RIETI Report April 2004

Japan's Fiscal Crisis <RIETI Featured Fellow> TSURU Kotaro

Greetings from RIETI

Many aspects of Japanese art and culture play off on the conflict between order and chaos, and none more so than "manzai," Japanese stand-up comedy. Although there are solo stand-up comedians in Japan, manzai refers specifically to double-acts composed of a "tsukkomi" (a straight man) and a "boke" (a funny man). The two begin their act by making some interesting or witty social observation, which naturally gets misinterpreted or distorted by the boke. The boke then continues to take the subject matter completely off the rails and tries to carry it in the most absurd directions possible, as the tsukkomi appeals to the audience claiming that his friend has lost his mind. While the tsukkomi tries to restore order by correcting his partner's misunderstandings, yet only more are made through puns and innuendo. When the boke's sublimity reaches its peak, the tsukkomi administers the renowned slap to the back of the head bringing his friend back down to earth again, and the process begins once more. The rantings of the boke would not be funny if it were not for the presence of the tsukkomi who embodies social order, and while the boke's anarchy is celebrated and encouraged it is always kept in check by the firm parental hand of the tsukkomi; flexibility that is monitored by discipline. For the first of this month's newsletters, RIETI Report spoke with Senior Fellow Kotaro Tsuru and heard about how a skillful balance of flexibility and discipline could be used to deal with the fiscal crisis facing Japan that is in need of urgent attention. (DC)

RIETI FELLOWS NOW

TSURU Kotaro
Upon graduating from the University of Tokyo with a B.S. in mathematics in 1984, Kotaro Tsuru joined the Japanese government's Economic Planning Agency (EPA) as a government economist. During his time at the EPA, he also received an M.Phil. in Economics from St. Antony's College, the University of Oxford. From 1995 to 2000, Tsuru served as a staff economist at the Organisation for Economic Co-operation and Development's Economics Department in Paris. Upon returning from France he took up the position of research economist in the Institute of Monetary and Economic Studies at the Bank of Japan, before becoming a senior fellow at RIETI, a position he has held since RIETI's establishment in 2001. Having been reinstated at St. Antony's College, Oxford, in 1999, Tsuru finally received a D.Phil. in Economics in 2002 for a thesis entitled "Japan's bank-borrower relationships in transition: Theory and applications." His range of expertise includes corporate governance, the financial system (banking), the employment system and political economics.

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Interview

Japan's Fiscal Crisis

RIETI Report: Japan's fiscal condition is in a critical state. As a foundation for prescribing measures to restore the nation's fiscal health, how would you assess the current state of the economy and what lessons have we learned or failed to learn throughout the economic doldrums of the past decade?

Tsuru: The Japanese economy went through drastic change between the bubble era of the late 1980s and the 1990s onward. In the 1990s, Japan's growth potential, as a baseline of economic performance, declined. At the same time, the cyclical amplitude was reduced. As a result, even when the economy was somewhat on an upward trend, people hardly felt it and overall sentiment remained depressed. Against such a backdrop, the government implemented a total of 11 economic stimulus packages, which resulted in massive fiscal deficits while bringing no clear-cut recovery.

However, there were some changes made. Various mechanisms and systems that had been established on the assumption of long-term growth and stability - the corporate management system, the employment practice, company-to-company relationships, and so forth - have lost their foundation. Distinguishing between the leading industries and the declining industries used to be easy, but no longer. The result is a growing gap between the winners and losers within the same industry. Companies undertaking management innovations, including those in so-called structurally depressed industries, have been successful, while those relying on government policies have been losing out. So, in a sense, we can say that there has been a good deal of changes in corporate behavior. At the same time, however, there still remain areas where no sufficient changes have occurred. Generally speaking, industries closer in nature to the public sector are slow to change.

RIETI Report: So, efforts by individual companies have come to count more, which is probably a positive change partly attributable to the deregulation and structural reform that were pushed forward in the 1990s. At the same time, however, the government also attempted to carry out fiscal reform. Why did it fail?

Tsuru: Indeed, Japan did try but failed to address the fiscal problem. The Fiscal Structural Reform Law was enacted in late 1997 but then frozen only a year later. As it turned out, Japan is about the only industrialized country that failed to achieve fiscal reform in the 1990s, during which many countries - including the United States, Canada and member states of the European Union - successfully restored fiscal stability.

One of the reasons for the failure was the absence of an exemption clause which would have allowed the government to implement fiscal measures, regardless of restrictions under the law, in cases of emergency. Around the time the law was enacted, the Japanese economy was plummeting into a critical condition and it became impossible for the government to keep to the stringent fiscal restrictions that the reform law had imposed. With no built-in flexibility provided under the law, the government had no choice but to abandon it altogether. Then, those who had been critical of the austere policy came back with reinforced influence.

Another reason is that the fiscal structural reform of the late 1990s was so preoccupied with meddling with mathematical targets that it failed to cut into the mechanisms which bloat the budget; the question of how and with what incentives various players - bureaucrats including both financial ministry officials in charge of budget assessment and those from spending ministries, politicians in the ruling party and on the opposition, and the businesses or interest groups behind them - interrelate with each other. Without changing these mechanisms or the incentive structure, fiscal reform cannot move forward.

After the single-party rule by the Liberal Democratic Party ended in the early 1990s, even more players - parties that formed the ruling coalition at the time - came to engage in the rent-seeking game in budget formulation, which resulted in further expansion of the budget. This follows the experience of many other countries, and a dispersed budget decision-making authority tends to increase the size of the budget. So, the decision-making authority needs to be centralized and the political process of formulating the budget changed accordingly. Specifically, a top-down decision-making system should be adopted allowing the prime minister and the finance minister to set an overall budget framework, while leaving the actual formulation work to the Ministry of Finance and letting individual government ministries decide on the details as to how they spend their respective budget.

RIETI Report: The so-called "Six-Point Reform" in the late 1990s, through which the Fiscal Structural Reform Law was enacted, was also implemented in a sort of top-down manner under the leadership of then Prime Minister Ryutaro Hashimoto. How should the new decision-making system differ from this?

Tsuru: The Six-Point Reform agenda was pointing in the right direction and not necessarily a total failure. For instance, the "Big Bang" financial reform, one of the six pillars, has been fairly effective. The fiscal structural reform, however, was implemented with the wrong timing - in the midst of a banking crisis at home and a financial crisis in Asia - and in the wrong way (leaving too little room for flexibility). Also, I think that it might have been impractical for a single prime minister to keep an eye on all the six areas - administrative, fiscal, financial, economic, social and educational systems - at the same time. Today, the fiscal problem is the issue of utmost urgency. So, we should set a clear focus on this problem as we cannot afford to allow any more delay.

First of all, the current structure of the chronically deficit-ridden budget must be changed in the next two to three years, for instance, by setting numerical targets for reducing expenditure. Such numerical targets must not be uniform for all policy areas but differ according to a priority established by top-down decision. In addition, we need to improve the overall efficiency of the budget mechanism with regard to expenditure and the budget formulation process. But this will probably take five to six years.

RIETI Report: How can budget efficiency be improved? Does it mean greater flexibility?

Tsuru: Flexibility is important but there is always a dilemma between discipline and flexibility. Greater flexibility tends to lead to lax management and greater fiscal deficit. But when discipline, or self-binding commitment, is too strict, it undermines flexibility and restricts the government from acting spontaneously when it needs to. The question is how to turn this inevitable dilemma into a benign tradeoff. Sufficient flexibility means allowing the government to implement fiscal measures at its discretion so that it can take timely actions in cases of emergency. At the same time, however, the government must be held accountable for the results of its decisions. In other words, the government must fully disclose information regarding its adopted policy measures and the results of their implementation so that taxpayers can evaluate the effectiveness of such policies and make their feelings known come election time. By implementing such a mechanism for public scrutiny, fiscal discipline could be maintained while allowing policy flexibility.

RIETI Report: Given the current political situation and the pervasive public indifference to politics or government policies, where can we start?

Tsuru: First and foremost, everyone must understand that there is a fiscal crisis and share a sense of urgency about it. In implementing hard-to-swallow reform measures, a supra-partisan agreement on the general direction they are to take must first be reached, establishing a platform for parties to discuss and compete with each other over policy that can achieve the common goal.

One thing is clear - nothing can be solved by prolonging this policy of procrastination. And I believe a substantial portion of the general public is coming to share this view. But unfortunately, we have yet to see a clear link between such changes in public sentiment and election results. And once again, information disclosure is the key to changing this.

RIETI Report: For the moment, signs of economic recovery are emerging. What should be the government's response to this?

Tsuru: An improved economic situation would facilitate the implementation of measures that the government could not dare take before. Fiscal reform, in essence, means either one of two things - increasing tax revenue or cutting down on expenditure. Either way, these measures would be a blow to the economy. And as a prerequisite for implementing such measures, the overall economic environment needs to be the one that is ready to absorb some of the expected negative impacts. Improved sentiment may lead to optimism and dilute the sense of crisis. But now is not the time to slacken the reins.

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EVENTS INFORMATION

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Brown Bag Lunch Seminars

All BBLs run 12:15 - 13:45, unless otherwise stated.

4/20 Speaker: Peter McCAWLEY (Dean, Asian Development Bank Institute)
Moderator: NAKABAYASHI Mieko (RIETI Fellow)
"The Washington Consensus and Current Approaches to Development in Asia"

4/26 Speaker: Lee BRANSTETTER (RIETI Visiting Fellow / Associate Professor of Finance and Economics, Columbia Business School)
Moderator: TAMADA Schumpeter (RIETI Fellow)
"What is the impact of academic science on industrial R&D in Japan? New evidence from co-publication and patent citation data"
(in Japanese)

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This month's featured article

Japan's Fiscal Crisis <RIETI Featured Fellow> TSURU Kotaro

TSURU Kotaro Fellow, RIETI

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