Japan delays fiscal adjustment at its peril

Against the backdrop of a Japanese economy that has now slid into yet another economic recession, Prime Minister Shinzo Abe is giving serious consideration to delaying the second value-added tax increase scheduled for next year. This would all too likely be a serious long-term economic policy mistake.

While such a delay in the scheduled tax increase might spare the Japanese economy from a further fiscal headwind in the immediate term, it would do so at the cost of further exacerbating Japan’s precarious public finances. That in turn would heighten the risk of a major Japanese sovereign debt crisis down the road. With that in mind, Abe should recognize that the Japanese space for fiscal policy maneuver has long since run out. Accordingly, his efforts to revive the Japanese economy should now focus on much-needed structural economic reform and on support for an even more aggressive monetary policy than that being presently pursued by the Bank of Japan.

{mosads}By any measure, Japan has by far the worst public finances among the world’s major industrialized economies. It still has a structural budget deficit of 7 percent of gross domestic product (GDP) and a gross public debt of 240 percent of GDP. According to the International Monetary Fund (IMF), over the next few years Japan will need at least 6.25 percentage points of GDP in fiscal adjustment if it is to place its public debt to GDP ratio on a firmly declining trajectory.

The need to restore public debt sustainability is all the more urgent in Japan’s case, considering that a rapidly aging population is resulting in a marked decline in its household savings rate. Over the past two decades, Japanese household savings has declined from as high as 12 percent of disposable income to a position of virtually no savings at present. Equally disturbing is the fact that there is every prospect that Japanese household savings will turn considerably negative over the next few years as its population continues to age at the fastest rate amongst the major industrialized countries.

In framing the appropriate economic policy response to Japan’s present economic circumstances, Japanese policymakers must recognize that in addition to the country’s deflation problem, it also has a long-term public finance sustainability problem. Couched in different terms, Japanese policymakers have to recognize the dangers of having a high level of public dissavings, soon to be accompanied by the prospect of large household sector dissavings as its aging population draws down its savings to finance its retirement.

While it is certainly tempting for Japan to delay fiscal adjustment for the sake of attaining its inflation objective, such delay only heightens the probability that Japan, like all too many countries before it, will have a full blown sovereign debt crisis down the road. Were that to occur, Japan might find that it will have a very much weaker currency and a very much higher inflation rate than that for which it is currently bargaining. For this reason, Japan might be best served by a combination of gradual budget consolidation, even more aggressive monetary policy easing than the Bank of Japan is presently pursuing, and much needed structural economic reform.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.