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Japan and the Limits of Keynesianism
DEC 28 2010, 12:24 PM ET30

Japan's budget is in a truly terrifying state. Reading about the
government's behavior reminds me of the worst accounts of compulsive
spenders on the verge of personal bankruptcy--a sort of "What the
hell, we're screwed anyway, so let's not think about it and maybe go
to Cabo for the weekend." The budget's structural position is what is
known technically to economists as "completely hosed"; borrowing now
exceeds tax revenue, and debt service costs now eat up almost half of
the tax revenue the government collects. "Unsustainable" is too weak
to describe the situation; I don't know how they're doing it now.


To be sure, a lot of people have been awaiting the inevitable collapse
of the Japanese government's finances for the better part of a
decade. I know all the arguments for why this isn't such a big
problem: their debt is financed domestically, much of it through the
postal savings system that pays little for its borrowing, and the
Japanese are extremely patriotic about their nation's financial
needs. That may shift the locus of the problem, but it doesn't
actually solve it; eventually, no matter how patriotic they are, the
Japanese are going to want to use some of those savings to support
themselves in their old age. Some sort of crisis virtually has to
ensue.

When I was starting out as a journalist, I frequently had Japan used
to illustrate Adam Smith's precept that "there's a lot of ruin in a
nation"; any time someone was tempted to get hysterical about
government borrowing in America or elsewhere, someone else would
inevitably point out that Japan's debt burden was well over 100% of
GDP, and the country still hadn't collapsed. But while there is a lot
of ruin in a nation, there isn't actually an endless supply, and Japan
may well be finally approaching the limits.

Felix Salmon views this as a symptom of a broader political failure:

The situation in Japan is particularly depressing because the country
has no major ethnic or political rifts. Sure, there's political
jostling, both within and between the parties. But it's nothing
compared to the vitriol and mistrust that we see in the US, and
somehow I can't imagine Greece-style riots in Japan either. But still
the technocrats can't make any headway.

The lesson here, I think, is that it's very, very hard for a
government to enact a serious fiscal adjustment unless and until the
bond market forces its hand. The Brits are trying, of course -- and
we'll see whether or not the coalition government can succeed. But as
we saw with George W Bush, the fiscal rectitude of one administration
can be more than wiped out during the course of the next.

Even now, with the attention of the world more concentrated on
sovereign fiscal issues than ever, the Japanese government can still
contrive to raise agricultural subsidies by 40% and send child-care
payments soaring, including payments to families who don't need the
money. It's even getting rid of highway tolls. Oh, and it's cutting
the corporate tax rate.

From a bond-market perspective, this basically just means an ever-
greater supply of JGBs: we're still a very long way from any real
credit risk, given the political power of the owners of those bonds.
But as a lesson in fiscal political economy, Japan is much more
worrisome.

I see it a little bit differently: Japan has simply reached the limits
of Keynesian policy in an economy which has never managed to jolt
itself back up to a healthy rate of growth. Demographics is obviously
a big contributor to that slow growth, and there are a whole host of
secondary factors one could nominate, but whatever the reason, they
have now had two decades of anemic growth, which they have fitfully
attempted to address with stimulus. Maybe not enough stimulus, maybe
badly designed, but they've certainly tried to follow the basic
Keynesian playbook: borrow money and spend it when times are bad, in
the hopes that you can bring back growth.

But for Japan, at least, the growth has not materialized. Few
economists would advise undertaking a fiscal adjustment, on the scale
that Japan requires, in the face of the current crisis. The problem
is, there hasn't been a good time for retrenchment in 20 years. I
can't blame the politicians for trying to restore some semblance of
normal growth in the run-up to elections. But at some point, they're
going to have to cut back, whether or not it's a good time.

Matt Yglesias suggest that it's irrational to retrench ahead of the
bond market, when what they ought to be doing is trying to have more
economic growth, but their lack of economic growth really isn't for
lack of trying. I think every economist who has ever had an opinion
on currency has been solicited, at one point or another, to come up
with a plan for Japan, but they've all failed, either because the
plans weren't politically feasible, or because the money supply simply
stubbornly refused to inflate no matter how hard it was pumped.

Given the menu of actual policy options, it would probably be best for
Japan to attempt fiscal adjustment now. The earlier you deal with a
fiscal problem, the smaller the problem is . . . and doing it in
advance gives you rather more discretion about how and when the cuts
are made, which gives everyone, espeically the people who are now
dependent on the government, time to adjust. But it's not hard to see
why it hasn't. Which of us would volunteer to be the guy who cuts
pensions and farm subsidies while there's a recession o