This month's featured article
Fiscal Reconstruction and Voter Awareness toward the Election
MORIKAWA MasayukiVice President, RIETI
(RIETI Consulting Fellow at the time of writing this report)
Rising long-term interest rates
Amid signs that the rapid economic deterioration since autumn 2008 is finally coming to an end or has at least bottomed out in certain segments, long-term interest rates are on the rise in the United States and other advanced economies. The interest rate on 10-year U.S. Treasury notes, which dipped to around 2% at the end of last year, has turned upward since the beginning of this year, reaching a near 4% level at the moment. In Japan as well, the interest rate on long-term government bonds, which stood at 1.1% at the end of 2008, has temporarily exceeded 1.5% and while this may be a minor movement in the historical perspective, it does indicate an upward trend.
The recent rise in long-term interest rates has been caused by a combination of factors including signals of economic recovery, inflation expectations, and market movements in anticipation of a hike in key policy interest rates. However, the massive oversupply of government bonds, resulting from growing fiscal deficits in countries across the world, has been cited as a contributing factor. Market participants are now increasingly focusing on how these countries will or can restore fiscal health after addressing the immediate crisis.
Against this backdrop, in Japan, a key government policy panel compiled the Economic and Fiscal Reform 2009 (Basic Policies), which aims to renew fiscal health while enhancing the nation's medium-to long-term growth potential and reassuring society, through the implementation of various measures, including those set forth in the earlier announced J-Recovery Plan. The panel has also set new fiscal consolidation targets. Under the guiding principle of "boldness in the short term and responsibility in the medium term," the plan stipulates that the ratio of public debt to the gross domestic product (GDP) should be put on a steady downward trend by the early 2020s and that the government must seek to achieve, without failure, a surplus in the primary balance within 10 years. These targets can be perceived to be intended to show the government's commitment to ensuring fiscal sustainability so as to maintain market confidence.
Impact of growing government financial liabilities on the economy
It is a well-known fact that on a stock basis, Japan's fiscal condition is the worst among advanced economies. According to statistics compiled by the Organization for Economic Cooperation and Development (OECD), Japan's general government gross financial liabilities were about 170% of its nominal gross domestic product (GDP) in 2007, the highest among the OECD countries and more than twice the OECD average of about 75%. The figure has since further worsened, both in terms of the denominator and numerator, as Japan's GDP decreased and fiscal deficits expanded during and in the aftermath of the economic crisis. In its latest World Economic Outlook released in April 2009, the International Monetary Fund predicts that Japan's ratio of gross public debt to GDP ratio will increase from 196% in 2008 to 227% in 2010, and 234% in 2014, and the net public debt to GDP ratio from 88% in 2008 to 115% in 2010 and 136% in 2014, in both of which "public debt" refers to general government financial liabilities.
Many empirical studies have been conducted on the effect of government financial debt on long-term interest rates. Findings differ substantially depending on factors such as the research target country, the data analysis period, and the method of estimation. According to a representative study by Engen and Hubbard (2005), which is frequently cited on this subject, a one percentage point increase in the government debt to GDP ratio would increase the long-term interest rate by two to three basis points in the U.S.(note 1) Meanwhile, in a survey conducted about two years ago by myself and fellow researchers about economists' perceptions of economic parameters, the median estimate of the corresponding parameter was 2.5 basis points in Japan. However, this function is believed to have non-negligible nonlinearity. It must be noted that the impact on long-term interest rates could increase sharply once government financial liabilities exceed a certain threshold.
Needless to say, a rise in interest rates has a negative impact on the economy by putting downward pressure on investment in plant and equipment as well as in housing. Unlike short-term interest rates, which are a monetary policy variable, long-term interest rates are an endogenous variable. Thus, the effects of an increase in long-term interest rates on the macro-economy are dependent on factors that have caused the rise in interest rates. A general implication based on various macro-models is that a one percentage point rise in interest rates would result, with a slight time lag, in a decrease of 0.3 to 0.5 percentage points in GDP growth. Looked at from the supply side, a rise in interest rates exerts an adverse impact on potential growth through such channels as increased costs of capital, suppressed investments in plant and equipment as well as in research and development, and slower growth in capital stock and total factor productivity. It is a matter of course that the growth of the national economy has a positive impact on the nation's fiscal health. At the same time, however, there also exists a reverse channel, through which improved fiscal health has a positive impact on economic growth(note 2).
Public support for measures to improve the economy and fiscal health
Restoring a nation's fiscal health involves cutbacks on fiscal expenditure, tax hikes, or a combination of both. The crucial question is whether incumbent leaders can win public support for such measures and the resulting burdens. In this regard, an empirical study conducted by Brender and Drazen (2008) provides interesting findings with respect to the theory of political business cycles(note 3). Based on data on 350 election campaigns in 74 democratic developed or developing countries, they estimated the effects of changes in the fiscal balance to GDP ratio during the term in office, or in the year of election, on the public support given to the incumbent leaders (i.e., the probability of reelection), using a logit model. Contrary to conventional wisdom, they found that a one percentage point improvement in the fiscal balance, relative to GDP made during the term in office, would increase an incumbents' probability of reelection by three to five percentage points and the same improvement made in the election year would boost incumbents' chances of reelection by seven percentage points, as far as developed countries are concerned(note 4).
This analysis is controlled for the effects of GDP growth and other like factors as explanatory variables. Thus, the possibility that both the improved fiscal balance and higher public support for incumbents, may be attributable to the robust economic performance, is ruled out as an alternative explanation for the observed result. The study also provides analytical results which effectively negate the reverse causality that incumbents have been able to carry out fiscal reform because they are already politically popular and powerful leaders. These estimation results only represent average or statistical properties; hence, there are naturally many instances in which individual countries deviate from the aforementioned pattern. Also, as noted in Brender and Drazen (2008), circumstances differ depending on the nature of government expenditures and tax policies. However, their findings indicate that, in general terms, voters in developed countries are interested in the improvement of economic conditions and tend to appreciate fiscally austere policies.
Meanwhile, one question in the Japanese government's Social Awareness Survey, asked respondents to answer a multiple choice question about areas of the economy they felt were "heading in a positive or negative direction." On the whole, respondents selected many items as heading in a "negative direction." Along with areas such as "economic performance," "employment and labor conditions," and "inflation," "Government's budget" has consistently ranked highly as an area perceived to be moving in a "negative direction." As shown in the figure below, in 2005 and 2006, when the Japanese economy was in an expansion phase, people were more aware that fiscal conditions - as opposed to the economy or employment - "was an area heading in a negative direction." When analyzed by type of respondent, men in the working age population, people in managerial positions, technical specialists, and business owners (including those in the commercial, industrial, and service business sectors) had a particularly high propensity to select "Government's budget" as an area heading in a negative direction. The pattern of change in the proportion of respondents citing "Government budget" is substantially similar to the pattern of actual changes in fiscal conditions, i.e., the ratio of fiscal deficit to national income (R2=0.69).
(Source) Created based on the results of "Shakai Ishiki ni kansuru Yoron Chosa (social awareness survey)" conducted by the Cabinet Office.
Meanwhile, the survey conducted in January 2009, at a time when the global recession deepened and began to take its toll, found a sharp rise in the number of respondents choosing "economic performance" and "employment and labor conditions" as heading in a negative direction. This indicates that people came to attach significantly greater priority to measures to improve the economy and employment conditions. However, given their strong pro-cyclical nature, it is highly likely that the priority of measures addressing these factors will gradually come down if the economy begins to recover. The idea of "boldness in the short term and responsibility in the medium term" set forth in the latest Basic Policies can be thought of as being consistent with people's awareness about priority issues.
- Refer to Engen, Eric M. and R. Glenn Hubbard (2005), "Federal Government Debt and Interest Rates," in Mark Gertler and Kenneth Rogoff eds. NBER Macroeconomics Annual 2004, Cambridge, MA: The MIT Press, pp. 83-138. The OECD's Economic Outlook Interim Report March 2009 provides a table listing the estimated effects of public debt on interest rates, taken from leading relevant studies in the past. It shows that the estimated impact of one percentage point deterioration in fiscal balance relative to GDP on long-term interest rates differs significantly, ranging from below one percentage point to 30 basis points and above.
- Because cutbacks on fiscal expenditures and tax increases for fiscal reconstruction have negative effects on aggregate demand on a short-term basis, the net impact of these measures is affected not only by interest-rate sensitivity but also by other factors such as output gaps and the magnitude of multiplier effects.
- Brender, Adi, and Allan Drazen (2008), "How Do Budget Deficits and Economic Growth Affect Reelection Prospects? Evidence from a Large Panel of Countries," American Economic Review, Vol. 98, No. 5, pp. 2203-2220.
- In developing countries, no statistically significant relationship is observed between the improvement of fiscal balance and election results.
Upcoming Elections will Determine the Next Government but Political Confusion will Likely Continue
Faculty Fellow, RIETI
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