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Setting sun
National Review, July 20, 1998 by Alan Reynolds
The revival of the Japanese economy depends on fundamental tax and penalty reforms.
In March 1992, I wrote "Fear Japan's Feeble Economy" for the Wall Street Journal. That piece was ridiculed by industrial-policy enthusiasts such as Eamonn Fingleton of The Atlantic, who remained confident that Japan's economy would grow faster than ours. Since 1992, however, Japanese economic growth has averaged less than 1.3 per cent a year, and much of that has consisted of wasteful make-work projects.
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Until recently, news reports were still saying that Japan was "on the brink" of recession. By now, however, it is pretty obvious that Japan's economy has declined during four of the past five quarters. As of April, industrial production was down 6.2 per cent from a year before. Retail sales have been running about 8.5 per cent lower than a year ago. Numbers like this are beginning to raise concerns even among Japan's most ardent admirers. But attention to the immediate crisis is not enough. There are quick-fix policies that could probably shorten the recession, but they would do nothing to counteract the longer-term suffocation of Japan's economic vitality.
At a recent lecture at the Keidanren (the highly influential Federation of Economic Organizations) in Tokyo, I had the opportunity to become better acquainted with the way Japan's economic bureaucrats think. To my surprise, they still take seriously the sort of primitive Keynesian macroeconomics that dominated college textbooks in the early Sixties. They even practice the ancient alchemy of calculating "multipliers," and they talk about "planning" and "pump-priming."
All this might be quaint and endearing, except that it has provided handy excuses for politicians and central bankers who hope to avoid blame for past blunders and controversy about future plans. Policy options are artificially limited by archaic theories, in which the only things that seem to matter are budget deficits and interest rates. So, a whole series of prime ministers have wasted some $700 billion on public-works schemes since 1992. Imagine what could have happened if even a modest fraction of that money had been used to cut punitive tax rates on capital and skill.
Public works don't work. Taking money from taxpayer Smith to pay builder Jones doesn't "stimulate" anything. In fact, the net gain is less than nothing, because 1) public works keep labor and capital in Japan's notoriously unproductive construction sector, and 2) the added taxes required to pay interest on the added debt distort behavior in ways that retard economic progress.
No amount of government borrowing and spending will get Japan out of this mess, because a boom-bust monetary policy and a destructive tax policy created it in the first place.
In the late Eighties, U.S. officials became eager to talk the dollar down in a misguided attempt to lower our trade deficit. Their success led to a rising yen, which had the effect of holding down Japan's inflation, and particularly its industrial costs. Imports priced in dollars (such as oil) were getting cheaper in terms of yen, boosting Japanese profit margins. The rising yen also lured American investors into Japanese stocks and real estate, because even a small rise in the value of Japanese assets was greatly magnified when converted back into dollars. Meanwhile, the Bank of Japan was bankrolling this bubble with enthusiasm, increasing the flow of bank reserves and currency by more than 11 per cent a year from 1987 to 1989.
A couple of years later, the Ministry of Finance and Bank of Japan underwent a conversion; they became missionaries for austerity, eager to deflate the bubble they themselves had inflated. Tax and monetary policy was changed with the explicit aim of depressing the value of Japan's real estate and stocks. In 1989, Japan slapped a 26 per cent tax on stockholder capital gains or, alternatively, a 1 per cent tax on the value of stocks traded. In 1992, another new tax was levied on large landholders, with the aim of sinking the value of land. Since land was a major asset behind many stocks, that gave the stock market another downward shove. Meanwhile, the Bank of Japan shrank the monetary base by 2.8 per cent a year in 1991 and 1992, ensuring further deflation of asset values.
In 1998, the Bank of Japan finally began increasing bank reserves and currency, yet with little effect on the broad money supply, which is up only 43.8 per cent. This does not mean the central bank is impotent. Banks are fearful of bank runs, and so they want to hold more reserves than legally required. Households are fearful of banks, and so they are hoarding currency (home safes are selling well). What The Economist calls a "super-loose" policy is obviously not loose enough so long as prices of goods and assets are falling.
It is a dangerous myth that Japan's monetary policy is loose or impotent simply because interest rates are so low. To a businessman whose prices have been falling at a 5 per cent rate, Japan's 1.6 per cent prime rate feels like a rate of 6.6 per cent. Besides, monetary policy does not operate through interest rates alone. It also operates on liquidity and on future price expectations, and therefore on asset prices. If the Bank of Japan bought as many securities as necessary in order to prevent prices from falling, then numerous "bad loans" would become good, and deflated assets would begin to look like bargains. To the extent that the resulting improved investment prospects arrested the flight of capital from Japan, a non-deflationary monetary policy could even strengthen the yen (contrary to the predictions of most economists).
