Japan and the Limits of Keynesianism

Japan's budget is in a truly terrifying state.  Reading about the government's behavior reminds me of the worst accounts of compulsive spenders on the verge of personal bankruptcy--a sort of "What the hell, we're screwed anyway, so let's not think about it and maybe go to Cabo for the weekend."  The budget's structural position is what is known technically to economists as "completely hosed"; borrowing now exceeds tax revenue, and debt service costs now eat up almost half of the tax revenue the government collects.  "Unsustainable" is too weak to describe the situation; I don't know how they're doing it now.

To be sure, a lot of people have been awaiting the inevitable collapse of the Japanese government's finances for the better part of a decade.  I know all the arguments for why this isn't such a big problem:  their debt is financed domestically, much of it through the postal savings system that pays little for its borrowing, and the Japanese are extremely patriotic about their nation's financial needs.  That may shift the locus of the problem, but it doesn't actually solve it; eventually, no matter how patriotic they are, the Japanese are going to want to use some of those savings to support themselves in their old age.  Some sort of crisis virtually has to ensue.

When I was starting out as a journalist, I frequently had Japan used to illustrate Adam Smith's precept that "there's a lot of ruin in a nation"; any time someone was tempted to get hysterical about government borrowing in America or elsewhere, someone else would inevitably point out that Japan's debt burden was well over 100% of GDP, and the country still hadn't collapsed.  But while there is a lot of ruin in a nation, there isn't actually an endless supply, and Japan may well be finally approaching the limits.

Felix Salmon views this as a symptom of a broader political failure:

The situation in Japan is particularly depressing because the country has no major ethnic or political rifts. Sure, there's political jostling, both within and between the parties. But it's nothing compared to the vitriol and mistrust that we see in the US, and somehow I can't imagine Greece-style riots in Japan either. But still the technocrats can't make any headway.

The lesson here, I think, is that it's very, very hard for a government to enact a serious fiscal adjustment unless and until the bond market forces its hand. The Brits are trying, of course -- and we'll see whether or not the coalition government can succeed. But as we saw with George W Bush, the fiscal rectitude of one administration can be more than wiped out during the course of the next.

Even now, with the attention of the world more concentrated on sovereign fiscal issues than ever, the Japanese government can still contrive to raise agricultural subsidies by 40% and send child-care payments soaring, including payments to families who don't need the money. It's even getting rid of highway tolls. Oh, and it's cutting the corporate tax rate.

From a bond-market perspective, this basically just means an ever-greater supply of JGBs: we're still a very long way from any real credit risk, given the political power of the owners of those bonds. But as a lesson in fiscal political economy, Japan is much more worrisome.

I see it a little bit differently: Japan has simply reached the limits of Keynesian policy in an economy which has never managed to jolt itself back up to a healthy rate of growth.  Demographics is obviously a big contributor to that slow growth, and there are a whole host of secondary factors one could nominate, but whatever the reason, they have now had two decades of anemic growth, which they have fitfully attempted to address with stimulus.  Maybe not enough stimulus, maybe badly designed, but they've certainly tried to follow the basic Keynesian playbook:  borrow money and spend it when times are bad, in the hopes that you can bring back growth.

But for Japan, at least, the growth has not materialized.  Few economists would advise undertaking a fiscal adjustment, on the scale that Japan requires, in the face of the current crisis.  The problem is, there hasn't been a good time for retrenchment in 20 years.  I can't blame the politicians for trying to restore some semblance of normal growth in the run-up to elections.  But at some point, they're going to have to cut back, whether or not it's a good time.

Matt Yglesias suggest that it's irrational to retrench ahead of the bond market, when what they ought to be doing is trying to have more economic growth, but their lack of economic growth really isn't for lack of trying.  I think every economist who has ever had an opinion on currency has been solicited, at one point or another, to come up with a plan for Japan, but they've all failed, either because the plans weren't politically feasible, or because the money supply simply stubbornly refused to inflate no matter how hard it was pumped.

Given the menu of actual policy options, it would probably be best for Japan to attempt fiscal adjustment now.  The earlier you deal with a fiscal problem, the smaller the problem is . . . and doing it in advance gives you rather more discretion about how and when the cuts are made, which gives everyone, espeically the people who are now dependent on the government, time to adjust.  But it's not hard to see why it hasn't.  Which of us would volunteer to be the guy who cuts pensions and farm subsidies while there's a recession on?