The Fiscal Crisis in Advanced Democracies and Issues for Japan

Does democracy promote economic growth? The answer is surprisingly complex. In an article titled “Which Came First—Democracy or Growth?” Rubén Hernández-Murillo and Christopher Martinek of the Federal Reserve Bank of St. Louis introduce three earlier studies on the correlation between democracy and growth: (1) Robert J. Barro, “Democracy and Growth”; (2) Daron Acemoglu, Simon Johnson, and James A. Robinson, “The Colonial Origins of Comparative Development: An Empirical Investigation”; and (3) Edward L. Glaeser et al., “Do Institutions Cause Growth?”(*1)

Barro looked at about 100 countries over the period from 1960 to 1990 and found that those where political rights increased tended to have higher levels of growth. But he also found that in countries that had already achieved medium levels of democracy, further increases in the political rights of the masses in some cases caused growth to slow by inviting income redistribution policies (pork-barreling and the like).

Acemoglu and his coauthors found a strong correlation between protection against government expropriation and economic growth. Looking at former European colonies, they found that growth was limited in Spanish colonies, where the main goal was to transfer resources to the home country. By contrast, in places like Australia, New Zealand, Canada, and the United States, institutions were created that provided checks against government expropriation, and the colonies grew to the point of becoming independent.

Glaeser and his coauthors looked at countries that were dictatorships with high levels of poverty as of 1960 and examined their growth rates over the following 40 years. They found that it was hard to evaluate economic performance just on the basis of political systems. China, for example, achieved one of the world’s highest growth rates while maintaining its one-party dictatorship. But China also adopted various policies like those of advanced democracies, such as the de facto protection of property rights and policies promoting investment and education.

Today’s China is hard to label as having a socialist economy. It is a fiercely competitive dog-eat-dog society on a par with the United States. When I recently asked a woman who works at a Chinese financial institution about China’s socialism, she laughed, with an expression that seemed to say “Such a question in this day and age!” and explained: “China’s a capitalist economy controlled by the Communist Party. I learned the spirit of socialism from the Japanese people when I was studying in Japan.”

According to a survey recently published by the European Bank for Reconstruction and Development, support for democracy has dropped sharply in the Central and East European countries that joined the European Union after the collapse of the Berlin Wall. The recession accompanying the turmoil in the euro area has caused an increasing number of people to think that the old days of dictatorship were better. This is a dangerous sign for democracy.(*2)

The Looming Fiscal Crises in Europe, America, and Japan

The sovereign debt crisis of the euro area has severely shaken the economy not just of Europe but of the world. The leaders of the euro-area countries still seem to be determined to support the single currency, but they have been unable to come up with effective measures to calm the jitters in financial markets. Under the democratic system of government, many of these leaders are facing important domestic elections, and they need to balance their moves against the sentiments of their countries’ voters; this makes matters more difficult.

In fact, though, the United States is actually in worse fiscal straits than Europe. According to the International Monetary Fund’s figures on general government gross debt as a percentage of gross domestic product, as of September 2011 the figures for the four biggest countries of the euro area were Germany 75.0%, France 87.8%, Italy 114.1%, and Spain 77.4%, while the figure for the United States was 115.4%.(*3) As the population ages, with members of the baby-boom generation reaching retirement age, the increased cost of social security benefits will put a crimp on US public finances. Up to now high income earners in the United States have enjoyed unfairly favorable treatment in terms of their effective income tax burden, and correcting this ought to be an urgent priority, but as we saw last summer, it is difficult for Congress to reach an agreement on deficit cutting. And supporters of Republican members of Congress, particularly those in the Tea Party movement, have been sharply critical of the moves taken by the federal government and the Federal Reserve Board in response to the financial crisis since the autumn of 2008. They consider it outrageous for the administration to use large amounts of public funds to rescue the rich financiers on Wall Street, causing the government to swell. So fierce have their criticisms been that it would be hard for the government and the Fed to respond nimbly to a future shock like the one that struck in 2008.

In this respect China’s one-party dictatorship has been showing its strength. In a democratic government, budgetary measures ordinarily must be approved by the legislature, and implementing them takes time. So often it is up to the central bank to act as the first responder in the face of an emergency situation. But in China it is possible to carry out fiscal measures with the same sort of speed as monetary policy. China’s ability to maintain a high rate of growth even in the wake of the September 2008 collapse of Lehman Brothers and the ensuing financial crisis was thanks to its nimble response in implementing macroeconomic countermeasures. But the Communist Party of China faces a dilemma: As its policies cause per capita income to rise and people come to enjoy more comfortable lives, they also start to want democratic government and freedom of speech.

If financial market participants were asked to identify democratic states that seem to have dysfunctional politics, Japan would probably be high on the list. Japan’s fiscal condition became even worse after the March 2011 earthquake, but most politicians, with their eyes on the next election, have tried to avoid talking about fiscal austerity and tax hikes. According to the IMF outlook cited above, Japan’s government debt will rise to 253.4% of GDP as of 2016, far higher even than Greece’s figure of 162.8%. Japan now has a high level of household saving, and via individuals’ deposits in domestic banks, this saving is providing enough money to buy up the bonds the government is issuing. Japan is also running a large current account surplus. So the fundamental conditions here are completely different from those in Greece. But even so, I believe it is very dangerous for politicians to resort to populism and close their eyes to the need for restoration of fiscal discipline.

Japan’s Shackles: Declining Competitiveness, Shrinking Population

If we examine the historical record, we find that Britain’s government debt rose to as high as 337% of GDP in 1819, following the American Revolution and a series of wars with France. The figure declined after this, though, and as of 1914 it was just 29%.(*4) In this light, one might think that Japan still has room to increase its public debt. But there is a decisive difference between the Britain of the nineteenth century and today’s Japan. Britain was able to achieve a dramatic decrease in the size of its debt relative to its economic scale thanks to the expansion of its economy, which was a result of the Industrial Revolution and population growth.

The chances of Japan’s experiencing dramatic economic growth like that generated by the Industrial Revolution are slim. What we actually face at this point is a decline in the competitiveness of Japanese companies relative to their fast-advancing rivals in the emerging countries of Asia. Japanese manufacturers have lost the lead to these rivals in terms of the high quality that used to be their selling point. In a column published in Time on October 30, 2011, Michael Schuman offered this harsh assessment: “One of Japan’s biggest problems is its refusal to admit its economic system has failed. By the 1990s, Japan's model—government-led, export-dependent and manufacturing-focused—fell out of touch with a changing global economy as other Asian countries started catching up and challenging Japanese dominance in core industries. Yet policymakers in Tokyo still cling to this model today.”(*5)

And when it comes to demographics, Japan, with a population expected to shrink over the century to come, is in a situation opposite that of nineteenth-century Britain. According to the medium variant of the population projections by the United Nations, Japan’s working-age population—the age 15–64 cohort closely related to economic growth—is estimated to have fallen 6.5% from the 1995 level as of 2010 and is expected to decline by 36% by 2050. The working population in the United States, by contrast, is seen as having grown by 19% from 1995 to 2010 and is expected to grow by 38.6% in the period through 2050. Though, as noted above, an aging population is expected to cause the fiscal deficit to grow in the United States as well, the situation in Japan is more serious.

The size of the burden that the working generation bears in supporting the retired population is shown by the ratio of seniors (those aged 65 or over) to the working-age population. According to the UN, this ratio was 10% in Japan as of 1970, rose to 35% in 2010, and will climb to 70% in 2050 (at which point the ratio will be 35% in the United States, 47% in Europe, and 32% in China).

If Japan’s current economic difficulties were the result of a temporary downturn, then increased government spending could be used to stimulate the economy and restore it to a growth path, generating increased future revenues that could be used to pay for current borrowing. But given the aforesaid demographics and Japanese companies’ loss of competitiveness, if the government uses expansionary fiscal policy to cover the shortfall in domestic demand, this will aggravate the issue of who will repay the debt.

A Liquidity Trap of Unprecedented Scale

It will be difficult to accelerate economic growth just with monetary policy measures by the Bank of Japan. Since the BOJ is not as good at policy presentation as the Fed and other monetary authorities, it tends to be seen as being unenthusiastic about loosening, but in fact it has actually taken some quite bold measures. It has been buying large amounts of Japanese government bonds and other assets from the market, and the ratio of its balance-sheet assets to GDP is continuing to run at the highest level in the world. As of early December the ratio was about 31%, against 19% for the Fed.

Even if we look at the breakdown of its assets, the BOJ cannot be said to be much more conservative than the Fed. The latter has bought large amounts of treasuries and mortgage-related securities, and its holdings of them are equivalent to 17% of GDP. Meanwhile, the Japanese government debt that the BOJ has acquired (totaling ¥92.5 trillion as of December 10, 2011) is of shorter term than the US treasury securities that the Fed has been buying, but the BOJ has also been buying relatively high-risk assets (including stocks, stock market index funds, and real estate investment trusts), which the Fed has not. Its total holdings of these investments plus government securities come to 21% of GDP.

In addition, the volume of Bank of Japan notes (paper currency) outstanding is 17% of GDP. From the 1980s through the early 1990s the figure was on the order of 6% or 7%, but it has grown to an extraordinary degree since then. In the United States, meanwhile, the volume of Federal Reserve notes is now 7% of GDP. And it is said that less than half of this paper currency is circulating domestically; given the dollar’s position as the key currency, large amounts of greenbacks are held around the globe. So by comparison the volume of BOJ notes outstanding is remarkably large.

On a per capita basis, the volume of BOJ notes comes to ¥630,000 for each Japanese. And the total volume is about ¥45 trillion more than it would be if the ratio to GDP were still 7%. Much of this is being held by individuals as “money under the mattress.” In addition, financial institutions have more than ¥20 trillion on deposit with the BOJ in excess of their reserve requirements. This immense volume of money is lying unused and not stimulating economic activity. The BOJ has poured immense amounts of funds into the market, but the money is not circulating. We are seeing a liquidity trap of unprecedented proportions.

It might be possible to overcome the deflationary trend in the Japanese economy and escape from the liquidity trap if we could push the value of the yen down considerably. But other countries are unlikely to acquiesce in a move by the Japanese authorities to intervene in the foreign exchange market for the express purpose of making the yen depreciate. If Japan were to do so, the US Congress might adopt retaliatory trade measures. The rise of the yen in recent years is a result not just of purchases by overseas speculators but also of the large-scale repatriation of funds by individual and institutional investors (such as banks, investment trusts, and pension funds) wishing to avoid the risks involved in holding on to their overseas assets. As long as this risk aversion persists among Japanese investors, the only way to push the yen down over the short term would be for the government and the BOJ to adopt policies so reckless that even Japanese would become afraid to keep their assets within the country.

If the government were to further increase its fiscal outlays by a large margin and have the BOJ purchase its growing issues of government bonds, eventually most Japanese would probably come to feel that the authorities were trying to decrease the real value of the public debt by inducing inflation. In that case people would withdraw the money they have on deposit at Japanese banks and send it overseas, causing the yen to fall. But the decline in the volume of bank deposits would make it impossible for Japanese banks to keep buying government bonds, and so the yield on them would rise sharply. Overseas speculators would likely see this as a good chance to sell Japanese government bond futures short on a large scale. This in turn would force Japanese banks to book huge losses on their government bond portfolios, which would increase the risk of a crisis in the financial system. Implementing this sort of massive fiscal stimulus might be one option that the authorities could take, albeit a risky one, if the volume of outstanding government debt were not as huge as it is, and if the Japanese government had the self-discipline required to end this sort of policy at an appropriate juncture. But the fact that the national debt has already swollen to such a great degree might be viewed as evidence that Japanese democracy has not been functioning properly and our government has become incapable of this sort of self-discipline.

A Patient, Orthodox Approach to Fiscal Rehabilitation

In order to avoid a fiscal collapse, Japan should adopt a patient, orthodox approach to increase growth expectations rather than tricky maneuvers aimed at achieving an instant cure. As I noted above, many Japanese manufacturers of exported goods no longer have the competitive edge they enjoyed in the 1980s and earlier, and their profits have declined sharply. Unless they can increase their earnings and hike their employees’ wages and salaries, consumer spending will not increase, and the deflationary trend will persist.

First of all, companies must foster the talent required to develop original products capable of attracting consumers in overseas markets. Though their Asian rivals have been closing the gap, Japanese companies still have many technologies that others cannot readily match. Though there is no need to be overly pessimistic, we need to recognize that today’s Japan lacks ideas for turning technologies into earnings. When Steve Jobs, founder of Apple Inc., died last October, China’s newspapers, television, and magazines were full of discussions on the question of how to foster creativity like his. This is an important topic for Japan as well.

Second, we need to encourage highly talented people from other countries to come to work in Japan. Even in Germany, which is seen as conservative when it comes to accepting immigration, in 2001 a commission on immigration led by former Bundestag President Rita Süssmuth “made the recruitment of a highly skilled work force the centerpiece of its proposal to overhaul the immigration system.” In the background to this move was a recognition on the part of Germany and other nations that “they were in a race for workplace talent. Just as in the nineteenth century, when powerful states fought one another for territory and natural resources, now they were competing for brain power: the scientists, engineers, entrepreneurs, and high-end business managers who fuel the dynamism of the international economy.”(*6) And in a speech he delivered last May, US President Barack Obama spoke out in opposition to the tightening of restraints on immigration: “Look at Intel, look at Google, look at Yahoo, look at eBay. All those great American companies, all the jobs they’ve created, everything that has helped us take leadership in the high-tech industry, every one of those was founded by, guess who, an immigrant.” After applause, he continued, “So we don’t want the next Intel or the next Google to be created in China or India.”(*7)(*8)

Sony’s Walkman revolutionized the way people listen to music all around the world. As of the late 1970s, when the Walkman was launched, Japan’s median age was 31. Now it is 45. With a population so loaded with middle-aged and older people, Japan has an advantage when it comes to developing products targeting seniors—a process where experience is of the essence—but it finds it hard to come out with products capable of attracting consumers in fields like information technology, where flexible thinking is required.

Sending Out the Message that Japan Is Intent on Fiscal Rehabilitation

The book I.O.U.S.A: One Nation. Under Stress. In Debt, written as a companion to the much-discussed documentary film I.O.U.S.A, presents the basic thinking of America’s fiscal conservatives. For example, former Secretary of Commerce Peter G. Peterson is quoted as declaring: “The idea that we’re slipping this check to our kids for our free lunch [today’s debt-financed benefits] is essentially a very immoral proposition, in my view.”(*9) And Alice Rivlin, former director of the Office of Management and Budget and vice-chair of the Federal Reserve Board, stated: “I think the real reason to not run a deficit is that it is not fair to our grandchildren or our children, future taxpayers, whoever they are, to pass them the bill for the things we want to do now.”(*10) These sentiments are highly relevant for today’s Japan.

When I talk to overseas market participants, sometimes they ask me, “With such a big national debt, won’t Japan’s young people flee overseas?” It is true that today’s younger Japanese are likely to be at a major economic disadvantage by comparison with their seniors. But fortunately—if that is the right word—most of them are inward-looking and disinclined to head abroad. As long as they continue to obediently pay money into the Japanese treasury to cover the debts and pensions of the previous generation, it may be possible to avoid a collapse in the price of Japanese government bonds. But if the authorities adopt fiscal policies so reckless that these young people decide they want to escape from the country, we will see the situation deteriorate in a downward spiral too terrifying to watch.

I do not mean to reject Keynesian fiscal policy. I believe it is worthwhile to use public funds for projects that promise future increases in productivity. And the social security system must be properly maintained and enhanced as a safety net. But it is dangerous for politicians to resort to populism with a view only to the next election, disregarding the burden on future generations. Fortunately the current administration of Prime Minister Noda Yoshihiko is proclaiming the need for a hike in the consumption tax. I believe it is extremely important to keep projecting the image, both domestically and internationally, that Japan is headed toward the rehabilitation of its public finances over the medium to long term.

Title background photograph: The October 2011 Paris meeting of the Group of 20 finance ministers and central bank governors (from the Ministry of Foreign Affairs website)