Eurozone crisis: Still bubbling away

The debt crisis in Europe seems a long time ago but a political hiccup in Italy shows that its revival may not be that far off.

Around this time last year, weeks would go by without this blog commenting on anything but the Eurozone crisis.  The turning point came near the end of 2012 with a bit of imaginative policy making by the European Central Banks who said they were willing to do “whatever it takes” to save the euro.  By the start of 2013, the worst seemed to be over (Good and Bad in 2013), but many of the problems still had to be fixed.  This year has seen the economic problems in Europe simmering away in the background rather than being likely to erupt as in 2012.  However, the turmoil in Italy at the moment shows that it does not take much for things to heat up again.  Europe may not dominate the headlines as in the recent past but it is never too far from the front pages and here is a look into why.

Politics in Italy are tricky at the best of times but an election earlier this year left the country with a fragile coalition.  A fresh saga was triggered as the constant distraction that is Silvio Berlusconi looked to pull his support from the government after being convicted of tax fraud in August.  Yet it was Berlusconi who suffered from his latest attempt at meddling as he was forced into a dramatic U-turn which involved providing support to the government in order to avoid seeing his own party rebel against him.  After a jump in the interest rate on Italian government bonds, the weakening of Berlusconi cheered investors as he had held sway over Italian politics for a long time despite Italy having not benefited much from his time in power.

Although Italy has avoided the unwelcome prospect of another round of elections, the problems that the country faces are greater than the immediate political woes (for some background, see Bigger than Berlusconi).  This year, the government budget deficit is expected to top 3%, which is the upper limit for EU countries, with government debt approaching 130% of GDP.  The coalition government lacks the political capital to push through the necessary reforms to get the economy moving ahead to help generate the tax revenues needed to reduce the shortfall in the government’s finances.

Italy is hampered by a problem which is typical for countries in Europe feeling the strain in the aftermath of the Eurozone crisis – voters weary of austerity measures with little to show for their perseverance.  Mainstream political parties who have been pushing government cuts have seen their support eroded by fringe parties which promise relief through policies which will have negative long term effects.  The democratic process has struggled to deal with the consequences of the economic slump and mounting debts following the global financial crisis.  Voters have been stuck with two unappetizing options – enduring the hardship of austerity with scant rewards or repelling against spending restrictions but becoming an outcast in the financial system.

The same themes can be seen being played out in Portugal and Greece among others.  Greece has witnessed the rise of the far-right extremist Golden Dawn party which has fed off the frustration of Greek voters.  Local elections in Portugal resulted in heavy losses for the ruling party who had pushed through austerity measures.  Despite all the hardship endured in these two countries, further bailouts are seen as necessary to deal with the stubbornly high levels of government debt.  The economic stagnation in Europe continues with countries like Greece still suffering with GDP down by 6.4% in 2013.  Portugal, Italy, and Spain among others also ended 2012 with lower GDP. 

While the European Central Bank has staved off the immediate threat of crisis, the flipside is that the pressure for reforms has eased.  As such, politicians can no longer blame the financial markets for their unpopular policies.  Leadership in Europe has also been lacking with the national elections in Germany drawing the attention of Angela Merkel away from Europe.  Coalition negotiations in Germany following the elections in September will leave Europe seemingly leaderless for a few more months.  The Eurozone crisis may have been put on the back burner but it could still boil over at any point if not watched.

Inflation – Then and Now

Inflation is driven by different factors now that the West is no longer the only engine of growth in the global economy but why might that be important?

Life is always better as the top dog, whether it be on the playground or at work. The same holds true for the global economy where large and growing countries have others banging on their door to offer whatever they might need.  As a result, the global economy shapes itself around the countries at the top of the pecking order and these countries benefit as a result.  One seemingly innocuous way this plays out is through inflation.  Inflation in Europe and the United States has always moved in tune with their economies due to there being no other significant sources of demand.  But the switch to a global economy with other major players has resulted in international commodity prices being driven by what is going on in other countries as well.  This means that inflation is not what it used to be.  And, if inflation is different, must monetary policy change as well?

Inflation is the economic phenomenon of increases in prices, where prices will rise if demand increases at a faster rate than supply.  Due to globalization, many goods are now traded on international markets and growth in the global economy will push up demand (and the price) for any goods.  While demand can fluctuate dramatically in a short period of time, changes in supply typically take time.  Prices which rise due to expanding demand as an economy grows may remain high as increases in production require more time to catch up.  This is not so much of a problem when an economy is growing as consumers will have more money in their pockets and won’t be as bothered by higher prices.  Thus, it is easier to accommodate prices rising at a faster rate when the economy is prospering. 

In the past, the main source of demand for most products came from Western economies (Europe and the United States) along with Japan, with inflation moving in line with economic growth in these countries.  The level of synchronisation between these economies was also high so that growth spurts came at the same time and inflation was typically timed to when the economy was ready for it.  But this all depended on there being no other big economies which were out of sync with the West.

However, the economic rise of China and emerging markets put paid to this convenient form of inflation.  The number of factors which determined global commodity prices had increased and the economy in China was large enough to move to its own rhythms.  China’s entry into the global economy was initially a boost for Europe and the United States in some ways with low-cost manufacturing helping to bring down prices at the beginning of the century.  Yet, economic growth in China did not slow with the onset of the global financial crisis and prices for many global commodities kept climbing higher as a result.

High inflation is never good but it is even worse when an economy is struggling to climb out of recession.  Rising prices during slow economic growth further depress spending and put pressure on profits at companies when times are already tough.  Being an open economy with few of its own resources, the United Kingdom has had to suffer through both a stagnating economy and high inflation.  For example, real GDP in the UK edged up just 0.8% in 2011 while inflation reached as high as 5.2% in September.  Yet, the Bank of England did not change its monetary policy to quell inflation in 2011 as it was clear that the origin of the inflation was overseas. 

However, the situation may not always be so clear cut.  And it is not the first time that inflation has been out of whack with what is going on in the economy.  Interest rates were kept down in the lead up to the global financial crisis as inflation was weak due to cheap goods coming in from China.  The lower borrowing costs spurred on the lending binge which accentuated the crisis.  Inflation was picked out as a gauge which reflects the strength of an economy but it is questionable whether that is still the case. 

Europe and the United States are already struggling to deal with the rise of new challengers (for more on this, refer to A New Inconvenient Truth) as well as the aftermath of the global financial crisis (see economy still stuck in a rut for more).  Shaping monetary policy around something which is influenced by external factors is not going to be helpful in steering clear of trouble.  And, inflation in itself is not enough of a negative for the economy to be managed for its own sake (go to time to rethink inflation?).  Monetary policy should instead look at other measures of economic health such as unemployment which is obviously something that needs to be lower (to a certain degree). 

A more relevant basis for monetary policy would help bring much-needed clarity with regard to the direction of monetary policy as we wait for the Federal Reserve to start the long process of ending its quantitative easing policy.  Central banks have a lot to answer for in terms of their role in the lead up to the global financial crisis and improving the way in which the economy is managed would go a long way toward making amends.

Quantitative Easing - Harder to End than to Start

The Federal Reserve changes tack on its change of tack in monetary policy which will make it less credible in the future.

It is still a month away from Halloween but something seems to be scared Ben Bernanke, the chairman of the Federal Reserve.  Bernanke was expected to announce that the Federal Reserve would be buying fewer bonds in September but surprised most pundits (including Your Neighbourhood Economist) by deciding not to make any changes with the status quo.  The unexpected bonus of a delay to the start of “tapering” helped push stocks in the United States to record highs but gains were limited by worries about the future direction of monetary policy.  By backing down from a change in policy, the Federal Reserve has made its job of finding an exit from quantitative easing more difficult while also making it trickier for investors to understand the big question that still remains – how far off is the beginning of the end for quantitative easing?

The Federal Reserve began to signal a change in direction in May and June using its own version of forward guidance where central banks outline future policy through using economic data as markers.  The current policy of the Federal Reserves has entailed buying US$85 billion in bonds each month with interest rates set at close to zero – its forward guidance in July put forward an end to bond buying by the time unemployment reached 7% with interest rates to rise once unemployment had fallen to 6.5%.  With unemployment expected to reach its first target by the middle of 2014, there was an anticipation that the Federal Reserve would move to reduce its bond purchases before the end of 2013, so as to ensure a more gradual decline in quantitative easing which would be less painful for the economy. 

Yet, investors drew their own conclusions from the forward guidance and took it as an excuse to sell bonds whose prices had climbed to record highs (for more, see Managing Expectations).  As lower bond prices translates to higher interest rates for bonds, the bond sell-off resulted in interest rates on benchmark US government bonds increasing from around 2% to close to 3%.  This ran contrary to the gradual adjustment which the Federal Reserve was attempting to facilitate to ensure that the nascent economic recovery would not be choked off by higher interest rates. 

The jumpy market reaction along with slower improvements in the US job market were enough to spook the Federal Reserve into keeping the quantitative easing going.  Only time will tell whether the cautious approach was the right call but Your Neighbourhood Economist fears that Ben Bernanke may have been too timid for his own good.  While there is always the possibility of gremlins lurking in the economy somewhere, the timing did seem as good as it will ever be for starting the drawn-out process of tightening monetary policy.

Unemployment in the United States has fallen to 7.3% in August compared to 7.9% in January (even though part of the fall is due to some people not bothering to look for work any more).  And, while the size of the market reaction was a tad overdone, investors always factor in events ahead of time – as such, the bond sell-off was just the normal response to an end to actions by the Federal Reserve which have propped up both the markets for bonds and stocks.  So, any further movements in the financial markets were likely to have been muted.  But as it happens, prices for bonds and stock perked up as investors looked forward to continued efforts by the central bank to prop up the markets.

With the Federal Reserve forgoing an opportunity to pare back its bond purchases in September, market participants are trying to figure out the possible timing for the inevitable change in policy.  The Federal Reserve meets again in October but will have few new bits of economic data to sooth its concerns over the strength of the economy.  The subsequent meeting of the Federal Reserve is in December with this seen by many as the next chance for action. 

The cautious approach by the Federal Reserve does have its costs.  It is a fad among central banks these days to signal in advance of changes to policy, but by choosing not to follow through with the expected change of policy in September, investors will be less likely to believe the Federal Reserve in future.  In the short-term, it is unclear what will be sufficient to trigger the beginning of the end of quantitative easing – weak economic data for the rest of 2013 may see the “to taper or not to taper” saga drag on for a while yet.  The resulting uncertainty and likely volatility in the financial markets may be even more harmful than the expected tightening of monetary policy. 

A central bank is only as good as its word and the Federal Reserve has cheapened its own words.  That is a scary prospect considering the current hands-on management of the economy by the Federal Reserve and how much it will have to do to talk its way out of this management role.

Beware of a Flood of Funds

Surplus cash in the global financial system has a history of leaving havoc in its wake and quantitative easing may be making the situation worse.

There is a lot of cash sloshing around the international financial system at the moment.  Central banks are still buying heaps of bonds and there are few places in the actual economy where people are willing to invest money.  Not having cash around in the financial system can make life very difficult as shown by the credit crunch where lending by banks ground to a halt and the global economy came close to collapse.  But too much cash in the financial system can cause its own troubles.  Cheap credit is one of the causes of the global financial crisis.  More recently, emerging markets have been tested by the coming and going of a massive tide of global funds.  What can be done to ensure that more of the world is not drowned in an excess of cash?

It may seem strange but there is a lot of spare cash around at the moment but no one wants to use it.  Companies are hoarding money as business people are not confident in being able to make money through new investments, and consumers are paying off debt while being worried if their jobs are safe.  Adding to this, banks are reluctant to lend as new regulations are prompting banks to be more cautious about the amount of loans on their books. 

Central banks have tried to alleviate this problem by making it cheaper to borrow, firstly, through reducing interest rates to close to zero, and when this has not worked, printing more money with which to buy bonds.  The bond purchases also serve to further lower borrowing costs, but businesses and consumers currently seem averse to taking out fresh loans no matter how cheap it is to borrow.  Nevertheless, the bond buying continues with the Federal Reserve alone buying US$85 billion in bonds each month.  The extra cash is not going into the actual economy as there is no demand for it and it is free to be moved to anywhere in the world.

So this money is not like a still pool of cash where money can be drawn as necessary, but rather more like a tidal system where funds will flow in one direction for a certain period of time before switching to another direction depending on the alignment of economic factors.  Any free funds will always move in search of higher returns and the flows shift as economic circumstances change.  The transient nature of the funds creates economic problems due to the temporary effect of lowering interest rates and creating a surge in lending, only for the money to flow out again at the first signs of trouble.  These flows of cash now dominate the world economy like never before and can leave havoc in their wake (for more, see Where is all the money going?).  

This ebb and flow of funds is given as one of the reasons behind the global financial crisis.  The size of the pool of cash had swelled due to a glut of savings in Asia which were invested in the United States.  The resulting lower borrowing costs spurred on excessive lending which extended to sub-prime loans, eventually causing the near collapse of the financial system.  Almost the reverse has been the case in previous weeks.  Extra cash generated by the bond purchases by the Federal Reserves and other central banks had found refuge in emerging markets which had continued to grow in the aftermath of the global financial crisis.  But the tide turned with the paring back of quantitative easing in the United States, which is expected to result in higher returns from investments in the US markets. 

The worst of the effects have been experienced by India, Turkey, and Indonesia who had grown more reliant on the money coming in from overseas due to imbalances in their own economy.  But emerging markets have shored up their defences after having often been caught up in the wash of global finances.  Countries with developing economies often build up large foreign exchange reserves which are used to counteract the outflow of funds (which was ironically behind the glut in savings in Asia seen as responsible for the global financial crisis).  The use of controls which restrict the movement of funds have also become commonplace and are even somewhat sanctioned by the IMF (who are typically ideologically opposed to any limits on the free movement of resources).  Even the new range of banking regulations in the United States and elsewhere, such as rules on higher levels of capital buffers, can be seen as a buttress against the swirling forces of global finances.

However, the new measures being adopted in developed countries and in emerging markets have the goal of merely preventing the symptoms of the problems created by the surplus funds.  Furthermore, foreign exchange reserves and capital buffers come with their own costs – this money could be put to better use when the economy actually needs the extra funds.  Would it not be better to deal with the problem itself?  Central banks could come up with a way of soaking up the surplus money in the world’s financial system.  Considering the global scale of financing, this might require a new role for an international organisation such as the IMF.  It would also involve a rethink of quantitative easing and the tools available to central banks since the freshly printed cash from central banks has added another deluge of funds and has created problems of its own (see Perils of doing too much for more detail).  It would be a sad day for economists if the aggressive policies from central banks to revive the economy from the latest crisis sow the seeds of greater instability in the future.  

Managing expectations as part of monetary policy

In trying to ease concerns about higher interest rates through forward guidance, central banks have ended up doing the opposite.

Managing expectations when you work with people in an office environment can be tough but imagine dealing with the multitude of global investors as well as the international press.  This is what central banks have to cope with.  Central banks have tried to provide greater clarity regarding the direction of monetary policy using forward guidance – linking changes in policy to improvements in economic data.  The plan was to ease concerns that monetary policy would be tightened too soon through fewer bond purchases and eventually higher interest rates.  But forward guidance instead triggered the selling of government bonds with investors now expecting tightening of monetary policy sooner than central banks are suggesting.  Why have investors reacted in this way and what might central banks do in return?

A change in monetary policy was always going to be a tricky proposition considering the influence that the central banks have built up over the markets due to their purchases of billions in bonds as part of quantitative easing (refer to Caution - Windy Road Ahead).  It all started with a statement by the Federal Reserve in the US in June that it was considering tapering off its bond purchases which currently amount to US$85 billion.  Any new policy initiatives in the US are predicated on the pledge by the Federal Reserve that interest rates will remain at their current low levels until there is substantial improvement in the labour market.  This is one version of forward guidance that has also been adapted by Mark Carney, the new governor of the Bank of England, who also linked future decisions on monetary policy to the unemployment rate in the UK (for more, see Same low interest rates but for longer).  The reasoning behind forward guidance is twofold – to assure potential borrowers that interest rates will stay low for a few years yet and to placate fears that tightening of monetary policy will hurt the nascent economic recovery.

Not much of a market reaction was expected from these announcements as central banks were signalling that changes to the status quo would be gradual depending on the state of the economy.  However, investors have reacted in a way that seems to suggest that tightening of monetary policy is imminent, that is, by selling off government bonds.  The interest rates on government bonds have risen from record lows and 10-year bonds issued by the US and UK governments have both reached close to 3% (lower bond prices due to selling results in higher interest rates on bonds).  Why did the markets respond in this way to seemingly innocuous comments?

Cautious investors had been big buyers of safe assets such as UK and US government bonds due to the weak state of the global economy coupled with the sovereign debt problems in Europe.  This had capped off a period where bond prices had followed an upward trend for a few decades, which is a long time in investment markets.  Higher bond prices had pushed interest rates to painfully low levels so the timing was ripe for investors to move their money somewhere else.  All that was needed was a trigger and this ended up being the statements on forward guidance.  It is as if the mere mention of the end of the current loose monetary policy got investors thinking that a bond sell-off was coming and that it would be better to beat the rush.

For holders of UK government bonds, data on the economy has added to the reasons to sell.  The OECD released economic forecasts in early September which predicted that the recovery in the UK would pick up pace faster than in other countries.  A potential housing bubble in the UK adds to concerns that the Bank of England will have to increase interest rates earlier than planned.  Mark Carney also left plenty of escape clauses in the forward guidance pledges which allows the central bank the freedom to act but gives rise to worries that interest rates will not stay low for as long as has been suggested.

The rebellion of the markets against the careful planning of the central banks does throw up a few issues.  Considering that both the US and UK have mountains of government debt, higher interest rates will translate through to greater limitations on government spending which, in turn, will hurt the economy.  The fortunes of the global economy have also taken a hit with higher returns on bonds prompting investors to repatriate money invested in emerging markets over the past few years when there were few other investment options.  But the rush of money leaving places such as India and Turkey has brought howls of protest as well as fears about the ramifications of the end of quantitative easing on international finance.

It is central banks that now have to make the next move.  Yet this could involve doing nothing.  The tightening of monetary policy was never going to be easy and the recent jumpiness of investors could be just seen as collateral damage.  This would be a prudent option if central banks believe that there is nothing else that they could do to dictate the directions of the market.  But, on the other hand, central banks may decide to wrest back control of the expectations of investors.  Such a course of action could be prompted by fears that interest rates on government bonds, which act as a benchmark for interest rates throughout the whole economy, are too high at a time when the economic recovery is just starting in earnest.  Since forward guidance has shown that mere words are not enough, central banks may have to act, possibly with more bond buying.  Such a shock would bring investors back into line and serve as a reminder not to second-guess central banks.  However, with central banks likely to be keener to step out of the limelight (for What's the rush?), investors are likely to be left to their own devices.

Time to reform the Microsoft Monopoly

Windows software is used by many of us every day but is it right that we have to pay the price for Microsoft’s follies?

One reason why economist are always plugging reforms is that they often enable greater competition which is good as it pushes firms to offer better products for lower prices.  The opposite of this is monopolies who dominate a sector of a market resulting in higher prices and lacklustre products.  There is one monopoly in particular that Your Neighbourhood Economist loves to hate – Microsoft. 

Over 90% of the world’s computers run a version of Windows (including the one that this blog is being written on) which provides Microsoft with a captive audience and allows it to charge high prices for its products generating bucket loads of profits.  However, the failure of Windows 8 and a host of other products shows that Microsoft does not have a great track record in terms of customer satisfaction – it seems to prioritise extending its empire above anything else.  But the influence of Microsoft is even worse than that and here is why.

The dominance of Microsoft comes through a phenomenon known as a network effect.  This is where a product becomes more useful (and valuable) to each user as more people use the product.  The software products from Microsoft have become the global standard for exchanging documents between computers and this has locked everyone into Microsoft’s software with few other options outside the mainstream.  The same phenomenon can be seen elsewhere with Twitter and Facebook but the ease of switching does not result in user being beholden to one provider of a service such as has been shown with the rise and fall of MySpace. 

Economic theory shows that it is optimal for firms operating as monopolies to charge higher prices than normal to extract maximum profits from its consumers.  Microsoft seems to be doing a good job of this and generated US$23 billion in surplus cash in the past fiscal year from revenue of US$78 billion.  Some of this cash would go towards making improvements to its software products but a substantial portion is also spent on extending its influence to other areas.  Its first big foray was bundling of its own web browser with its other software in the late 1990s to shut out a rival in the shape of Netscape.  But this proved to be the first of many costly strategic errors as Microsoft ended up with a hefty legal bill after being found to have abused its dominant market position.

Microsoft has struggled to get its foot in the door in a range of burgeoning Internet markets such as online searches and social networking but it has lacked the market nous of rivals such as Google and Facebook.  It has also been left trailing in the wake of Apple and Google in terms of software on tablets and smart phones with electronic manufacturers cautious about dealing with Microsoft.  This is because Microsoft’s profits on its computer software have come at the expense of the firms that make the hardware and the market for computers as a whole with sales of PCs expected to decline by around 10% in 2013.

Microsoft comes across as a company from a different era, lacking a consumer focus and being unable to innovate fast enough.  It seems to have more of an engineering mind-set with new product development as not one of its strong points – its only one popular offering has been its Office software over twenty years ago which was first pioneered by Apple.  This is perhaps best personified by its Windows 8 software, which was an attempt to use its free reign in PC software to rescue its fortune with tablets and phone by imposing the same touch-screen format on PCs as well but instead further alienated consumers due to its being ill-suited for use on computers.  Such a slip-up with its main product would be the death of most other firms but Microsoft lives on.

One of the basic notions behind capitalism is that a prospering company is good for the whole economy as it’s presumed to be providing a product which is in demand.  But Your Neighbourhood Economist would argue that Microsoft fails this test.  Its position in the PC market means it’s more like a tax which many PC buyers have no choice but to pay hurting both consumer and computer makers with few benefits – Microsoft uses its market ascendancy for a series of failed attempts to gain footholds elsewhere.  This will be the likely conclusion of its purchase of Nokia’s mobile phone business with Microsoft’s previous venture into hardware, its Surface tablet, resulting in a US$900 loss in the previous fiscal year.  Its rivals could not be more different – Apple generates almost religious fervour in its products while Google invests money in such far-fetched schemes as driverless cars and glasses doubling as wearable computers which could benefit society well beyond its mainstay business of online searches.

Having made the case that Microsoft has monopoly control and that this is resulting in higher prices with scant benefits for consumers, the only thing that remains is deciding what should be done.  One line of thought could be to strip Microsoft of its ownership of its Window software due to its market abuse and allow other firms to provide their own versions.  But there is a notion in economic theory that innovation deserves financial reward to ensure that firms will take risks in developing new products in the hope for a pay-out in the future.  So even though many who invested in Microsoft have already been richly rewarded, the company does deserve some financial compensation. 

With this in mind, Your Neighbourhood Economist would argue for a licensing agreement whereby other firms would get access to the technology behind Windows software and are able to add improvements to attract their own customers.  This is because the software from Microsoft is so widespread that it is part of digital infrastructure needed to do business and allowing such key infrastructure to be managed by one firm has been problematic.  This possible solution is similar to the way in which other monopolies have been dealt with in the past – phone companies who have gone to the trouble of laying down cables are no longer allowed to monopolise the market and must offer up the use of the cable to other firms but at a fee.  Microsoft’s time has come and gone but we should not all have to suffer because of it.

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…