Nikkei Veritas – Market Eye column., 7th April 2013
Japan suffers from a barrage of bad advice from economists, in which the new government seems sadly prone to believe. It is assumed that Japan’s economy has performed for many years below its potential and that the policies of fiscal and monetary stimulus designed to speed growth have been basically correct but pursued with inadequate vigour. This is half right and half wrong. Japan is not fully realising its potential, but the gap isn’t large and the fault is not that policies are correct but insufficiently bold, but that they are ill considered.
To understand why current policies are wrong, it is essential to understand the key problem, which is that Japan has a structural savings’ surplus. Those who assume that more fiscal or monetary stimulus will solve the problem are assuming that the lack of demand is a cyclical problem, which will disappear if and when confidence returns to the economy. They assume that companies will then invest more and consumers will then spend more. These assumptions are held in the face of the evidence to the contrary, which shows that companies already invest too much rather than too little and that household savings are low and are not therefore holding back consumption.
Japan is currently running a government budget deficit which is estimated by the OECD to amount to 9.9% of GDP. This deficit must, as a matter of identity, be equal to the combined flows of the foreign, household and business sectors. To get the economy growing, either the deficit must expand or the cash flows of the other sectors must fall. The Abe government is hoping to do both. It is planning to increase the deficit by 2% of GDP and to reduce the cash flows of other sectors with the help of the Bank of Japan. Under its probable new Governor Haruhiko Kuroda and his team, a much more aggressive monetary policy of quantitative easing is likely than under the current Governor Masaaki Shirakawa.
Neither fiscal expansion nor quantitative easing gets to the root of the problem and, unless they are supplemented by tax reform, they will fail to get Japan on the road to sustained recovery. Fiscal expansion is clearly a temporary expedient. Japan already has an excessive level of national debt at 214% of GDP, and the fiscal deficit must be reduced to not more than about 2% of GDP over time to prevent the ratio from growing for ever. It is therefore planned that the value added tax will rise from 5% to 8% on 1st April next year, with another increase of 2% eighteen months later.
If there is to be a solution to Japan’s problems it cannot therefore come from fiscal stimulus, unless it will produce a fall in the cash flows of other sectors, which will not be reversed when the deficit is reined in. This is the standard assumption of those economists who favour fiscal expansion following the precepts of John Maynard Keynes, who saw the problem as one of “pump priming” which, by stimulating demand in the short-term, would revive the “animal spirits of entrepreneurs”. If the problem in Japan today was that business investment was too low, this would be a sensible assumption on which to base policy. But, far from being too low, business investment in Japan is too high and the problem of excessive cash flow in the business sector is because investment has been too high in the past.
Business investment in Japan amounts of 13% of GDP, compared with only 10% of GDP in the US. As the size of Japan’s workforce is falling and that of the US rising, Japan’s GDP will grow over time at 1% to 2% p.a. more slowly than that of the US, unless labour productivity in Japan is a great deal faster than it might have been or than it will be in America. Even though US investment is no doubt too low, it is too high in Japan and, while an increase would help short-term demand, it would make Japan’s longer term problem worse. As the fiscal stimulus will have to be reversed soon, any short-term help will be brief and the longer term effect will be damaging. Fiscal stimulus is clearly not a sensible policy for Japan.
The case for monetary stimulus is nearly but not quite as bad. It is associated with the call to have at least 2% inflation. If nominal interest rates remain low, then inflation will cause real interest rates to become negative and there are several ways in which this could help. It might stimulate more business investment in Japan and, as Abe called for higher investment prior to the election, this ill-judged hope may be common. A rise in inflation might stimulate consumption, but this is not very likely. Household savings are low in Japan, currently amounting, on a net basis, to only 3% of disposable income. In the past inflation has discouraged rather than encouraged consumption. The most promising effect of negative real interest rates would be to weaken the yen. This would be really helpful to Japan and should be encouraged, even though it would be unpopular in other countries. There are also hopes that inflation would help reduce the size of the national debt ratio, but these are absurd. At any bearable rate of inflation the impact on government debt would be similar to reducing the weight of an elephant by shaving its tail.
Neither fiscal nor monetary policy has worked in the past, nor will an increase in the dosage of these prophylactics make them effective now. To accelerate Japan’s growth it is first necessary to understand the key problem, which is that the country has a structural savings’ surplus. Japan’s companies are investing 13% of GDP, which is too much, and paying for this entirely out of their depreciation. The result is that they will save more than they invest unless they either pay-out more of their profits in dividends or invest abroad all their net profits after dividends. A rise in overseas’ investment is both likely and indeed an essential part of increasing Japan’s current account surplus. (The level of net foreign investment is the same as the current account surplus; the two have to be identical). But, as Japan is already investing too much at home, it is essential to get Japanese companies saving less. This can either be achieved by having them pay-out more dividends or by having lower depreciation. Over time falling investment means lower depreciation, so things will be better providing that investment falls, which is why getting it to rise is such a foolish aim.
The process could, however, be speeded up if the tax on companies was reformed. At present the rate is too high. It is 40% and well above that in other countries. But the level of depreciation is also far too high. The correct rate of depreciation depends on the rate at which labour productivity is rising. This has fallen in Japan from around 4% in the 1980s to around 1.5% today, but depreciation allowances have not fallen and should now do so massively. The excess level of depreciation can be seen by comparing profits and depreciation in Japan and the US. In Japan depreciation is 190% of profits after tax and in the US only 60%. While US companies overstate their profits, Japanese companies understate theirs.
A reform of corporation tax which reduced depreciation allowances and the tax rate could produce exactly the same revenue as today, but would mean a sharp jump in the published profits of companies and their dividends. This would help to tackle Japan’s structural savings’ surplus as a rise in household incomes would increase consumption and a large rise in profits should push up the stock market and boost confidence.