Richard Koo of Nomura is out with his latest note. The famed economist, who authored Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications, and The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, discusses Japan in depth in his note titled ‘Significance of weakness in emerging currencies’, Koo focuses on the land of the Rising Sun. Koo believes that the recent crisis in emerging markets markets a new era and that both the UK and the US face identical economies to which Japan faced in 1997. However, Koo believes that only one of those countries are implementing the right policy changes, in order to avoid two decades of Japan style stagflation. Additionally, Koo addresses the question of how (and whether Japan) can ever reduce its huge budget deficit. Below are some excerpts from the report issued on August 27th 2013.
Koo: Recent turmoil in emerging economies marks opening of tumultuous new era
Taiwan’s central bank has traditionally been quick to check on and if necessary restrict capital inflows, making its governor, Perng Fai-nan, an unpopular figure at certain foreign financial institutions. But it was only because the authorities kept such inflows in check that the Taiwanese economy escaped from the 1997 Asian currency crisis largely unscathed.
The lesson for emerging economies today is that in a world in which the industrialized economies are free to engage in quantitative easing at will, local authorities need to have the courage to restrict capital inflows or stop them altogether.
It should also be remembered that the recent rise in US interest rates occurred simply because Mr. Bernanke said the Fed was considering scaling back its bond purchases. If the Fed were to actually discontinue its purchases under QE3 or sell the bonds in its portfolio, the resulting increase in rates would likely be much larger.
In that sense, both the US and the emerging economies that will be affected as quantitative easing is wound down need to prepare themselves for a tumultuous era.
Koo: US tries to avoid Japan’s 1997 mistakes
The situation in Japan in 1997 was identical to that of the US today as it tries to avoid a fiscal cliff of its own.
The 10-year JGB was then yielding about 2.5%, not far off the 2.8% yield on the 10-year Treasury note today. The US private sector is also a net saver to the tune of 6.7% of GDP.
Fed Chairman Ben Bernanke and other US authorities who had studied Japan’s 1997 experience warned repeatedly against austerity policies and even coined the phrase “fiscal cliff” in an ultimately successful attempt to prevent the US from following in Japan’s footsteps.
Mr. Bernanke also went so far as to say that if the US economy did fall off the “cliff,” the Fed would be unable to address the resulting economic fallout. Thus the US appears to have learned from Japan’s experience and is trying not to repeat its mistakes.
Koo: UK ignores Japan’s 1997 experience and falls into double-dip recession
On the other side of the Atlantic, the Bank of England, headed by Mervyn King, completely ignored Japan’s experience and declared the UK economy could be supported with monetary accommodation in the event the Cameron government undertook deficit-reduction efforts. In the event, however, the UK economy fell into a double-dip recession despite the largest quantitative easing program in history.
At that time, the UK private sector was also a net saver to the tune of about 8% of GDP even with the BOE’s policy rate at a modern-day low of 0.5%. Mr. King may have subsequently recognized his error, as it was said that towards the end of his term this June he often spoke about the limitations of monetary policy.
Fiscal consolidation counterproductive when private sector is saving despite zero interest rates
Three years ago, interest rates and private savings trends in the US and the UK were very similar to those of Japan in 1997. The US authorities noted those similarities and moved to avoid repeating Japan’s mistakes, and as a result the US economy is now in the midst of a modest recovery. The UK, in contrast, fell into a double-dip recession because the authorities there ignored Japan’s experience. The lesson to be learned is clear.
It should be obvious from the experiences of Japan, the US, and the UK that the authorities must not pursue fiscal consolidation when private sector as a whole is saving in spite of zero interest rates.
Nor can the negative impact of fiscal consolidation be offset with monetary policy at such times: no matter how much policy is eased, money stays within the confines of the financial system because there are no willing borrowers in the private sector.
Koo: Fiscal error today would cause more damage than in 1997
I remember well the events of 1997. Foreign investors began selling their Japanese assets as soon as Prime Minister Hashimoto announced at the beginning of the year that the government would pursue a course of fiscal consolidation. This eventually grew into a powerful wave of selling referred to as “sell Japan.”
Japanese stocks and the yen fell together. Japanese banks were paralyzed as both the numerators and denominators of their capital ratios took heavy hits, and the resulting credit crunch further exacerbated the already severe economic damage.
As a consequence of this policy misstep, Japan’s fiscal deficit grew from ¥22trn in FY96 to ¥38trn in FY99, an increase of 72%, even as the government raised the consumption tax rate and cut spending. It took 10 years to bring the deficit back to its original level. The economic damage would be immense if Japan were to make a similar mistake today.
The fiscal deficit is currently running at ¥45trn, twice the ¥22trn figure of 1996, as a result of the global financial crisis. And the national debt now stands at 240% of GDP, also twice the level of 1997.
In summary, Koo says that government spending has supported the Japanese economy over the past 20 years and must continue to do so until households and businesses resume borrowing and spending.
Koo: Fiscal stimulus necessary if consumption tax is to be raised
Returning to the question of the consumption tax hike, there is no economic justification for raising the tax rate at a time when the private sector is saving money in spite of zero interest rates. But raising taxes now, when half the political responsibility for the decision can be passed on to the DPJ, is an attractive proposition for the LDP because it knows it must eventually hike the tax. The LDP also knows how difficult it is politically to raise the consumption tax. But if it is going to raise taxes for that reason, it needs to offset the negative economic impact with fiscal stimulus, as I argued in my last report.
A huge fiscal stimulus would not be required. When the consumption tax rate was raised in 1997, the government also decided to forgo a large supplementary budget, abolish the special tax credit, and increase the public’s share of social security costs in a fourpronged plan to reduce the deficit. Today all we have to deal with is the consumption tax hike.
In 1997, the combined impact of the tax increase and the other three measures was about ¥15trn. This time I estimate the cost of offsetting the impact of the tax hike alone would only be about half that amount. Since a 1ppt increase in the consumption tax is expected to raise additional tax revenues of ¥2.0–2.5trn, fiscal stimulus totaling ¥6.0– 7.5trn should be sufficient to compensate, ignoring any psychological factors coming from higher taxes.
Koo: How can Japanese national debt be reduced?
As might be expected in a country where raising the consumption tax rate by just 3ppt generates such heated debate, there is widespread concern over the question of how to address the national debt, which currently stands at 240% of GDP.
he debt has grown as large as it has for a very simple reason: neither the authorities nor the media understood that Japan was in a balance sheet recession. Consequently, the government did not provide sufficient fiscal stimulus in a sustained fashion, the only medicine that works during such recessions.
With the exception of Prime Minister Keizo Obuchi, who declared he would not try to stimulate the economy and reduce the fiscal deficit at the same time, and Prime Minister Taro Aso, who had to deal with the global financial crisis, all Japanese governments over the past decade and a half have tried to achieve both of these conflicting goals simultaneously, and that is why the recession has lasted as long as it has.
Japanese cabinets have repeatedly approved fiscal consolidation plans that have no hope of succeeding during a balance sheet recession, and governments have strictly followed those plans. But of course none of the deficit-reduction targets were achieved, and all they did was unnecessarily prolong the recession.
Koo: Japan should use Hong Kong as model for tax reforms
In short, Japan needs to act much more boldly than the US did under President Reagan. I think the tax system of Hong Kong, often said to be the most supply-side-oriented tax regime in the world, offers a model in this regard.
The highest income tax rate in Hong Kong is 17%, and the effective rate is 15% of net income. There is no capital gains tax, no tax on dividends, and no inheritance tax. Hong Kong has been able to achieve such rapid development despite so many challenges because this tax system offered maximum motivation to residents.
In addition, Hong Kong makes what is probably the most effective use of available land in the world, and as a result everything seems to work despite an extremely high population density. During the Reagan presidency there were some who argued the US should use Hong Kong’s tax code as a model. And even in the US, gifts from foreigners to US citizens are tax-free in an attempt to attract capital from overseas.
Koo: Policies needed to dramatically alter perceptions of Japan
If the Abe administration were to cap the income tax, corporate tax, inheritance tax, gift tax, and consumption tax rates at 15% or 20%, I suspect the entire world would wake up and take notice. The result would be a fundamental change in perceptions of Japan.
I think many Japanese would become more motivated, and the number of companies operating in the red would fall sharply as businesses eliminated much of the inefficient spending carried out simply to avoid paying taxes. The transfer of assets from the elderly, who own the majority of financial assets, to younger generations would accelerate.
These trends would not only lead to greater efficiency and productivity throughout the economy but would encourage foreigners to invest in Japan and prompt wealthy Japanese to bring their assets home.
Capping all of these taxes at 15% or 20% may seem beyond the realm of probability in a country that dislikes reform as much as Japan. But I think Japan’s current fiscal position warrants more discussion of similarly unorthodox approaches.