Japan’s prime minister Shinzo Abe appears to have won a supermajority in the Diet’s Upper House, with the Komeito party’s help, enabling him to change the constitution. He has now announced that his first priority, before changing the constitution, will be another $100 billion government spending program. Given the sorry state of the economy, we have some suggestions he may not be considering about how Japan’s constitution needs to be changed – to ensure that policies like those of the last 25 years will never be repeated and a Japanese bankruptcy may perhaps be avoided.
Abe wants to alter the Japanese constitution to remove the demilitarization provision put in after World War II, thereby allowing it to increase defense spending to counter North Korea, China and other threats in the region. That is probably a good idea strategically; it suffers from two problems. First, the Liberal Democrat Party’s coalition partner Komeito is historically pacifist, so does not agree with Abe’s desired constitutional revision, which is in any case unpopular with voters. Second, any increase in defense spending, however necessary, would be piled onto a government budget that is far out of kilter, hence making that much more serious problem worse.
Komeito also has its own ambitions for constitutional revisions, including such things as forcing the government to obey environmental dictates, thus imposing further costs on Japan’s already overburdened economy. In other words, if the genie of constitutional reform is allowed out of the bottle, that genie is likely to produce a mass of changes that would in total put the Japanese economy in even worse shape than it is already.
Make no mistake about it, the Japanese economy, for decades the envy of the world, is now in sorry shape. The producer price index fell 4.2% in the year to June, driven down by the relentless rise in the yen, which is up some 15% against the dollar in the past year so even with interest rates below zero, the economy is suffering quite high real rates of interest. Productivity growth is running at minus 2% per annum, and productivity levels are below those of 2007. Most dangerous, the budget deficit is expected by the Economist’s team of forecasters to run at 6.2% of GDP in 2016 – and public debt is in excess of 250% of GDP.
As I have written before in these columns, only on two occasions in human history has a country’s public debt risen to 250% of GDP without a debt default. Both of those occasions were at the end of major wars by Britain (who found it easier than most countries to run up public debt, having a major financial center handy and a reliable credit reputation.) On the first occasion, in 1815, the debt was worked down by rigorous government austerity – bringing the budget to full balance in only four years after the war ended – and a pro-growth set of economic policies that brought economic growth rates never seen before – the Industrial Revolution. On the second occasion in 1945, Britain brought its debt down by inflating the currency over a 30-year period, impoverishing its middle classes as it did so.
Neither of these possibilities appears open to Japan. There is no Industrial Revolution awaiting it; indeed, Japan’s productivity appears to be steadily declining. And while every government since the late 1990s has attempted to stimulate inflation, Japan’s deflation appears to be getting steadily worse. Default on Japanese government debt thus appears inevitable. Admittedly, by forcing long-term interest rates down to minus 3% they could start paying off debt even with the current deficit, but there is no reason to think such a wayward policy would be technically feasible without crashing the banking system.
Abe’s proposed constitutional change appears more or less irrelevant to this problem. There are things he could do, in making Japan’s workforce more flexible, but he has had four years to do those things and has been stymied by vested interests – if indeed his efforts were more than symbolic. Now he has announced that his major new initiative, having won the Upper House election, before attempting constitutional change, is another 10 trillion yen ($98 billion) stimulus package of government spending, perhaps bringing the ultra-high speed train from Tokyo to Osaka forward from 2045 to 2037.
It is difficult to exaggerate the damage that this program will inflict. An extra 2% of GDP in government spending, no benefit from which will accrue for over 20 years, will be added to the deficit, already the largest in the rich world, under the assumption that it will in some magical way succeed where over 25 years of such Keynesian stimulus plans have utterly failed. Japan has suffered since 1990 from ever-expanding government spending, much of it on infrastructure projects favored by rural areas and large construction companies that are major LDP donors.
Not only has this spending failed to revive the economy (which was not in too bad a shape before 2007 but has deteriorated badly since), but it has distorted resource allocation in the real economy, made worse by the recent programs of Bank of Japan securities buying. Abe, elected to solve the problem, has instead pursued leftist Keynesian policies of public sector expansionism that have made it much worse.
The goal of a true constitutional change is thus completely clear: to Abe-proof the Japanese fiscal and monetary system, so that never again can Keynesian lunatics destroy the country’s wonderful, jewel-like economy and society.
The first need, clearly, is a balanced budget amendment. From the fiscal year beginning in April 2019, the government must ensure that its net borrowing requirement from the markets is zero or negative. It may be objected that this will starve capital investment, but the reality is that Japan has all the infrastructure it can profitably use, given that the population is gently declining, and that state directed capital investment is almost always wasted. Only by running a balanced budget can Japan begin to make progress on its gigantic debt. The constitutional provision will leave it open whether the government balances the budget through tax rises or cutting spending. In practice, however it is glaringly obvious that Japan needs to cut spending by at least 10% of GDP, and get back to the 30% of GDP in public spending that it had before 1990.
However, that will not be enough. Monetary policy in recent years has played as big as role as fiscal policy in destabilizing the Japanese economy. Here the best provision is one that the IMF, USAID and other aid agencies sought to write into the constitutions of the newly emerging East European economies in the 1990s: that the central bank cannot finance the government. The strictest form of this provision, that the central bank cannot buy government bonds, would make monetary policy management difficult but no matter; central banks do such a poor job of this they are better having their hands tied. Unlike the first new provision, this one should operate with immediate effect.
In Japan, the central bank already has a gigantic portfolio of government bonds, corporate bonds, stocks, real estate, used cars and old furniture. This should be hived off into a separate agency, whose sole mandate would be to sell the rubbish as quickly as can be done without disturbing the market. Once the government’s financing need has been eliminated, such a sale should proceed relatively quickly, at good prices, although negative interest rate bonds, used cars and old furniture will inevitably be sold at a discount.
A third constitutional provision, more radical than either of the first two, would eliminate the central bank’s discretion in monetary policy, since it has proved so appallingly bad at it. The ideal amendment would provide for Japan adopting a gold, silver or bimetallic standard (the latter being the country’s tradition during the Tokugawa period) with a fixed parity of the chosen standard against the yen and appropriate coins minted, to ensure that the populace had access to the monetary standard, unlike in the phony Bretton Woods system of 1944-71. The date for adoption of this standard would be two years after that for the balanced budget, i.e. the beginning of the fiscal year 2022.
By being the first country to revert to a metallic monetary standard, Japan would cement the confidence in its system that had been gained from the budget balancing in 2019-20. By the standards of today’s Japan, the standard would be mildly inflationary, since it would eliminate the current deflationary tendency. At the same time, it would give lenders, especially domestic savers, complete confidence that the Japanese government was not about to adopt the disgraceful practices of the British government in 1945-79, so that their savings were safe.
If Japan really wants to solve its problems, it should adopt these three constitutional amendments, by all means along with Abe’s removal of the demilitarization provisions, but not Komeito’s environmental nonsense. These three reforms, shrinking the government, preventing the diversion of resources towards useless government paper, and stabilizing the currency on a long-term basis, would being a revitalization of the Japanese economy, reversing the decline in productivity that has been such an unhappy feature of the Abe years. They would also prevent any future Japanese government from adopting such foolish, self-destructive policies, in other words they would Abe-proof the system.
Mass bonfires of Keynes’ collected works could be held in major cities, to celebrate the new constitutional arrangements.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)