As the October deadline for raising Japan's value-added tax (VAT) draws closer, there is some expectation that Prime Minister Shinzo Abe might postpone the increase for fear of destabilizing fragile economic growth.
He would be wise to do so.
The Japanese economy has been performing quite well, but even a minor slowing would be painful. With the China-U.S. trade conflict impinging heavily on all Beijing's economic partners including Japan, this is a risky moment for a VAT shock.
While Japanese tax policy will not be formally on the agenda at the Group of 20 finance ministers' gathering in Fukuoka this weekend, officials are meeting as doubts are mounting over the global economy: the International Monetary Fund warned on June 5 that the U.S.-China trade conflict will cut global output by 0.5%
Japan's previous VAT hike, in April 2014, was universally blamed for undermining already-feeble growth in the country.
The current policy dilemma is sharper because of the current imbalance between monetary and fiscal policy, with the two arms of macroeconomics working in opposition.
Even without fiscal contraction from a VAT hike, the budget stance is already contractionary. The budget deficit has shrunk by 3% of gross domestic product since 2012 to 3.8% last year, and a further similar contraction is implied by the policy objective of balancing the budget by 2025.
Monetary policy, on the other hand, is actively expansionary, with both the policy rate and the bond rate at zero, supplemented by vigorous quantitative easing.
The VAT increase would exacerbate this macro-imbalance. The abnormally accommodating setting of monetary policy leaves no room for further monetary stimulus if the economy weakens after the VAT increase. Fiscal stimulus at that stage would be a politically embarrassing back-flip.
Why take the risk?
Those supporting the October VAT schedule point to the looming fiscal burden of Japan's aging population, giving urgency to the task of ensuring budget viability. The budget has been in continuous deficit throughout the "lost decades" since the early 1990s. As a result, public debt now equals 240% of GDP, more than twice the norm in advanced economies. Many see this as unsustainable, needing urgent action.
Could this dilemma be resolved by drawing on the current radical rethink of U.S. fiscal policy? America's recovery from the 2008 financial crisis was painfully slow. Leading economists such as Olivier Blanchard, former chief economist at the International Monetary Fund, and former U.S. Treasury secretary Larry Summers argue that the American economy is experiencing secular stagnation, bogged down by chronically weak investment and excessive saving. The economy has lost its mojo. In short, the United States now faces a problem familiar to Japan during the "lost decades" -- an era of limp growth.
For Summers and Blanchard, the answer is fiscal stimulus through budget deficits, sustained for however long is necessary. Blanchard has reinforced this argument by pointing out that, with interest rates well below nominal growth rates, modest budget deficits can be sustained without raising the ratio of public debt to GDP or risking a runaway debt burden.
The radical medicine being proposed for America may be applicable, too, in Japan. A new paper from Blanchard applies this argument to Japan, arguing that there is no pressing need to raise VAT.
But does this secular stagnation idea apply to Japan? Certainly, Japan has had the "lost decades" of low growth and its current pace of around 1% looks puny by global standards. But the Japanese labor force is declining by around half a million workers each year, so output-per-worker gives a better measure of performance. On this measure of growth, Japan is among the highest in the advanced economies of the OECD. What's the problem? Japan is doing fine considering its unique circumstances.
Blanchard disagrees. He cites the inability of the Bank of Japan to achieve its 2% inflation target as evidence that Japan is still mired in secular stagnation, disguised by the Bank of Japan's energetic monetary expansion. Despite a decade of zero interest rates and more quantitative easing than elsewhere, inflation is half the 2% target and not expected to reach this often-postponed objective for another three years.
Zero interest rates mean that monetary policy has reached the limit of its potency to support demand. At the same time, zero interest rates mean that fiscal policy can put aside the conventional economic wisdom embodied in the "golden rule" -- budgets should be in balance over the course of the cycle.
Instead, Blanchard shows that modest budget deficits -- 2-3% of GDP -- might be safely maintained until higher inflation indicates that the economy is operating at full potential. In Blanchard's words: "if aggregate demand needs to be sustained, it may be better to rely more on fiscal policy and less on monetary policy..... It may be better to be ready to increase the value-added tax rate when it is needed rather than to increase it now."
Japan itself provides the counter to the usual hand-wringing about deficits and debt. Three decades of deficits and a mountain of accumulated public debt is not only supported by financial markets, but has not put upward pressure on interest rates.
Blanchard gives a powerful caveat: deficits should be productively used. So, no more bridges-to-nowhere.
But since Japan's ratio of public investment to GDP has fallen from 9% to 5% over the past fifteen years, there should be room for output-enhancing projects -- and public services. Female participation in the workforce has increased significantly over recent years, but better child-care would encourage fertility and workforce participation. Augmented steady growth would provide more full-time, higher-skilled, better-paid jobs for women.
Prime Minister Abe has shown no inclination to allow further slippage in the October timetable for raising the VAT. It may be administratively too late to delay as many businesses have already made their preparations, and politically damaging to be seen to be hesitating.
Perhaps there is a way around the problem. The government could provide substantial fiscal stimulus to soften the transition to a higher VAT and to step back from the commitment to restore budget balance by 2025. The American radical rethink of fiscal policy might translate neatly into the Japanese environment.
Stephen Grenville is nonresident visiting fellow at the Lowy Institute in Sydney and former deputy governor of the Reserve Bank of Australia.