The ongoing economic crisis in Europe is an entangled mixture of fiscal and financial crises. The Greek fiscal crisis only compounded and spread the sense of uncertainty across the European market, where the economy was already fragile with its banking system having been hit by the global financial crisis. The current situation is a relative lull compared to the turmoil in May, but there remains a long way to go before reaching the "exit." It is expected that uncertainty over the credibility of the euro will linger for a significant period of time.
Japan is no different in that it is beset with huge fiscal challenges. Although the Japanese economy bottomed out in March 2009 and has since been on a recovery path led by exports, the situation does not allow any optimism. In the face of this situation, the newly launched government of Prime Minister Naoto Kan set out its intention to "pursue economic growth and fiscal reconstruction in tandem."
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Demand expansion and supply-side innovation are the engines of economic growth. Let's look at the demand side first. Now that Japan is being rocked by a tidal wave of population aging, it is unrealistic to expect a remarkable increase in domestic demand in the short-time horizon. Thus, for the time being, it is important for Japan to seek to grow in tandem with the growth of the Asian market and promote the expansion of region-wide demand, as set forth in the government's Basic Policies for the New Growth Strategy announced on December 30, 2009.
On the supply side, reducing the effective corporate tax rate is important in terms of promoting corporate research and development (R&D) activities and enhancing the competitiveness of companies. Thus, it is a welcome development that the government explicitly acknowledged the need to lower corporate taxes in its recent report "Industrial Structure Visions 2010" as did the ruling Democratic Party of Japan (DPJ) in its campaign promises for the forthcoming House of Councillor election.
Prime Minister Naoto Kan insists that restoring the fiscal health of the country will lead to an increase in demand and hence economic growth. His logic is convincing in part but dangerous in some aspects. In a country with large public debt, fiscal reconstruction by means of tax hikes and cuts in expenditures could boost consumer demand by eliminating uncertainty about the future. This is what is referred to as a "non-Keynesian effect" of fiscal discipline. However, it remains to be seen whether simply removing future uncertainty will lead to robust economic growth driven by technology development.
Given the trend of population aging that will continue into the future, the demand for medical and nursing care services is bound to increase in the coming years, which would generate huge demand for the construction of medical and nursing care facilities as well as for the labor force to work in those facilities. As a way to make this happen, the Kan administration is seeking to prioritize social security expenditures in fiscal resource allocation. The thinking of the administration is not only appropriate but also desirable from the viewpoint of realizing a more just and equitable society.
However, the logic behind the idea that fiscal expenditures in the medical and welfare sectors would generate jobs and bring about economic growth is essentially same as the logic in insisting that public infrastructure projects would bring about economic growth. Just as the construction of highways was needed in the 1960s when Japan was in the midst of its high growth period, increasing public expenditures on medical and welfare services is necessary today as the population is aging rapidly. But it is highly questionable whether boosted expenditures would lead to technological innovation and drive economic growth.
The biggest obstacle preventing medical and nursing care services from becoming a growth industry is the fact that those sectors are subject to financial support from, and control by, the government. Because wages for medical and nursing care workers are kept low and the provision of pricey services restricted by government regulations, nurses and care workers are chronically in short supply and so are services.
Meanwhile, in the face of the chronic shortage of medical and welfare services, elderly people feel compelled to hoard money for a rainy day, amassing enormous financial assets to the tune of several hundred trillion yen in total and dampening consumption by that much. An increase in the degree of freedom increases in terms of market entry and pricing for services would bring an increase in the supply of services in accordance with the market mechanism. The profit-seeking behavior of private-sector companies may activate technological innovation and eventually the government's vision of economic growth driven by the medical and welfare sectors may become reality.
In short, while it is important to prioritize social security expenditures in allocating fiscal resources, this must be accompanied by the deregulation of the medical and welfare sectors (to increase freedom in terms of market entry and pricing), which indeed should be the primary objective. It goes without saying that, in proceeding with deregulation, the government needs to enhance the public support system so as to enable the poor and vulnerable to access adequate medical and nursing care services.
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Increasing productivity is essential to getting the Japanese economy out of the ongoing low growth trap. The question is what factors inhibit productivity growth in Japan? According to recent political economic research on economic growth, the presence of significant vested interests in once-successful business models and/or technology lineage inhibits productivity growth. Those with vested interests interfere and prevent the introduction of new technologies and business and, as a result, technological innovation does not materialize.
The figure below shows the result of the Bank of Japan's Short-term Economic Survey of Enterprises in Japan ("Tankan") regarding the question of how sample companies perceive banks' lending attitude. The percentage of companies finding banks' lending attitude "accommodative" is plotted along the vertical axis and the percentage of those perceiving the attitude as "severe" along the horizontal axis. From this, we can see that a significant percentage of companies considered banks' lending attitude as "severe" and only a small percentage of companies found banks "accommodative" in the early 1980s but the proportion reversed as the economy expanded toward the late 1980s. In contrast, the first decade of the 2000s is generally characterized with the co-presence of conflicting views. That is, throughout the decade, the percentage of companies finding banks' lending attitude "accommodative" remained fairly high and so did the percentage of those finding banks' lending attitude "severe." This seems to suggest the growing mismatch between need and availability of financial resources in which financial resources are easily accessible to those with vested interests but hard to come by for those without.
(Source)Created by the author based on the BOJ Short-term Economic Survey of Enterprises in Japan (All Enterprises).
In a situation where there exist such problems, it is believed that a measure designed to reduce resistance from those with vested interests would be effective as a way to facilitate productivity growth. The imposition of some sort of tax on asset holdings may be functional as a growth policy in addition to being a fiscal reform measure.
Vested interests surface in the form of overvalued assets. Established companies, those with technology lineage and business models that were successful in the past, hold highly valued assets. The emergence of powerful rivals with new technologies would cause a sharp decline in the value of those assets. Thus, in order to prevent this from happening, those having vested interests in established companies - creditor banks, shareholders, general creditors, etc. - would try to block the entry of rivals with new technologies by using various kinds of political and economic means. Vested interests represent the overestimated value of "legacy assets," i.e. assets embodying outdated technologies and obsolete business models and held in the forms of stocks, loans to corporate borrowers, etc. And the behavior and decision-making of vested interest holders trying to preserve the value of those assets inhibit technological progress and hamper economic growth.
"Legacy assets" primarily refer to bad assets but may be more broadly defined to include outdated technologies and obsolete business modes. Based on the latter - i.e. broader - definition, significant portions of Japanese assets (national wealth in the form of financial assets and the like) that have been built on the success of the conventional Japanese-style economic system can be defined as legacy assets. Any reform that is designed to accelerate the metabolism of technologies and business models is destined to be met with resistance from vested interest holders because such action would reveal the obsoleteness of legacy assets and reduce the value of their legacy assets.
Due to the fact that vested interest holders' resistance to the introduction of new technologies is typically accompanied by political action, it is difficult to solve the problem of vested interests through market competition. This can be termed as "negative externalities" of legacy assets. (A "negative externality" is a negative impact caused by a market failure on economic entities outside the market.) If we could correct externalities by means of government policy, it would be ideal in terms of enhancing the vitality of the economy. One possible policy option is to impose a Pigovian tax on the holdings of legacy assets.
If asset holdings are taxed, the value of legacy assets that can be preserved by vested interest holders through resistance would be reduced by the amount of taxes. This would reduce the benefit of clinging onto legacy assets, which could induce changes in the direction of facilitating the introduction of new technologies. For instance, banks may become less constrained by precedents in making lending decisions and make their loans more accessible to new businesses. This, if realized, would facilitate the market entry of entrepreneurs with new technologies and business models, bringing new vitality to the economy as a whole. Just for record, when assets are held in the form of money, moderate inflation has the same effect as taxes on asset holdings.
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The above discussion is meant to be a thought experiment. The government may as well consider the taxation of legacy assets as an actual policy option but there are many details that would have to be worked out before implementation. For instance, we must be able to distinguish legacy assets from normal assets, which is a very difficult task.
However, if we do nothing to change the situation, letting the current low growth continue and allowing the fiscal situation to deteriorate further, we could end up steering our country into a fiscal catastrophe, where a crash in Japanese government bonds, high inflation, and an excessive depreciation of the yen would take place all at once. This would have the same effect as that of having financial asset holdings taxed at very high rates. Moreover, in the case of a fiscal catastrophe, the rate of inflation (tax) would be beyond the government's control. Thus, in order to avert a fiscal catastrophe and stimulate economic growth, we may as well seriously ponder the possibility of decreasing the value of assets held by those with vested interests by means of inducing inflation or levying taxes on asset holdings in an adequately controlled manner.
* Translated by RIETI.
June 17, 2010 Nihon Keizai Shimbun
