Japan Should Rethink Its Stimulus

Op-ed in the Financial Times

January 15, 2013

What happens when an economy runs out of fiscal space? The presumption is embodied in the image of "hitting the wall." Under this assumption, public debt exceeds a certain limit and financial confidence collapses. As a result, interest rates rise, the currency falls, and panic ensues. At times this scenario holds true—for economies with sizeable foreign-denominated public debt or for economies that create political breakdowns.

 Japan demonstrates a different reality about the problems of excessive debt—one that Shinzo Abe, its new prime minister, should keep in mind as he launches a fiscal stimulus package. Japanese public debt has ballooned for 20 years, rising from 60 percent to 220 percent of gross domestic product (though the true figure net of government holdings may be 130 percent). During that time Japan has been in recession, recovery, and back in recession, but interest rates on Japanese government bonds (JGBs) have remained below 2 percent for the past 13 years. While the debt accumulated, the yen appreciated from Y130 to Y78 to the dollar, before reversing to Y89 over the past few months.

Japan was able to get away with such unremittingly high deficits without an overt crisis for four reasons. First, Japan's banks were induced to buy huge amounts of government bonds on a recurrent basis. Second, Japan's households accepted the persistently low returns on their savings caused by such bank purchases. Third, market pressures were limited by the combination of few foreign holders of JGBs (less than 8 percent of the total) and the threat that the Bank of Japan (BoJ) could purchase unwanted bonds. Fourth, the share of taxation and government spending in total Japanese income was low.

Getting away with something is not the same as getting off cost-free. Each of these factors enabling the ongoing fiscal deficits has had its costs to Japan. Stuffing bank balance sheets with JGBs has constrained commercial lending by those banks—even during the recovery of 2003–08—which harmed small and new business development. The persistently low returns on Japanese savings have further squandered investment opportunities, thereby creating a negative feedback loop with deflation and older savers' risk aversion. The absence of external pressure has fed the combined long-term appreciation of the yen and stagnation of Japanese stock market returns, both severely distorting the economy. Needed public investment and funds for adequate healthcare and disaster recovery have been crowded out by debt payments, given a relatively fixed share of government in Japanese GDP.

When I and others advocated aggressive stimulus in Japan in the second half of the 1990s, it was intended as a temporary response to three conditions. First, the recession was acute, severe, and eroding the stability of a Japanese financial system already weakened by substantial non-performing loans. Second, the actual stance of Japanese fiscal policy then was, on balance, contractionary. And third, the net public debt level was low enough that short-term stimulus would not crowd out public investment (let alone private investment).

The case for continued deficit spending in Japan ended by mid-2003. Though it is often overlooked, Japan's economy recovered well following a rectification of financial and macroeconomic policies—including banking recapitalization—in 2002–03. From 2003 to 2007, per capita real income growth was the same in Japan as in the United States (averaging 1.8 percent annually) and kept pace with the United States on average even during the volatile years of 2008–11. Meanwhile, the costs of running recurring deficits during an expansion accumulated.

Mr. Abe's new fiscal stimulus initiative is therefore questionable. Not because another 2 percent of GDP will be the proverbial tipping point on Japanese debt sustainability, for the factors protecting Japan from overt fiscal crisis remain. Nor because it will be ineffective; if anything, when combined with monetary expansion and a likely consumption tax rise in the near future, I expect its multiplier and thus short-run impact to be high.

The additional stimulus in Japan is counterproductive because it adds to the long-term costs without addressing Japan's real problem: a return to deflation and an overvalued exchange rate. The BoJ pursuing a higher inflation target through large-scale purchases of a wide range of assets, as Mr. Abe and his economic adviser Koichi Hamada rightly advocate, would be sufficient and appropriate.

Persistent fiscal policies that fail to adapt to changing cyclical conditions result in long-term damage. This holds true whether a government errs on the side of excessive austerity, as in Europe of late, or on the side of unjustified indiscipline, as in Japan since its recovery a decade ago. Either way, the consequences are real, though rarely as dramatically visible as hitting a wall. Italy, the United Kingdom, and the United States should fear the structural damage of following Japan's example if fiscal expansion is not timed to end with recovery. When a large country with its own currency reaches its fiscal limit, growth ends not with a bang but a whimper of declining vitality and diminishing resilience.