They will be multiplied several fold if the danger of an uncontrollable spread of radiation from the damaged reactors is not contained. Either way Japan will need a huge reconstruction program over the coming months and years.
Official estimates of damage — without taking into account potential spread of greater radiation damage — suggest reconstruction costs could exceed 25 trillion yen (US$309 billion, around 6 per cent of GDP). The damage bill could increase further.
In principle, Japan can easily fund reconstruction, drawing on both public and private resources. Despite twenty years of economic stagnation it remains a wealthy country, with a huge stock of accumulated national savings, as seen in the nearly one trillion dollars of foreign reserves (second largest in the world). Clearly the public sector will need to bear a large share of the cost of reconstruction, particularly the reconstruction of public infrastructure.
There are now intense debates over how this public sector reconstruction effort should be financed, given the current high level of government debt of close to 200 per cent of GDP, with proposals ranging for deep cuts to current government expenditure programs, higher consumption and/or income taxes and increased government borrowings, including the possibility of the Bank of Japan directly purchasing government bonds (‘monetizing the debt’). The government is expected to announce soon a reconstruction plan that will include a combination of such measures.
The policy debate boils down to how different ways of funding reconstruction will affect:
- the size of government debt
- the exchange rate
- inflation or deflation and
- overall economic activity.
Large scale reconstruction after a disaster produces a ‘construction boom’, with demand increasing for all kinds of goods and materials, some of which can be easily imported but others are primarily sourced domestically. This not only stimulates economic activity but also increases construction sector prices, particularly prices of domestically sourced inputs in relatively limited supply. Over time, this can lead to higher economy-wide prices although price pressures may be restrained because of the long recession there has been in the Japanese construction sector.
Consider the options for financing reconstruction:
- diverting spending from current spending programs
- introducing new taxes to raise revenues
- borrowing from the public
- ‘monetizing the debt’ by direct purchase of government bonds by BOJ.
The first two tend to minimise the increase in government debt and have a muted impact on aggregate demand. Reductions in private spending due to higher taxes will be offset by increased government spending on reconstruction. On the other hand, reconstruction will have a more muted positive impact on aggregate demand because of reductions in other government or private spending. While the precise nature of spending cuts and the form and level of new taxes will influence the impact on prices and overall economic activity, overall they are likely to be fairly minor. Thus cuts in current transfers may reduce private spending and higher taxes may induce a drawdown of savings, thereby inducing some capital inflows and appreciation of the currency.
Those who view increasing government debt as a serious destabilising factor tend to support some combination of the above options as the primary vehicle for financing reconstruction. Some therefore see the current crisis as a politically opportune moment for scaling back on ‘populist spending programs’ and introducing revenue raising new taxes. However, it is not realistic to expect that required extra spending can be fully financed by spending cuts in other areas alone, so maintaining government debt at current levels will require additional taxes.
Raising finances by bond sales to the public increases government debt to the private sector and any expansionary impact will be (at least partially) offset by reduced private sector spending. There is then the danger that the public will demand higher yields to compensate for risk of government default, destabilising bond markets and generating volatile capital flows and currency fluctuations.
Monetizing the fiscal deficit also increases government debt, but to the Bank of Japan. It also increases money supply, tends to depreciate the exchange rate, and generates upward pressure on prices. Generally governments who monetize fiscal deficits end up with an inflation problem. But whether the Japanese economy that has battled deflation, rather than inflation, for two decades is likely to face a surge in inflation because of government debt being monetized is a matter of debate.
The current debates in Japan over reconstruction not only mirror the current global debate about the efficacy of economic stimulus programs but also echo the divisions over expansionary policies during the past two ‘lost decades’ of economic stagnation. They even hark back to the 1930s when Takahashi Korekiyo, the Finance minister often described as ‘Japan’s Keynes’ is credited with engineering Japan’s rapid recovery from the Great Depression with expansionary fiscal policies.
According to reports Bank of Japan Governor Masaaki Shirakawa is under fire for refusing to consider 1930s-style purchases of government bonds to fund reconstruction from the nation’s record earthquake. In appearances before the Diet this week, Shirakawa opposed direct buying of government debt, a step allowed in extraordinary circumstances with the permission of the Diet. The policy would undermine confidence in the yen and provoke a surge in consumer prices, Shirakawa said at parliamentary fiscal and finance committee hearings. ‘If this isn’t a special situation, what is? Kozo Yamamoto, a Diet member with the opposition Liberal Democratic Party, said in an interview this week. Yamamoto advocated a 20 trillion yen (US$247 billion) reconstruction program funded by Bank of Japan debt purchases. A group of ruling-party lawmakers submitted a similar proposal to Finance Minister Yoshihiko Noda on 18 March, according to a web log posting by DPJ member Yoichi Kaneko.’
Japanese bond yields have in fact continued to fall even after the disastrous events of March 2011 and that there are no signs of any inflationary pressures. In the current circumstances, after two decades of battling deflation and a stagnant economy, more reliance on monetizing the debt is likely to maximise the stimulus effects of reconstruction while alleviating the pressures on currency appreciation. Some inflation may be a welcome thing in Japan and economic growth will itself tend to lower government debt.
At the same time, any measure that expands government debt could trigger a crisis of confidence in bond markets and dangerous instability unless a clear medium term plan to service additional debt is put in place as part of the broader recovery strategy. On the other hand, the disaster has already dealt a blow to consumer confidence, and an overly cautious approach to financing reconstruction may lead to Japan missing the opportunity to move the economy out of deflation.
Sisira Jayasuriya is Professor and Nobuaki Yamashita is lecturer in the School of Economics and Finance at La Trobe University in Melbourne, Australia.
I agree with this argument almost entirely, especially on the point that this is a good chance getting Japan out of its deflationary trap. But as long as Mr Shirakawa remains Governor of the Bank of Japan, this strategy is not likely to be implemented. The best thing would be for the Japanese Government to encourage him to step down. That in itself could change the policy atmosphere and the market’s sentiment if we get the right replacement. As the article says, the government can deal with the reconstruction from the disaster which is not so large that it will lead Japan into a fiscal crisis, and it should continue push for social welfare reform and fiscal reconstruction.
Very thorough piece … though a bit perplexed why another very good idea that was proposed in an FT op-ed article by Carmen and Vince Reinhart has failed to gain any traction in this debate.
Essence of their op-ed “Japan Must Dip Into Its Rainy Day Fund” is that Japan should encash some of its sky-high forex reserves that are parked in (low-yielding) U.S. T-bonds and use them to finance reconstruction. This will cause the least possible disturbance to Japan’s public finances and, conducted with adeqaute signalling, will not have damaging exchange rate effects. If there is a time for this ‘rainy day’ fund to be used, this IS it!
And it will not be the first indirect usage of foreign exchange holdings to support a domestic policy goal. China used its reserves to fund the racapitalization of its major state-owned banks (via a special purpose vehicle – Central Huijin Investment Company, which has since been absorbed by the state-run SWF). Its time for Japan to contemplate exercising a similar option.
Best, Sourabh
Reinhart and Reinhart’s proposal that Japan should use its holdings of US treasuries to finance (at least some part of) the reconstruction is interesting and, at first sight, attractive. So it seems puzzling that it has not been taken up by Japanese authorities. It may be that this is partly motivated directly or indirectly by the desire not to antagonise the US Fed by countering its monetary policy stance. But as some others have pointed out the more likely reason is Japanese concern about its expected impact on the currency.
The availability of a huge stock of external assets makes Japan’s overall situation very different from many other countries with large fiscal deficits which are currently confronting actual or potential major financial crises. This is not always given adequate weight when discussing Japan’s overall financial position and implications of some further expansion of government debt, especially as such new debt is aimed at financing rebuilding of productive capital assets and infrastructure. Reinhart and Reinhart, as many others, highlight the well recognised dangers of a sharp expansion of government debt. But, we feel that they dismiss too lightly concerns about the potential negative impact of substantial currency appreciation in the current circumstances by simply asserting that: ‘higher domestic demand from reconstruction spending can offset the negative external demand effects of an appreciated Yen’.
In fact, any signal that Japan will repatriate substantial US Treasury holdings for reconstruction that will take several years is very likely to produce a sharp and sustained Yen appreciation. Recall that the expectation in currency markets that Japanese would sell foreign assets to bring funds home was at least partly responsible for the strong Yen appreciation in the immediate aftermath of the March 11 disaster. If the combination of short term supply disruptions and large scale reconstruction efforts then produces some upward pressure on prices, markets are also likely – given the reputation of the BOJ – to interpret that as signalling higher interest rates, which may stimulate further currency appreciation with strong negative impact on the business confidence and plans of Japanese export industries. Japanese are rightly concerned about the dangers of a sharp currency appreciation at a time of fragile global demand and when the domestic economy is reeling from both internal supply disruptions and falls in consumer spending. These concerns are particularly acute in the current context of loose US monetary policies which stimulate large capital inflows into Asia and intensify currency appreciation pressures.