It is likely that the Japanese economy will continue to shrink in fiscal year 1998, for the second consecutive year, by more than 2 percent from the previous year. The woes of the economy stem from various factors, the most important of which is that individuals and enterprises are worried about the strong uncertainties toward the future course of the economy; too many unsolved problems lay ahead. To stop the vicious circle of economic downturn and to bring the growth path into a recovery track, an environment where people are able to concentrate on consumption and investment with confidence based on their optimal choices in the future must be established. "The expected rate of economic growth"among households and enterprises should be restored as soon as possible, before the recent economic stimulus package of approximately 27 trillion yen brings about its full economic effects.
The Economic Strategy Council has examined the following macroeconomic issues:
(1) What is the potential growth rate of the Japanese economy in the medium and long run?Furthermore, such issues are being investigated as the measures to restore fiscal"sustainability"by indicating medium and long-term projections of fiscal balances that are consistent with the desirable scenario of economic recovery.
(2) What would the recovery path look like, if the measures to revive the economy explained below are implemented?
(3) What kind of crisis scenarios would we have to cope with in the future?
The Economic Strategy Council has arrived at the following conclusions:
(1) The Japanese economy maintains a potential growth rate of slightly over 2 percent per annum;In this chapter, econometric analyses with a macroeconomic model were exercised, and the results of surveys collected from various experts and intellectuals were utilized (see note 1.)
(2) Once sufficient structural reforms are implemented, the Japanese economy should pick up after FY1999, and come back to the potential growth path of 2 percent in FY2001;
(3) The labor market may become unwound more rapidly than expected. If so, unemployment would inevitably rise temporarily. However, this situation should be seen positively as the best occasion for Japan; necessary measures will make the country "a new human resource enriched nation";
(4) It is crucial that the sustainability of fiscal balances should be restored to eliminate the fears of people and the market regarding the fiscal bankruptcy;
(5) While the economy should be guided to a self-supported recovery path through the bold implementation of structural reforms, all such policy efforts ought to be made, giving the priority to thorough expenditure cuts with the aim of a"small government"with due consideration of their effects on the economy, selling-off national property and using it better, and rationalization of tax bases.
1. Scenarios for Economic Recovery
(1) The Potential Growth Rate of the Japanese Economy
The contemporary Japanese economy has been surrounded by two"confidence crises": the increasing unrest surrounding the financial system, and declining expectations on economic prospects. However, we believe that the economy can recover a sufficient growth potential early, if people strengthen their expectations about the future. Implementing all structural reforms that aim toward a competitive society that thrives on global trends, and putting the bubble economy completely behind us are instrumental to enhance that movement.
Considering labor input, capital stock, and technological progress (total factor productivity), we conclude that the economy would still be able to grow by slightly over 2 percent per annum (see note 2). This potential growth rate of the economy has been supported by the results of the surveys collected from various experts and intellectuals.
The following are three reasons to judge that the potential growth rate will be at least 2 percent:
1) Labor input is unlikely to make a positive contribution because of the declining number of births;Some points are worth remembering regarding the magnitude of the potential growth rate.
2) Capital stock is expected to increase moderately as new areas receive significant investment and excess capital stock is eliminated;
3) Improved economic efficiency will lead to a rise in total factor productivity because implementation of economic reforms makes the allocation of labor force and capital more appropriate.
(2) Time Needed to Restore Potential Growth
On the one hand, the vicious circle of deflation must be avoided by expansionary macroeconomic policies for the economy to regain its potential growth rate of slightly over 2 percent. On the other hand, deflationary pressures will inevitably arise as the process of full settlement of the bubble economy progresses. The experiences of the United State and Sweden in the early 1990's with financial crises should be remembered. They recovered with credit contraction ending, about two years after massive public money had been injected.
The Economic Strategy Council judges, based on such lessons, that the most likely scenario is for the economy to come back to the potential growth path around FY2001. However, this scenario depends on two conditions: that the short-term economic policies are immediately implemented, and that various structural reforms, outlined in the chapters below, are carried out in a bold manner.
It is true that the magnitude of potential growth varies according to policies and economic environment. But, under the assumption of the potential growth rate of at least 2 percent, the Economic Strategy Council considers the output gap and the targets of macroeconomic policies in the following way.
If the output gap reaches 20 to 30 trillion yen according to an estimate of the maximum supply capacity, then a large demand-creating package would be advocated to close that gap immediately back to the 2 percent growth path. However, the existing capital stock includes many non-performing assets (bad capital stock) such as obsolete business machinery and properties generating no money as a result of the proliferation of speculative bubbles, and their ultimate bursting. Therefore, while the bad loans should be disposed of, policies ought to be aimed simultaneously toward facilitating the adjustment and elimination of such overly equipped capital stock.
With this argument in mind, it is important to characterize the coming two years as"the most intensive settlement period of the bubble economy,"during which the inactive assets of financial institutions and non-financial corporations should be disposed of seriously (concrete measures are described in Chapters 3 and 4.) The aims of the macroeconomic policies ought to be limited to avoiding the risk of falling into a vicious circle of deflation.
(3) Three Scenarios
Three scenarios for the future economy are examined concerning different growth paths for economic recovery. Among these, two of them--which oppose each other in terms of the success of structural reforms--are:"a scenario of stagnation"that delays structural reforms;"a scenario of reviving economy"that implements them quickly and thoroughly.
(A scenario of stagnation)
If the current inefficient structure of the economy is kept intact, with insufficient implementation of structural reforms, the Japanese economy is doomed to long-term stagnation. Under this scenario, private consumption and business investment stagnate heavily as the"the expected rate of economic growth"among households and enterprises fails to recover. Even the recent economic package fails to boost private demand on a sustainable basis. If this scenario comes true, the average economic growth rate over several years after FY1999 would be far below 1 percent per annum, risking the possibility of a rapid rise in unemployment (figure 1, scenario of stagnation.)
(A scenario of reviving economy)
To eliminate the above scenario, we must become determined to implement structural reforms at once. When the comprehensive economic reforms recommended below are fully executed, it is expected that the Japanese economy would proceed to a path toward economic revival (figure 1, scenario of reviving economy.) That is, after a severe drop in FY1998, the economy would head for recovery, and after FY1999 the economic packages to date will steadily begin to take effect. Even so, the strength of recovery for the first two years would be modest because the complete settlement of the bubble economy, including the disposal of bad loans, necessarily accompanies a significant dampening effect. In FY2001, the economy is projected to recover its potential growth rate.
Although there are many uncertainties, one scenario for recovery will be described below.
Because FY1999 and FY2000 are the period of complete settlement of the bubble economy, the balance-sheet adjustment must be steadily tackled. Therefore, rapid recovery can hardly be expected during this period. It should be noted that deflationary pressure may strengthen in the short run. The government must take full responsibility for macroeconomic policies. It is only after this process that the economy may embark on a path of real recovery.
When the complete settlement of the bubble economy and the various structural reforms lead to expectation of higher economic growth, business investment is likely to fully rebound. At the same time, recovery in private consumption supported by rising household income will help the economy back to the potential growth path around FY2001.
The unemployment rate would rise slightly until FY2001 as the output gap widens. After that, it might decline moderately as the economy gets back to its potential. Even if this is the case, it should be noted that a remarkable decline well below the current level is unlikely. This is because there is a possibility of labor shedding as enterprises face excess employment, and because mismatches between labor demand and supply continue due to changes in industrial structures and technological progress.
Although the structural reforms may have some negative effects in the short run, they will help economic revitalization in the medium run. It is necessary that both employers and employees deal with this situation positively. The government needs to make efforts toward broadening the safety net for unemployment. At the same time, it should provide with sufficient vocational training and human resource development whereby incentives of workers are highly stimulated. Now is the best time to build "a new human resource enriched nation" (concrete measures are described in Chapter 2).
(Scenarios for crises)
In addition to the above scenarios, there are three possible scenarios for crises, although they are less likely to occur. It is critical to avoid them by any means necessary.
First, the risk of a vicious circle of deflation.
A vicious circle may be triggered so that worsening corporate profits caused by declining prices under economic stagnation dampen wages, reduce private consumption, and slow investment. Although the recent economic package is thought to reduce to a significant extent the possibility of this happening, it is necessary to continue monitoring the situation closely.
Second, the risk of an overall financial crisis.
If the soundness of financial institutions is not restored by April 2001, when the pay-off is placed to failed banks, the possibility that a large sum of money shifts away from ailing banks some time before that date exists. If so, a fear would arise that the authorities could not control the market, resulting in a grave financial crisis. Financial institutions are required to utilize fully the recent public money of 25 trillion yen for capital injection, and to implement immediately drastic restructuring and bold management for better profitability. All these will help the financial market to stabilize.
Third, an external risk of a sudden change of overseas economies like that of the United States.
Furthermore, the problems of year 2000 in computers (the so-called Y2K problem) should be well prepared by the government and people by themselves. The Y2K problem will not only impede the functioning of computer systems in companies and public offices, it may also cause serious problems to daily life by the malfunctioning of embedded micro-chips, the replacement of which is said to be almost impossible.
2. Government Fiscal Balances in the Medium and Long Run: a Road Map for Sustainability
(1) Importance of Eliminating Fears of People and the Market Regarding Fiscal Worsening
Japan's fiscal deficits are projected to rise to nearly 10 percent of nominal GDP in FY1998, which is the worst level among the industrialized counties. Contributing factors are the implementation of both economic stimulus packages so far totaling 76 trillion yen and the very recent one of 27 trillion yen to cope with the worsened economic environment brought on by the burst of the bubble, and the rapid decline of tax revenues in the central and local governments under the shrinking economy. As a result, people are worrying about future tax hikes, and the market takes into consideration the risk of interest rate rises caused by the oversupply in the bond market. As a matter of fact, the financial market has given a warning against the future bankruptcy of the government, as is evidenced by the grade cut of Japanese government bonds and the rise in long-term interest rates.
It is natural to freeze the Fiscal Structure Reform Law for the moment to stop the acceleration of the economic downturn. However, if the fiscal worsening is left untouched for a longer period, the distrust of the Japanese economy will continue. This situation would inevitably increase the risk of a sharp rise in domestic interest rates and a rapid outflow of capital abroad, which will damage the soundness of the future economy of Japan.
To be sure, it is not easy to improve the fiscal balances in the short run, because the magnitude of deficits on a flow basis has become extraordinary as the result of increased expenditures to date, and because outstanding debts have risen enormously. However, it is very important to improve the pessimistic consumer sentiments and to eliminate the fear of rising interest rates by the market. To this end, a clear road map for a better fiscal situation should be revealed immediately.
(2) Possible Fiscal Crisis If Structural Reforms Are Delayed
If a scenario of stagnation should come true, the fiscal balances (the sum of the central and local governments, excluding social security funds) would be estimated to worsen to a truly critical level as a result of delayed structural reforms (figure 2). Namely, the ratio of government deficits to GDP, which is around 10 percent in FY1998, would remain high for a decade with no noticeable improvements in sight. As a result, the ratio of government long-term debt to GDP would increase monotonically from about 110 percent in FY1998 to about 200 percent in a decade. Even in the scenario of reviving economy the ratio of long-term debts to GDP keeps rising, though the yearly fiscal balance improves slightly because of an increase in tax revenue.
The fiscal situation could be called non-sustainable if the economy fails to revive and fundamental reforms are postponed. The revival should only follow the "scenario of reviving the economy"which fosters strong economic recovery through structural reforms. Only after this scenario comes true should measures to reduce the fiscal deficits fundamentally be taken. All these policies combined will open the environment for sustainable economic development in Japan.
(3) A Road Map for Restoring Sustainability
In theory, the conditions to restore the sustainability of fiscal balances are twofold:
1) Deficits in the primary balance--the fiscal balance excluding interest payments--should be eliminated as soon as possible;The primary balance at present is in deficit slightly over 6 percent of nominal GDP, or more than 30 trillion yen in FY1998. This means that maximum efforts to restore the balance are required. In addition to securing tax revenue increases with the recovery of economic growth, additional measures may be necessary in the from of either spending cuts or tax hikes (or both). The example of the United States in the 1980's, when it suffered from twin deficits, is illustrative. It attained two goals of economic revitalization and fiscal deficit reduction simultaneously, mainly because it implemented drastic deficit reduction measures under the 1993 Omnibus Budget Reconciliation Act (OBRA 1993) on top of the high economic growth brought about by economic revitalization through deregulation.
2) Nominal GDP growth should be bigger than nominal interest rates.
1) Excessive hikes in interest rates driven by the market should be avoided by setting a priority direction for fiscal soundness;The Economic Strategy Council proposes five recommendations to restore fiscal sustainability:
2) Monetary policy should remain loosened for the moment to offset deflationary effects generated by measures to improve fiscal deficits.
When these measures to cut fiscal deficits are executed, the following should be kept in mind.
First, there is a risk of rebounding fiscal deficits through consequent economic recession if expenditure cuts and tax hikes should be implemented in an across-the-board and dogmatic way, neglecting economic trends.
Second, taking into account the above risk, the most important point on deficit reduction is that the economy should be geared into a self-supporting growth path by implementing drastic structural reforms. During this process, slimming the public sector and streamlining administration are essential.
Third, restructuring the public sector (concrete measures are elaborated in Chapter 2) should contribute to re-energizing the economy through making resource allocation more efficient and expanding new growth opportunities in the private sector.
Based on these considerations, the strategic steps needed for economic revival, and that are consistent with economic conditions in the next decade, can be designed in three stages:
Intensive settlement of the bubble economy (around FY1999-2000)
Fiscal and monetary policies must give highest priority to economic recovery and stabilization of the financial system. Structural reforms are to be implemented immediately, and safety nets must be provided. Examples of reforms are the complete clearing of the legacy of the bubble economy, and industrial revitalization, including development of human resources and intellectual bases.
Return to a growth path and economic rehabilitation (around FY2001-2002)
The fiscal policy would shift to neutral to economic growth after closely ascertaining a shift of the economy toward a self-supported growth path. Monetary policy should remain eased. Structural reforms recommended in this report should be carried out in full.
Full-fledged economic revival through fiscal consolidation and structural reforms (around FY2003-)
A medium-term program for fiscal consolidation should be steadily put into effect with real structural reforms in place. The primary balance of the government should be equalized in around 10 years, paying close attention to economic conditions, which should be on a self-supported growth path. Monetary policy would shift to neutral.
Regardless of these three stages, such reforms as administrative reform, realization of small government through further deregulation, establishment of local sovereignty, fundamental reform of taxation, reforms of education, judicial system, and social security system must be implemented as soon as possible.
The Economic Strategy Council concludes that the goal of restoring fiscal sustainability will be out of our reach unless these measures are implemented.