Ageing and deflation in Japan

Inflation rates across industrialized economies have been remarkably low in the past decades, and at the same time these economies have been subject to considerable demographic ageing. Nowhere has this been more true than in Japan. What are the government's or the central bank's incentives to set policy that triggers lower inflation if the population gets older? I do not see where monetary policy would matter, but the fiscal theory of inflation may tell us something.

Hideki Konishi and Kozo Ueda study the latter in an overlapping generation model where the fiscal authority has a shorter lifespan than residents, but takes into account the impact of its actions on future governments. The fiscal theory of the price level tells us that inflation goes up when more debt is accumulated, and that is certainly the case when the population gets older and requires more retirement benefits. But the authors point out that this does not necessarily hold once you take into account the endogenous responses of income tax rates and public expenses. Then, because of the policy response it matters why the ageing is happening: lower mortality or lower fertility. Deflation is more likely in the former case. Now we just need someone to bring this to the data...

High Japanese debt will become a problem

Japan has been able to sustain unusually high debt levels for a long time, even when other countries were facing debt crises despite having lower debt to GDP ratios, and more sustained GDP growth. What makes Japan so different, and what does this imply for the sustainability of Japan's debt?

Charles Yuji Horioka, Takaaki Nomoto and Akiko Terada-Hagiwara analyze the recent evolution of Japanese debt and have a grim outlook. Up to a few years ago, the debt was largely financed by Japanese households saving towards retirement. But as Japan is continuing through its demographic transition toward an older population, this source of funding is going to quickly dry up, if not reverse itself as an older population requires more transfer payments. During the few last years, an increasing share of debt was bought from abroad by investors looking for safe alternatives during times of financial turmoil. This temporary funding allows to mask the underlying drying up of internal funding. This foreign debt also carries a shorter maturity, so we may expect soon some problems in Japan, especially if other investment opportunities start looking better. Unless the Japanese government gets its fiscal house quickly in order, we may see again a country struggling with its debt.

Do clean-car subsidies disguise protectionism?

The US has complained for decades that Japan is making it difficult for American companies to export cars there. The complaints were about regulation, prices, and subsidies. Japan has had a rather easy time dismissing these complaints with the mere fact that US car companies are very reluctant to build right-hand driven cars, which are required for driving on the left side of the road in Japan. The latest US complaint is about subsidies for clean cars, which again are supposed to favor Japanese cars. I would answer that the US could maybe build cleaner cars, but let us have another look at the issue.

Taiju Kitano studies the current Japanese subsidies and the American proposal on how the subsidies should be structured. The subsidy is for scrapping old cars for replacement by fuel-efficient ones. At issue is the method for determining which fuel-efficient cars qualify. Japan has its own method for setting fuel efficiency, but this is not calculated for cars with low production or imports, like US models. That disqualifies them for the subsidy. Later, foreign ratings have been accepted for qualification, but the US complained that its city-driving standard is used, while a city/highway combination were more appropriate. Japan claims its standard is close to the city standard in the US.

The use is not solely about calculation of fuel-efficiency standards, it also about potential market shares. Kitano thus estimates an oligopolistic model to determine demands in each market and thus demanded quantities under different policies. If the goal is to improve overall fuel efficiency, both policies score equivalently. The US one would be, however, much cheaper because new cars become eligible and they substitute for cars that command larger subsidies. The US is thus mainly helping Japan reduce its expenses, while having no impact on pollution or even a positive one on profits of Japanese car makers.

Reduce inequality by increasing the number of school days

Some children have the bad luck to be born in a poor environment or a dysfunctional family. For them, school is the great equalizer that gives them a chance to still make in reasonably well in life. That works only if they can be in school and out of bad influence long enough (the "incarceration" hypothesis). Unfortunately, in areas where there are few school days and where especially the Summer break is long, all the good work is easily undone. In particular where there is inequality, we see the richer kids go to Summer camps to reinforce what they learned or learn some more, while the poor ones linger at home and forget a year's worth of school.

It is thus not surprising to see that Daiji Kawaguchi finds that fewer school days leads to more inequality. He looks at the 2002 school reform in Japan that abolished school on Saturdays. Comparing time diaries and test scores of students before and after the reform, he finds a dramatic change in the distribution. Students after the reform studied one third less at home, and the decline was even steeper in poor households. The impact on test scores is that the slope against socio-economic factors becomes 20-30% steeper. This is just from removing two half days of school a month. I wonder how this would translate in an international comparison where the school year ranges from 180 days in the US and France to 220 days in South Korea.

The minimum wage under deflation

Whether the minimum wage is a good tool for poverty alleviation remains controversial. Still, it has proven politically impossible to reduce the minimum wage, which means that the only way to reduce its bite is to wait for inflation to eat the real minimum wage away, if this is you want. A minimum wage that is deemed to be too high then gradually gets back to an appropriate level. Of course, this assumes that there is positive inflation. What if there is deflation?

Ryo Kambayashi, Daiji Kawaguchi, and Ken Yamada look at Japan that has been characterized by some prolonged deflationary episodes. They look at the period from 1994 to 2003, where the cumulative inflation reached a whooping -0.5% (CPI) or 3-5% (median wages), a bit unfortunate that the sample for which wage data was available just happens to have little deflation to show. But the nominal minimum wage, which is set regionally, looks from the graphs to increase by about 12%, thus there is still a change in relative wages, like what could be seen in some other countries. The authors then find that the lower tail of wages is compressed, especially for women where half of this effect is attributable to job loss. This is not inconsistent with other studies.

Japan's lost demographic decades

Since the asset bubble burst in Japan in 1990, the economy has stagnated despite significant policy efforts. Interest rates have been very low all along and fiscal policy has certainly not been austere. What was once labeled a lost decade has now become a pair of lost decades. Can only the burst bubble and the issues with the Japanese financial system be blamed?

Reiko Aoki thinks the demographic change in Japan has a large role in this extended stagnation. As is well know, Japan is aging considerably, and this has of course a dramatic impact of the savings picture. Financial institutions that were built to accommodate rapid growth and a young population looking to safeguard massive amounts of savings struggle to deal a much older population that is in the phase of eating its savings. Worse, as institutions need to adapt to the new situation, reform is hindered by the large voting block of the elderly whose interest lies in the short-term provision of their pensions.

Quite obviously, the current imbalance in the demographic pyramid is the problem. Aoki thinks that fertility must be encouraged. This has worked little in other economies, but may be much easier to implement politically than the best solution, get people to retire later. Immigration is another solution, but as other countries are looking to embrace similar solutions, we may run out of willing young migrants. And Japan is not the obvious choice for a migrant, given the high entry cost in terms of integration.

How Japan financed WWII

71 years today, Japan attacked Pearl Harbor and opened a new front in its global war. Why would a relatively small country take on a much larger adversary when it is already stretched with other wars and occupations? In particular, how do you find the resources to wage such wars, and by resources I mean not just the financing but also the physical resources?

Gregg Huff and Shinobu Majima offer part of the answer by looking at the financing of the Japanese occupation of Southeast Asia. Japan had a strategy that invading troops needed to be self-sufficient. This means that they had to either confiscate (tax) or acquire goods through money creation. To a large extend, the latter was performed through the issuance of military scrip, which is unbacked military notes, along with bilateral clearing arrangements with the occupied countries. This allowed not only to finance local occupation but also transfer substantial resources to Japan, in the case of Indochina up to a third of its GDP.

You would think that money creation on such a massive scale would create hyperinflation or at least high inflation. That does not seem to be the case, at least in the sense that the price levels increased as much as the money supply. One could have expected that given the circumstances inflation would have been significantly higher than money growth if market participants were forward-looking and money velocity would increase (think of hyperinflation à la Cagan). Huff and Majima trace this missing hyperinflation to the fact that money was needed to act as a medium of exchange and store of value, despite very substantial seigniorage taxes. There was not viable alternative, in part because of Japanese coercion. I think this would not have worked in more modern economies where more assets are available.

Trust in government and preferences for redistribution

Scandinavia is puzzling for Americans or Southern Europeans. Taxes are very high, yet people are happy about paying their taxes and there is surprisingly little tax fraud or evasion. Why is there such tax morale? Of course, these taxes buy you services that you do not need to obtain on the market, such as social assistance, low crime, and health insurance. But even high incomes, who should prefer a model of market goods with little redistribution, are happy. What could one do to get this apparently Pareto improving outcome?

Eiji Yamamura does not provide directly insights about Scandinavia, but what influences regional tax morale in Japan. It turns out that if you have high trust in government, and you share it with your neighbors, you are more willing to accept income redistribution through taxation, and you perceive the tax burden to be lower. Thus, there is no miracle. You need a better government if you want higher tax morale.

Is a lost decade ahead?

It is quite obvious that the current economic situation in both Europe and the United States is not healthy. It has been argued that in both cases policy uncertainty or the inability of authorities to take decisions are detrimental to economic activity, and private investment in particular. It is not difficult to rationalize this with simple theory. The question is whether this could have some longer term consequences.

Kenza Benhima and Baptiste Massenot find that yes, we could be ahead of a lost decade like the one that Japan experienced in the 1990's. They take a simple real business cycle model, a model that is the least likely to produce very persistent deviations from trend or permanent departures from the growth path. They only amend the model in two ways: investors have a decreasing relative risk aversion, instead of constant, and they can choose between two technologies, a risky one with higher returns and a safe one with low returns. The model then exhibits two equilibria: the standard RBC one, and a second, self-fulfilling one, a trap where capital is mis-allocated into overly safe assets, there is little growth if any, and interest rates keep getting lower thereby reinforcing the trap.

These results are consistent with Japan during its lost decade. Total factor productivity decreases, essentially because of a mis-allocation of resources. Assets are mostly safe ones in the trap, compared to risky ones before. And the interest rate keeps declining. Interestingly, the resulting economy in the bad equilibrium looks like it had a bad technology shock, even though technology is just fine. This makes it consistent with the Hayashi-Prescott claim that Japan's lost decade was due to bad total factor productivity draws. The same applies to the Caballero-Hoshi-Kashyap claim that banks in Japan kept lending to unproductive firms, preventing better ones to enter and raise total factor productivity. Even Krugman's liquidity trap fits in the story because interest rates are very low in the trap as well.

And recent data in Europe and the US seems to be consistent with this trap as well. The only way out is a coordinated action of all market participants. The only ones that could make this happen are the authorities. Unfortunately, they seem to be quite far from that.