Section 3 Recent Development of Fiscal and Monetary Policies

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The Japanese government repeatedly implemented economic stimulus packages to cope with prolonged recession since the collapse of the bubble economy and the Bank of Japan has been continuing easy monetary policies. But these policies failed to lead to a sustainable economic recovery led by private demand. Meanwhile, the government has come to huge fiscal debt due to fiscal stimulus packages, increase in social security-related expenses, and decrease in tax revenues caused by the prolonged recession and tax cuts.

The government needs to promote fiscal structural reform. The main purposes of the reform are 1) reduction of the huge fiscal deficits and 2) review of government spending. The question is how to promote the fiscal structural reform amid the ongoing deflation. The Bank of Japan, for its part, is required to carry out effective monetary easing policies to overcome the deflation. The Japanese central bank has been taking quantitative monetary easing policies since March 2001, but their effect on the economy is not necessarily clear.

In this section, the problems involved in the fiscal and monetary policies and their effects on the economy will be examined.

1. Impact of the Fiscal Structural Reform on the Macro Economy

blackcircle Impact of the fiscal structural reform on the macro economy

First, let' s take a look at the scale of national and local governments' expenditures. On an initial general account budget basis of national government, starting 85.0 trillion yen in FY2000, decreased to 82.7 trillion yen in FY2001 and to 81.2 trillion yen in FY2002. Under the initial local public financial program, expenditures increased to 89.3 trillion yen in FY2001 from 88.9 trillion yen in FY2000, but decreased to 87.6 trillion yen in FY2002.

The reduction in the scale of expenditures reflects the efforts for fiscal structural reform. With fiscal deficits of both the national and local governments expanding and their outstanding debts staying at a high level, it is important to promote fiscal structural reform, as we stated in last year' s annual report on Japanese economy and public finance. At the same time, however, cutting government outlays in itself has some negative effects on the macro economy in the short run. Examining the macro effects of fiscal policy is important in considering development of macro economy as well as ideal fiscal policy.

However, the above figures are all based on initial plans. They do not include supplementary budgets and those carried forward from the previous term. Moreover, in public finance, the impact of social security funds is huge. With those points in mind, we will examine the macro effects of fiscal policy by referring to the movement of the general government in the National Account.

A standard tool to use in examining the macro-economic effects of fiscal policy is multipliers. A multiplier shows how much gross domestic product, etc. can be increased by increasing government spending or by implementing tax cuts. For example, an increase in public investment, which in itself is an increase in effective demand, will further increase effective demand for private consumption, business investment, etc. as it increases wages and profits. A public investment multiplier shows how much increase in gross domestic spending, etc. has been achieved as a result of an increase in public investment. A reduction in individual income tax also has a similar spillover effect, as it increases disposable income and thus increases private consumption. A tax cut multiplier shows how much gross domestic spending, etc. is to be increased by a tax cut.

However, the magnitude of the multiplier differs depending on forms of fund raising. If fiscal spending or a tax cut is financed by public bonds, its effect is relatively large. But if it is financed by taxes, its effect is relatively small. The former is referred to as a budget deficit multiplier and the latter as a balanced budget multiplier(67). We will study two factors: 1) the size of fiscal spending and 2) the financing method for fiscal policy.

blackcircle Fiscal spending of the general government is currently leveling off

The total fiscal spending of the general government (See Figure 1-3-1) leveled off in FY1999 and 2000, after remaining on an increasing trend throughout the 1990s. Let' s take a look at the breakdown of fiscal spending.

Figure 1-3-1 General Government's Expenditures

The final consumption expenditure of the government has consistently been on an increasing trend. This is largely due to an increase in medical benefits in kind. Medical benefits in kind are the portion of the value of medical services, etc. paid by social insurance funds excluding fees paid by individuals. Public fixed capital formation began to decrease in FY1999 and kept decreasing in FY2000 and 2001. This was due to a sharp decrease in fixed capital formation by local governments, which are responsible for some 80% of the public fixed capital formation of the general government(68). Although public investment was slashed by 10% in the initial budget for FY2001, the actual decrease in public investment is expected to become smaller--as envisioned in the initial budget--since most of the additional public investment incorporated in the second supplementary budget for FY2001 is to be executed in FY2002.

Social security benefits transfer is on an increasing trend, mainly for pension payments, against the background of the population aging.

Although the annual expenditure of the central government has been slashed on an initial budget basis and public investment is on a decreasing trend due to the fiscal structural reform, the overall fiscal spending of the general government is currently leveling off due mainly to an increase in social security-related spendings. Spendings remains at almost the same level when combining the public fixed capital formation and final consumption expenditure of the government, which are themselves part of final demand and considered to have a relatively large spillover effect(69).

blackcircle Tax revenue decreased and budget deficit increased slightly

Next, let' s take a look at the revenues of the general government (See Figure 1-3-2).

Tax revenues increased in FY2000 as a huge amount of postal savings time deposit matured during the year. In FY2001, however, tax revenues are believed to have decreased, as the effect of such special factor was smaller and as taxable income is decreasing, which can be seen from the decline in Nominal GDP(70).

Social security contributions as a whole increased slightly in FY2000 (up 0.5% over the preceding year) as a result of the introduction of a nursing-care insurance scheme, although pension contributions decreased due to a decline in Nominal GDP. Social security contributions are also expected to post a slight increase in FY2002 due to full-scale introduction of the nursing-care insurance scheme and the hike in employment insurance premiums.

The budget deficit, which is the difference between fiscal spending and revenue, is expanding due to a decrease in tax revenues. The balance of savings and investment (See Figure 1-3-3) narrowed in FY2000 due to the special factor mentioned earlier, but is estimated to have widened in FY2001.

Figure 1-3-2 General Government's Revenues

Figure 1-3-3 Factor Analysis of General Government Budget Deficit

blackcircle The short term negative impact on the macro economy was small

The short-term impact of FY2000 - 2001 on the macro economy can be summarized as follows.

1) If final consumption expenditure of the government and public fixed capital formation, whose multipliers are relatively large, are combined, fiscal spending remained almost unchanged. Although their spillover effects may be different, generally speaking, the fiscal spending is not considered to have had a considerable negative impact on the macro economy.

2) The slight increase in budget deficit is considered to have increased the multiplier effect in the short term(71).

Although the fiscal structural reform made progress in FY2000 - 2001, public finance as a whole is not considered to have had a major negative impact on the macro economy in the short term.

blackcircle Structural deficit and cyclical deficit

Fluctuations of fiscal deficits include both the portion of fluctuation resulting from discretionary fiscal policies and the portion of the change in fiscal balance caused by business cycles. From this standpoint, the factors behind fluctuations of fiscal deficit were divided into cyclical balance (fluctuations of fiscal balance caused by business cycles) and structural balance (fiscal balance excluding the cyclical balance) (See Figure 1-3-4).

According to Figure 1-3-4, cyclical deficits decreased slightly in FY2000, whereas structural deficits remained almost unchanged if the decrease caused by the maturity of huge amounts of postal savings is excluded. In FY2001, structural deficits are expected to have decreased slightly, whereas cyclical deficits are expected to have expanded due to the deterioration of the economy. The portion of cyclical deficits that increased automatically in response to business cycles can be viewed as the portion corresponding to the effect of the built-in stabilizer. Considered from this standpoint, it can be said that the negative effect of the decrease in structural deficits was offset by the positive effect of the built-in stabilizer in FY2001.

Figure 1-3-4 Structural Budget Balance and Cyclical Budget Balance of General Government

blackcircle Efforts for the fiscal structural reform

The outstanding balance of long-term debts of the national and local governments is increasing, as the huge fiscal deficits remain undiminished. The balance of long-term debts of the central government stood at 491 trillion yen at the end of FY2000 and 514 trillion yen at the end of FY2001 and is expected to come to 528 trillion yen at the end of FY2002. The balance of long-term debts of local governments stood at 181 trillion yen at the end of FY2000 and 190 trillion at the end of FY2001 and is expected to come to 195 trillion yen (all figures include those overlapping with national government' s debts) at the end of FY2002. The balance of long-term debts of the national and local governments combined is expected to come to about 693 trillion yen (about 140% of GDP) at the end of FY2002. The ratio of bond issue to total general account expenditure has been staying at a historically extremely high level in recent years and is expected to come to 36.9% at the end of FY2002.

Since the public debt outstanding has come to a high level and jeopardizes the sustainability of public finance, the government has stepped up its efforts for fiscal structural reform.

According to "Structural Reform and Medium-Term Economic and Fiscal Perspectives" (January 2002), (hereinafter referred to as the "Reform and Perspectives" ), the government strives to improve the quality of fiscal spending through the fiscal structural reform and keep the size of government (the ratio of spending of the general government to GDP) during the "Reform and Perspectives" period at the same level as its current size. With regard to public investment, for example, the "Reform and Perspectives" says that, throughout the target period, the government will strive to limit public investment to the level seen before huge amounts of additional stimulus measures were made and make focused, efficient investment, while taking into account the economic trends of the time. It also says that the level of public investment by local governments should be reviewed in the same way as in the case of central government investment. It envisages that as a result of these efforts and steady growth led by private-sector demand, the combined primary balance deficit(72) of the national and local governments will be reduced to nearly half the current level by around FY2006 and will be turned into surplus in the early 2010s.

blackcircle Deflationary effect of the fiscal structural reform

In this way, public spending should be restrained in the fiscal structural reform for the time being, with the aim of turning the primary balance into surplus. This is something that must be done in order to ensure the sustainability of public finance. At the same time, however, it may have a negative effect on the macro economy in the short term. How to present specific procedure for the fiscal structural reform is an important agenda at a time when the Japanese economy is still in a fragile state.

Connected with this, the question of whether or not the non-Keynesian effect can be observed in Japan as was observed in Europe' s experience is important. It was generally believed that a tax increase or a cut in fiscal spending reduces aggregate demand and thus has negative impacts (Keynes effect) on GDP and private consumption. On the other hand, the non-Keynesian effect means that fiscal reconstruction rather have positive impacts on private consumption depending on economic or fiscal conditions(73).

If such an effect can be expected, the deflationary effect of the fiscal structural reform would be offset. But, what is important as the precondition for such an effect to take place is people' s trust in government' s commitment to the fiscal structural reform. The fact that long-term interest rates are stable at low levels means that at the present moment the market is maintaining its trust in the sustainability of public finance to a certain extent. Under such circumstances, it is important to steadily implement the items delineated in the "Reform and Perspectives" and consolidate this trust. blackcircle Review of the contents of fiscal spending is also important The "Reform and Perspectives" points out the importance of lessening the negative impact of fiscal spending on the macro economy through reviewing the contents of fiscal spending. It calls for increasing the productivity of the private sector and shifting fiscal spending to fields that can induce private capital investment by reviewing the contents of fiscal spending in order to ease the negative impact on the macro economy of a cut in the size of fiscal spending.

Public investment forms social capital stock which enhances the productivity of the private sector. Social capital stock has mainly two effects. One is a direct effect in that an increase in social capital stock itself enhances productivity. The other is an indirect effect in that an increase in social capital stock enhances the marginal productivity of private stock and thus induces private capital investment. The latter is a private investment inducing effect.

According to various researches on the productivity effect of social capital(74), the effect varies by type of industry and by region. The findings show that, generally speaking, the productivity effect is particularly high in the secondary and tertiary industries and in urban areas. Therefore, in promoting social infrastructure, while keeping the productivity effect of social capital in mind, it is necessary to develop social infrastructure that will form the foundation for affluent national life and strong economic activity in the most efficient way from the viewpoint of allotting the limited resources efficiently.

In the initial budget for FY2002, under the policy of "reducing 5 trillion yen, while redistributing 2 trillion yen to focused areas," the emphasis in budget allocation shifted to prioritized areas (the environment, the aging of the population and declining birthrate, revitalization of local communities, revitalization of urban areas, promotion of science and technology, and human resources training/education/culture and the realization of an IT nation). It is important to continue focused budget allocation in the future based on this idea.

blackcircle Bold and flexible measures

Since late 2001, the government has carried out bold and flexible policy measures in light of the dramatic changes in the economic situation in the wake of September 11. The government has compiled the "Immediate Action Program for Structural Reform" and, based on this, formulated and implemented a 4.1-trillion yen second supplementary budget for FY2001, thereby further accelerating the process of structural reform and averting a deflationary spiral. These measures are designed to improve the quality of public spending and commit fiscal structure reform in the medium term, and to prevent the economy from falling too excessively in the short term. Their effects were mainly seen in the April-June quarter of 2002.

When further promoting the fiscal structural reform, it is important to take bold and flexible policy measures as required, while closely watching their impact on the macro economy.

2. Macro Effects of the Quantitative Easing

blackcircle Expected effects of the quantitative easing

Since the collapse of the bubble economy, monetary policy has basically been broadly accommodative conditions. Until March 2001, the Bank of Japan used short-term interest rates as its operating target and lowered the rates continuously. For example, the official discount rate was lowered a total of nine times after July 1991 and dropped to 0.5% in 1995(75). In July 1995, the uncollateralized overnight call rate target was set at a level below the official discount rate. The target level of the uncollateralized overnight call rate was lowered to 0.25% in September 1998 and a "zero interest rate policy" was adopted in 1999(76).

However, with the economy entering a recession phase and the deflation continuing, it became necessary to ease the monetary policy moreover. In response, the Bank of Japan decided at its Monetary Policy Meeting in March 2001 to change its operating target to the outstanding balance of the current account at the BOJ and keep it in place until the deflation came to an end(77) and set its immediate target at around 5 trillion yen (an increase from around 4 trillion yen). This represents a shift to "quantitative easing" (78). Since then, the target level was raised gradually. In addition, the central bank increased the amount of its overnight purchases of long-term government bonds as a means to raise the level of the outstanding balance of the current account(79) at the BOJ.

The quantitative easing is said to have two effects in stimulating the economy. The first effect, which is common to that of past monetary easing measures, is to lower interest rates. However, since short-term interest rates are already close to zero percent and due to the non-negativity constraint of nominal interest rates, we cannot expect a further fall in short-term interest rates. Therefore, reductions in long-term interest rates are expected.

The second effect is through "portfolio rebalancing," which is particular to quantitative easing. This is the effect of creating the expectation that an increase in no-risk, no-return assets of the outstanding balance of current accounts at the BOJ would change asset managements not only financial institutions but also in the economy as a whole and would increase higher-risk, higher-return assets. Higher-risk, higher-return assets are, for example, bank loans. Needless to say, an increase in bank loans means that the real economy would be revitalized(80). The effect through interest rates was observed to a certain extent at the time when the quantitative easing was adopted. Since how long short-term interest rates will remain at their current low level is important for long-term interest rates, the BOJ' s commitment to continuing the quantitative easing until the deflation comes to an end is significant in that it has set a "timeframe." However, with long-term interest rates already at low levels, we cannot expect more than a certain level of effect(81).

The next question is the effect of "portfolio rebalancing." We will examine the effect of the quantitative easing, focusing on this point. Our conclusion is that the transmission effect through bank loans, which has been known as the transmission mechanism of the monetary policy, is hardly working. But transmission of the effect through currency depreciation may be effective.

blackcircleMonetary base shows high growth rates

First, let' s examine the change of the monetary base (See Figure 1-3-5).

Figure 1-3-5 Change of Money Supply

Before 1998, monetary base had been moving steadily due mainly to a rise in the amount of cash currency in circulation. Between 1999 and 2000, the contribution of the outstanding balance of current accounts at the BOJ increased due partly to the reduced opportunity cost caused by the zero interest rate policy and partly to increased liquidity preference triggered by the Y2K problem.

After the implementation of the quantitative easing in March 2001, the contribution of the outstanding balance of current accounts at the BOJ increased further in response to the Bank of Japan' s move to gradually raise the target of the outstanding balance of the current accounts of the BOJ(82). Meanwhile, the outstanding balance was kept at a level considerably higher than the lower range of the target. Cash in circulation also posted a high growth rate towards the end of FY2001 ahead of the proposed the removal of deposit insurance. As a result, the growth rate of monetary base rose from 1.2% (year-on-year) in March 2001, or shortly after the adoption of the quantitative easing, to 27.6% (year-on-year) in June 2002.

Such a high growth rate of monetary base is almost unprecedented(83). Even measured by a certain rule based on the growth rate of GDP and the velocity of money, the growth rate of monetary base is high, indicating that ample funds were supplied(84).

As a result, the call rate dropped to virtually zero percent. This is indeed a low level. However, if the optimal call rate level is calculated by, for example, a certain rule based on the growth rate of prices and supply-demand gap(85), it can be seen to be a negative interest rate. This suggests that the current call rate level has come to pass due to the non-negative constraint of nominal interest rates. It can be said that quantitative easing is necessary for this reason.

blackcircle The growth of money supply is low

When monetary base increases, money supply normally increases as well via credit creation through bank loans. The ratio of the growth of money supply to the growth of monetary base is called the money multiplier.

When the money multiplier is constant, the growth rate of monetary base corresponds to the growth rate of money supply. However, a comparison of their year-on-year growth rates shows that while the year-on-year monthly growth of monetary base rose from 1.2% (March 2001) to 27.6% (June 2002), that of money supply (M2+CD) rose only slightly from 2.5% to 3.4%(86)(See Figure 1-3-5). This means that the money multiplier has declined sharply.

The money multiplier shows how much credit has been created through financial intermediary function. The money multiplier basically rises when the credit creation is active. However, if banks and other private sectors increase the outstanding balance of the current accounts at the BOJ and cash holdings, cash in circulation slips out of the credit creation process, and the money multiplier declines.

In order to examine factors that caused fluctuation of the money multiplier, the factors were divided into the reserves/deposits ratio of the financial sector, the cash/deposits ratio of the financial sector, and the cash/deposits ratio of the non-financial sector (See Figure 1-3-6). The money multiplier declines (rises) when the reserves/deposit ratio of the financial sector rises (declines), when the cash/deposits ratio of the financial sector rises (declines), and when the cash/deposits ratio of the non-financial sector rises (declines).

The money multiplier has been on a long-term downward trend. This is mainly due to a rise in the cash/deposits ratio of the non-financial sectors, such as households and firms. The preference for cash in portfolios has strengthened against the prolonged low interest rates.

During the 1999 - 2000 period and after 2001, the money multiplier declined much steeper than its long-term downtrend. This is because both the cash/deposits ratio and the reserves/deposits ratio of the financial sector rose. The decline during the 1999 - 2000 period can also be attributed to a fall in the opportunity costs of holding liquidity and to moves against the Y2K problem. The decline after 2001 can also be attributed to the fact that the monetary base supplied by the quantitative easing was not fully used in the process of credit creation, as well as to moves related to the proposed abolition of full deposit guarantee and management integration. Behind all these is the decline in bank loans. Bank loans decreased because 1) the corporate sector has been repaying debts to banks as part of its efforts to dissolve excess debts, and 2) the banking sector has been reducing loans to risky corporations due to their reduced capacity to accept risk.

Behind the low growth of money supply, the credit creation function did not work fully due to the strong preference for cash in portfolios and the decline in bank loans.

Figure 1-3-6 Changes in Money Multiplier

blackcircle Money supply and GDP

Next, let' s look at the relationship between money supply and GDP.

It is generally believed that there is a strong correlation between money supply and GDP. This is because if financial institutions supply deposits through financing or purchase of bonds, it increases business investments by an increase in lending and a decline in interest rates, and stimulates economic activity. At the same time, on the demand side of money, as a result of the increased economic activity, it increases the demand for deposits as a means of settlement (transactions demand).

A study of the long-term relationship between money supply and GDP shows that it was stable until around 1997. However, such a stable relationship has not been observed since 1998(87). During this period, money supply kept growing, albeit marginally, while Real GDP sometimes posted negative growth.

Behind this, money demand except for transaction demand increased. It was brought about by such factors as the financial unrest in the autumn of 1997, the so-called Y2K problem in the late of 1999, and the deterioration of fund-raising conditions for low-rated corporations in 2000 and in late of 2001. In addition, with interest rates staying at extremely low levels, there was a shift to liquid deposits due to the maturity of huge amounts of postal savings time deposit from 2000 to 2001 and trust funds' fall below par due to the business failure of Enron in the autumn of 2001.

As just described, it can be said that the lack of Real GDP growth, despite the increased money supply, has been due to the increase in money demand except for transaction demand.

blackcircle Quantitative easing and depreciation of yen

The effect of the quantitative easing cannot be verified by the main transmission mechanism of the monetary policy (the route via bank lending). This is because bank lending is decreasing, the growth of money supply is low, and Real GDP growth is stagnant, despite the high level of the outstanding balance of current accounts at the Bank of Japan and the high growth rate of the monetary base.

When we expect the "portfolio rebalancing" effect of the quantitative easing, we do not, of course, necessarily expect only its normal spillover effects. What is expected of this effect is that it would create an expectation that an increase in no-risk, no-return assets of the outstanding balance of current accounts at the Bank of Japan will cause a change in asset management as seen from financial institutions and from the economy as a whole and lead to an increase in higher-risk, higher-return assets. Therefore, higher-risk, higher-return assets are not limited to loans. Rather, there are various routes through which the effect of the monetary policy is transmitted other than an increase in loans. Among the routes other than an increase in lending is, for example, currency depreciation. That is to say, an increase in no-risk, no-return assets of the outstanding balance of the current accounts at the Bank of Japan would increase demand for external assets and this in turn would cause currency depreciation.

In fact, the yen' s exchange rate vis-à-vis the U.S. dollar stood at 116.4 yen in February 2001, and shortly before the adoption of the quantitative easing, began to depreciate, reaching 133.5 yen one year later in February 2002. This suggests that the quantitative easing may have been effective in reducing the value of the yen.

In order to examine the effect of the quantitative easing, we have estimated the function that explains the movement of exchange rates since 1990(88). According to the estimation, the growth rate of monetary base including the outstanding balance of the current accounts at the Bank of Japan, is statistically significant. This suggests that the depreciation of the yen may have been caused by the effect of the quantitative easing(89).

Of course, various factors affect the movement of exchange rates. Such factors may have caused the depreciation of the yen. The example mentioned above is the movement of long-term interest rates, which is believed to have a big impact on exchange rates. In the United States, interest rates fell in the middle of FY2001, reflecting increased uncertainties about the U.S. economy in the wake of the September 11 attacks, but rose in the second half of FY2001 because of rising expectations of an early recovery of the U.S. economy. Since the yen depreciated further from the end of the calendar year to the end of the fiscal year, it can be attributed to a rise in the expected earnings rate of dollar-based assets. Moreover, since overseas portfolio investment was low from the end of the calendar year to the end of the fiscal year, it cannot be said that the increases in the outstanding balance of current accounts at the Bank of Japan and in monetary base directly brought about "portfolio rebalancing during the period." However, since overseas portfolio investment increased before and after the period and the yen was on a weak trend after 2001, the quantitative easing may have had its effect.

The quantitative easing may have had a positive impact on the real economy through its effect of yen' s depreciation.

Figure 1-3-7 Change of Real Exchange Rate and Relative Gap of Monetary between Japan and U.S.

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