Cutting this much won't hurt.

Photographer: Kazuhiro Nogi/AFP/Getty Images

The Two Sides of Japan's Deficit Trap

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Japanese Prime Minister Shinzo Abe looks like he's trying to get serious about deficit reduction. This is a good thing. The economy has mostly normalized -- a highly relative term in an economy whose long-run real potential growth is only slightly above zero. Japanese unemployment is at its lowest level in 18 years. That means that the time for fiscal stimulus is over. But with a budget deficit of 7.7 percent of gross domestic product in 2014 (compared with 2.8 percent in the U.S.), Japan now needs fiscal consolidation. Recognizing this, the Abe government has released a fiscal blueprint that includes flexible spending caps. 

Abe’s measures, although a step in the right direction, won’t be anywhere near enough to get the job done. The administration’s projections for deficit reduction rely on an incredibly rosy assumption for 2 percent annual GDP growth. In the U.S., 2 percent would be respectable, or even a little slow. In Japan, where population is shrinking, it’s pie in the sky. It's about as realistic as the 4 percent growth rate that Republican presidential candidate Jeb Bush has promised to deliver if elected. Unless Japan decides to suddenly open its borders to a truly huge and unprecedented inflow of immigrants, the 2 percent thing isn't going to happen. 

Here, in the languid words of the Wall Street Journal, is the crux of the budget problem:

Curbing spending in social welfare like medical costs remains a pressing issue, but the administration is reluctant to show how much cuts would be needed in fear of offending voters.

Japan’s government has two main areas of spending it could reduce. The first is payouts to local governments, which are heavily dependent on the national government for their revenue in Japan’s highly centralized system. The second is transfers to the elderly, through social security and health care. 

Local government payouts are difficult to cut because of politics. As political scientist Ethan Scheiner has described, the dominance of Japan’s long-ruling Liberal Democratic Party depends on an unofficial quid pro quo system -- the LDP uses its control of the central government to deliver payouts to regions that vote to maintain its control. The old saying of “to the victor, the spoils” is in full force in Japan. Although this system has weakened somewhat in recent decades, fiscal centralization still makes it devilishly difficult to lower payments to local governments. 

The other, even bigger thing that Japan could cut is benefits to the elderly. Much of Japan’s government acts as a massive conduit for transferring resources from the young to the old, via taxes and spending. Abe has promised to cap social security spending. But few believe that this will actually happen, because of the vast political power of the elderly. Japan has an inverted population pyramid -- the old are numerous, and have higher turnout than the young. This means they can use their numbers to threaten any leader who doesn’t pay them as much money as they would like (this is also a problem in the U.S.). Japan is a gerontocracy. 

That leaves two ways for Japan to cut its monster deficits: 1) inflation, and 2) productivity growth. 

Sustained higher inflation would erode both the deficit and the debt. It is basically a tax on the elderly, who saved most of their money in bonds, postal accounts and bank deposits. After Abe and the Bank of Japan unleashed the “first arrow” of Abenomics -- monetary easing -- inflation surged into the 1 percent range. But keeping it there has been a problem; already, the rate is drifting back to zero. Even a sustained burst of quantitative easing, and a promise to do whatever it takes, appears to have generated only a brief flash of inflation. That bodes ill for Japan’s ability to inflate away its debt or reduce its deficit through higher nominal growth rates. 

Sustained productivity improvements are another potential source of growth. Abe’s new corporate governance code and other measures will raise productivity in the long run, by encouraging the slimming down of old, unproductive companies and the emergence and growth of new, more productive ones. Already, there is some evidence of a new focus on profitability and shareholder control at Japanese companies. But in the short run, the way you improve productivity is by firing people. That’s great for companies’ bottom lines, but it isn't very helpful with the near-term deficit, because the unemployed and the underemployed pay little or no tax and often receive government aid. For productivity to work its magic on growth, you need to wait for the new, more productive companies to be born and grow, and that takes time. 

So the easy, win-win solutions seem out of reach for Japan’s budget. The only real answer is to cut local government payouts and transfer payments to the old -- exactly the things Japan’s political system is set up not to do. In other words, the deficit reduction fight is a stern test of the ability of Japan’s ruling class to be leaders, rather than politicians. They have to resist the urge to pander, and persuade the public to accept painful compromises. If they can’t, Japan is going to find itself in trouble.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net