Financial Crisis and Long-term Stagnation in Japan: Fiscal Consolidation under Deflationary Pressures

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1 Financial Crisis and Long-term Stagnation in Japan: Fiscal Consolidation under Deflationary Pressures Paper for New York University Workshop October 7-8, 2010 Mitsuhiro Fukao 1 Keio University and Japan Center for Economic Research 1 Most of the estimations and data processing were carried out by MM. Yoshinori Shida and Hayato Suzuki of Keio University. I would like to thank their excellent research assistance. 1

2 1. Japanese deflation started in mid 1990s 110 GDP Deflator of Japan (2000=100 for unadjusted index) 105 GDP deflator unadjusted for consumption tax hikes GDP deflator adjusted for consumption tax hikes Note: Adjusted for changes in consumption tax in April 1989 and April

3 2. Japan's nominal GDP has been flat for 20 years Japan's GDP Trillion yen Real GDP Nominal GDP

4 3. Negative shocks for Japan since 1990s Industrial Production of Japan (2005=100) Extreme Appreciation of the Yen Global Financial Crisis Crush of the Asset Price Bubble Financial Crisis in Japan

5 4. Japan has been unlucky for the past 20 years : Crush of the bubble economy Land and stock prices fell sharply : Very strong yen started deflation Extreme appreciation of the yen pushed GDP deflator inflation rate into negative range : Financial Crisis in Japan Successive failures of Sanyo Securities, Hokkaido Takushoku Bank, Yamaichi Securities, Long-term Credit Bank of Japan and Nippon Credit Bank => Market participants do not trust each other : Global Financial Crisis Collapse of export market induced a sharp fall in industrial production 5

6 5. The very strong yen in started deflation 160 Real Effective Exchange Rate of Japan 2005=100 BIS narrow index

7 6. Monetary policy has been constrained by zero-lower bound since mid 1990s Market Interest Rates in Japan Overnight Call rate 10-year JGB Rate

8 7. Declining working-age population aggravate Japan's problem Fertility rate at 1.4 means half-life time is 70 years (-1.0 percent per annum) Fertility Rate in Japan

9 8. Declining potential growth rate Trillion Yen at 2000 price GDP Gap 400 Actual GDP Potential GDP Natural GDP Estimated by Cobb-Douglas production function: ln Y t = 0.28 ln K t ln L t + ln TFP t Y t : Real GDP, K t : Capital input adjusted for capacity utilization, L t : Labor input measured by man-hours, 9

10 9. Potential growth rate is depressed by declining working age population 6 % Contribution of Production Factors to Potential Growth Rate Potentail Labor Input Potential Capital Input Total Factor Productivity Potential Growth Rate

11 10. Deflation is caused by low capacity utilization of capital and labor % GDP Gap and Core-core CIP inflation rate GDP Gap Core-core CPI inflation rate Bank of Japan target of CPI Inflation rate: One percent GAP level consiten with one percent CPI inflation

12 11. Estimation of Natural GDP and long-run Phillips Curve (1) Definition: Natural GDP is defined to be the GDP level that is consistent with 1 percent CPI inflation rate. The Bank of Japan has an objective of aiming 0-2 percent consumer price inflation rate (CPI). (2) Phillips Curve Core-core CPI equation was estimated to calculate the natural level of GDP. πt = 0.459*Σ⁴i=1 πt-i / *Σ 8 i=5 πt-i / *Gt et π t : Core-core inflation rate G t : GDP gap defined as (Actual GDP - Potential GDP) et: Error term. This equation is solved for GDP gap, G, at π= 1. The result was This means that when actual GDP is percent below the potential GDP, the inflation rate converges to one percent. 12

13 12. Tracking performance of price equation 4 % Core-core CPI Inflation Rate: Actual v.s. Predicted 3 2 Actual Core-core CPI Predicted Core-core CPI Notes: (1) Estimation Period: 1991:Q1-2009:Q3. (2) Core-core CPI adjusted for consumption tax increases is seasonaly adjusted by X-12-ARIMA. This inflation rate is soomthed by 3-quarter moving average. 13

14 13. Saving Investment Balance and Budget Deficit Private surplus has been more than enough to absorb government borrowings. As a result, Japan has been running current account surplus over the past 30 years Saving-Investment Balance of Japan Ratios to GDP Projection by the IMF Private Investment Private Savings Private Surplus General government deficit Current Account Surplus Budget Deficit Note: IMF World Economic Outlook, April

15 14. Expanding public debt of Japan The general government gross debt is exceeding 200 percent of GDP. This level of gross debt is the highest since the end of World Wart II General government gross debt General government net debt Debt of Japanese Government Ratios to GDP (%) Projection by the IMF Note: IMF World Economic Outlook, April

16 15. Fiscal crisis scenarios Politicians have not succeeded to persuade voters to raise taxes. Long-term government bond interest rate has been very low. Old households who owns a dominant part of private savings is conservative. They have been sticking to the yen deposits and yen bonds. Risk takers who invested in foreign assets lost money due to the appreciation of the yen. Fiscal crisis may be triggered by a massive shift of asset from yen to foreign currencies. (i) A very weak yen will stimulate the economy and push up prices, (ii) An exit from deflation will push up long-term interest rates, (iii) The government will have to pay much higher interest rate on its debts, (iv) The interest payments may surpass tax revenues and public confidence will be eroded. On the other hand, the Japanese economy will also get positive effects from the weaker yen: (i) Japan's export will grow rapidly and stimulate the economy, (ii) Tax revenue starts to grow as nominal GDP increases, (iii) The government will get profit from foreign reserves (more than US$1 trillion), (iv) Private investors will get profit from massive net foreign assets (about US$1.5 trillion) (v) The Bank of Japan can start to use interest-rate policy to stabilize the economy. 16

17 16. The net creditor status of Japan makes the fiscal crisis less possible. 140 External Assets and Liabilities of Japan GDP Ratios (percent) Asset Debt Net Asset

18 17. Fiscal consolidation under deflationary pressures In order to avoid negative effects on deflation and employment from fiscal consolidation, it is necessary to support the economy by monetary policy. However, the effect of monetary policy is severely constrained under deflation. The limit on traditional monetary policy instruments Zero-lower-bound for policy interest rates Open market purchases of short-term government papers are no-longer effective Base money and zero-interest short-term government papers are perfect substitutes Long-term bond yields cannot be pushed down below a certain level No upside and large downside for bond investors It is not necessary for the Bank of Japan to provide direct credit to business sector Japan has large government sponsored lending institutions. Limit on non-traditional policy instruments Push down the yen by massive interventions in the FX market Beggar-thy-neighbor policy: not appropriate Purchase real assets such as TOPIX based mutual funds and REIT Would push up asset price deflation in the short run However, long-run effect is doubtful Will not be able to change cash flows of companies and real estates 18

19 18. Tax policies to stimulate the economy while increasing net tax revenue There are a few possible ways to raise tax without too much hurting the economy. Raise indirect taxes while cutting payroll and corporate taxes. It can raise inflation expectations with front loading effects on consumption and investment. The combined changes in taxes should be revenue enhancing. (i) Gradual increase in consumption tax and a reduction in social security tax Tax increase For example, raise consumption tax by 2 points every year for five years. This policy can increase tax revenue by about 24 trillion yen. This policy can push up CPI inflation rate by 1.4 percent per year. Tax cut Eliminate social security tax for basic pension. Abolish poll tax for basic pension (16,000 yen/month for Kokumin Nenkin) Reduce payroll tax for employee pension by 6 points (16% => 10%) This policy can improve confidence in government pension system. Reduce tax burden on regular employees. => More stable jobs. (ii) Gradual Increase in carbon tax would also be useful. 19

20 19. Gesell tax as a negative interest rate policy It may be the ultimate weapon against deflation. What I propose is a modified version of Gesell tax (stamp duty on money. 2 ) Levy tax on the outstanding amount of government guaranteed financial asset, it is possible to set nominal return on safe assets at a negative number. I For example, the government levy tax on the balance of all government-backed financial assets such as bank deposits, government bonds, postal savings, cash, etc., at the rate that is slightly higher than the deflation rate until deflation is stopped. It is easy to tax deposits and government bonds. In order to levy tax on cash, the Bank of Japan may introduce new banknotes and charge fees for exchange with old notes. The Bank of Japan can exchange yen in old money with yen in new money. 2 See Chapter 23 of Keynes (1936). Goodfriend (2000) also discussed the possible taxation on currency to fight against deflation. 20

21 20. The effects of Gesell tax Induce investors to shift from taxable assets to non-taxable assets. Deposits and public bonds => Stocks, real estates, foreign assets Decrease savings and stimulate investment Stimulate bank lending and inter-corporate lending Public bonds and central bank deposits => Loans to private sector Stimulate Inter-corporate loans Cash and deposits => Receivables Yen would be depressed somewhat. Government will get massive tax revenue 2-percent tax would yield revenue of about 30 trillion yen or six percent of GDP The government could use the revenue to stimulate the economy. Side effects of the policy Gesell tax on the government liabilities may be regarded as a partial default. Once deflation is overcome, the nominal interest rate would rise. May induce sharp falls in bond prices 21

22 21. Policies to Improve Japanese Growth Rate Immigration Policy Encourage immigration of intelligent foreigners to Japan. Japanese Language Proficiency Exam is carried out in 51 countries. 550,000 students take this exam every year and about 50,000 pass the 1st level. 1st level is usually required to study at Japanese Universities. Give 5-year working visa to all the foreigners who passed 1st level Give permanent visa or allow naturalization after working for 5 years in Japan or for Japanese companies, Example: Japan Sumo Wrestlers Association Effects of this policy Working age population is declining by about 600,000 persons per year. The migration of 50,000 people and its relatives is not enough to stop declining population. Japanese-speaking foreign workers will help expansion of Japanese companies in Asian markets. This policy will expand the role of Japan as a trading and financial center in Asia 22

23 References Fukao, Mitsuhiro (2003): Financial Strains and the Zero Lower Bound: The Japanese Experience, BIS Working Paper No. 141, September. : Financial Crisis and the Lost Decade," Asian Economic Policy Review, Vol. 2, No. 2,December : "Financial Strains and the Zero Lower Bound; The Japanese Experience," in ed. Takatoshi Ito and Andrew Rose, Monetary Policy with Very Low Inflation in the Pacific Rim, University of Chicago Press: Chicago, 2006, pp : "The Effects of 'Gesell' (Currency) Taxes in Promoting Japan's Economic Recovery," International Economics & Economic Policy, January Gesell, Silvio (1906): The Natural Economic Order, Berlin. Goodfriend, Marvin (2000): Financial Stability, Deflation and Monetary Policy, paper for the Ninth International Conference at the Institute of Monetary and Economic Studies, Bank of Japan, on The Role of Monetary Policy under Low Inflation: Deflationary Shocks and Their Policy Responses, July Keynes, John M. (1936): General Theory of Employment, Interest, and Money, London: Macmillan. 23

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