Beware fiscal consolidation

Much has been written in Indian newspapers of the danger and unsustainability of fiscal deficits, but little has been said about the risks of fiscal consolidation. It is therefore salutary to look at the economic effects of Japan's attempts to reverse its fiscal deficits.

A recent book Making Fiscal Policy in Japan (Oxford University Press, 2000) by Hiromitsu Ishi, the President and Professor at Hitotsubashi University, is very instructive. In order to see matters in the correct perspective, it will be necessary to look briefly at Japan's post-war economic history since the Fifties.

After initial settlement policies, Japan embarked on a growth induced recovery programme from 1955. The essentials of that policy were (1) a rapid growth of aggregate demand with low interest rates and an easy credit policy and (2) an export oriented policy to avoid the constraints of balance of payments shortages.

The Japanese were fortunate on both these aspects of policy for their proximity to Korea and Vietnam. America needed a reliable industrial support base for conducting their distant wars. However apart from this fortuitous piece of good fortune, an implicit principle of Japan's policy was "Stability should be readily sacrificed to growth".

The Japanese policy makers had one simple outstanding purpose and that was to catch-up with the West. In this pursuit, they achieved astonishing and now well known results throughout the Sixties. It is not my intention to enumerate individual aspects of their expansive policies except to state that by 1970, the Japanese economy had become the second largest in the world only next to the United States.

However, 1971 brought about the first serious hurdle to fast growth. The sudden sharp rise in oil prices was ominous. It was estimated that if the Japanese demand for oil continued to grow, there would have to be an unbroken chain of tankers extending from Ras Tanura to Yokohama, to satiate demand.

Clearly such levels of growth were unsustainable both physically and economically. Something had to give and President Nixon with characteristic American bullying, compelled Japan to revalue the yen in the expectation that this recessionary step would slow down Japan's export potential.

Throughout the period of rapid growth Japanese policy makers were able to avoid fiscal deficits, because the ratio of tax yields to GNP had maintained 20  per cent, which was the second fiscal rule that they had adopted.

In fact, growth through the Sixties had been so fast that to keep to a constant 20 per cent, the authorities could afford to make large tax reductions "in particular on individual and corporation income taxes".

However with the slow down of the Seventies, the first fiscal rule of balancing the budget had to be modified, and the authorities had to rely on financing the revenue-expenditure equilibrium by issuing bonds to finance shortfalls.

The Japanese have a policy of distinguishing between fiscal capital and current imbalances, by financing the former with construction bonds and the latter with national bonds. Until 1965 no national bonds had been issued. This was not as a consequence of tight monetary or fiscal policies, but a result of astounding growth rates during the phase of catching up with the West.

"However the balanced budget policy had to be altered with the passage of time."(Ishi, page 127). It became apparent that high effective demand could not be maintained with tax revenue alone. The government was forced to borrow. This was clearly not a popular policy with Japan's Ministry of Finance (MOF).

Like all finance ministries they were alarmed at the growing shortfalls that had to be financed by bond issues. Yet they were compelled to tolerate this state of affairs during the late Seventies and early Eighties.

But by 1985 they had had enough. A sharp correction in the fiscal deficit was introduced, and that was relatively successful because of the windfall tax revenue that came about as a result of large increases in nominal corporate and income profits, partly as a consequence of the boom in real estate and stock market prices.

In the reconstruction period after the war, Japanese banks had invested both in land and more actively in the stock market. They were therefore directly beneficiaries of rising prices, and indirectly they also benefited as the security of their loans to private clients improved. On private sector principles they were therefore willing lenders to entrepreneurial projects.

Something needs to be said particularly about the real estate boom which has subsequently been described as a 'bubble'. The characteristic that motivated the bubble is now thought to be a departure in nominal values from fundamental values.

Typically, the Emperor's Palace in the Marunouchi district of central Tokyo was valued at higher levels than the whole of California. This was thought to be the most dramatic example of an abandonment of fundamental values.

Yet there is nothing very precise or fundamental about real estate values. My recollection is that ever since 1960 Japanese land prices were startlingly high. At the time, this was attributed to the large population that had to live in the small coastal belt between Tokyo and Osaka. At any rate no one thought land prices were unusually high. It is only hindsight that that vision developed.

In any event, higher nominal incomes did wonders for fiscal consolidation. Tax revenues rose and a stringent MOF was able to curb expenditure. The only fly in the ointment was the fact that Japan could not raise interest rates without a storm of international protest based on the argument that they would attract too much footloose capital.

However, finally between May1989 and August 1990, the Bank of Japan increased the official discount rate five times from 2.5 per cent to 6 per cent.  Fiscal Consolidation was now complete.

What were the consequences? As is well known, the Japanese economy collapsed. Asset prices tumbled so that the banking system was riddled with loans against non-performing assets. Banks have been blamed for reckless lending, but my observation is that Japanese banks are like much of Japanese society, rather conservative.

The real cause of Japan's collapse was fiscal orthodoxy, which again was the end result of conservative thinking in the corridors of power.

Throughout the period of fast development in Japan, there has  been a continuous struggle between those who have sought to exploit fully Japan's industrial potential and those who have advocated sound finance.

The lesson to be learnt from Japan is that, if the initial step is taken to expand capacity through deficits, it is a fatal error to attempt a reversal of that policy by fiscal consolidation. The only solution is to assist the boom to continue and hope that time will slow it down.

Japan's post-war development is an admirable example of economic mistakes and their consequences. Perhaps it was a mistake for the country ever to embark on deficit financing after 1970; however those were the policies that enabled them to keep their growth rate at a level they had been accustomed to; what is certain is that the effort for fiscal consolidation in the late Eighties was a disaster. No amount of deficit financing now is able to wipe out the devastation caused by 'sound finance'.

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