TCS Daily

Japan's Recovery Is Fragile

By Christopher Lingle - December 20, 2005 12:00 AM

Were the consequences not so dire, the spectacle might be amusing. Over much of the past 15 years, Japanese officials and market analysts have heralded the emergence of economic data indicating the end to a persistent period of slow growth. In a few weeks or months and sometimes days, new data forces a reversal, accompanied by explanations for the continuing slump that seems never to go away.

The latest cause for optimism is the preliminary July-September quarterly results that indicate an expansion in GDP by 0.4 percent from the previous quarter, or 1.7 at the annualized rate. This marked the fourth consecutive quarter of positive growth, albeit at a slower pace during the April-June period of 3.3 percent on an annual basis.

The truth is that Japan's economy remains in a deflationary recession because insolvent banks and corporations were kept alive after the bubble burst in the late 1980s by deficit spending and the Bank of Japan's cheap credit. Despite massive fiscal deficits and ultra-loose monetary policy, Japan's per capita GDP has only grown by 0.6 percent since 1990. After its impressive performance as Asia's first "miracle" economy, its long-term growth potential is unlikely to exceed 2.5 percent.

Certainly, there is some good news. There is less excess debt, reduced excess capacity and unemployment has been easing. Lower unit labor costs have allowed rising profitability and improved global competitiveness in some sectors. And there has been a substantial unwinding of the crossholding of shares by banks and corporations and the shareholdings have to be registered according to current market values.

But much of this good news overlooks that damaging effects of the "tax reforms" that are on the cards. A Tax Commission has urged that taxes be raised or reductions that were granted earlier on be eliminated. This includes abolishing half of the flat-rate tax cuts for national and local income taxes in 2006 while the rest are expected to meet the same fate in 2007. There would also be increases in individual social-security contributions that could increase the burden on households by up to 3 trillion yen.

The tax commission also suggested raising consumption taxes. Of course, the increased burden of higher consumption taxes will fall heavily on those with lower incomes. As it is, Japan's indirect taxes are already at 43 percent. Similar rates in the US are 7.5 percent.

In 2003 the total burden of taxes and social welfare costs imposed on citizens was over 36 percent of GDP. Factoring in fiscal deficits raised the burden ratio to over 47 percent of total income. This compares unfavorably with the average per capita tax burden of 28 percent for all member countries of the OECD.

With Japan's low economic growth, it is unlikely that increases in income will be high enough to offset increases in taxes and social security obligations. This means that more than what is given with one hand will be taken away by the other.

This higher burden is the "reward" to the taxpayer for sitting back while the LDP bought political support with its wild frenzy of deficit spending under the guise of economic stimulation. But the only conspicuous economic effect of all the fiscal pump-priming is that Japan's debt-to-GDP ratio rose from 60 percent in 1990 to nearly 120 percent in 1999. Then it was at least 140 percent during 2000 and is now close to 151 percent. Presently, it is about twice as large as the same ratio for the US and Germany, and it continues to grow in both absolute and relative size.

At the heart of Japan's problems are its corporatist politics and its industrial structure. These were designed to avoid the adjustments required by the vagaries of market impulses that can lead to corporate and banking failures. Despite some changes and reforms, these arrangements still haunt the economy and hold it back.

While Japan crept towards needed changes, the 1990s became widely regarded as the "lost decade" for Japan's economy. Unfortunately, there is little indication for optimism about recovery during the first 10 years of the new millennium. That would mean a cycle of 20 mostly bad years after the bursting of the bubble.

To set right Japan's low levels of consumption expenditures, lagging corporate investment and wobbly financial system is not about monetary policy. It is about sorting out microeconomic problems that require more liquidations, bankruptcies and layoffs before a full recovery can occur.

Japan's leaders must make bold moves to loosen the grip of the current deflationary recession or this era may be remembered as when a full generation of Japanese lost hope for their future. But this also means that they must understand that the deflationary pressures are caused by the real side of the industrial structure. Japan's deflation is not a matter of insufficient liquidity or spending as is evident in the fact that super-loose monetary policy and massive deficit spending have not solved the problems.

A better way forward for Japan would be to reduce regulations and implement permanent cuts in tax rates. With income in the hands of businesses and consumers, there can be a sustained expansion through higher investment that provides the basis for permanent increases in household consumption. Then there can be a sustained economic recovery that might give some hope to Japan's youth.

Christopher Lingle is Senior Fellow at the Centre for Civil Society in New Delhi and Visiting Professor of Economics at Universidad Francisco Marroquin.


TCS Daily Archives