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Readers' Voices: Volume 4

Getting Japan's economy back on its feet

The economic situation in Japan leaves a lot to be desired. There is substantial under-utilisation of productive resources though it is difficult to know precisely how large is the output gap. The fiscal situation is dismal, with public debt rising rapidly and the threat that population ageing and a clean-up of the financial sector could add to debt build-up. At the same time, continued deflation in combination with the zero floor on nominal interest rates prevent real interest rates from providing necessary stimulus.

Going forward, fiscal consolidation cannot be postponed much longer. Such consolidation could add further to economic slack and deflationary impulses. The extent to which it will do so depends on the degree of Ricardian behaviour by households. Given the current fiscal situation, some degree of Ricardian behaviour seems likely but it may not be perfect. And Japan does not seem to have the pre-conditions that have characterised countries which in the past have enjoyed stimulatory fiscal contractions. For example, long bond rates are already low and cannot be lowered much further by any positive confidence effects of fiscal consolidation.

In circumstances where weak supply outstrips even weaker demand and where fiscal consolidation is likely, if anything, to add to demand weakness, the question arises what can be done to boost demand. While weaknesses in the banking system undoubtedly impair the monetary transmission mechanism, weak credit growth is probably mainly a demand phenomenon. Hence, cleaning up the banking sector is presumably a necessary component of getting Japan's economy going again but is unlikely to be a sufficient condition.

In his article "A weaker currency will make Japan stronger"( Financial Times, 2 April 2003), Kumiharu Shigehara argues that some demand stimulus could come from a lower yen exchange rate, though he sees this only as one element in a comprehensive strategy aimed at restoring Japan's economic fortunes.

A counter-argument against a lower yen in the current circumstances is that a re-distribution of global demand towards other regions that already have low inflation and nominal interest rates is a bit of a zero-sum game. However, this argument should probably not be exaggerated. If combined with unchanged nominal interest rates, depreciation in Japan would lead to lower real interest rates. At the same time, central banks in other parts of the OECD still have some margin of manoeuvre for allowing a fall in real interest rates to offset the demand effects of an appreciation of their currencies. Hence, a yen depreciation met with appropriate monetary policy response in other regions would be associated with some fall in world real interest rates and thereby be expansionary. When that is said, it would obviously have been easier for other central banks to respond to a substantial yen depreciation some years ago when inflation and interest rates were higher.

Mr. Shigehara also suggests that other Asian currencies should move at least some way in sympathy with the yen. This argument may be less clear. Asian economies are presumably best placed to benefit from any revival in Japan's domestic economy consequent on depreciation. And a depreciation of other Asian currencies vis--vis the dollar would make it more difficult to prevent an increase in US real interest rates given the current low level of nominal interest rates.

Likewise, it is not clear that that it would be productive to enact a wind-fall tax on profits generated by a large fall in the yen exchange rate. Even though it were to be applied, as suggested by Mr. Shigehara, only to Japan's big, (super-competitive) companies, such a tax could easily cut off part of the investment response to a lower yen. And the feed-through of higher profits into wage settlements may also be a healthy inflation-generating mechanism.

While yen depreciation —not diluted through movements in other Asian currencies and windfall taxes— may provide some helpful stimulus to the Japanese economy, the question is whether it is sufficient. This is partly because other central banks with already-low policy interest rates may have difficulties in offsetting the demand impacts of a large yen depreciation, limiting the magnitude of any helpful realignment. But it is also the case that Japan's is a fairly closed economy implying that there may be limits to the benefits of a more modest yen depreciation.

These considerations suggest that it might be useful to at least consider whether other instruments could be used to boost domestic demand. Apart from any re-jigging of public budgets in the direction of generating larger multiplier effects of the existing budget deficit, such instruments might comprise an un-orthodox use of the tax system to "artificially" reduce real after-tax interest rates. Experience from other countries — think of US mortgage interest relief or changes in capital income taxation in the Nordic countries — suggests that such tax incentives can have non-negligible effects. A tax on financial assets combined with a tax credit on debt should in principle have some of the same effects as a fall in nominal interest rates. While the effects are not guaranteed, Japan may not be in situation where one can afford to ignore potentially helpful policies.

The writer is a senior official of an international organization.