woes.

December 20, 2019

January 28, 2020

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