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Japan’s economic fantasy

by Kevin Rafferty

HONG KONG — Belatedly, Japan’s leading politicians are waking from their coma and realizing that the country’s economy is in a massive mess hit by a triple whammy of low growth, heavy debts and an increasingly aging population.

Talk in the runup to Sunday’s Upper House elections is when and by how much to raise the 5-percent consumption tax. The good news is that there is a sort of Japanese-style consensus about the inevitability of doubling the tax. The bad news is that 10 percent is not going to be sufficient to close the government deficit or get on top of the debts.

The worse news is that the tax will have to go to at least 20 percent and maybe as high as 37 percent if Japan wants to escape the debt trap, according to economists who have looked closely at the government’s own figures.

The worst news of all is that Japan’s leading politicians are still living in a make-believe world of their own where hard economic facts and figures do not intrude.

Only one party is advocating an early rise, to 8 percent by 2012, in the consumption tax. Another party has a 2020 time horizon for the tax to go to 10 percent. Prime Minister Naoto Kan, having raised the specter of a Greek-style failure if Japan does not get to grips with its deficits and debts, has now backed away from setting a firm timetable for tackling them via a consumption tax increase.

To be fair, Kan has suggested a national debate over tax issues, but he needs to go further and launch a grand debate on the economy and society and how Japan can get out of the deep hole that its politicians and bureaucrats have dug. For years, dirty deals between bureaucrats and politicians, with the active compliance of construction companies, allowed massive spending on ugly but election-sweetening projects, like town halls, bridges, Shinkansen lines. Now the bill is coming due when Japan can least afford it.

The outline facts are clear. Japan’s government debts are the highest the world has ever seen, at 219 percent of gross domestic product, according to the International Monetary Fund. They have continued to rise as the economy has responded only sluggishly to government stimulus spending, and will rise more steeply as the rapidly aging population puts extra demands on health and welfare payments without a corresponding increase in income from taxes paid by a declining work force. Social security costs are rising by ¥1 trillion a year and account for ¥27.3 trillion or 30 percent of the budget.

Japan’s economy has been undergoing important structural changes with the decline in “lifetime employment” under which employees join a big company from school or university and stay for life, making them dedicated company men, promising them moderately well paid jobs and comfortable pensions in return for their loyalty.

Lifetime employment did not apply to everyone, but its gradual decline has had a knock-on effect throughout the economy and society, making people nervous and reducing Japan’s fabled household savings rate to U.S. levels, though the pot of savings is still huge.

The effects are only slowly filtering through because young people are tending to marry later and stay in the family home longer — which has only exacerbated the population crisis that will be felt in the next 20 to 50 years as Japan’s population declines from 126 million to 95 million.

In spite of Kan’s clarion call for action, the Japanese elite continues to live in an unreal world. Japan has been sheltered from the chill winds of international debt markets because 94 percent of government bonds are held by Japanese institutions at low interest rates. This is good for the government short-term, but the long-term price is that the big pension funds cannot earn enough to pay for the proper retirement of the increasingly elderly population. It does not help that the stock market is at about a quarter of its 1989 record high level.

But politicians continue to believe in magic. The former ruling Liberal Democratic Party is “targeting” that Japan’s growth will be 4 percent a year over the next three years. Kan’s Democratic Party of Japan forecasts 3 percent a year until 2020. They’re kidding themselves, say all respectable economists, pointing out that for the past 10 years even 2 percent growth has been unachievable.

On the LDP’s optimistic projections for growth, even if the consumption tax is raised to 10 percent next year and personnel costs at central and local governments are simultaneously slashed by 20 percent, by 2020 Japan’s budget will be ¥1.9 trillion in the red. Ministry of Finance officials are beginning to say that a 20 percent consumption tax is “inevitable.”

One of the most respected economists in Japan, Robert Feldman of Morgan Stanley MUFG, has just issued a devastating critique of the government’s fiscal management strategy, in which he accuses the government planners of sloppy economics.

The first of his damning five points is that “The basic calculations include an implicit assumption that there will be unspecified sources of demand other than fiscal spending and external demand to close the output gap over the next five years.” He adds, “The ‘fiscal control’ scenario advocated (by the strategy) is not based on model calculations. The exact policies to achieve this fiscal control scenario are not specified.” Feldman questions the “counter- historical assumption” that the planners have made in positing that the difference between the interest rate and the growth rate is zero.

Devastatingly, the economist says that the fiscal management strategy, “advocates a tax-and-spend strategy to close the fiscal gap. However, reasonable parameter values in a simple Keynesian model of the economy imply that the tax-and-spend approach would require tax/spending hikes of 16 percentage points of GDP in order to close even the 4 percent fiscal gap that the framework calculates. This is the equivalent to raising the consumption tax rate from 5 percent today to 37 percent.”

And that would devastate the economy. All is not lost — quite. Japan has forgotten that economic growth can essentially be raised in two ways — by a rise in population or growth in productivity. Restructuring and liberalization of the economy would yield productivity gains, though at the cost of unemployment, and key government allies have dug their heels in against restructuring. Allowing foreign workers in would be another solution, but faces fierce popular opposition.

Kan has one way out. The honest prime minister has to be honest with his people about the problems, put the issues and choices before them and stimulate a popular debate.

Kevin Rafferty is author of “Inside Japan’s Powerhouses,” a study of Japan Inc. and internationalization.