Post-COVID public finances must be sustainable

“How is the debate over restoring fiscal sustainability playing out in Japan?” A foreign economist on a recent visit to Japan asked me this question, reminding me of the near-total absence of debate recently about putting this country’s public finances on a sound footing. For many years prior to the outbreak of the novel coronavirus, the government prioritized a set of policies aimed at achieving a surplus in the primary balance — government net borrowing, excluding interest payments, on consolidated government liabilities.

The deficits in both the primary balance and in public finances, including government debt servicing costs, had been steadily on the decrease. There remains the need, however, to scrutinize whether the government has done enough to realize a “surplus” in the primary balance in a way that will create a fiscal environment in which tax revenues alone cover policy expenditures for social security and public works.

In fiscal 2012, just before a series of “Abenomics” strategies advocated by then Prime Minister Shinzo Abe got started, the deficit in the primary balance was equal to 5.7% of Japan’s nominal gross domestic product, while that in public finances was equivalent to 6.9%. In fiscal 2018, the deficit in the primary balance shrank to 2.3% of nominal GDP and that in public finances to 3.2%.

As COVID-19 began spreading in the closing months of the fiscal year ending in March 2020, the government’s fiscal management abruptly went into crisis mode in response to the pandemic. Fiscal deficits have since swollen, and outstanding government debt has snowballed further. In a nutshell, Japan’s public finances are in a more precarious state.

Despite these difficult fiscal circumstances, unprecedentedly low interest rates have helped Japan’s fiscal management. The government’s fiscal 2022 budget projects a total of ¥1.085 quadrillion in outstanding government debt, equal to 192% of Japan’s GDP. Nevertheless, annual interest costs of the government debt are expected to be limited to 1.4% of the GDP, or just over ¥8 trillion. While Japan far outpaces other major economies in terms of outstanding government debt, the percentage of interest payments on this debt out of overall budgetary expenditures remains on par with peer economies.

It is true that the Bank of Japan’s ultra-loose monetary policy has kept the country’s interest rates low. Yet, it is more important to note that the Japanese economy has been trapped in an economic slump worsened by so-called secular stagnation. For the past 30 years, interest rates in major economies have continued to fall. Japan has ridden on the low-interest-rate bandwagon only to see its economic slump spread. Corporate investment in Japan has been sluggish over that period, a development that can be seen as both a cause and a result of the slump. The Japanese private sector’s savings have continued to surpass its investment, with its net savings surplus continuing to exceed 5% of GDP, which is larger than the government’s fiscal deficit or funding shortfalls.

At the end of the day, the corporate sector’s surplus funds have been effectively financing the government’s fiscal shortfalls. Against this background, the government has had no difficulty procuring funds to finance its fiscal shortfalls. This is why Japan’s long-term interest rates have remained low irrespective of the continuous ballooning of public debt. Likewise, the Japanese economy has continued to look stable on the surface, even though it has actually been stagnant.

What now worries us is that the Japanese economy is unlikely to remain on the stable-at-low-levels path now that a global trend has emerged to raise interest rates to fight inflation, which is gathering pace as the COVID-19 pandemic fades. So, it is obvious that the time has come for Japan to give serious thought to adequately managing post-coronavirus public finances.

Main cause for concern

A potential increase in government bond yields is a key concern for the future of fiscal management. So far, ultra-low yields on Japanese government bonds have enabled the government to make ends meet in public finances management, even amid the unabated bloating of outstanding government debt. If interest rates rise while the government is saddled with massive outstanding debt, it will have to face a sharply increased burden of interest payments.

According to the Finance Ministry, an increase in interest rates that is 1 percentage point higher than its projections would inflate its annual principal and interest payment burden by ¥3.7 trillion in 2025. Covering this additional amount via consumption tax revenues would require a 1.7 percentage points hike to the consumption tax. This potentially enormous extra burden reflects the sheer size of outstanding government debt.

The coupon on outstanding government bonds will remain fixed until maturity, so a future increase or increases in interest rates will only affect coupons on new issues and refunding issues in government bonds. For that matter, the average remaining life to maturity of Japanese government bonds is currently about nine years, and 32.3% of them are to be redeemed in 10 years or later. Even so, should there be actual interest rate increases, the government’s interest rate payment burden will keep rising year after year.

But the reality might not be that simple. What will matter most is the cause of an increase in interest rates. If inflation triggers an interest rate hike, the government’s interest payments will climb and its tax revenues will go up, thanks to higher consumer prices that will raise nominal prices on which taxation is based. As long as there is an increase in tax revenues corresponding to that in consumer prices and the rise in interest payments matches that in nominal interest rates, there will be no net increase in the pressure on public finances. Speaking from the perspective of economics, when consumer prices and interest rates rise in tandem, there is no change in both real interest rates and the burden on public finances.

However, when yields on government bonds rise due to increased concerns about public finances, things will hardly go so smoothly. If nominal interest rates go up without inflation, public finances will come under stress as real interest rates rise as well. This is why there are worries in Europe that the Italian and Greek economies will be in serious trouble if there is a sharp rise in interest rates.

The existing fiscal situation in Japan is not similar to that in Italy and Greece, but the size of Japan’s outstanding public debt is exceptionally vast. Therefore, it is crucial to convince all relevant markets that Japan’s public finances are being managed in a healthy manner. In this context, it was significant that Japan acted ahead of the COVID-19 pandemic, setting a goal of realizing a surplus in the primary balance and actually striving to achieve that goal. In the post-coronavirus process of fiscal management, it is necessary to redefine the schedule for accomplishing Japan’s fiscal goal.

Increase investment, raise wages

I want to raise a more important point regarding a particular economic scenario in which interest rates rise faster than consumer prices, pushing up real interest rates. If we want to see the economy recover, we have to prepare for an increase in real interest rates.

First, we need to acknowledge that real interest rates in Japan have been significantly low because private-sector businesses have been unenthusiastic about using funds for new investment and have instead accumulated surplus funds. In other words, economic stagnation has helped the government’s fiscal management.

That said, the post-coronavirus economy should not be allowed to return to secular stagnation. To revitalize the economy, it is essential for businesses to increase investment and raise employees’ wages so that people’s income will increase. If this happens, the corporate sector’s surplus funds will decrease, making real interest rates rise. This would be an inconvenient development for fiscal management.

Nonetheless, the government will have to implement a fiscal policy focused on accelerating private-sector investment. For example, it should earmark a massive amount of public money to assist semiconductor production. The government recently said Japan’s public and private sectors need to invest a total of about ¥150 trillion in the coming decade to realize its decarbonization strategy. The government is already considering floating special-purpose government bonds to raise as much as ¥20 trillion for up-front investment.

While fiscal and industrial policies for stimulating private-sector investment are essential, they will make it harder for the government to realize fiscal consolidation. This dilemma makes the issue more complicated. To inspire the private sector to increase investment without worsening public finances, it is effective to secure fiscal resources through taxation and other measures as needed.

This is an economic theory known as the balanced fiscal budget multiplier. A collective fund for decarbonization will need future fiscal spending that will rely on future fiscal resources and, as such, is similar to the above theory. There is a precedent similar to the decarbonization fund — following the Great East Japan Earthquake in 2011, the government introduced ad hoc post-disaster reconstruction taxes to finance reconstruction programs.

How should Japan revitalize its economy without undermining fiscal soundness? A new approach to manage its public finances must be adopted, different from the one that has been in place throughout the era of secular stagnation.

Motoshige Itoh

Itoh is a professor emeritus at the University of Tokyo. He also served as a professor with the Faculty of International Social Sciences at Gakushuin University until March 2022.