Japan, the need for good luck and good policies.

Andrew Smithers
Nikkei Veritas - Market Eye column, 2nd December 2009

In my last article I took an upbeat view about the election of the new DJP government. I expressed the hope that this would lead to a major change in the economy as well as in politics. For this to happen the new government needs the right approach, good luck and good policies. Its instincts seem to be good, as it favours consumption over investment. It has also begun with two important bits of good luck. The first is that it came to office at the right time, since the election virtually coincided with the worst point of the recession. Its second piece of luck was that voters seemed to vote against the LDP rather more than for the DJP. The result is that the new government has not started with high expectations, and this makes it less likely that voters will be quickly disillusioned.

In addition to good instincts and good luck, good policies are needed and here the main requirement is that fiscal policy must not be tightened too quickly. The GDP figures just published show a strong bounce in the economy, but this was largely due to an end to inventory destocking and the effect is likely to fade away soon. Nonetheless the early signs are encouraging and, provided that fiscal policy remains stimulatory and the world economy continues to pick up, the economy should grow at an acceptable rate over the next year or two. In time, the economy will have become sufficiently strong for a change in economic policy to be sensible. When this happens it is important that monetary policy should lead the way and only later should fiscal policy become less lenient.

If monetary policy is tightened before fiscal policy, then interest rates will move up faster and probably earlier than they would otherwise and the exchange rate should remain strong. This will help consumption in several ways. One is that wages should be rising with the stronger economy and the improvement will not have been held back by either increases in tax rates or by the rise in prices that would come from a weak exchange rate. Another is that the rise in interest rates will increase the incomes of many households, which have large sums on deposit with the banks and the Post Office.

Just as this policy should help consumption, it should hold back investment, which will be deterred by the rise in interest rates and would be stimulated were the yen to weaken. Japanese households have much less disposable income relative to GDP than any other major developed economy and a switch from savings and investment to consumption is needed to bring the economy into a better balance and to improve the welfare of Japanese people.

But the policies which will contribute to achieving a better balanced economy will not, in general, appeal to Japanese business, which tends instinctively to favour exports and investment. It is therefore essential that the government should turn a deaf ear to the complaints of companies and, as the DJP has not had the same financial support from big business as the LDP, the new government should find this easier than any administration for the past 50 years.

When short-term interest rates rise, and perhaps even before, bond markets all over the world are likely to fall and it is important that this does not frighten the Japanese government into a premature change in fiscal policy. All over the world the yields on bonds are very low and are likely to rise when the economy picks up and the increase will be particularly sharp if investors become worried about inflation.

Japan is often seen as being particularly vulnerable to a sharp rise in bond yields, because of its high level of national debt. In many ways, however, it is better placed than either the US or the UK. Japan is a country of high tax rates, but has the lowest tax revenue of any G5 country. This is largely the result of the high proportion of Japanese savings that comes from untaxed depreciation. This will mean that the tax revenue should rise rapidly provided that recovery comes with a better balanced economy. It is easier to raise tax revenue when it is low than when it is already high, and particularly easy when tax rates are already high but not collecting much revenue.

Success for the new government will depend on continued fiscal stimulus and a refusal to be deflected by complaints from business over rising interest rates and a strong exchange rate. If it perseveres, and its luck continues, the DJP could remain in power for many years ahead.