Our 2014 exclusive interview with top economist Takatoshi Ito is as relevant today it was back then. It is essential reading for anyone wishing to understand Japan’s economic problems and how leading contender for the Bank of Japan Governorship might go about tackling them.
Prof. Ito was earlier short listed as a candidate to head Japan’s central bank, a role now occupied by Governor Kuroda. Instead, he was handpicked by Prime Minister Shinzo Abe to lead a task force that proposed reforms to Japan’s huge Government Pension Investment Fund. In January 2015 he moved to New York City to teach at Columbia University.
Below is the conversation which took place just before he moved to NYC:
SOLOMON: Ito-sensei, over the last quarter-century real GDP growth among the advanced economies has dramatically slowed to about 2% from their post WWII highs. Japan, for instance, enjoyed an average growth rate of 10% per year between 1950 and 1973. Would you not agree that a key problem today is that societies are unwilling to squarely face tough issues requiring the redraw of written and unwritten social contracts entered into when high growth prevailed? Consider for instance pensions schemes that were never designed for people to live much past 70 years of age.
PROF. ITO: Yes, that is especially true of Japan’s pension plan that assumes a 2% or higher growth rate, when the new normal potential growth rate is between .5 % and 1%.
When an economy is growing, governments can afford to give a generous pension to the first generation. As long as it continues to do so, the pension can be rolled over into ever bigger amounts in a perpetual Ponzi scheme. That was shown by Paul Samuelson back in the 50s. But when growth rates decline and population growth turns negative, the infinite Ponzi scheme ceases to work.
Then the government must (1) claw back the pensions of those already retired or (2) tell those nearing retirement that their pensions are smaller than promised or (3) tell young people paying into the system that they will not receive back the same amount they put in over their lifetimes. They had better enroll in a private pension scheme, in which case they are paying double.
The idea that productivity growth rates in western economies has come way down is the ‘secular stagnation all over hypothesis’, originally advanced by Alvin Hansen and recently popularized by U.S. Treasury Secretary Larry Summers. In Japan’s case, you need to separate the impact of demographics from the overall growth rate. Real productivity growth per worker hasn’t changed much here and is about the same as that in other advanced economies. Assuming Japan achieves an average 2% productivity growth rate per worker every year, you must subtract 1% to 1.5% off that figure as a result of population decline. It’s that subtraction that’s tough. Japan must pay for mounting debts caused by growing social entitlements and the national defense budget and so forth.
SOLOMON: Robert Alan Feldman, the managing director and chief economist at Morgan Stanley MUFG Securities, recently remarked that the consumption tax hike scheduled for October 2015 from 8% to 10% will be insufficient. Do you agree?
PROF. ITO: Of course 10% is not enough. That rise is a done deal unless something terrible happens between now and December. Between 2015 and 2020, further action is needed to achieve fiscal sustainability.
The medium-term plan is to close the nation’s primary balance (the fiscal balance less interest charges) by 2020. That would likely require either a 5% increase in the consumption tax from 10% to 15% with good economic growth or a hike in the consumption tax to 20% without a spurt of growth. It entirely depends on the growth rate and whether you can cut social entitlements. A big push for a further tax rise is probably needed after the Upper House general elections in 2016. Or if he is confident, the Prime Minister can lift it earlier.
As I see it the tax hike road map includes new legislation in 2017, with actual rate increases scheduled for 2018 or 2019 in the run up to the 2020 Olympic Games. Then there will be a construction boom along with many foreigners spending money in Japan. That would be a good time to increase the consumption tax further from 15% to 20%.
SOLOMON: What impact will the higher consumption tax have on the national budget?
PROF. ITO: The budget of the central government’s general account is about ¥100 trillion. Ordinary tax revenue and miscellaneous revenues covers roughly 60% of that. Therefore, ¥40 trillion of newly issued Japanese government bonds (JGBs) are required. Each one percentage point in tax-hike equates to ¥2.8 trillion of additional revenues. If we can jump the consumption tax rate to 20% from 10%, we could cut the budget deficit from ¥40 trillion to the ¥10 – ¥15 trillion range. You could completely close the gap by raising the consumption tax to 25%, the same rate as in Sweden.
SOLOMON: Social entitlements consume 1/3rd of the national budget and are expected to grow rapidly. How should the government deal with that?
PROF. ITO: The increase in the social entitlements is the result of Japan’s aging society. As more people retire, medical costs increase and more people draw on their pensions to live. To contain social expenditures, the government can slowly increase the retirement age at which people are first allowed to draw on their full pensions (now 65 years of age). It can also increase copayments and turn to means-testing for health-care benefits. There are many other proposals. The Administration needs to pick and choose ways to mitigate increases in social security costs.
Central government currently spends ¥ 30 trillion on social entitlements that are growing by ¥1 trillion each year. The government could cover the increased costs by raising the consumption tax by 1% every other year if it chose to do so. However, it would be better to cut social expenditures by reforming the old-age pension system and not by exhausting the consumption tax. The consumption tax is a powerful weapon. Once you exhaust it, it’s ‘game over’. In the end, any budgetary gap must be filled with increases in the consumption tax.
SOLOMON: If you were Prime Minister would you cut the corporate tax rate and if so, to what? How would you go about doing it?
PROF. ITO: The U.S. and Japan have the highest effective corporate income tax rate of any advanced nation at 40%. All other countries tax their corporations at between 15% and 30%. To encourage international firms to invest in Japan or at least stop further ‘hollowing out’ (i.e. firms relocating overseas) I would lower the corporate tax rate to 25%.
To make up the tax shortfall, I would also broaden the corporate and individual tax base. Corporations would need to pay tax regardless of their profitability to help pay for social services the country provides such as policing. Individual income tax deductions would shrink. Rich people would start paying more tax as they will be from next January when inheritance deductions are cut.
SOLOMON: Are the main domestic buyers of JGBs, like the BOJ and insurance companies, reaching the limits of their ability to absorb more purchases? If so, when?
PROF. ITO: Not yet. In 10 years that may become a reality. As long as household and corporate depositors continue to pour money into financial intermediaries like banks, then those intermediaries are happy to continue buying bonds.
Behind the insurance companies and deposit taking institutions (e.g. banks), there are depositors. If the depositors continue to pour money into those financial intermediaries, then those intermediaries are happy to buy JGBs. But the system could break down.
One danger is that household savings will decline along with Japan’s aging demographics. In 10 years time there will be a significant decline in household savings as baby boomers draw down their life savings. Another danger is corporations that are increasing their bank deposits. That’s unusual given interest rates are so low. They’re even paying back past loans. I don’t think this will continue forever because it contradicts textbook economics. I expect, in the near future, companies will find better ways to invest their money, either by building factories or increasing their dividends or wages. Then the inflow of deposits to financial intermediaries will shrink and so will their capacity to hold bonds. My prediction is that in 10 years time this will be a serious constraint. Before then I suggest the government balance its budget. We have until then to do so.
SOLOMON: May we discuss the Government Pension Investment Fund (GPIF)? Both you and the Abe administration are encouraging GPIF to hold fewer JGBs and to allocate more assets into global equities, because it is underweight equities compared to pension funds elsewhere. Along with the effects of quantitative and qualitative easing (QQE), what’s to prevent capital flight into higher yielding assets overseas?
PROF. ITO: Provided the government avoids falling into the trap of moral hazard, that won’t happen.
Through QQE the BOJ is buying a huge amount of JGBs from megabanks and other investors. That pushes yields down, lifts equity prices and depreciates the currency. When institutions and investors sell their bonds to the BOJ, they need to invest elsewhere. Some of this gets invested in higher risk equities and foreign assets which stimulate consumption due to the wealth effect. Minimally, exporter’s profits go up. These are all good for the economy.
QQE shifts the risk of plummeting bond prices onto the public sector, something which may happen at any time. In effect, QQE socializes bond-crash risk. That’s O.K. because the central bank does not need to maximize profits. They don’t have to mark-to-market and can endure a crash.
We only have to worry if the government becomes complacent by issuing debt to pay for an expanding structural deficit. This is moral hazard. It occurs when the BOJ buys newly issued JGBs when yields are falling. It’s bad. To prevent it, the fiscal authorities must stick to fiscal consolidation which has an opposing tightening effect. In summary, we want the central bank to be easing the money supply, thereby forcing investors into higher yielding and riskier investments to offset the tightening effects caused by fiscal consolidation. Overall this policy mix of monetary easing and fiscal tightening should contribute to the expansion of the economy.
SOLOMON: If the government fails to meet its growth targets and there’s less tax revenue than was expected to close the fiscal deficit, is the plan to continue with more QQE?
PROF. ITO: Yes. Yes. QQQE.
SOLOMON: At what point does QQQE turn into printing money to pay for the budget deficit?
PROF. ITO: Never. There is a fine distinction between structural deficits and cyclical deficits. If the growth rate is lower than the government expects then it has to decide whether this is due to a cyclical downturn that will naturally correct itself or one that systemic. If it’s cyclical and the inflation rate stays lower than the target rate of 2%, then the BOJ can print as much as it wants. If it’s structural, then Japan must endure lower growth, increase its efforts to achieve growth through structural reforms and possibly increase taxes.
SOLOMON: How does one tell the difference between a cyclical and structural deficit?
PROF. ITO: Ask the economists.
SOLOMON: (Silent and looking perplexed).
PROF. ITO: You have low opinions of economists (said teasingly)? Winston Churchill didn’t like economists either.
Mervyn King, the UK’s former Governor of the Bank of England, was also concerned about moral hazard. To address this concern, there were explicit agreements drawn to prevent a change in debt management policies as a result of quantitative easing in Britain. In Japan, there could be a similar understanding between the central bank and the fiscal authorities. If you stretch your imagination, it already exists: The 2% inflation target document signed by the previous Governor in January 2013 says, if you read it carefully, that the BOJ and the government shall cooperate on these efforts.
I speculate, without holding any inside information, that Mr. Kuroda insisted that PM Abe will increase taxes even if the economy does not expand exactly as planned. That would be accompanied with additional monetary easing. The BOJ is pursuing a 2% inflation target and will do anything to achieve it: As long as the fiscal consolidation efforts are there, then they’ll be more easing on the monetary side. That’s the deal.
SOLOMON: Referring to my original concern that societies resist confronting difficult issues which involve the kind of painful measures you have spoken so clearly about today, might it not take a crisis for the Administration to push aside vested interests?
PROF. ITO: We must avoid a crisis. If the leadership is there, we don’t need a crisis to make the needed changes.
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