Democracy Facing Fiscal Crisis

How Democracy’s Ills Cause the Economy to Ail


Democracy tends to cause government spending to expand. This mechanism can be seen in developed countries around the world. Is it possible for democratic states to rein in their deficits? Economist Inoki Takenori offers his analysis.

Politics and the Economy Are Linked

Looking at the state of Japan’s politics in recent years and the jockeying among parties and politicians, Japanese people tend to fall into a state of masochistic malaise, thinking that no other country can be in such a mess. We need to recognize, however, that the political picture is similarly bleak in the United States and a number of the countries in the European Union. And it is not just Japan but most of the developed world that is currently in the throes of fiscal and economic policy paralysis, with political leaders unable to come up with strategies to straighten out public finances and achieve sustained economic growth. About the only countries where budget deficits have not turned into a political football are China, Russia, and South Korea.

In the wake of the Great East Japan Earthquake earlier this year, Japan’s prospects seemed totally bleak, and so it must have struck many people as strange that the Japanese yen subsequently rose in the foreign exchange market. Initially the yen’s appreciation was attributed to moves by property and casualty insurance companies to buy yen in preparation for earthquake-related claims payments. But the actual movements in the exchange rate are all determined by relative valuations. And the consensus now is that the yen rose against the dollar and euro because the political paralysis and poor economic prospects of the United States and the EU are even worse than Japan’s. This is probably the correct interpretation. The democracies of both the EU and the United States have fallen into a state of inability to reach political decisions based on appropriate long-term views.

Numbers are the basic indicators of the state of an economy’s health, but if we look only at numbers, we are liable to exaggerate individual factors and to jump to the conclusion that economies whose figures are similar must be suffering from the same ailment. In fact, though, the nature of the problems differs somewhat from one country to the next. For example, the fiscal crisis in Italy is of a different sort than that in Greece. In Greece’s case, investors have been selling off their holdings of the country’s government bonds, and the flow of funds into the national treasury has dried up, making it impossible to compile a budget; furthermore, the authorities’ ability to collect taxes has started to erode, reflecting problems in tracking the incomes of wealthier citizens. In other words, the fiscal crisis is due to a combination of bloated expenditures and defective revenue flows. Just four or five years ago Greece was a star performer within the EU in terms of its economic growth rate and the length of its working hours; it is hard to believe this country has fallen so far so fast. In Italy, by contrast, the problem is that the government’s outstanding debt is 120% of the country’s gross domestic product, a medium-term issue. Within the EU there are growing fears that Italy will end up defaulting on its government bonds. While keeping these sorts of differences in mind, I would like to cite what I see as some key points underlying a problem common to various countries, namely, the fact that their political systems are making their economies sick.

Financial Markets Spooked by Budget Deficits

As a result of the recession following the financial crisis that struck in the summer of 2008, production and employment declined, and in the United States tax revenues shrunk sharply; this led to increased issuance of deficit-financing bonds. The crisis seems to have been set off not merely by a lack of liquidity but also by the insolvency of commercial banks caused by defaults on loans (particularly so-called subprime mortgages) for purchases of homes by low-income borrowers and others, which spread through the financial system as a whole. In the face of this situation, President Barack Obama in July 2010 signed into law a voluminous piece of legislation commonly called the Dodd-Frank Act (what might well be considered a modern version of the Glass-Steagall Act of 1932) to provide a legal framework for restoring healthy financial markets. But there is much skepticism about the degree of effectiveness of this law reregulating financial transactions. Some criticized the president for passing up the opportunity to achieve meaningful reform of the financial system in exchange for securing enactment of a suprapartisan health insurance reform plan. And even if the Dodd-Frank Act makes US banks behave more prudently, the instability in global financial markets cannot be eliminated unless Britain and the EU take matching steps. So a key element of the problem remains unsolved. There is no telling when another financial crisis may strike.

Financial markets and government budget deficits have a strong effect on each other. As noted above in the case of Greece, when financial markets get the jitters, the market for the huge amounts of government bonds resulting from budget deficits may be shaken. And financial markets are tied together closely by the bond market, in which government obligations are the central element. Meanwhile, we must not overlook the mechanism by which failures of financial institutions can generate fiscal risks. When banks’ bad loans reach a critical level, central banks and governments have often stepped in to protect their shareholders and creditors with large-scale rescue packages. The bigger a bank is, the more likely it is to be considered “too big to fail.” But the practice of providing such bailouts has given rise to a type of moral hazard, making banks even bolder in taking risks. They are pushed toward high-risk investments by the belief that the government will provide public funding for them if they get into trouble. This increases the probability of falling into a “doom loop.” In the case of the United States, because President Obama has failed to squarely address the issue of financial market regulation, the fiscal risk from big bank bailouts remains grave. The most serious cost for the economy as a whole is the loss of jobs resulting from the financial crisis, whose impact hurt the real economy. The financial services sector that is supposed to provide necessary lubrication for the real economy has ended up pushing the latter around—a clear case of the tail wagging the dog.

Turmoil in the Political Arena Clouds the Future

The instability these days is not limited to the financial markets. The turmoil in politics is also heightening the level of uncertainty about the future. And the unrest in the Middle East can only act as a negative factor on the recovery of the global economy.

But instability on the international scene is nothing new. What makes the situation grave is the state of domestic politics in the developed countries. The turmoil in the Japanese political arena surely needs no exposition. And when the jockeying among parties and politicians turns into a free-for-all with no foreseeable outcome, the heightened uncertainty has a tremendous impact on the economy. Consumption and other forms of economic activity depend on the ability to forecast the future and calculate probable results. Investment is based on a reckoning of prospective profits; though it is impossible to avoid uncertainty, investing is not gambling. Though risks may be present, investments are made on the strength of bright outlooks of one sort or another, and these investments result in increased employment and production. As I noted above, no fundamental reform of the financial markets has been carried out since the 2008 financial crisis. Political leaders have failed to display firm stances on this matter.

The situation in the United States is similar to that in Japan. The two major parties there have implemented a confused welter of shortsighted policies for almost 30 years. With the enactment of Medicare Part D (subsidizing the cost of prescription drugs for seniors and people with disabilities) as a Republican initiative in 2003, the US Congress gutted the rule that new spending must be matched by new revenues. And in drafting the budget for 2010, President Obama put off $4 billion in federal government spending cuts. Meanwhile, no serious steps have been taken to secure new tax revenues. It seems fair to say that both the Republicans and the Democrats have been pandering to the public. If we look at the size of expected future spending on medical care and social security, it seems that the possibility of a declaration of bankruptcy at some point cannot be totally ruled out.

Here in Japan, meanwhile, the government’s position on the fiscal deficit lacks consistency. Though I am no fiscal hawk, in the wake of this year’s earthquake I suggested it might be necessary to raise funds for reconstruction not just through special bond issues but also with a (temporary) hike in the consumption tax. People pounced on me for making such a remark “at a time when the economy is so bad.” The bill for post-earthquake reconstruction, even excluding the costs relating to the nuclear plant disaster, is expected to be well over ¥20 trillion. This may seem like a small amount by comparison with the total national debt, which is now approaching ¥900 trillion. And it may seem logical to pay for the reconstruction effort with specially issued reconstruction bonds. But today’s Japan needs to display a sense of community, with everybody among the present generation of Japanese making some sort of contribution to support the rebuilding drive. It seems to me that it is up to politicians to promote a sense of national solidarity in the face of a crisis like this.

On November 8, 2011, the secretaries general of the DPJ, LDP, and New Kōmeitō reached agreement on a 25-year redemption term for the reconstruction bonds associated with the third supplementary budget for fiscal 2011. (Photo: Sankei Shimbun)

Those who assert that hiking the consumption tax will send the economy from bad to worse are wrong on two counts. First of all, we can expect reconstruction-related investment both from the private sector and the government to emerge in amounts sufficient to make up for any decline in the disposable incomes of individuals. The amount of any increased tax take will be spent. What is important is effective demand. Secondly, relying on taxes other than the consumption tax will have an even graver effect on the economy. A higher income tax on individuals will exacerbate inequality among income strata and age groups, and higher taxes on corporations will put them at a competitive disadvantage internationally, so the consumption tax should serve as the main source of additional revenue for reconstruction. But in mid-November the ruling Democratic Party of Japan and the two biggest opposition parties, the Liberal Democratic Party and New Kōmeitō, agreed on a plan to raise ¥10.5 trillion in reconstruction funds mainly through hikes in individual and corporate income taxes, with a redemption term of 25 years, a halfway figure, for reconstruction bonds issued by the government. They did not turn policy in a direction that would have promoted a sense of solidarity among the current generation of Japanese. 

Recognizing Democracy’s Chronic Disease

Why are so many liberal democracies struggling with fiscal problems? The reason is clear to see: Politicians need to win elections. If they fail to do so, they are out of a job. Not many ordinary citizens are eager to get into politics in the face of this risk. The basic mechanism of representative democracy, whereby people win political office by securing votes in an election, is a double-edged sword. Candidates promise voters various economic benefits in order to win their votes. So democracy is inherently biased toward increased government spending. Even if a piece of legislation is enacted funneling benefits to a particular group, the additional cost for each individual citizen will probably be negligible. So those who have no direct connection with or interest in the benefits to be generated by the law tend not to question its merits or oppose it. If anything, they may support it in hopes of cooperation from the law’s backers in securing passage of legislation benefiting their own group at some future juncture. When the benefits are concentrated and the costs are spread widely and lightly, awareness of the burden is minimal. This mechanism allows the passage of numerous bills causing government spending to swell.

This inherent tendency in representative democracy for the public sector to grow results in the politicization of economic issues. People’s biggest concern is who has the power to serve their particular interests. Democracy seems to assure fair elections by giving each person one vote, but in practice results may emerge that bear no clear connection to the votes people cast.

People in the United States and many other countries have tended to see politics and the economy as being tightly linked together to serve as a “money tree” that they can rely on to enjoy living standards beyond their income. So in the United States people piled up personal debts, including housing loans, and in many countries the government’s debts ballooned as the result of favor-currying fiscal expenditures. It seems fair to say that finance ministry mandarins are the ones who try to restrain the working of this mechanism. The accumulation of red ink in public finances based on the myth of the money tree has blocked governments from adopting policies to create jobs. The victims are those who have a strong will to work but are unable to find openings—particularly unemployed young people.

The European Central Bank in Frankfurt, Germany, administers monetary policy for the 17 states of the euro zone.

Another problematic factor is the existence of the EU, which is a “demi-state,” not merely because it lacks a constitution but also because it is not integrated fiscally, and so it lacks an institution like the finance ministry of an ordinary country. Furthermore, it is composed of members whose labor costs and productivity levels are widely divergent. And, having adopted the euro as their common currency, these member countries have been forced to surrender their monetary policy independence; this leaves them unable to maneuver even when they face a fiscal crisis. Instead they must rely on the uniform policy adopted by the European Central Bank. But the ECB does not formulate its monetary policy democratically. Naturally enough, it is influenced by economic conditions in the bigger, stronger countries of the euro area. Here we can see the problem of “democratic deficiency” that the euro has introduced.

In Japan, meanwhile, we hear talk of building an “East Asian Community.” But before we imagine that we can achieve something similar to what the Europeans did in creating the EU, we should realize that the history of community building there goes back more than 1,200 years to the time of Charlemagne and be more aware of the troubles that Europe has experienced in the past. Also, when we talk about building a community in East Asia, we must consider the crucial international relationships involved—in particular, what lies ahead for Sino-Japanese relations in the context of the rival initiatives of the Trans-Pacific Partnership and ASEAN+3 (the members of the Association of Southeast Asian Nations plus China, Japan, and South Korea), both seeking to create broad free trade agreements, and whether there is a chance of a cold war between China and the United States.

The Constant Rebarbarization of the United States

Policy measures cannot restore a seriously ailing economy to health overnight. An economy is in some ways like a human body. Not all of its ills can be cured with medicine or surgery. Sometimes a single pill is enough to drive the pain away, but other times the ailment is an intractable one that can only be endured. Economic policy is not a panacea. The popular illusion that it is, accompanied by excessive reliance on the government and central bank, may itself be a source of moral hazard.

We should also recognize that though the state of the economy is certainly bad, it is probably in better shape on the macro level than it was during the Great Depression 80-some years ago. Even in the United States the unemployment rate was above 25% during the 1930s. Currently it is at a plateau of around 9%. Of course I do not mean to say that we should accept the current poor state of the employment picture. But if people place their hopes in a panacea that does not exist, they will complain even more about politicians’ failure to provide a cure, and politics will deteriorate all the more. We need to avoid falling into this sort of vicious cycle.

We must also bear it in mind that the status and role of the United States in the global economy are very different from what they were 80 years ago. In the 1920s the United States was a lender in the international capital markets, and it supplied large amounts of funds to Germany so that country could maintain the value of its currency and continue to pay its reparations for World War I. Germany experienced a boom in consumption, and as a result both Germany and the United States saw their housing and stock markets explode. The crash in the global economy came at a time when the United States was dominating it.

The crisis that has occurred in the post–Cold War world is one in which the United States is again the lead player, but this time it is an international borrower. The inflow of capital from countries like China and Japan allowed Americans to go on a spending spree, consuming beyond their means. And of course the prime example of this was the lending to low-income people buying homes. The United States is certainly an unruly giant. But at present there is no other country that can replace it as the core actor in global politics and the global economy.

An open market economy like that of the United States is subject to repeated cycles of overheating and contraction, and it has an insatiable appetite for less-regulated markets. When a crisis strikes, people are temporarily chastened, but after a while their wild instincts reassert themselves. This sort of “rebarbarization” is a feature of the US economy. And I think we can say that it is the United States’ responsibility as a great nation to find ways of controlling these wild instincts by law and the power of politics.

United States politics Greece economy financial crisis Democracy EU deficit-financing government bonds foreign exchange GDP deficits unsecured loans insolvency Dodd-Frank Act Lehman shock two major parties employment Inoki Takenori