Is fiscal stimulus necessary to get Japan out of its doldrums?
By R.A. | WASHINGTON
JAPAN seems to be preparing to embark on a major effort to right its economic ship. As it does so, an interesting debate is emerging over just what the Japanese economy needs. Japanese Prime Minister Shinzo Abe has applied strong pressure on the Bank of Japan, and it is rumoured that the Bank will respond. At its next meeting, the Bank is expected to raise its inflation target to 2% (from a 1% goal), while also scaling up its asset purchases. Meanwhile, the government is moving to enact a major fiscal package.
Are both necessary? Adam Posen, until recently a member of the Bank of England's Monetary Policy Committee and critic of British austerity, argues that Japan doesn't need more fiscal stimulus but can get the job done with monetary policy alone. Paul Krugman, by contrast, argues that at the zero lower bound a combination of fiscal and monetary expansion is exactly what's necessary to get the economy moving. Who is right?
The answer depends on what one thinks is ailing the economy. In fact, there's a lengthy list of problems, many of them structural. But I think it's worth beginning with demand, specifically, the path of nominal output. Consider:
Nominal GDP growth faltered in the late 1990s, corresponding to Japan's "lost decade" and its initial descent into deflation. NGDP growth then recovered in the 2000s, a period during which Japan matched other rich countries in growth in output per person. With the onset of crisis, however, it tumbled dramatically and now remains well below the pre-crisis trend. Problem one has to be solving this issue.
It's hard to say whether deflation qua deflation is a problem for Japan; David Keohane offers some reason why it might be here. My sense is that it is a problem, but mostly so because it represents an obstacle to raising NGDP. Deflationary expectations have to be eradicated to get nominal growth back up.
How to do that? Looking back at the past two decades of Japanese growth, it is difficult to detect a clear relationship between Japanese deficits and nominal output. Since the crisis, fiscal deficits have been large and growing. That stands in contrast to Britain, which ran large crisis deficits but has since been reining them in. It seems as though monetary policy rather than fiscal policy has been the bottleneck. Price indexes reflect this; deflation has returned as a chronic problem since the crisis. So too does the value of the yen, which has appreciated significantly over the last half decade.
If monetary policy was the bottleneck, does it follow that monetary policy alone can turn things around? Market reaction since Mr Abe's campaign suggests that fiscal policy isn't necessary to raise expectations for inflation and growth. Both the yen and Japanese equity prices have moved in the expected direction since markets began to anticipate expansionary action (though one could also argue that the action markets were anticipating was cooperation between the fiscal and monetary authorities).
There are three things to think about. One is monetary policy credibility. Low or negative inflation expectations have become entrenched in Japan, and it will take a regime shift in policy to alter that. An aggressive push by the Bank of Japan—especially coupled with a change in target—could be enough, but if the aim is a shock and awe campaign that's sure to change perception it's hard to see how a big new fiscal stimulus could hurt.
The second consideration is more mechanical. If the problem is excess Japanese saving leading to underemployed resources, then massive dissaving by the government is one way to address the problem. Alternatively: if you want more NGDP, then one to get there is to have the government create more NGDP—assuming its action doesn't crowd out private activity.
That gets to the third and trickiest issue: how does Japan's enormous (and growing) stock of public debt affect things? At first glance, it would seem to be a boon to efforts to fight deflation. From a fiscal-theory-of-the-price-level point of view more debt means a greater chance that the government is forced (or opts) to inflate its obligations away. Fiscal stimulus, you might say, is part of a campaign to produce so much debt markets can't help but shy away, such that deflation can't help but be dispatched.
But I'm not sure that's necessarily how things would play out. Successful stimulus would lead interest rates to rise. Crowding out of private activity could quickly become a problem, particularly as interest payments balloon with rising rates—unless the debt is mostly monetised which, under those circumstances, could mean an unpleasant and destabilising loss of control of inflation. One might argue that the government can't credibly provide fiscal stimulus; that either the stimulus must fail, leaving ample room for continued state borrowing at low rates, or it must be very quickly unwound through spending cuts and tax increases to avoid a debt crisis, in which case full Ricardian Equivalence might actually hold (for once) leaving the multiplier at zero.
Alternatively, markets could perceive that the threat of such nasty outcomes will constrain monetary policy—which has been the bottleneck, you'll remember—preventing the desired turnaround in that way. Maybe Mr Abe would then carry out his threat to revoke the central bank's independence, but maybe not.
I think I lean toward Mr Posen's view. Fiscal stimulus is neither necessary or sufficient for Japanese recovery, and though it could enhance a new monetary expansion it also carries some potentially serious risks. But I'm not that confident in the conclusion. Japan is a strange case. I suppose that makes the big upside of the situation (for economists, not the Japanese) the possibility that we'll learn something.
