What Europe has to teach Japan

As the Japanese government mulls a higher sales tax to improve its finances, what do the experiences of Europe over the past few years suggest?

When thinking about the problems with the economy in Europe – feeble economic growth, high levels of debt, and banks shackled with bad debts – Japan has been seen as a lesson of what not to do.  Europe had the luxury of learning from Japan’s mistakes – Japan tried to ride out the problems while Europe has been more proactive in sorting out the mess following the global financial crisis.  It could be argued that Europe has come further in a few years than Japan has come over the past two decades, and with Japan considering a move to improve its dire finances through higher sales tax, it seems a good time to see whether Japan has anything it can learn from the experiences of Europe.

Talk of crisis in Europe is significantly more muted these days with the worst of the Eurozone debt troubles having been left behind in 2012 (for more, refer to Both good news and bad news for Europe).  Recent data showed that the economy in Europe grew marginally in the second quarter of this year giving rise to hopes that a brighter future awaits.  A key element of Europe’s gradual return to health has been its austerity.  Japan has been saved from the forced cut backs imposed by some governments in Europe as domestic savers in Japan are reliable buyers of government bonds there.  But the absence of any pressure to rein in spending has a downside as well in the form of more and more debt.  

Normally, gradual and mild rises in interest rates act as a warning signal as in Europe when buyers of bonds shun the debt of any country that seems likely to default.  So even without any signs of trouble being on its way, debt in Japan could all of a sudden reach a point where a large chunk of the holders of its debt decide to jump ship resulting in financial meltdown.  The lack of urgency has meant that austerity has never taken off in the same way that it has been embraced by leaders in Europe. 

Japan is trying a different tack as a means to sort out its finances – a higher sales tax.  This option has long been thrown around as a possibility in Japanese politics and has dominated headlines in Japan with the Abe government considering a two stage rise in sales tax from 5% to 10% by October 2015.  The two different approaches – to cut spending or raise revenues – are both plausible solutions but it seems strange that Japan and Europe have chosen different routes to solve similar problems.  Europe has had more success with its way of doing things but that may be a sign of great resolve instilled through higher interest rates.  Some countries in Europe have adopted measures to increase their income but it begs the question – why has the Japanese government not made more of an effort to rein in its spending?

Government spending in Japan was 15% higher in 2012 compared with 2007 before the global financial crisis but government revenues have fallen by over 8% over the same period.  One of the key reasons behind Japanese politicians’ aversion to cutting spending is its patronage style of government.  Political leader divvy up the resources that come with the levers of power in the same way that traditional community bonds would dictate.  Support of those in power comes through rewarding your followers, and even though this old-style source of power is on the wane, it is where the current ruling party has a reliable support base in rural districts which are overrepresented in the Japanese parliament.  So the reasoning behind the approach of the Japanese government would be that higher taxes will spread the pain whereas cuts to spending will hurt your supporters.

The Abe government in Japan has been trying lots of other tricks including even greater increases in spending in 2013 through a fiscal stimulus package (see When Keynesian policies won't work for why this is not likely to work) along with expansionary monetary policy (which is unlikely to do much good either – see Don't hold your breath).  Yet, spending seems to have passed being useful considering the countryside in Japan is already covered with roads and bridges that see little traffic as well as a multitude of small plots of land farmed by the elderly with government support.  This seems even more incongruous considering that the population in Japanese is declining which will see further falls in revenue and higher spending on pensions and medical bills for the elderly.  This means that the reforms proposed by the Abe government are even more crucial in order to make the falling number of workers even more productive.  Or else, Japan might have to resort to another policy option used in Europe – default…