The ministry that cried wolf – The diplomat
The first cry of the “wolf” came in 1975 when, during the post-oil shock recession, Japan did what countries do in a recession: it ran a deficit. Nevertheless, the Ministry of Finance (MOF) has issued a “fiscal emergency declaration”. Three years later, as deficits continued, the finance ministry declared that unless Japan quickly restored fiscal balance through tax hikes and spending cuts, it would “collapse”. In 2010, he told Prime Minister Naoto Kan that if he did not raise the consumption tax, Japan could experience a catastrophic debt crisis like the one ravaging Europe. So when Deputy Finance Minister Koji Yano recently criticized new Prime Minister Fumio Kishida’s budget package, insisting that his deficit spending was like “the Titanic heading for an iceberg”, he was simply carrying on a long tradition. .
If the ministry’s warnings had been accurate, he would have served the nation. In reality, it has been repeatedly, long and stubbornly wrong. To be fair, MOF has allies among well-respected economists. In 2012, two of them predicted that, without a consumption tax of 15-20% (compared to 10% today), the Japanese government bond (JGB) market would collapse between 2020 and 2023. .
MOF’s balance sheet
In the mid-1990s, the MOF convinced Prime Minister Ryutaro Hashimoto to raise the consumption tax from 3% to 5%, which would have posed no problem for a healthy economy. Unfortunately, as Washington had warned, Japan’s health had been undermined by a growing mountain of bad debt. Indeed, the April 1997 tax hike plunged the economy into a severe recession, which greatly amplified the banking crisis, further deepening the recession. When Washington demanded a return to 3%, the secretary general of the ruling Liberal Democratic Party (LDP) lambasted. “You have no idea how many prime ministers have been sacrificed…to introduce the consumption tax.” Months later, Hashimoto joined the list of sacrifices when voters punished the LDP in the Upper House elections, and he had to step down.
In 2010 and 2012, two other prime ministers, including Kan, suffered defeat when they bought the Finance Ministry’s scare stories of a European-style debt crisis and passed legislation setting the date for two more. tax increases. In reality, the only European countries in crisis were those which had “twin deficits”, ie a lot of domestic public debt combined with international debt. Japan, on the other hand, is a net creditor internationally.
The other victims of MOF’s bad advice were all the investors who repeatedly bet on a JGB price crash and repeatedly lost big. Betting on a JGB crash has become known as a “widowmaker”.
Cut pensions and health care for the elderly
The Ministry of Finance swears that, without fiscal austerity, the growing proportion of the elderly in the population will force the government to spend increasingly large shares of GDP on social security and health care, leading to a budgetary crisis . The numbers tell a different story. Spending peaked at 12.5% of GDP in 2013, then flattened. How did it happen? Even though there were more old people, the government cut spending per old person, with social security per old person down a fifth from its 1996 peak and health care per old person down. down 15% from its peak in 1999.
These cuts are one of the reasons why, among women over 65 living alone, the poverty rate has fallen to nearly half. In 2018, 45,000 elderly people were arrested, mostly for shoplifting, compared to 7,000 in 1989.
Either way, the increase in the number of seniors is leveling off, reducing the risk of a fiscal crash.
BOJ buys JGBs, reducing crash risk
The reasoning offered by the MOF offers seems plausible: the public debt-to-GDP ratio continues to rise; it can’t go on forever; eventually, investors will panic.
However, the Ministry of Finance speaks of the “gross” public debt, which reached 237% of GDP in 2020. However, this is a meaningless figure. This is because it includes the debt that one government agency owes to another. The Bank of Japan (BOJ) is not about to get rid of JGBs. What really matters is “net” debt, i.e. debt held by private investors, which has collapsed since 2013 when, in the name of fighting deflation, the BOJ bought up almost half of the JGBs. In doing so, JGBs held by others, mainly private investors, have fallen from 145% of GDP in 2012 to 103% today.
Moreover, what really triggers bond crises is not the size of the debt per se, but the fear that the government can no longer pay the interest bill. Japan does not have this problem. In 2021, because the BOJ pushed interest rates to the basement, interest payments fell to just 0.4% of GDP. This is negligible compared to the peak of 1.9% almost 40 years ago. If Japan didn’t suffer a crisis when the private debt and interest bill were so much higher, why should it suffer one now?
The MOF’s response is that interest rates won’t stay low forever. When they inevitably rise, then comes the crisis. Again, this sounds plausible, but it defies Japan’s experience. The BOJ has proven that it can keep interest rates very low, as it has for more than a quarter of a century. Since Japan does not need to borrow from the rest of the world, it can control its own interest rates. Would the BOJ really allow a financial cataclysm rather than continue to flood the system with much needed money?
MOF’s blind spot
Certainly, the Ministry of Finance was not alone in fearing that large chronic budget deficits could lead to a crisis. There is a difference, however, between making a judgment that turns out to be wrong, then changing your mind, and being impervious to new evidence. The MOF suffers from the latter syndrome.
Like generals still fighting the last war, or even the war before it, the MOF is still tortured by the national trauma of hyperinflation in the years following World War II. In MOF’s mind, this inflation was cured by the “balanced budget” policy of a banker named Joseph Dodge whom the American occupation appointed in 1949 to dictate fiscal policy. The side effect was a recession that ended when the Korean War boosted demand for Japanese exports. Economists are still debating whether Dodge’s cure was worse than the disease, but the MOF is still in the grip of its doctrines. Prior to Dodge’s arrival, the MOF had no commitment to a balanced budget, but from then on fear of hyperinflation and adherence to the “Dodge Line” became imprinted in the DNA. from the MOF and the BOJ. When Japan faced an economic downturn in 1965 and the World Bank suggested deficit spending to spur recovery, MOF officials retorted, “Mr. Dodge told us not to. New recruits are always indoctrinated into this creed.
No crisis, but no more corrosion
No one denies that Japan’s chronic deficits have consequences. The impact, however, is not a financial crash but a slow continuing corrosion of the economy. This difference in diagnosis requires a very different prescription.
First, the deficit itself is not the cause of Japan’s economic ills, but rather a symptom of weak private demand. Thus, the first priority is to tackle the root causes of this weak demand, which are the slowness of real wages and the hoarding of cash by companies.
Effective reform requires tax and expenditure policies to be consistent with long-term growth, so as to broaden the tax base. There are countries where a consumption tax is acceptable, but Japan is not one of them. This is because it makes weak consumer demand even weaker. Other more attractive taxes are available. On the spending side, paving riverbeds and providing credit guarantees to zombie companies not only depresses growth, but makes the public wary of any tax increases, as they feel the money would be wasted. .
Finally, chronic deficits increase the pressure on the BOJ to maintain its ultra-low interest rate policy and, while it is needed now, extending it indefinitely weakens the foundations of the economy. For example, 36% of all bank loans now bear less than 0.5% interest and 17% less than 0.25%. These negligible rates keep zombie companies in business, hurting other, healthier businesses, stunting GDP growth. Interest on deposits provided the elderly with a large part of their income. Not today. If you deposit 10 million yen ($88,000) on a one-year term deposit, your interest will only be ¥1,000 ($8.85). No wonder 40% of retiree household spending each year comes from their savings. How many will run out of savings before they run out of years?
Better growth will not solve all fiscal problems, but it would make them much more manageable. On the other hand, undertaking tax hikes and spending cuts without structural reform will further aggravate fiscal problems.