Budget deficits: A look at Japan

We are told that public sector deficits are a disaster and that we must all adopt "austerity" in order to reduce these, else the sky will fall. This appears to be a persuasive story, and it is strongly promoted by the IMF and other international financial bodies, albeit with a few reservations just lately. The prescriptions have been imposed without regard to the different circumstances in different places and at different times. They have been disastrous in real terms everywhere they have been followed, and it seems to me to be obvious that they do not work. In this context I was interested in this paper about Japan

http://www.inginvestment.com/idc/groups/co...&sub=Whitepaper

This has not been issued by some leftie group or by those who call themselves "heterodox" economists, who reject the neoclassical school overtly: it is a paper produced by ING Investment and they are a dutch financial institution engaged in banking and asset management on a global scale

There are a number of points in the paper which are worth thinking about.

It is first important to realise that Japan suffered a major economic collapse in 1991. No matter what anybody tells you, that was entirely predictable at the time. The triggers were not so clear, but the fact was that property prices in Japan in the 1980's were absurd. And naturally that bubble burst. The important point about Japan was that it has never recovered from that collapse, and economists talk of Japan's "lost decades" for that reason. So what we seem to have is a country which led the way in terms of bubble and burst: the story is quite similar to others we have seen more recently, though there are also significant differences, particularly in Japan's resistance to "inward investment"; immigration; and imports.

What this paper shows, however, is that Japan has chosen a different path to dealing with these problems. And while it is true that they have suffered some decline in employment and real wages; and have had low growth for 20 years, some of the policies they have adopted are a direct test of the theories which underpin the austerity story. The results are not what we are told will happen if a country does not adopt that narrative

1. Japan has run government deficits since the mid 1990's. They grew until 2001 and then declined until the 2008 recession, when they climbed again. These are not trivial deficits: in 2001 the government debt to GDP ratio was 120%. That is a level which is said to be completely unsustainable when we are discussing Greece or other periripheral countries in the EU: and is one of the main reasons for the attack on the people of those countries.

The paper says

It goes on to say that those same deficits have not revived growth, and suggests that that is due to the use made of the deficit spending: although government spending increased as a share of GDP government investment fell in the same terms.

What seems to be obvious is that the deficit did not lead to bankruptcy, as we are told it must: and so the story of the current orthodoxy appears to be challenged

2. One reason we are told that large deficits will lead to bankruptcy is the effect on government debt of the high interest rate which has to be paid to finance those deficits. According to the mainstream theory, risk of default is perceived as higher if there is high deficit: and that means that lenders demand a greater return on their money. This is said to be inevitable.


The author believes this is because Japan is a sovereign state. It issues debt in its own currency. It controls interest rates through the central bank. Most of its debt is held by domestic financial institutions and so the footloose speculators have little impact. In short, the government and the central bank can control the cost of borrowing if they choose: always supposing they are in fact sovereign. The problem for countries like Greece is that they are not: and that is another reason for believing that membership of the eurozone is a thoroughly bad idea while the ECB etc are wedded to mainstream theory and do not act as a proper central bank for all the members

3. Another justification for austerity, much discussed in this country, is that if a country does not cut its deficit the ratings agencies will downgrade their credit rating: and once again this means that the cost of borrowing will rise and the sky will fall


I have asked before why we should listen to these bodies, given their appalling record on assessing risk in the sub prime market etc. It seems to me that they have nothing to offer at all in terms of expertise; they are paid by the people they are supposed to assess; and their whole business plan is the same as that adopted by the tailors who made the emperor's new clothes. What this particular outcome seems to show is that they are utterly irrelevant and can be safely ignored.


Again that ability depends on being sovereign: and the countries in the eurozone are not. But they could be if the ECB did act as a central bank. While it does not the ratings agencies may well be important: but only because the democratic governments have abdicated their power and responsibilities to the market. Certainly not a law of nature, as we are encouraged to believe. It is telling that the author notes that


In other words if the government keeps the yield low the private sector which holds the bonds does not get so much income. I wonder if these two facts could be related? I think we should be told!!

4. According to mainstream theory, high government debt underpinned by the issue of currency leads inevitably to inflation. And inflation gives them nightmares, for reasons which do not appear to be rational. Once again the Japanese experience does not support the theory and so I think they should all relax. We already know that since the 2008 crash there has been a great deal of currency issued in the form of quantitative easing, yet inflation is not rampant. The response is that we will be sorry when it inevitably does come, as it must on the basis of theory. Or that all bets are off at the "zero lower bound" (which really amounts to an admission that the theory does not work, so far as I an tell) I am inclined to cross the bridge of hyper inflation when we come to it: or at least when we can see the river in the distance. That view is also reinforce by Japan's experience:


Far from seeing increased inflation due to an increase in the money supply, Japan has seen the opposite. Since 2000 core consumer prices have fallen while the monetary base has risen in 9 of the 12 years; and the rate of inflation has fallen over the same period

I don't think so. It is quite hard to get to grips with this stuff so do not take what I say as necessarily correct.

I think that part of the problem is that we tend to read about these things as if they are a) real and b: stand alone.

Inflation is defined, at least some of the time, as a general rise in the price of goods and services over time. That is not in itself very easy to measure, because different measures of it give different results. So it is open to error, and to honest disagreement, and to manipulation, even in discussing what the rate of inflation actually is. That is then compounded when discussing what it actually means.

After that there are other questions about whether inflation is a good or a bad thing and why that might be: and there are also said to be different kinds of inflation (which are really related to what we think of as the causes).

Imagine that you earn £20 per year and the cost of everything you buy is also £20. If in year 2 you earn £40, and the cost of those same things you buy is also £40 there has been 100% inflation: in theory that is the case if inflation is said to be the price of goods and services. But for you there has been no inflation in practice, because in both years you buy the same things and you spend all your money. From this it can be seen that inflation does not matter: not at all. It is mere accountancy with no effect in the real world.

But in that same real world it does matter: because for some reason that perfect alignment does not happen. For some people, at least, the things they buy will go up to £40, but their earnings/income will not rise by the same amount. If you are one of them you will have to buy less. This is often described as a fall in the value of your money: but it isn't, so far as I can see: it is a fall in the value of your work.( Obviously some people do not work, and they get their income in some other way: but if that income goes down they will still not be able to buy so much.)Money, it seems to me, is only a tape measure, if viewed in this way. What matters is that some things have gone up and others have not gone up so much: whether what does not go up is wages, or rents, or whatever other way you get your share, you are worse off if it is your share which does not keep pace: so functionally workers and rentiers and benefits recipients are all in the same boat. They are all fighting to maintain or improve their share of the real output (that is, stuff). In that scenario the prices have gone up, and the income of at least some of the people has not gone up so much: but since the prices have gone up somebody is getting the surplus, and so somebody has won the fight to increase their share: and somebody has lost.

This, I think, is what is meant by two different kinds of inflation respectively called wage inflation: and cost inflation. In wage inflation the idea is that the workers succeed in increasing their remuneration. In the scenario I have just outlined that could mean that shareholders or employers have a corresponding decrease: but that is not what happens. What happens, insofar as it can be managed, is that prices go up so that profit is maintained. And this is obviously the workers' fault, and not the fault of those who refuse to see a reduction in their share.

Cost inflation is when the price of some input other than labour goes up: so for example the increase in the price of oil in the early 1970's increased costs of production across most sectors: and that led to prices going up. That would have been a consequence no matter what happened to profits and to wages, if you assume that there was some sort of reasonable balance between all those groups before the huge hike in one of the costs of production.

As we have seen in other threads, the dispute is then about what is reasonable behaviour in face of these different kinds of pressure. The conventional story is that in response to rising prices the workforce did not accept a reduction in their share and so wage inflation added to the cost inflation and it was all downhill from there. Again it was the workers' fault. That profits fell, then quickly recovered, is neither here not there in that narrative. Twas ever thus.

In face of the hike in inflation predicated on the oil price rise in those years there was another phenomenon, which is generally called "stagflation". This is described as a situation in which the economy is not growing but inflation is.

Economic growth is defined as the increase in the amount of goods and services produced by an economy over time. But again it is measured in money. Consider again a person who is earning £20 per year and spending that same £20 on stuff in year one. This person is making 10 widgets a year to make his money. His employer is selling those 10 widgets for £5 each, and if there are no other costs he is making £30 profit. As we saw, if the wages and the prices double the following year nothing changes. The worker gets £40 and spends £40 for the same amount of stuff he consumes: and the employer sells widgets for £10 and makes £60 profit. But if the worker makes 20 widgets in the second year a number of things can happen. The employer can sell the widgets for £5 each and still make £60 profit. So this year the price of widgets has fallen relative to wages, and that means that more people can afford to buy a widget. Effectively the increase in production has produced a fall in the price: or to put it another way, a rise in productivity (economic growth) has offset some of the inflation. If our worker spent some of his remuneration on a widget,then in year one he spent a quarter of his income on a widget: in year two he spent an eighth: so he has effectively had a real increase in his wages.

There are alternatives. Let us imagine that the lower price means that 40 people want to buy a widget this year: but there are only 20 available. Now we have too much money chasing too few goods, and so the price will rise (this is not at all necessary, nor obvious to anyone but an economist: but that is what they say). So instead of selling his widgets at £5 the employer now sells them at £7.50: and in this year, instead of making £60 profit he makes £110. The increase in productivity has still offset some of the inflation for the worker (though not so much): and it has offset the inflation for the employer too: he has increased his profit. The general inflation rate will also be lower, because the price of widgets has fallen and inflation is the sum of all the price changes in the economy: so if one falls it will bring it down below what it would be, if everything else rises by 100%.

The employer could also maintain the price at £10: in that case he will sell 20 widgets for £200 and make £160 profit: the worker will have no benefit at all, but he will not lose. Economic growth will increase by more (because it is measured in money) and inflation will be unaffected at 100%

And there is a shortage of widgets.

In year 3 the employer will want to make more widgets because of that shortage. Ideally he will spend some of the increased profit to help him to do that: so he will perhaps employ another worker, or buy a better machine for making widgets, or reorganise his production so that he gets more widgets for the same input. Whatever he does he will produce more widgets, and what we are told is that he will do this until he gets the same price for a widget as it costs to produce one.

The difference here is between those who think that the supply side (making widgets) is what drives the economy: and those who think the demand side is the crucial thing. According to the monetarists, as far as I can follow their logic, inflation happens because there is too much money about. Too much money is defined as more money than there are goods, and so what you need to do is increase production so that there is plenty of stuff: then prices will fall to the minimum, on the basis of the mechanism of producing till you cannot sell at more than the cost of production; and inflation will wink out of existence like socks do in my washing machine. While you are getting to that state, however, you have to ensure that there is no increase in the money. In year one above, the worker had £20, the employer had £30, so the total supply of money was £50. In year two it was £100. The supply of money doubled and that allowed the price to double. According to the monetarists all money comes from government: so if the government just refused to print any more money year two inflation could not happen. As we saw, nothing changed except the amount of money, so the simple solution is to hold that steady, then inflation will disappear. As you say, I think that does not work because the basic premise is wrong: all money does not come from government: the banks lend what they do not have. Ultimately that does have to be covered by issued currency: but since the banks are too big to fail the option of just refusing to make any more is not on the table. Monetarism of that sort is not much talked about now, though it was fashionable in the early 80's. But monetary policy is still seen as the main mechanism for controlling the economy, and inflation targetting is the way to do it. So central banks use interest rates and asset purchases and QE and all of that to try to control the amount of money in the economy.

The reason that I do not think that credit creation by the banks is the cause of inflation, as your question suggests, is this: for inflation to happen there has to be too much money AND too few goods. This is because they say that price is set by the interaction of supply and demand: though that is a truly mysterious process in itself. You can have as much money as you like sitting in a vault or on a computer: if it is not trying to buy stuff it cannot be demand. If there is no demand price will not rise, by virtue of the theory itself.

So far as I can see this idea that people will continue making widgets until the costs equal the price, and there is no profit, is ridiculous, for the simple reason that not everyone wants a widget. You run out of demand long before you hit that point. People will not make widgets if they cannot sell them, no matter how low the costs of production. Any cost is a loss in that situation and you break even by cutting the costs to nil: which you do by not making widgets. Once again it is not about money: it is about stuff.

http://bilbo.economicoutlook.net/blog/?p=22121

It seems that the post above did not really answer the question: but the link does, I think