Japan's fiscal crisis- An Anatomy of a Keynesian Failure

In 11 Big Surprises for the Next Decade We Wrote:

Japan's Government Bond Market Implodes- The Japanese government and economy got used to record low interest rate. But the combination of government debt reaching 230% of GDP and the ageing population cashing in via the pension funds on the government bonds cause a total implosion. In only 2 month the yield on 30 year government bond went up to 4% causing a panic selling and forcing the government to finally cut the deficit. The deficit cut where not enough, and Bank of Japan did what it knew best- printed money. Only this time, to there big surprise it resulted in inflation, and just ordinary inflation-hyperinflation. The markets discovered that they where worried about the wrong country. Japan became the first modern country in 21st century move towards hyperinflation.

This is why:

1. The crisis and the stimulus packages of Japan’s government boosted the budget deficit to more than 10% of GDP in 2010. The reduction in the budget deficit – from 8.2% of GDP in 2002 to 3.2% in 2007 has rapidly been reversed, making the target of a primary budget surplus for central and local governments by FY 2011 a sick joke. Gross government debt is projected to rise to 200% of GDP in 2010, and to 100% in net terms. The December 2008 program to upgrade the social welfare system would make fiscal consolidation even more challenging as it implies increasing public social spending from its current level, which is below the OECD average.

2. Japan’s government borrows from Japanese households. But Japanese households are retiring, and traditionally retirees run down their savings.

3. In the past, the Japanese government had a captive domestic market in which to place its debt. A large pool of domestic savers, made cautious by prior painful experience with risk assets and an increasingly fragile economy, was happy to own as much government debt as possible. But those savers are now retiring, and running down their assets.

4. Japan’s economy collapsed into deflation just as its demographics ‘rolled over’ in the mid-1990s, and now the investors who funded the government’s serial attempts to revive the economy are retiring.

5. Japan’s demographic decline started in the early 2000s and retirees run down their assets. For the past three years, however, JGB purchasing has levelled off. Of course, household direct purchases of JGBs are a small share of total ownership, as buyers, banks and insurance companies are far more significant. But these corporate buyers are only really recycling the same diminishing pool of Japanese savings. Hence the current trend implies that Japan’s savers will grow less able to continue funding a deficit that is currently running at more than 40% of government expenditure.

6. Japan’s public pension system is characterized by a two-tiered structure. The lower tier consists of a flat-rate basic pension that all participants stand to receive at retirement. The upper tier is an amalgam of earnings-related occupational pension schemes. The basic pension emerged covers not only employees but self-employed persons and full-time housewives. Participation in the basic pension is compulsory from age 20 to 59, and the full flat-rate benefit is paid out at the pension age except in cases with an incomplete contribution record (less than 40 years) or an exemption period. In contrast, the upper tier consists of the Employees’ Pension Insurance scheme for private sector employees, and various Mutual Aid Associations for public sector employees. For a low-income household earning half this income of 174,000 yen, the monthly pension will amount to 179,000 yen. On the other hand, for a high-income household with twice as much income of 696,000 yen, the monthly income is indexed to 620,000 yen, resulting in a monthly pension of 315,000 yen. In this way, the EPI portion of the monthly pension increases with household income. However, the replacement ratio of the monthly pension varies widely from 59.7% for the model household to 94.0% for the low-income household, and 43.5% for the high-income household. This inverse relationship between the replacement ratio and income indicates that the basic pension produces an income redistribution effect.

7. Aside from the two-tiered structure, two other features of special importance to individuals as well as the public pension system are the indexation of benefits and the benefit payment period. In Japan’s public pension system, participants pay in contributions for approximately 40 years, and then receive benefits for the next 20 years. In principal, the present system indexes the starting benefit each year to the wage growth rate, and subsequent benefits to the inflation rate.

8. Past population projections have underestimated the growth of life expectancy and decline of the total fertility rate in Japan. This means the pay-as-you-go public pension system is coming under increasing strain because fewer workers must support more retirees who are also living longer. Despite the need to raise contributions and reduce benefits in the long term, political considerations prevent bold moves in the short term. In the past, when actuarial valuations of the pension system were done every five years, it was customary to set the benefit level first, and then to calculate the required contribution level. This method allowed policymakers to avoid politically sensitive decisions on contribution rate hikes and benefit cuts.

9. It is not likely that the international capital markets will fund the Japanese government’s deficit in the future, especially if its bonds are offering only a 1.5% yield. But if international investors were to demand triple that, pricing JGBs in line with international bond market peers it will destroy Japan’s public finance since current debt service already amounts to 35% of pre-bond issuance revenues.

10. Japan’s population is aging at the fastest rate in human history (as measured by the speed with which the share of the elderly in the total population has increased over time) and is now virtually the most aged in the world. In 2006, the share of the elderly in the total population was 20.6%, which implies that more than one-fifth of Japan’s population was elderly, and this ratio is projected to increase further to 28.7% by 2025 and to 35.7% by 2050, according to official Japanese government projections.

11. Japan’s household saving rate showed a steady upward trend from the mid-1950s until the mid-1970s, increasing from 11.9 percent in 1955 to a phenomenal level of 23.2 percent in 1974 and 1976, but has shown a downward trend since then, falling to the 2 to 3 percent level in recent years.

12. Japan’s household saving rate was one of the highest among the OECD member countries during the 1975-85 period. It ranked first in 1975, was second only to Italy in 1980 and 1985,and was 1.6 to 1.8 times the OECD average in these years. However, Japan’s rank among the OECD member countries as well as the ratio of her household saving rate to the OECD average both fell steadily during the subsequent twenty years, falling to 17th place (43percent of the OECD average) by 2005.

13. According to the life cycle hypothesis, the household saving rate will be higher in a country with a younger population because the young typically work and save, whereas the elderly typically retire from work and dissave their previously accumulated saving. Conversely, one would expect a country’s household saving rate to decline as the population of that country ages and its elderly dependency ratio increases. However, one would also expect a country’s young dependency ratio, defined as the ratio of children to the working-age population, to exert downward pressure on its household saving rate because children, like the elderly, contribute to consumption without contributing to income. Japan’s population is now virtually the most aged in the world, but until recently, Japan’s population was the youngest among the industrialized countries. In 1975, the share of the elderly (those aged 65 or older) in Japan’s total population was only 7.9 percent, which was the lowest among the OECD member countries at the time (this ratio was 3.6 percent in South Korea in 1975, but South Korea was not yet an OECD member country at the time). Thus, if the life-cycle hypothesis is applicable, the young age structure of Japan’s population can explain why Japan’s household saving rate was so high in the past. The low ratio of the aged population to the working-age population was by far the most important cause of Japan’s high private saving rate during the 1975-84 period, and the same undoubtedly holds for her household saving rate. The share of the population aged 65 or older to the total population in Japan is projected to increase from 17.8 percent in 2007 to 28.7 percent in 2025. This will cause its household saving rate to continue its rapid decline. A number of authors have projected that the rapid aging of Japan’s population will cause Japan’s household saving rate to decline to zero or even negative levels by 2014-24 if all other determinants of the household saving rate remain constant. The age structure of Japan’s population can explain the level of its household saving rate as well as trends over time therein and that it is a major determinant of future trends in Japan’s household saving rate as well.

14. Japan’s public pension system can be divided broadly into the Employees’ Pension System to which private salaried workers and their spouses belong, the Mutual Aid Association Pension System to which government workers and their spouses belong, and the National Pension System to which the self-employed and all others belong. The first tier pension (the “basic pension”) is common to all three systems. These public pension systems are essentially operated on a pay-as-you-go system. Thus, in a society in which fertility is declining and the population is aging, it becomes necessary to raise the contribution rate in order to maintain benefits at their original levels, and this, in turn, requires younger cohorts, whose net transfer from the public pension system is negative, to increase their own saving for retirement. These effects are common to all three public pension systems.

15. Japan’s high household saving rate was a temporary phenomenon and it was high in both absolute and relative terms during the 1955-95 period (especially during the 1960s and 1970s) but it was not unusually high during the prewar and early postwar periods or after 1995; The age structure of Japan’s population can explain the level of its household saving rate as well as trends over time therein and that it is a major determinant of future trends in Japan’s household saving rate as well; The rapid aging of Japan’s population is likely to cause Japan’s household saving rate to continue declining and to cause it to become zero or even negative in the near future;

16. Next year, the MoF expects that ratio of revenues generated from bond issuance to rise above 100% i.e. tax revenues will be less important than borrowing as a source of income.

17. Japan’s misery over the past two decades, since its own bubble burst in 1991, offers a strong warning that major reforms are necessary, both during and after any major crisis, and that neglect, in combination with deficit spending, may lead to permanent decline.

18. Japan has failed to reform its domestic service industry, focusing instead on half-hearted supply-side reforms to squeeze one more drop of productivity out of its old industries, such as cars and TVs, thereby remaining dependent on exports and vulnerable to crises abroad.

19. Rapid population ageing and the plan to improve social welfare programmers put upward pressure on health spending. despite a 7½ per cent cut in medical fees and prices since 2000, health spending has risen significantly in recent years, which has weakened the fiscal position as more than 86% of health care is publicly financed. Under the current framework and utilisation patterns, health-care spending is projected to rise by around 2% of GDP by 2025, owing to rapid population ageing. Beside that, there is growing dissatisfaction with the quality of health care, which culminated in the 2008 decision to upgrade social welfare programs. Universal coverage requires improving compliance in paying premiums, a step which the government is refusing to take.

20. Japan failed to adjust to the challenges of demographic ageing. A policy deadlock is blocking necessary reforms, suffocating Japan’s productive firms, producing ever more public debt and putting Japan’s flexible governance model and strong social partnership at risk.

21. During the long, slow upturn from 2002, domestic demand never gained momentum. Sales of durable consumer goods remained flat or even retreated. Car sales, for example, remained on a strong declining trend, even during the good times. As a result, when external demand faltered, the domestic economy could not pick up the slack. The main reasons for this heightened dependence on external demand are the aging of society and employees’ stagnating incomes. While retiring employees were cutting back to make sure that their life savings would last, younger employees struggled to cope with a whole batch of supply-side reforms that were meant to improve the productivity of Japanese industry to offset the costs of retirement of an entire generation.

22. Today, more than a third of employees and more than half of younger employees find themselves in irregular, limited, and temporary work, which is often not covered by social security. The slump in domestic demand may even have initiated a vicious circle. Japan’s large and extremely productive corporations are increasingly looking for opportunities abroad. Instead of focusing on new opportunities in the large domestic service sector, they have rationalized their »old« industries to meet booming demand in the world market, especially China and emerging Asia.

23. During the boom in the United States and China, Japan’s policy-makers blew the chance to substantially reform the domestic economy, while Japan’s old industry products, from steel to cars and TVs, got a second wind. As a result, only supply-side reforms that served the competitiveness of export industries were carried through. Reforms that might have increased domestic demand and the attractiveness of the service sector, such as postal privatization and retail and construction deregulation, were stymied.

24. Japan sits on a pile of public debt amounting to 200 percent of GDP. So far, Japan has had the highest debt burden, but also one of the lowest levels of financing costs in the world. Already this year, however, the government will probably seek financing by issuing new debt for more than 50 percent of the budget, severely increasing the risk of spiraling out of control.

25. The public burden is being felt ever more by the younger generation, which already has to carry the largest number of pensioners in the world while struggling to make ends meet in temporary and low-productivity jobs.

26. After the burst of a homegrown bubble in 1991, policy, especially fiscal, tried to reignite growth with one fiscal package after another. It worked only during times of strong overseas demand; the economy resumed its stagnation when exports started to sputter. After another economic low a decade ago, frustration among the Japanese public was already sufficiently ingrained for the phrase Japan passing (i.e. giving up on Japan) to become widespread in the Japanese media.

27. The most important change from the glorious past is that Japan has changed from the world’s youngest emerging country into the oldest industrial nation at precipitous speed. The share of the productive population between 15 and 60 years of age has already fallen by almost 10 percent compared to previous decades.

28. By 2025 the median age in Japan will be 50, and by 2050 two employees will have to support one retiree.

29. In Japan’s seniority-based system, in which even top-notch university graduates rarely start with salaries of over 2,000 euros a month, the income squeeze at the top of the age pyramid is an especially big problem because it serves to turn one of the core advantages of Japan’s business model on its head. After World War II, employees started young in companies that rewarded them with little more than the promise of participating in future growth. By keeping consumption low, employees invested heavily in their companies which, in turn, needed to tap global markets in pursuit of buyers of their products and heavy investment. These companies kept their promises and reimbursed their lifetime employees with bonuses, perks, and retirement packages. A major part of the strong performance of Japanese corporations during the 1960s and their underperformance in the 1990s can be explained by this long business cycle of low costs and investment at first and high pay outs at last. Similarly, their return to profitability and low unit labor costs coincided with the retirement of their lifetime employees from the mid-2000s.

30. Japan’s economy is not automatically shifting to a new equilibrium with slightly lower growth, but higher consumption on the part of the aged and higher productivity on the part of the young. Japan’s now rich older generation sits on the world’s largest stock of financial assets, but does not seem inclined to spend it. According to regular surveys, more than 80 percent of the population is scared of the potential instability of the pension and healthcare system. As voters, they fiercely defend their savings.

31. Japan is unable to adjust with structural changes and reforms. In the course of becoming one of the world’s leading industrial powerhouses, Japan went through a phase of equally astounding economic and social changes with admirable flexibility and stability. But little was due to miraculous government policy. Transformation in Japan was for the most part achieved by concentrating capital, resources, and people in Tokyo and Osaka, which emerged as huge industrial clusters. While the economy was growing strongly, the system, which evolved into the world’s largest regional transfer system during the1970s, actually managed to produce a high level of regional income equality. But it did not turn Japan’s countryside and provincial capitals into centers of self-sustaining growth. Today, Japan’s growth center in Tokyo, with a GDP the size of France, therefore remains dependent on income earned abroad, while the rest of the country depends on transfers from the center in Tokyo.

32. By the mid-1990s, not only was Japan’s financial heart at the risk of failure, but the entire industrial landscape was seriously hit. Banks became technically bankrupt, while bad debt from insolvent corporations kept increasing. For the first time, Tokyo’s economy had stopped growing, while the countryside started to fall apart when taxes and transfers receded. The Japanese government triedto stabilize the economy by putting together one public works package after another. The buzzword of the time was financial socialism. By the time this policy ended in 2002, Japan’s public debt had increased to 160 percent of GDP and industrial productivity had collapsed.

33. When overseas demand subsided in 2008, Japan’s economy almost imploded. At first, the impact of the global recession seemed to take the form only of falling external demand for Japan’s exports, lower earnings of Japanese companies abroad, and the appreciation of its safe-haven currency.

34. During previous recessions, private demand remained fairly stable. When the economy deteriorated, Japanese households started to dig into their savings, so that the share of consumption in incomes increased, while the savings rate declined. However, since most Japanese people feel that they have been more in than out of recession for the past 20 years, the household savings rate gradually has, recession by recession, declined to about 4 percent.

35. During any of Japan’s crises consumers were even more difficult to convince to shop more, so the government has taken up the slack again and again. Some economists in Japan have even started to argue that this is fine, at least for the time being. When consumers are unwilling to buy and save too much, the government has to do the consumption work for them, and for the greater good. So as long as households are willing to buy public bonds (at low prices) and pay their taxes, it does not really matter who pays for additional nursing care; if households will not do it, the government will do it for them.

36. The government has shown a remarkably different spending preferences than the general public and has been unable to spend on products or services that would have increased domestic growth in the long term. The famous bridges to nowhere, for example, did not add to economic growth after their construction but resulted in constant maintenance costs. The government has therefore been unable to convince the public to pay for its (consumption and investment) services through higher taxes. It has had to cover investments with public bonds and meet costs with a confusing and opaque network of finance and investment agencies that have grown to the size of an additional public budget.

37. Even where government spending is widely accepted, as in the health sector, the results remain problematic. Almost all of Japan’s hospitals are technically bankrupt because tightly regulated insurance payments do not cover their costs. To keep the hospitals operational, local governments have to bail them out at the end of each fiscal year, and then ask the central government for additional transfers to cover their spending. The hospitals are unable to plan ahead and invest in new services or specific community needs. Costly pediatrics, for example, have almost ceased to exist at many hospitals; many effective medicines remain out of reach; and hospitals keep their patients waiting in lengthy queues, or hospitalize them for as long as possible to increase much-needed fees.

38. New and often larger service operations (in retail, wholesale, logistics, and so on) are usually run by younger workers and often threaten older outlets, which usually sustain the lifestyles of older people. Here again the government feels stretched between creating opportunities for greater efficiency, which is necessary to support the young and the sustainability of the aging society in the long term, and protecting aging structures so that the older generation remain in business for longer. In Japan’s aging society, actually both are needed; the status quo, however, keeps the young in unproductive or crisis prone lines of business and the old afloat only on credit.

39. Bureaucracy is widely regarded as exceptionally powerful and reaches into many areas of life. Japan is mired in red tape. Regulations are inflexible and are rarely reviewed. The Japanese governance tends to favor the status quo and prevents sweeping reforms. Innovative domestic corporations often run into trouble when they want to do differently, beyond exploiting minor (legal) loopholes. Foreigners regularly run into trouble when trying to contact ministries for information or evaluation after setting up operations. They often trigger cumbersome reviews of their operations usually not imposed on Japanese companies (because they do not ask and remain off the radar). A typical Japanese company, for example, runs the risk of an auditing by the tax office about every 50 years, a foreign company, asking for advice, has a good chance to be checked immediately. Instead of making sure that potentially survival-threatening law suits do not occur, and instead of using government (information) services as a hedge against legal problems, it seems smarter in Japan to learn about the rules of the game from other sources and to keep the government at arm’s length. If things go wrong, a serious, often public apology and a comparatively mild fine will often be sufficient. If things go seriously wrong, however, help is in short supply.

40. Beyond forking out supplementary budgets, major policy initiatives remain fairly unlikely. Public spending has reached its limits, while supply-side, cost-cutting reforms have become unpopular and would not be effective during a crisis. It seems that the lawmakers of both major parties, the LDP and the DPJ, are unable to deliver policy initiatives that could break the ice. The LDP’s traditional role was to distribute income from the growth centers in Tokyo, Osaka, and Nagoya to the regions, and not to force economic policy initiatives and major reforms on the public. Economic policy was drafted by the bureaucracy, especially the Ministry of Finance and the Bank of Japan (BOJ). For decades, therefore, Japanese lawmakers were able to handle policy as a kind of family business that had matured into second or third generations of inherited parliamentary seats (more than 50 percent ofLDP seats). Today, they seem to have grown entirely out of touch with the economy and powerless outside of their constituencies and factions. The bureaucracy, on the other hand, can only tweak the system, push for a tax cut here and a change in labor market regulations there, but of course has no powers for major reform or change. The result is a formidable policy deadlock, from top to bottom.

41. The main tools of economic policy, fiscal and monetary policy are not effective anymore. Today, the BOJ cannot provide an effective stimulus because its main role has become that of safeguarding the huge stock of monetary assets that Japan’s retiring employees have been saving. Furthermore, any policy that looked remotely inflationary would not only hurt retired consumers, but would also be interpreted as a bailout of the indebted government, which would push long term rates immediately to unsustainable highs.

42. The biggest problem is certainly fiscal policy. At a ratio of public debt to GDP of almost 200 percent, interest rate payments have become a potential problem, accounting for a quarter of the government’s budget, despite Japan’s extremely low interest rates. Should interest rates shoot up, the government would be scrambling to fill the hole.

43. The tax structure is another inherited problem. Up until the 1990s, the government obtained about 70 percent of its income from direct taxes on major corporations and their employees. The self-employed contributed only about 10 percent and about one third of smaller corporations did not pay any taxes. Smaller shops did not pay taxes, and when a value added tax was introduced in 1989 they were not required to pay them. The same applied to labor income, which was taxed and filed at major corporations, but much of the remaining workforce (about 50 percent) did not pay any taxes. Japan still has one of the smallest tax bases in the OECD and has traditionally taxed only a fairly small number of productive companies and employees. But this system no longer works. The corporate cash cows of the high-growth areas are reeling, while high income employees are retiring and the rest of thecountry continues to run on subsidies. Direct tax income is down to only around 50 percent, about 70 percent of corporations no longer pay taxes, and temporary employees often refuse to pay even obligatory social security contributions. The necessary consequence would be to reduce the corporate tax rate of 40 percent to much lower levels to provide some breathing room for the few productive and tax-paying corporations. Income taxes, at the same time, must be reduced in parallel with the exit of employees from the labor market by increasing the consumption tax. From an economic point of view, such reforms are almost unavoidable and have been discussed for a long time, but nobody seems able to do anything.