Nikkei Veritas – Market Eye column, 3rd March 2011
The tone of the debate in Japan about the budget deficit has changed. Although the political obstacles to change are great, there seems to be a greater sense of urgency over the need for its reduction. A key sign of this was the appointment of Kaoru Yosano as minister for rebuilding Japan’s tattered public finances.
Budget deficits are of course a problem for all developed economies and attitudes to their reduction vary greatly. For example, Germany has a relatively small deficit, but seems bent on cutting it back. Similar determination rules in the UK, which has a large deficit. But there appears to be no such conviction in the US administration, although the country has, like the UK, a deficit of more than 10% of GDP. Even if the resolve were there, political divisions and confusions in the US make the path to fiscal responsibility extremely uncertain.
While all agree in theory that the deficits must be reduced, there is far less accord in practice. The cry of don’t start now is common and can be indefinitely extended. Japan and the US have so far favoured delay. They have resembled St Augustine, who prayed for chastity “but not yet”. In both countries there are two causes for the delay. One is the political difficulty of getting decisions on either raising taxes or cutting expenditure. Both of these are probably needed if deficits are to be cut back, and neither are popular. There are also economic arguments against cutting the deficit. The two reinforce one another. Politicians don’t like to be unpopular, and they will be unpopular if they cut the deficit, even if the result turns out well. If they add the reputation of misjudgement to such unpopularity, their careers are at stake. As economic forecasting is uncertain, those who favour cutting the deficit need both courage and luck to survive.
Both action and inaction are risky. Action could lead to recession and inaction to an even worse recession if it sets off fears of rising inflation. In such circumstances there is a natural bias in favour of inaction, which is less easy to attack and can always be presented as caution. While the consequences of not taking action can be just as great as those of taking it, inaction is harder to blame. There is only one reason for cutting the deficits, which is that it is the correct policy. But there are several arguments against it, of which the most common economic one is that the time for it is not yet ripe. There is a fruit called in English the medlar which is rarely eaten, because it is rotten before it is ripe. Cutting back on budget deficits seems to have the same unpleasant characteristic. The time to do it will be passed before it’s ready.
I suspect that today the time is as ripe as it will ever be. The world economy is growing strongly; in many ways too strongly, as the sharp rise in the prices of food and other raw materials show. In China, Brazil and India there are worries about inflation and these concerns are not restricted to emerging economies. Inflation is already 2.4% in the Eurozone, 4% in the UK and although only 1.6% in the US it is rising rapidly. Even in Japan, it has been positive since last September.
Inflation may fall back again, though I see no current signs of this happening. If it does, it will then be more difficult to depress demand by attacking fiscal deficits. This is a strong argument for tackling them now. Inflation may just as easily rise further. In this case those economies which started their cut backs early will be less exposed to the dangers of rising expectations than those that delayed.
If the world economy is about to fall back into recession, then a country which has already started to cut its deficit is likely to suffer more than those which delay. But, while the political risks of action are greater than those of inaction, the economic risks seem to me to be the other way around. Bond yields are too low all over the world and, as they rise, among the many problems they will cause is that they will depress demand. Thus although rising taxes will dampen growth, the consequences of not raising them may be the same. The worst risk from delay is that fears of inflation may rise. This will force central banks to raise interest rates, even if the economy is weak.
I hope therefore that the Japanese government will have the courage to begin cutting the budget deficit, though I recognise of course that Prime Minister Naoto Kan’s low popularity and lack of control of the Upper House will make it difficult for him to push through tax rises.