Author: Adam S. Posen, Peterson Institute of International Economics
One of the striking things about the past few decades of Japan’s economic history has been the fact that textbook macroeconomics could have predicted most of it. Back in the late 1990s, this was a controversial point of view. Many people spoke about the ‘specialness’ of the Japanese economy, just as they have about the ‘specialness’ of recent monetary policy. This over-complication seems unnecessary. In the political economy of reform, as in macroeconomics, we can learn a lot from the Japanese experience.
The first lesson is that policy change is always possible, but ambition is required. In Japan, since the bubble, there have been periods of policy inaction, during which leaders too timid to implement reform found thousands of reasons not to do so. Then, every once in a while, along come figures such as Junichiro Koizumi and Heizō Takenaka, or Shinzo Abe and Haruhiko Kuroda. And, with no fundamental change in the party system or the form of government, action is shown to be indeed possible.
Sometimes, the excuse for inaction is that only a crisis can provoke fundamental reform. But waiting for a crisis — or worse, trying to provoke one — in order to be able to deal with a social or economic problem is a fundamentally flawed idea. In Japan, there have always been repeated cries to do something about some problem (decline of traditional industries, say, or fiscal sustainability), only to hear the response “we will when there is a crisis.” But the crisis never arrives.
The problem here is that the very definition of ‘crisis’ is circular. To people with this point of view, a ‘crisis’ is a situation in which you are forced to act; and since they are not forced to act, there’s no crisis, and therefore no need to act. But in countries like Japan or the United States, there will never be definitive crises. Smaller, less systemically important nations may indeed experience a definitive episode of capital flight or a definitive fiscal crisis. But Japan — like the United States — is, if not too big to fail, then at least too big to fall apart.
Similarly, in democracies with relative price stability, governments with legitimacy and an absence of large-scale political violence, massive populist movements that can force change are very infrequent. Some may have wondered why there were no protests against the Bank of Japan during the country’s long stagnation. But the same has happened in the United States: despite the terrible destruction of wealth during the global financial crisis, the Occupy movement hardly had an impact.
Second, in fiscal policy, specifically, there are important lessons to be learned from Japan’s policy shift. There used to be a widespread view that fiscal consolidation was difficult and that markets considered this difficulty a major threat to the functioning of economies. Also, it was widely thought that tax cuts were preferable to spending as an instrument of fiscal policy and that monetary and fiscal policy ought to be independent, with monetary policy not accommodating fiscal policy.
But each of these contentions — which have underpinned the dominant policy discussion in the United States, Japan and especially Europe over the past fifteen years or so — is wrong.
The problem in most countries that have sustained large fiscal deficits is an unwillingness to raise taxes or an inability to enforce taxes, not runaway public spending. Meanwhile, the major problem in the short term from bad fiscal policy is not that government spending crowds out private investment; the proven is that it crowds out better public investments, or, when consolidation happens, public investment is cut first, whereas public consumption is not.
Of course, Japan furnishes a cautionary tale: it is possible to have a lot of economically useless public investment, whether on infrastructure or education. But the other side of this coin is that the public and markets need to be more realistic and realise that large government investments take place as part of a portfolio. Not every project will yield a positive return.
In monetary policy, too, Japan’s recent experience shows that there is nothing wrong about central banks cooperating with fiscal authorities as long as it is on a voluntary basis. The Euro Group repeatedly misses this point. Japan, on the other hand, has seen very constructive cooperation between the Bank of Japan and the Abe government since January 2013.
The big question now for Japan is the shape that Abe’s third arrow will take. There is always room for structural reform and, as I argue, no need to wait for a crisis to enact it. But the third lesson is that there is no platonic ideal of reform to which policymakers can appeal, no laundry list of perfect policy settings that can be applied universally to all countries. Instead, governments must put productivity impact as the criterion for prioritizing reforms.
Despite some clamouring for it, corporate tax reform should not be a particularly high priority for the Abe government. There are much more productive structural reforms that can be made first. Of course, there is a justified concern that in Japan the burden of corporate taxes falls primarily on the most competitive companies and not on inefficient small companies. But fixing this problem will not have very big effects on the Japanese economy.
After all, what are the channels through which corporate tax cuts would stimulate growth? They are unlikely to promote corporate investment, since Japanese companies have been sitting on vast piles of cash and have not responded to interest rate incentives to invest it productively. This is increasingly common in companies worldwide but it is entrenched in Japan with its high capital to output ratio.
Some say that a tax cut will attract foreign investment into Japan. But it’s difficult to believe that the biggest impediments to more foreign investment in Japan are corporate tax rates rather than legal, cultural, linguistic and regulatory barriers. Perhaps, some say, corporate tax cuts would help rein back offshoring. But this would be a bad goal for the Japanese government to pursue. Offshoring has been a net source of productivity and growth for Japan. In fact, Japan is falling behind China, which has been actively deepening its supply chains within Asia.
It is a shame to see Abe’s reform opportunity wasted in part on worrying about corporate tax rates, just as it is depressing to see that the United States spends an unbelievable amount of time on marginal tax rates rather than tackling education and health reform. In both the US and Japan, health care is abysmally inefficient. If there were proper reform there, then either nation could live for a decade or more off of the attendant boost to economic growth.
Similarly, the returns on tackling the underutilisation of human capital in Japan dwarf the impact of everything else, including the problem of a declining workforce. If Japan were to get more of its university-educated women into the workforce, the demographic problem would go away for 20 years. If Abe accomplished this, the fatalistic whining about Japan’s supposedly intractable demographic crisis would cease to be an excuse or a constraint for its economic future. But the efforts made to date, while encouraging, are insufficient. About 420,000 women have rejoined the workforce over the past year or so. This is an impressive achievement. In absolute terms, though, this is a small fraction of what is possible for female labor force participation.
If Abe focuses his attention on the important structural impediments in the Japanese economy then there is every reason to believe that the Japanese economy can grow strongly in the future. And, if Abenomics does succeed, then there are plenty of benefits as well as lessons for the rest of the world.
Adam S. Posen is President of the Peterson Institute of International Economics. From 2009 to 2012, he was a member of the Monetary Policy Committee of the Bank of England.
This article is adapted from his keynote speech at the Columbia Center on Japanese Economy and Business ‘Restoring the Japanese Economy’ conference in May 2014.