Section 4 Evaluation of Fiscal and Monetary Policies

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1 Fiscal Policy Toward the Reform of Both Expenditure and Revenue in an Integrated Manner

The Japanese government has, up to now, devoted efforts to the reform of expenditure, but Japanese fiscal conditions have remained severe. In the 1990s, Japanese fiscal conditions continued to deteriorate due to a series of economic stimulus packages and decline in tax revenue during economic downturn, thus a large amount of government bonds were continuously issued every year. As a result, the central and local governments' long-term debt outstanding is expected to reach approximately 774 trillion yen (approximately 150% of nominal GDP) at the end of FY2005(35), which is the highest level among industrialized countries. This section analyzes the characteristics of Japanese fiscal conditions and effects of fiscal policies in Japan in recent years, and considers issues that lie ahead.

Gradual Improvements in structural (cyclically-adjusted) and cyclical fiscal balance

The analysis will begin with focusing on changes in Japanese government fiscal balances in relation to the economic cycle, which has a short-term effect on them. For example, during periods of economic recovery, fiscal balances improve due to natural increase in tax revenue and reduction in unemployment benefits, etc. Therefore, in terms of fiscal positions of general governments (central, local and social security fund), we will estimate cyclical fiscal balances, which are affected by economic fluctuations and structural fiscal balances, which are obtained when such factors are removed (Figure 1-4-1). The estimate shows that Japan's fiscal deficits since the 1990s mainly stem from increases in structural fiscal deficits reflecting discretionary fiscal policy and increases in obligatory social security-related expenses associated with the aging society.(36) Since FY1993, as the GDP gap has been negative, cyclical fiscal balances have also been negative.

Figure 1-4-1 Cyclical and structural fiscal balances of the general government

In recent years, however, both cyclical and structural fiscal deficits contracted in FY2003 and a further contraction of cyclical fiscal deficits is expected for FY2004 due to a rise in tax revenue from an increase in corporate profits and other factors. A contraction of both cyclical and structural deficits is also forecasted for FY2005 due to an increase in revenues (including income from social security contribution) and progress in curtailing expenditures.

Concept of fiscal sustainability

Since FY2002, fiscal deficits have been contracted; however, the level of which remain high. As a criterion of fiscal sustainability, it is widely acknowledged that a government debt-to-GDP ratio does not diverge over time. Given the relationship between nominal interest rates and economic growth rates (nominal GDP growth rates), it is possible to calculate the level of primary balance (relative to nominal GDP) required to meet this criterion. In particular, provided that nominal interest rates and economic growth rates are equal, achievement of primary balance maintains the government debt-to-nominal GDP ratio at the initial level and prevents it from diverging over time.(37) In this formulation, the achievement of primary balance describes the condition where revenues excluding bond revenues (deficits) and expenditures excluding interest payment and debt redemption are balanced. In other words, general expenditures for the year will not be financed by new borrowings, but by tax or other revenues for that same year.

Fiscal reconstruction and its impacts on economic growth

With respect to fiscal conditions of the OECD countries in the 1990s, an examination of changes in government-debt-nominal GDP ratios and their breakdown(38) shows that many of countries(39) that succeeded in reducing their government-debt-GDP ratios achieved primary surpluses, which significantly offset deficits caused by interest payment expenses. These OECD countries which have succeeded in fiscal reconstruction provide many cases where both fiscal reconstruction and economic growth were achieved, irrespective of their implementation of expenditure cuts.

Allesina et al. (2002) finds, in the empirical analysis using panel data of OECD countries, a negative impact of fiscal policies (public spending, taxes) on private investments. The mechanism that behind this relationship is that increases in government spendings, especially higher public wages and/or employment in the public sector lead increases in real wages in the private sector, which reduce corporate profits and thus have a negative impact on business investments.(40) Following the same analytical framework, our estimation results also suggest a negative effect of increases in government spending on private investments (Appended Note 1-9). In terms of macro-economic framework, a negative relationship between the size of government sector (government spending) and economic growth rates is observed, suggesting that there is a close relationship between the size of government spending and macro-economic performance.(41)

Variations in primary balance and their factor analysis

In the case of Japan, in the 1990s primary balance deteriorated due to the implementation of discretionary economic stimuli and lower tax revenues, resulting in an increase in government bond issues leading to an accumulation of interest payment expenses; thus, the government bond outstanding (relative to nominal GDP) increased remarkably.

Particularly, in terms of the primary balance (relative to nominal GDP) of central and local governments, a primary deficit has remained since FY1992. The level of primary deficits reached highest, since FY2000, at 5.5% in FY2002, and after being stable in FY2003, is expected to be lowered in FY2004 and FY2005.

We will investigate the variation in the primary balance of central and local governments (Figure 1-4-2).

Figure 1-4-2 Factor analysis of the variation in primary balance (central and local governments)

   Factors improving the primary balance since FY2002 are as follows.

(1) As a factor improving primary balance during this period, the curtailment of expenditures, especially that in public investments, which has continued since the end of the 1990s, has contributed most.(42) On the other hand, among the expenditures, final consumption expenditures (e.g. police, diplomacy, defense, education and public health, etc.) continuously contributed to the expansion of deficits in the 1990s, but have helped to improve the primary balance since FY2002.

(2) Other expenditures (capital grants for private corporations) caused deficits to expand because of a substantial injection of public funds into financial institutions in FY1998 and FY1999, but later have helped to improve the primary balance since FY2000.

(3) Social security-related expenditures have continued to increase every year due to the advancing age of society, and thus have been a deficit factor.

(4) In terms of revenues, tax revenues substantially decreased in FY2002 from the preceding fiscal year due to a decrease in corporate tax revenue etc. and constituted a major negative factor for the primary balance. A one-year fall in revenues was reduced in FY2003, however, and in FY2004 and FY2005, revenues are expected to constitute a positive factor for the primary balance.

We will summarize the factors contributing to the primary balance from a quantitative perspective. Primary balance of central and local governments is expected to show an improvement of 1.50 percentage points between FY2002 and FY2005, of which 1.17 percentage points can be attributed to the contribution of public investment reductions, which is approximately 80% of the improvement in the primary balance. In addition, revenues have turned into an improvement factor, contribution of which is projected to be 0.16 percentage points. This is due to higher corporate tax revenues generated by the recovery in corporate profits accompanying economic recovery in FY2003, and furthermore, also expected higher tax revenues including income taxes as well as corporate taxes in FY2004. As above, the improvement, in recent years, in the primary balance of central and local government is explained by continuing efforts on expenditure cuts and increased revenues. Note that among the expenditure categories, social security-related expenditures, on the other hand, are still expected to be a deficit factor, contribution of which is -0.51%.

Toward the Reform of both expenditure and revenue in an integrated manner

In the "Reform and Perspectives," the government stipulates a mid-term fiscal objective of achieving a surplus in the primary balance of central and local governments, combined in the early 2010s, and aims at restoring fiscal sustainability. To maintain fiscal sustainability, it is essential to steadily achieve this mid-term fiscal objective.

In the "Reform and Perspectives FY2004 Revision," it is stipulated for achieving a primary balance that the government aims to ensure the size of government (ratio of general government expenditure to GDP) does not exceed the FY2002 level until FY2006, and stays firmly on the path of public expenditure reform in accordance with local governments. Based on this initiative, a ratio of general government expenditure to GDP, which were at approximately 37.6% in FY2002, is expected to be reduced to 36.2% in FY2005(43). The "Reform and Perspectives FY2004 Revision" also states that beyond FY2007, the government aims to achieve a surplus in the primary balance in the early 2010s through continuing the same level of effort as before to improve the fiscal balance and realization of sustainable growth led by private-sector demand.

In order to achieve this mid-term fiscal objective, however, it is necessary to cancel at least an approximate 4% gap in the balance as a proportion of nominal GDP. Therefore, an improvement of the fiscal balance must be considered from the perspective of both expenditures and revenues.

To achieve this objective, the government will deliberate and reach a conclusion concerning the medium-term measures, from both expenditure and revenue perspectives, based on the three principles; (1) Principle of "small and efficient government": expenditure cuts and administrative reform will be carried out thoroughly to minimize the necessary increase of the tax burden as much as possible, (2) Principle of Vitality: Fiscal soundness will be pursued in balance with Economic vitality, (3) Principle Transparency: Options of reform and future prospects will be presented to the public as deliberations continue. Within approximately one year, the government will deliberate on medium-term goals for the central and local governments regarding the scale of government expenditure and the major areas of expenditure, as well as revenue, in an integrated manner.

It is important to achieve a primary balance and maintain fiscal sustainability.(44)

2. Evaluation of Quantitative Easing Policy

To solve the long-term problem of deflation, the Bank of Japan (BOJ) has implemented quantitative easing policy since March 2001. The following is an evaluation of the current status and effectiveness of quantitative easing policy, specifying points that merit attention concerning monetary policies that seek an exit from deflation.

Current status of quantitative easing policy

Quantitative easing policy relates to policy current account deposits opened by financial institutions in the BOJ, toward which the Bank makes two promises: (1) the BOJ will provide ample liquidity in excess of the amount of deposits required reserves by financial institutions under the reserve deposit requirement system;(45) (2) the BOJ will continue this abundant liquidity until year-on-year rises in the consumer price index (nationwide, excluding fresh food) are kept stably at 0% or higher.

Under the reserve requirement system, financial institutions must maintain a "required reserve" (about 6 trillion yen as of June 2005) in the BOJ's current account deposits. However, if the demand in funds rises, financial institutions sometimes hold funds in excess of the required reserve ("excessive reserves"). Quantitative easing policy facilitate fund raising by financial institutions by substantially increasing excessive reserves. Interest rates are held stably at low-levels and funds flow smoothly into various risky assets including loans. The policy is thus designed to help the economy overcome deflation.

The target amount of the BOJ's current account balance has remained at approximately 30-35 trillion yen since being raised to that level in January of 2004 (Figure 1-4-3). Between late 2004 and early 2005, a sense that funds were excessive arose among financial institutions, and the BOJ's fund-supplying operations were marked by frequent instances where, despite the BOJ offering fund supply, the amount that financial institutions requested did not reach the scheduled supply amount.(46)

Figure 1-4-3 Bank of Japan's current account balance and fund supply operations

Under these conditions, the ban on the removal of full deposit guarantees was lifted smoothly as scheduled and without confusion in April of 2005. Around the time the ban was lifted on time deposits in April 2002, there was a shift from time deposits, whose full protection ended, to ordinary deposits, which remained protected. At that time, moreover, there was a shift in deposits to city banks, where credit capability is considered high. Such a shift has not been seen for the present lifting of the ban.

Amid these developments, the BOJ is firmly maintaining quantitative easing policy based on the clarification of its commitment to continue the policies (October 2003)(47)(48). In the May "Monetary Policy Meetings," the BOJ stated in connection with the current account balance target, that when liquidity is extremely weak for reasons relating to the status of bidding by financial institutions or other factors, the current account balance could fall below the target range (30-35 trillion yen indicated above). The BOJ regards this elasticity of the lower limit as no more than a technical measure for monetary control, and will not change the framework of its quantitative easing policy aimed at curbing deflation.

Causes of variation in the BOJ's current account deposit balance

At the beginning of June, the current account balance dipped below the lower limit of 30 trillion yen (June 2, 3). The factors involved in the variation in current account balance can roughly be broken down into those relating to the following: (1) bank notes, (2) public finance, etc., and (3) monetary control. These are discussed in detail below.

(1) Bank note factors are at work when current account deposits are reduced or increased when a financial institution pays or receives bank notes to or from an individual or a corporation. After "new bank notes" were issued in November 2004, demand for bank notes increased and current deposits have been reduced.

(2) Public finance and related factors can be illustrated by the following examples: In order for the national government to pay pensions, it pays funds into the financial institution account of the recipient, and through this transaction, current account deposits are increased. Conversely, when a taxpayer pays funds to the government from his or her financial institution account in order to pay taxes, current account deposits are reduced. Increases in payments to the government through increases in tax revenues accompanying economic recovery result in a reduction in current account deposits.

(3) Monetary control factors are equivalent to factors that lead to excesses or shortages in current account deposits like (1) and (2) above. Therefore, when the BOJ supplies funds to financial institutions or performs monetary control in order to absorb funds, current account deposits increase or decrease accordingly. Specifically, monetary control is carried out through operations such as the purchase or sale of government bonds or notes. If, at that time, the holdings of financial institutions exceed the required reserve, an important factor is how much excess reserve they deem necessary to hold. Concerns about the financial system have diminished, and if the sense that funds are excessive strengthens among financial institutions, current deposits will not tend to accumulate.

Each of these factors are technical aspects of monetary control, and daily rises and falls in the current account balance occur due to various combinations of the factors (1) through (3). The current account balance's dip below 30 trillion yen at the start of June occurred as the sense of fund oversupply strengthened along with diminishing concerns about the financial system. The public finance factor (2) played an important part in this drop, when, on a day at the beginning of June when tax payments were temporarily heavy, there was an increase in payments of funds from the accounts of financial institutions to the national government.

Effect of quantitative easing policy

At the time that the quantitative easing policy was introduced (March 2001), the aim was to prevent continuous price falls and thereby build a foundation for sustained economic growth. When the targeted value of the current account balance was increased to 30-35 trillion yen (April, 2004), the stated objective was to once again clearly indicate the BOJ's policy stance toward overcoming deflation and increase the certainty of moves toward the economic recovery. The focus, then, was on overcoming deflation.

The abundant liquidity available under quantitative easing policy has had the effect of maintaining the stability of financial markets and creating a calm financial environment by responding to the liquidity demands of financial institutions during a period when concerns about the financial system were strengthening. The specific processes whereby policies demonstrate an effect can be formulated as follows.

(1) Policy duration effect: By promising to continue quantitative easing until the time when it can be confirmed that deflation will not return, rises in the interest rate level, including mid- to long- term interest rates, will be curbed;

(2) Portfolio rebalance effect: If in the asset portfolio of financial institutions, the proportion of highly safe assets such as BOJ's current account deposits increases, financial institutions will maintain an appropriate asset portfolio balance, and can be expected to increase holdings of comparatively high-risk assets such as loans;

(3) Expectation effect: Clearly adopting an anti-inflation stance can turn around people's attitudes toward deflation. An examination of quantitative easing policy from the perspective of these three policy effects yields the following conclusions: The "policy duration effect" probably has had an effect in maintaining mid- and long-term interest rates at a low level (Figure 1-4-4). At the current time, the "portfolio rebalance effect" should not be considered as having a clear effect at this point in time, given the fact that financial institutions have not significantly increased their lending. The "expectation effect" has probably played a role in the continuing moderate improvement in the household sector's outlook concerning prices in the future (Appended Figure 1-9 (2) above).

Figure 1-4-4 Policy duration effect and portfolio balance effect

The growth rate of the money supply remains low

Growth of the monetary base has fallen by about 2-3% year-on-year since the start of 2005 (Figure 1-4-5). This decline in growth can be attributed to the fact that, although the effect of increases in BOJ notes and the currency in circulation on raising the monetary base increased slightly after the issue of new notes in November 2004, the effect of the current account balance on raising the monetary base has not produced an increase because the target balance has remained constant since January 2004.

Figure 1-4-5 Trends of monetary base and money supply

During this time, the rate of growth of the money supply (M2 + CD) has declined to about 2.0% year-on-year. This decline can be explained by the fact that, even though the year-on-year decline in lending to corporations has eased, lending has not turned upward, and thus credit creation has not picked up activity. In order to increase the money supply, the credit creation function must be activated through increases in borrowing from financial institutions by corporations and other enterprises.

One of the indexes that expresses the strength of activity of the credit creation function is the monetary multiplier (money supply/monetary base). Up until around 2003, the monetary multiplier continued to decline but afterward, the decline ceased. There are two main reasons for this development.(49)

The first is that, under quantitative easing policy, the target value of the BOJ's current account balance has been maintained in the range 30-35 trillion yen since January 2004, and the year-on-year growth rate has declined. This reflects the major shrinkage in the contribution of the financial sector's reserve/deposit ratio, a factor in the decline of the monetary multiplier since the introduction of quantitative easing policy.

The second is the stabilization of demand from corporations and households which have sought ready cash because of diminished concerns about the financial system. This indicates that the cash/deposit ratio of the non-financial sector made virtually no contribution to the decline in the monetary multiplier since the beginning of 2004.

Stimulating a recovery of the monetary multiplier will require an activation of the credit creation function and an increase in bank lending.

Key monetary points toward exiting deflation

In light of the deflationary trend described in Section 3, a point that merits attention in terms of monetary action aimed at exiting deflation is whether or not conditions fostering a stable rise in the money supply can be achieved. Specific points include the following.

(1) As the disposal of non-performing loans proceeds, will the reserve lending capacity of financial institutions, including regional and small and medium financial institutions, steadily improve?

(2) Given that restrained capital investment by the business sector is inconsistent with the sector's strong profits, savings are tending toward excess, and, for this reason, demand for loans has also leveled off. Nevertheless, will the investment stance of companies become more aggressive?

(3) Fund raising by the business sector is shifting toward securities issues and the like, as well as effective use of available funds.(50) In this context, will borrowing increase?

If these possibilities become reality, growth in the money supply is likely to increase. With sure progress in implementation of the "Program for Financial Revival," doubts about the financial system have faded, and the reserve lending capacity of the financial institution side is improving (Figure 1-3-3 shown before). In addition, the propensity to borrow by the business corporation side is on a recovery trend (Figure 1-3-11 (2) shown above). These developments indicate that an environment conducive to activating financial intermediary functions and credit creation functions is being set in place by both fund lenders and fund borrowers. An improvement in this situation would be expected to lead to growth of the money supply.

Monetary policies for stable macro-economic administration

The BOJ has been firmly maintaining the framework of its quantitative easing policy to overcome deflation and is expected to continue these polices until deflation is overcome.

At this stage, however, when an exit from deflation has come into view, a key question is how to build a monetary policy framework to take the place of quantitative easing policy while preventing excessive rises in long-term interest rates caused by uncertainty about the direction of monetary policy. When this new framework is developed, discussion should focus on demonstrating a definite commitment concerning the mid- to long-term direction of monetary policy. What is also required for a monetary policy with responsibility for stable macro-economic administration is avoidance not only of deflation, but also zero inflation. As for the specific means by which the commitment could be demonstrated, various ideas have been argued, such as setting the target for fixed price growth rate or price level.(51) In any event, wide-ranging study is required concerning a plan for achieving stable market expectations and curbing excessive fluctuations in the market.

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