Understanding the Last Three Decades of Japanese Fiscal Policy

Since the “Lost Decade” – a term coined by Hayashi and Prescott to characterize Japan’s economic standstill following the burst of their asset price bubble in the early 90s – Japan has struggled to increase its economic growth^[2]. The lost decade eventually turned into the “Great Stagnation,” with an average annual GDP growth rate of 0.78% from 1991-2021^[3]. This stagnation starkly contrasts the unprecedented growth of post-war Japan, when annual growth averaged 6.22% from 1960-1990. The spike in Japan’s sovereign debt coincides strongly with their economic slowdown as the government attempted to promote aggregate demand through profligacy measures^[1]; however, there is more to Japan’s fiscal dynamics than just the bursting of the financial and property price bubble.

Determinants of Japanese Fiscal Policy

1.     The Ageing Population

When considering nearly any socio-economic issue in Japan, its population demographics are mentioned – and rightfully so; like much of the developed world, Japan has a rapidly declining population. While their estimated working age population (15-64) is 59.4% of the country, it is disconcerting that this number will drop severely over the next 15 years to roughly 50%^[4]. Social security and healthcare demands rise with population age, yet the smaller tax base leaves the government with less fiscal breathing room.

Some may be hopeful that productivity can be increased by filling vacancies with A.I. and robotics. Naoyuki and Hendriyetty^[5], suggest a productivity-based wage (rather than the norm, which is a seniority-based wage) and postponing the retirement age. According to the Ministry of Finance report^[6], Japan’s social security expenditure amounted to an estimated 23.8% of its GDP, while tax revenue was 18.6%. Conversely, France – the highest spender of OECD countries on social security (at 31.7%) – makes up for it by collecting 30.2% of its tax revenue. As social security expenditure is expected to grow, future generations may be worried about their tax burden^[7].

2.     Interest Rates

The debt-to-GDP ratio is only a small indicator of a country’s fiscal sustainability; prolonged debt ratio growth does not necessarily imply insolvency if growth continuously exceeds interest rates on government bonds^[8]. A simple reason is that interest rates on government bonds determine the cost of servicing fiscal deficits. This “rule of thumb” is described in the following equation^[9]:

$\frac{B_t}{Y_t} – \frac{B_{t-1}}{Y_{t-1}} = (r-g) \frac{B_{t-1}}{Y_{t-1}} + \frac{G_t – T_t}{Y_t} + \frac{M_t – M_{t-1}}{Y_t}$

This equation represents the change in the government debt-to-GDP between two periods (left) which is influenced by the difference between real interest rates and economic growth, the budget deficit/surplus, and the issuance of new currency (seigniorage) on the right. If all factors are kept consistent, one can see that the debt ratio will decrease when growth exceeds interest rates (r < g). However, Japan’s Ministry of Finance^[6] heeds caution in assuming that interest rates will remain below the growth rate forever. Even though interest payments for most OECD countries – including Japan – are manageable, debt rollover risks can snowball when interest rates hike. Still, Japanese interest rates on government bonds (JGBs) are extremely low; one can see it has breached the zero-lower-bound on multiple occasions^[10].

3.     Inflation and the Liquidity Trap

Since the start of its recession in the 90s, Japan has experienced sustained stagflation hovering around (and even below) zero. Many may think this is good; however, macroeconomists such as Paul Krugman will disagree. In his seminal 1998 paper, Krugman argues that Japan has found itself in a liquidity trap where money and bonds essentially become perfect substitutes due to continued low (or negative) interest rates – greatly due to stagflation and interest rates reaching the zero-lower-bound^[11]. Even today, 25 years later, the Japanese economy fulfils this condition. Krugman argues that the Japanese economy needs inflation. He also says that the Bank of Japan (BoJ) needs to “credibly promise to be irresponsible” by ensuring consumers that prices will rise at a stable and continuous rate (ideally 2%). That paper was written a decade-and-a-half ago. Until now, Japan’s government and central bank have practiced fiscal profligacy and ultra-accommodative monetary policy (believed to stimulate inflation). Nevertheless, little has changed in terms of Japan’s stagflation.

4.     Behavioural Considerations

Much of the issue comes down to Japanese investment behaviour. The Japanese are more patient, and their households prefer higher savings. Matsuoka contends that this behaviour can be attributed to the higher discount factor that lower real interest rates allow^[12]. So, all of this coincides with the Keynesian theory that consumer preference for liquid assets (i.e., cash and savings) is necessary for a liquidity trap. Converse to this belief, Japanese household savings have significantly dropped over the last three decades, with net savings reaching 1.8% of GDP and 3.1% of disposable income, one of the lowest in the OECD^[13]. Savings used to be high as households prepared for retirement, but with extensive developments in social security, a dissaving trend occurred. Low-interest rates, in turn, allowed households to accumulate nocuous amounts of debt for a “next-to-nothing” price.

5.     Default Risk

Yoshino and Vollmer argue that Japan is less likely to suffer a debt crisis as opposed to a country like Greece (despite Japan’s debt-to-GDP being much higher) for the following reasons: (1) almost 90% of JGBs are held domestically; (2) the BoJ holds a significant share of JGBs and T-Bills; (3) Japan has a sovereign monetary entity, protecting it against a speculative debt crisis^[14]. Likewise, Matsuoka explains that investors in the bond market are hopeful that the fiscal situation will change; based on extensive literature in the field, Matsuoka then attempts to simulate the Japanese debt default risk^[12]. Their findings from 2015 imply that the probability of default will be over 10% if the debt-to-GDP ratio increases at its current rate for 20 years. The probability of default will amount to 80% if it continues for 50 years with a sovereign risk premium of 10%. While these findings do not sound very pressing, the current trajectory of fiscal deficits has continued for the last 30 years. Fiscal consolidation may be urgently needed.

Conclusion:

While it may be easy to say that more austerity is needed in Japan’s fiscal stance, the past 30 years have been filled with repeated financial crises – situations necessitating profligacy. Still, the Japanese economy is often cited to “break the rules” of our understanding of economics. Therefore, it makes an interesting case study for students and scholars of macroeconomics alike.

All of the figures used in this post were personally created using R: A language and environment for statistical computing^[15].

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REFERENCES:

^[1] International Monetary Fund. 2023. “World Economic Outlook: April 2023.” Accessed May 22, 2023. https://www.imf.org/external/datamapper/GGXWDG_NGDP@WEO/JPN?zoom=JPN&highlight=JPN.

^[2] Hayashi, Fumio, and Edward C Prescott. “The 1990s in Japan: A Lost Decade.” Review of Economic Dynamics 5, no. 1 (2002): 206–35. https://doi.org/10.1006/redy.2001.0149.

^[3] The World Bank. 2023. ‘World Development Indicators.’ Washington, D.C.: The World Bank. Accessed May 22, 2023. http://data.worldbank.org/data-catalog/world-development-indicators.

^[4] Ministry of Internal Affairs and Communications, Population Estimates, April 2023. Accessed May 22, 2023. https://www.stat.go.jp/english/data/jinsui/tsuki/index.html.

^[5] Yoshino, Naoyuki, and Hendriyetty, Nella. “The COVID-19 Crisis: Policy Recommendations for Japan.” The Economists’ Voice 17, no. 1 (2020). https://doi.org/10.1515/ev-2020-0017.

^[6] Ministry of Finance. 2022. Japanese Public Finance Fact Sheet. Tokyo: Ministry of Finance, April 2022. Accessed May 22, 2023. https://www.mof.go.jp/english/index.htm.

^[7] OECD. 2021. “Tax and Fiscal Policies after the COVID-19 Crisis.” Accessed May 22, 2023. https://www.oecd.org/coronavirus/policy-responses/tax-and-fiscal-policies-after-the-covid-19-crisis-5a8f24c3/#section-d1e33.

^[8] Horne, Jocelyn. “Indicators of Fiscal Sustainability.” IMF Working Papers 91, no. 5 (1991): https://doi.org/10.5089/9781451842081.001.

^[9] Calitz, Estian, Stan du Plessis, and Krige Siebrits. “Fiscal Sustainability in South Africa: Will History Repeat Itself?” Studies in Economics and Econometrics 38, no. 3 (2014): 55–78. https://doi.org/10.1080/10800379.2014.12097272.

^[10] Ministry of Finance. 2022. Interest Rate Historical Data (1974~). Tokyo: Ministry of Finance. Accessed May 22, 2023. https://www.mof.go.jp/english/policy/jgbs/reference/interest_rate/index.htm.

^[11] Krugman, Paul R. “It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap.” Brookings Papers on Economic Activity 1998, no. 2 (1998): 137–187. https://doi.org/10.2307/2534694.

^[12] Matsuoka, Hideaki. “Fiscal Limits and Sovereign Default Risk in Japan.” Journal of the Japanese and International Economies 38 (2015): 13–30. https://doi.org/10.1016/j.jjie.2015.05.003.

^[13] Latsos, Sophia. The low-interest policy and the household saving behavior in Japan. No. 159. Working Paper, 2019.

^[14] Yoshino, Naoyuki, and Vollmer, Uwe. “The Sovereign Debt Crisis: Why Greece, but Not Japan?” Asia Europe Journal 12, no. 3 (2014): 325–44. https://doi.org/10.1007/s10308-014-0387-5.

^[15] R Core Team. 2022. R: A language and environment for statistical computing. R Foundation for Statistical Computing, Vienna, Austria. https://www.R-project.org/.