After 20 Years of Debate on Fiscal Policy, Japan is Back to Where it Started

Faculty Fellow, RIETI

Japan's debate on fiscal policy seems to have taken a round trip over the past 20 years and returned to where it started.

In the early 1990s, when Japan was in the immediate aftermath of the burst of its economic bubble, it was widely accepted that providing economic stimulus through greater public spending and tax cuts would be sufficient to pull the country out of the economic slump, and the government implemented a succession of massive fiscal stimulus packages year after year. Back in the 1990s, we were having the same debate as we are today, with the only difference being that the government was less indebted and the population was less aged than it is now.

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The enormous public spending and tax cuts failed to revive the economy. As it turned out, the fiscal stimulus measures implemented in the post-bubble years ended up being a scheme to transfer excessive debt from the private sector to the government sector, with the government giving money to debt-ridden companies resulting from the burst of the bubble to take over their debt burden. They were an implicit scheme for disposing of bad loans (or government-prescribed debt waivers similar to tokuseirei debt cancellation orders issued by Japanese medieval rulers) under the disguise of fiscal stimulus measures.

Taking lessons from the experience of the 1990s, namely, fiscal policy failure and the resulting increase in the government's debt burden, policymakers in the 2000s turned to monetary easing as a way to put an end to deflation, acknowledging that Japan's fiscal situation was reaching a critical point. Today, more than a dozen years later, policymakers are once again attempting to try out fiscal policy as monetary policy, which has run out its course and failed to make a sufficient impact. Has everyone forgotten the course of events over the past 20 years? The possibility of implementing fiscal and monetary stimulus policies simultaneously, which is the same idea from years ago but is now called "helicopter money" policy, is being discussed as if it were something new.

One of the main themes of the debate on fiscal problems in the late 1990s was non-Keynesian effects, which refer to the following hypothesis: "The existence of government debt beyond a threshold level makes people concerned about the fiscal sustainability in the future and dampens consumption. In such an economy, restoring fiscal sustainability through tax hikes and austerity measures will improve the economy."

In Japan, where the consumption tax rate was raised in 1997 and 2014 with the economy taking a downturn shortly afterwards each time, non-Keynesian effects have lost popularity in recent years. However, more careful consideration shows that the economic downturn in 1997 is more attributable to the financial crisis that occurred when the problem of bad loans escalated uncontrollably, rather than to the consumption tax rate hike. Meanwhile, the weakening of consumption from 2014 occurred amid a confluence of multiple negative factors such as a decrease in inventories, an unusually cool summer, and an unusually warm winter. Thus, we cannot conclude that the consumption tax rate hike was the primary culprit of the economic downturn.

Recently, Harvard University Professor Carmen Reinhart et al. (2013) revived the debate on non-Keynesian effects, arguing that the presence of public debt exceeding 90% of gross domestic product (GDP) would lower the country's economic growth rate by 1.2 percentage points. This is a significant hypothesis that may be able to explain why Japan's consumption has remained stagnant for years. The prolonged weakness of consumption may be attributable not to the higher consumption tax but rather to the lingering concerns over fiscal sustainability in the future, which were not dispelled by raising the consumption tax rate to 8% and have been deepening with the aging of the population.

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Risks (possibilities) in the global economy, as referred to by Prime Minister Shinzo Abe, exist continuously. We need to consider the question of how much cost to pass on to future generations in comparison with such risks in the global economy and strike a balance.

Good political leaders compare the perceived risks and costs involved, prepare for the worst-case scenario based on the most conservative outlook, and take responsibility for the outcome of policy implementation.

Which should be given greater priority: the risks in the global economy or the cost for future generations? It may be difficult to find a scientifically verifiable answer to this question, but ultimately it is up to the judgment of political leaders based on their sense of values as to what kind of country they want to leave to future generations. The judgment is moral and political, not scientific. The shape of the country to be left to the next generation includes the cost of expenditures made by the current generation, which will be passed on in the form of government debt. There needs to be a set of core values around which the sense of values are built. Otherwise, political leaders would become directionless with their decision misguided by wishful thinking or affected by flattery.

According to one business leader, the ongoing developments concerning the consumption tax and government debt resemble the process in which Japan plunged into the Pacific War. Back then, military leaders, elite bureaucrats, and politicians took one makeshift measure after another in response to changes in the war situation. Preoccupied with an internal race to claim accomplishments, they continued to avert their eyes from the obvious reality that Japan was doomed to be defeated if it waged war against the United States.

Today, it cannot be said that we are seriously confronting the reality that Japan's social security system is unsustainable unless we restore the public finances. This is the problem of political morality among the political leaders as well as of Japanese voters who elect them. At the same time, it is also the problem of the political system.

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Being exposed to the pressure of elections every two to three years, politicians cannot resist the temptation to avoid the true issue by resorting to populist measures in a makeshift manner. The existing political system needs to be changed in order to enable politicians to make the right policy choices from a long-term perspective.

It is not generally known that Friedrich Hayek, an economist and philosopher, was pondering this problem. In Law, Legislation and Liberty (1973), a major work published in his later years, he pointed out two kinds of law for politicians to legislate, namely, the general rules of justice that everyone—including both those in power and the general public—must obey (normative law or nomos) and government decisions on the allocation of its resources such as public works projects (orders or thesis). Fiscal discipline, tax system design including the consumption tax rate, and the size of the government's budget are considered to be part of the realm of nomos.

Hayek argued that modern democracy fails to function properly because both nomos and thesis are determined by the same people (parliament). For instance, giving universal power to those who determine nomos or the general rules of justice (parliamentarians) is reasonable because they cannot be tempted to use their political influence. However, those who determine thesis such as the amount of funds allocated to specific public works projects (the same parliamentarians) are exposed to the temptation of pork-barrel politics. The authority of those determining thesis must be restrained. Otherwise, politics is doomed to corrupt.

Hayek called for a separation of tasks between the two chambers of legislature, for instance, in the case of Japan, giving the House of Councillors the power to legislate nomos and the House of Representatives the power to legislate thesis. More specifically, the House of Councillors would set the overall size of the government's budget, the consumption tax rate, and so forth, while the House of Representatives would determine the amount of budget appropriations for specific purposes such as pensions. By splitting the roles, the two chambers of the Diet would have a check and balance system and thereby prevent government debt from ballooning out of control.

Japan may be in need of such radical political reform as advocated for by Hayek, but such reform is not possible without amending the Constitution. Does this mean that Abe has been pursuing the right strategy to run the government? In order to realize any Constitutional amendments, the ruling parties need a landslide victory in the forthcoming House of Councillors elections. And for that, Abe has no choice but to resort to populist policies such as postponing the planned consumption tax rate hike. If he is truly determined to achieve his goal of amending the Constitution by winning the elections at all costs, he should be commended for having made sensible judgment as a political leader.

The transfer of costs to future generations, as symbolized by the postponement of the consumption tax rate hike, is a relatively new issue that emerged in industrial society over the past century. The finiteness of fossil fuel resources, the destruction of the environment, problems associated with nuclear power plants including the ultra-long-term management of radioactive waste, and the sustainability of the social security system financed by government debt are other examples of issues in which we must fight against the temptation to pass the costs onto future generations, and none of them had been assumed in the early days of modern democracy. Conventional democracy may not be capable of providing an answer to the question of how to ensure the sustainability of public finance, one of the most pressing issues facing Japan. Indeed, we are in the process of proving the impossibility of solving this question under the current system of democracy in Japan.

It may be the case that amendments to the Constitution are needed for the sake of overcoming those difficult challenges. And if such amendments lead to drastic reform comparable to the updated version of democracy as envisioned by Hayek, Abe's decision to postpone the consumption tax rate hike twice would be remembered as a landmark, decisive judgment in the political history of Japan.

>> Original text in Japanese

* Translated by RIETI.

June 20, 2016 Nihon Keizai Shimbun

August 23, 2016

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