Laggard Structural Reform Hurts Society's Weak

Fellow, RIETI

As more of the specifics of Prime Minister Junichiro Koizumi's structural reforms become clear, voices expressing disappointment and criticism grow louder.

What are the biggest problems with Koizumi's reform plans and what should be done to make them better? Finding the answers to these questions is crucial to the nation's successful transformation.

* The plan for the privatization of four heavily indebted road-building public corporations, announced late last year, will reduce the total cost of building new toll highways by more than 10 trillion yen but not scrap or retrench any of the construction projects included in the government's long-term highway development plan.

* In drawing up the blueprint for pension reform, the Koizumi administration decided to put a cap on the contributions to the public pension plan paid by employees and employers but made no significant changes in the financial structure of the troubled retirement program.

* The administration's proposal to cut state subsidies to local governments while transferring tax revenues to local treasuries for the sake of fiscal decentralization was widely criticized as meaningless number-juggling.

Most of the key decisions concerning these reform initiatives were made in haste toward the end of last year, and none came across as a significant step toward radical reform.

Proceeding only by baby steps

Admittedly, the administration's reform quest has been proceeding only by baby steps. But, as one policymaker has correctly pointed out, they nevertheless represent progress.

Koizumi started a broad range of structural reforms, including an overhaul of the road construction system, to eliminate the government's wasteful expenditures and thereby curb the rapid growth of the financial burden on future generations. In other words, the ultimate goal of his structural reform campaign is to restore health to the nation's public finances. Indeed, there has been slow and gradual progress toward that goal.

Look at the amount of government bonds to be issued in the next fiscal year, for instance. When the administration announced a plan to issue bonds worth over 36 trillion yen in fiscal 2004, it was accused of violating its pledge to cap new bond issuance at 30 trillion yen. But the Finance Ministry's estimation submitted to the Diet early last year put the bond issuance at over 41 trillion yen, even larger than the projected total tax revenue in the year. So the 36 trillion yen represents a substantial drop from the original estimate.

Bank cleanup is also progressing steadily, although public attention has been mostly drawn away from the topic to the highway and pension reforms.

As the taxpayer bailouts of Resona Bank and Ashikaga Bank showed, the government-led effort to evaluate bank assets more strictly and accelerate write-offs of bad debts in the banking system are making headway. A healthier banking system will reinforce the climate for the economy as a whole and set a foundation for robust, sustained recovery.

Since continued economic growth contributes more than anything else to lessening the burden on taxpayers, the effort to restore health in the banking sector, which has fallen from the headlines, should be the centerpiece of the Koizumi administration's structural reform strategy.

In its reform campaign, the Koizumi administration seems to be generally plodding in the right direction, moving toward reducing the financial load on future generations. The problem is the speed of reform. Unfortunately, political resistance and barriers to progress in reforms remain strong, and a national consensus on structural reform has yet to emerge.

Most of Koizumi's critics are pushing the argument that he is pursuing reform at the expense of the society's weakest areas. They say they are opposed to any reform that amounts to abandoning weaker components of society, such as rural areas, elderly citizens and education, for the sake of fiscal health. But the weak are usually those who suffer most when necessary reform is delayed.

Studies by economists have shown that the longer structural reforms are postponed the more likely it is that the eventual reconstruction of public finances will cause greater hardship to the poorer people of society than it will to the well-to-do.

Among the countries that pushed through budget reforms in the 1980s, the ones that started late had to cut spending on education and welfare more deeply than the early starters. In Europe, much of the burden from fiscal reform in the 1920s Depression Era fell on low-income earners.

That was because the deterioration of economic conditions caused by a delay in reform further undermined the already scarce political influence of the weak.

Since rich people and large businesses can easily transfer their assets overseas, they can protect themselves from the damaging economic effects of high interest rates that come with a growing budget deficit. But ordinary folks, especially underprivileged people, cannot flee their country to avoid getting hit.

A massive flight of assets overseas causes the country's currency to tumble, driving up import prices. At the same time, interest rates are raised to stop the currency crisis. Those who cannot transfer their assets overseas are hit hardest by the deterioration of domestic economic conditions.

The reforms that come late in such a situation are usually the measures previously rejected as amounting to an abandonment of the weak, or even harsher steps.

This familiar scenario is what unfolded in most of the countries that experienced a financial meltdown.

It is glaringly obvious that Japan can no longer put off reforms to restore budgetary health. Attempts to thwart reforms in this situation from the viewpoint of protecting the weak could eventually end up putting these same disadvantaged people in an even more dreadful hole.

Key for fundamental reformsWhat are the key conditions for rapid advancement of fundamental reforms? An important insight can be obtained from examining the process of fiscal reconstruction in the United States in the 1990s.

In the 1980s, the United States was suffering badly from the twin budget and current-account deficits. Fiscal reform was the biggest campaign topic of the 1992 presidential election. All the candidates promised to balance the government's books.

Japan's public finances are now in the worst shape of any in the developed world. Yet public interest in this problem is not strong enough to ensure that it is the top issue in national elections.

The sense of urgency is much weaker in Japan of today than in the United States of 1992 because the fiscal squeeze is not yet causing sharp pain to the people in this country. Americans at that time were actually feeling the pinch of the declining fiscal conditions.

In the early 1990s, America's swelling budget deficit was pushing up interest rates at home and arousing serious concern about a financial crisis. Interest rates were surging despite weak economic conditions. American consumers, racked by rises in mortgage and other interest rates, started demanding reforms to restore fiscal health.

In present-day Japan, in stark contrast, interest rates have been kept at virtually zero for over 10 years under the Bank of Japan's ultra-easy monetary policy to prevent troubled banks from going under.

Theoretically, a growing budget deficit should push up interest rates. But in Japan, the central bank's zero-interest-rate policy has shielded the people's lives from the effects of the ballooning public debt.

Consequently, the people of Japan are not feeling the real effects of the growing budget deficit. That's the reason for the lukewarm public responses to the fiscal reform campaigns by the administrations of former Prime Minister Ryutaro Hashimoto and Koizumi.

This situation, however, will change when interest rates start picking up. The BOJ is keeping interest rates at zero mainly because banks' balance sheets are still on a shaky footing. So, this policy will be terminated when the banking system becomes healthy again.

Then the swollen budget deficit will start driving up interest rates, taking a heavy toll in people's lives. That will inevitably engender an acute sense of crisis among the public, provoking loud calls for fiscal reconstruction. As a result, real national consensus on the need for serious structural reform will emerge.

If so, quickening the pace of efforts to put the banking system on an even keel and give additional bounce to the economic recovery so that the central bank can end its zero-rate policy is crucial to promoting structural reform.

The longer the necessary reforms are delayed, the harsher the measures that must eventually be taken will be on the weak. To keep that from happening, the administration needs to go all-out to make the banking system sound again to improve the climate for broad consensus on structural reform.

Debate has been raging for some time over virtually all the necessary components of structural reform, including an overhaul of the public pension plan. Instead of lamenting the slow progress in the Koizumi administration's reform effort, policymakers should try to work out specific measures before the nation is facing really radical changes.

>> Original text in Japanese

* The article was reprinted from International Herald Tribune / The Asahi Shimbun on February 12, 2004. No reproduction or republication without written permission of the author and The Asahi Shimbun.

February 12, 2004 Tokyo Shimbun

June 11, 2004

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