Annual Report on

The Japanese Economy and Public Finance


- No Gains Without Reforms V -

Cabinet Office

Government of Japan

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 Elimination of the negative legacy of the bubble economy
    The negative effects of the collapse of the bubble economy lasted more than ten years but now the adjustments in the economy needed to overcome these effects have been largely completed. The non-performing loans issue, which was a major drag on the economy and a big factor behind the long-term stagnation, has been normalized. In addition, Japan has also overcomes the issues of excessive employment and excessive capital stock, which were factors hindering economic revitalization. It can be concluded that the concentrated adjustment period has mostly achieved the hoped-for results, including the halt of the deflationary spiral and the disposal of non-performing loans.
    The ratio of non-performing loans of the major banks fell below 3% in the term ended March 2005. The disposal of non-performing loans involved considerable cost, but unlike the disposal measures taken in the 1990s, efforts were made to increase the rigor of asset appraisal and to strengthen systems for disposing of bad loans in financial institutions. For this reason, off-balance sheet accounting, the proper solution to the problem, moved forward. The problem of non-performing loans was normalized and concerns about the financial system were put to rest.
    In addition, the Industrial Revitalization Corporation fulfilled its role in financial institutions' adjustment of their mutual debt relationship and revitalizing the business of companies holding excessive debt. Further, by using out-of-court work-outs and company revitalization funds, the problems of many companies were dealt with not through bankruptcy but through revitalization, thereby easing the pain of increased unemployment.
    The financial system has been stabilized and the strength of the major banks is being restored. Positive efforts have commenced to channel the experience gained from disposal of non-performing loans into a forward-looking company revitalization business. The lending propensity of financial institutions has also improved. It is now important to ensure that the accomplishments of the concentrated adjustment period are instrumental in achieving sustained growth.

 Moderate recovery of the economy continues
    The economic recovery from the beginning of 2002 has entered its fourth year. Up to now, recoveries have averaged 2% growth annually. The current recovery has been substantially affected by Asia and the United States in both positive and negative ways. For example, production increases in the IT sector due to stronger external demand in the initial stage of the recovery provided support, but when external demand lost steam, it worked to depress domestic production. However, the driving force of growth is private-sector demand such as consumption and investment. When the problems of over-employment, excessive debt, and excess capital stock were ended, domestic demand lent firm support to economic recovery. In other words, the improvement in the balance of labor supply and demand for the first time in nearly 10 years raised consumption, and the growing strength of the business sector brought higher profits and increased investment. These developments bolstered the sustainability of the economic recovery.
    In the first half of 2005, crude oil prices rose sharply, and weakness in exports and other factors worked to depress the economy. At the same time, however, changes appeared that raised expectations of a prolonged economic expansionary phase. These are welcome developments for the domestic economy. Thanks to the end of over-employment, labor share, which has been undergoing continuous adjustments, has declined to the long-term equilibrium level. Sustainability of the current expansion phase depends partly on whether or not an improved demand and supply condition in the labor market leads to employment growth and wage increase.
    If the expansionary phase is prolonged, autonomous mechanisms of the economic cycle will require close watching. According to the determination of the Business Cycle, there have been four long-term expansions exceeding the post-war average economic expansion periods. If the economic expansionary phase is prolonged, the maturation of the economy will become an autonomous reversal factor, even without exogenous shocks. To give an example: (1) growth in corporate profits slows due to a downturn in consumer demand, (2) declining demand leads to an unintended rise in inventories and a sense of excessive capital stock, and (3) if these developments work cumulatively, they pose the risk of initiating adjustments in production and stock.

 Overcoming deflation still an important challenge
    The consumer price index (excluding fresh food) has declined year-on-year for seven consecutive years since FY1998. The seven-year cumulative figure is a decline of about 3%. Since the latter half of 2004, reductions in public utility charges (telecommunication, electricity, etc.) have contributed to the decline in the consumer price index. Although the sharp rise in crude oil prices in recent years has increased prices in upstream sectors, the pass-through to prices in downstream industries has been extremely weak. In addition, the GDP deflator has continued to fall year-on-year for seven consecutive years. This continuing moderate deflation is caused by the fact that supply and demand conditions remain obscure, as well as weak growth in the money supply, due primarily to continued negative year-on-year growth in bank lending. Deflation has delayed improvements in the efficiency of resource distribution and has the capacity to depress forward-looking economic activity that involves risk. It is necessary for the government and the Bank of Japan to continue to work together to strengthen and expand policies for overcoming deflation.
    The value of land assets (relative to GDP) has been reduced to half of the peak amount, and has declined to nearly the level of the first half of the 1980s. However, differences between geographical areas are arising in this land price decline. Although the rate of decline in the regions has slowed, the decline nevertheless continues. On the other hand, land prices in central metropolitan areas have turned upward, one reason being the healthy market for real estate-backed securities. In the regions, too, there has been a gradual recovery in some areas in the profitability of land, and if land transactions expand, the trend in land prices is likely to change.

 Aiming for small government
    There is no common global standard for the optimal size of government. The appropriate size of government for each country depends on that country's history, citizens' preferences regarding the benefits they receive and burden they shoulder, and the design of systems for provision of public services. An important point is when focusing on the future, however, to tackle problems as they arise, without postponing action until later.
    Under the current system, declining birth rates and the aging of the population will expand the size of Japan's government. According to an estimation for reference by a working group in the special board of inquiry for examining "Japan's 21st Vision" of the Council on Economic and Fiscal Policy, the size of general government will reach 48% relative to GDP in FY2030. From FY2005, this constitutes a substantial 11 percentage point increase. This means that the size of the Japanese government will approach that of countries in the euro zone. An estimation using OECD country data suggests that there is an inverse relationship between the amount of government spending and the economic growth rate. Therefore, there is a strong likelihood that if Japan's system is left as it is, the distribution of resources throughout the economy will become inefficient.
    Surveys have made it clear that the people of Japan are becoming more supportive of the idea of small government. The support of citizens is a powerful boost to policy promotion. The Basic Policies, 2004 calls for curbs on increases in government size, keeping, for example, the potential national burden to around fifty percent50%. Public works costs continue to be reduced, and spending relating to public services is moderating. Reforms are underway in social security, where the impact of declining birth rates and aging of the population is palpable. It is hoped that bold reforms focused on the future will be implemented on an accelerated schedule.

 Shift from the public sector to the private sector is the tide
    In the initial stage of economic growth, shortage of capital accumulation is often a restricting factor, and, at this stage, the role of government is decidedly important. However, when national saving increases and private-sector capital accumulates, the role of government declines. Therefore, in virtually all countries of the world, the historical trend has been to leave to the private sector those activities which it is better suited to accomplish.
    Since the Meiji government, the government has played a major role in the establishment of infrastructure in Japan. Shifting focus to the post-war economy, the former national telephone corporation and national railways under the public corporation system supported Japan's social foundation. Implementation of administrative reforms in the mid-1980s resulted in the privatization of these corporations. The form of management of NTT and JR has changed, and both companies have achieved major improvements in efficiency in the new competitive environment. Beginning in this fiscal year, market tests that compare private and public sector service provision efficiency have been introduced on a trial basis and the government in Japan is attempting to enter a new era.

 Improving convenience through private businesses
    The importance of the shift from the public sector to the private sector can be summarized in three points:
    Firstly, the shift from the public sector to the private sector, or the incorporation of the methods of the private sector, will improve in the quality of services and offer a variety of services. Some argue that the withdrawal of the public sector will result in unnecessary cost reductions and a decline in service quality. However, survey analyses of designated management entities have made it clear that private businesses are capable of improving the convenience of residents, who are their customers, so long as the setting of objectives by the government proceeds favorably. In addition, unlike the public sector, which tends to adhere to established conventions, the private sector can be expected to provide a diversity of services through its creativity and inventiveness. Particularly in fields including education, medical care, and nursing care, it can be expected that the provision of diverse services at suitable prices through the participation of private sector businesses will allow appropriate selection of public services through market mechanisms. At the same time, the business of the private sector is expected to thrive through increased service opportunities.
    Secondly, it is also important to reconstruct the government sector. Public finance plays a major role in resource distribution and promoting stable growth and income distribution. In order for public finance to maintain the ability to respond flexibly in this era of declining birth rates and aging of the population, the efficiency of the government sector must be improved. There are many types of economic activities which the public sector should carry out at a certain stage of economic development but should leave to the private sector at the next stage. It is necessary to constantly review the role of the public sector. Moreover, the reconstruction of the government sector will change the flow of funds substantially. Reform of Fiscal Investment and Loan Program has been underway since 2001, and results have been achieved. However, in light of the requirements of the era, it is important to promote the privatization of the postal service as the inflow toward reevaluation of the appropriate role of policy financing as the outflow.
    Third, the shift from the public sector to the private sector is also important from the perspective of reducing the fiscal deficit. If policy undertakings remain in the public sector, there is considerable room for a softening of budget restrictions. Budget discipline would have been maintained if authority for the budget had been given to the private sector. If there is no income backing, an expansion of the fiscal deficit will result. Japan carries the largest fiscal deficit of the industrialized countries, and in order to equalize the primary balance, a clear reevaluation of the causes of deficit expansion is required.

 Population decline begins
    In the 15 years since the collapse of the bubble economy, the structural problems of over-employment, excess capital stock, and excessive debt have been resolved, and have been replaced by the emergence of a new structural problem, namely, the decline in Japan's overall population. According to population estimates, Japan's total population will begin to decline in 2007. However, although the population is growing in some prefectures in Kanto, Tokai and in Okinawa, in other regions the population has already begun to decline. The regions in which population is declining account for about half of Japan's GDP but 80% of Japan's total land area. These economic and geographic relationships are a factor in the appearance of disparities between areas in economic recovery.
    There is no need for excessive concern about the problem of declining population, because population trends can be predicted in 10-year units and precautionary measures can be developed in advance. Through repeated analytical surveys, the economic outcome of population movements can be dealt with so long as policies are formulated to turn the outcomes into positive developments. What is important in this case is the need to eliminate bias toward the protection of vested interests. A highly effective means to this end is generation accounting, which explicitly takes into account future generations. Hopes are pinned on policy opinions in this regard.

 Approaching retirement of the baby-boomer generation
    An important and widely anticipated change concerning population movements is the mandatory retirement of the large block of people of the baby-boomer generation beginning in 2007.
    The baby-boomer generation made a big contribution to the development of the post-war economy. This generation constituted a major force not only by providing a body of diligent workers but also by exerting a significant influence on household trends in consumption and housing. This generation will begin to reach the age of 60 from 2007. The retirement of these people will have a major socioeconomic impact. If the period following the collapse of the bubble economy is examined, the baby-boomer generation, which worked under the systems of lifetime employment and seniority-based wages, was a factor in increasing labor costs. Consequently, this generation helped to exacerbate the harsh corporate environment left by the collapse of the bubble economy and had a negative impact on the employment of young people during that period. In recent years, however, the retirement of the baby-boomer generation has come into view, and youth employment is beginning to rise in both the mid-career employment field and new granduates employment field.
    Although in quantitative terms a balance has been maintained between retirement and new employment, the retirement of the baby-boomer generation presents a qualitative problem, that is, the difficulty of ensuring the highly-developed skills built up by the baby-boomer generation are handed on to the next generation. Japan's capacity in manufacturing depends heavily on these skills. In international comparisons, Japan's elderly have a high labor force ratio, but now the labor force ratio of this group is heading downward. From the perspective of the vitality of the Japanese economy, the importance of creating an environment in which people including the baby-boomer generation can exercise their abilities irrespective of age is increasing.
    In the area of household consumption, the baby-boomer generation is expected to lead the economy. The consumption of services and time is firm, and housing acquisition in the pursuit of convenience is brisk. In addition, in their financial asset preferences, the risk tolerance of the elderly group is high. In the years ahead, the baby-boomer generation is expected to create new lifestyles and to become a key element of demand.

 Promoting of market-driven reforms
    Expressing "from public sector to private sector" in different words, "from the state to the market" most appropriately reflects its content. That is, the fundamental essence of this shift lies in the importance it places on the role of markets.
    From the post-war period of high growth to the 1980s, growth was supported by moving people, goods, and capital into sectors with high earnings and high wages. Assisted by countermeasures against infrastructure bottlenecks, supplementary funding through guidance policy financing, and tax breaks, the economy was able to overcome such difficulties as the skyrocketing international balance of payments, oil crises, and currency shocks, and, as a result, increased in efficiency. However, since the 1990s after the collapse of the bubble economy, price signals have failed to fulfill its their role to as it had been expected. This is because, in the past, when the resources needed for production in some fields became relatively scarce, increases in the prices of these resources spurred the input of resources, but after the collapse of the bubble economy, an oversupply of resources occurred, and the withdrawal of resources became necessary. Therefore, without reform, growth will be difficult.
    Now that adjustment of the problems of excess in the economy has been completed, Japan has a good opportunity to move from defensive to aggressive reforms. Changes in relative prices fulfill a basic role in the distribution of resources. It is important to advance reforms that encourage the flow of resources into sectors with high productivity and profitability, in the concentrated consolidation period beginning this fiscal year. Eliminating factors hindering market mechanisms and enhancing the spread of economic effects will lead to the development of the acorn into a mightly oak tree.

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