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Will the New Government Put an End to Austerity?

Japan and the Fiscal Cliff

by DEAN BAKER

An event that has received far too little attention in the United States was the election of a new prime minister in Japan. Last month the people of Japan voted overwhelmingly to throw out the governing party and to support the return of the Liberal Democrats headed by Shinzo Abe.

Electing Liberal Democrats is not new in Japan; they have held power for most of the period since World War II. Even putting in Abe as prime minister is not new. He had earlier served a brief stint in this position from 2006-2007. Abe is a well-connected party boss who has worked his way to the top ranks of the party in the same way as other party leaders.

What is new is Abe’s stated agenda. Abe wants to get Japan off its two-decade-long path of near stagnation, promising a policy of vigorous stimulus. There are two main parts to this policy. First, he promises to embark on another round of infrastructure spending, with the goal being the direct creation of tens of thousands of jobs.

Perhaps more importantly, he wants Japan’s central bank to explicitly target a higher rate of inflation. If they follow Abe’s recipe, the central bank will commit itself to raising the inflation rate to 2.0 percent, buying as many Japanese government bonds or other assets as necessary to bring about this result. The goal is to reduce the real interest rate: the difference between the nominal interest rate that people actually pay on borrowed money and the rate of inflation.

Given the weakness of the Japanese economy it would be desirable to have a negative real interest rate; however, nominal interest rates will never fall below zero. People will not pay banks to hold their money. Since Japan was actually seeing modest rates of deflation, this meant that the real interest rate still remained considerably higher than would be desired.

However, if people actually come to expect the 2.0 percent inflation targeted by the central bank then it will mean that the real interest will turn negative. Firms that are able to borrow at near zero interest rates will have more incentive to invest when they expect that the items they are producing will sell for 6 percent more money in three years or 10 percent more money in five years.

The idea of deliberately targeting a higher rate of inflation was first put forward by Paul Krugman in a famous 1998 paper. While many prominent economists, including Federal Reserve Board chairman Ben Bernanke, endorsed Krugman’s position, no central bank has had the courage to actually test the theory by making it explicit policy. Inflation-phobic central banks found it impossible to accept the idea that ahigher rate of inflation could actually be a desirable policy goal.

This is why Abe’s agenda is so impressive. While Japan does have an independent central bank, Abe has made it clear that he will use his control of parliament to take away this independence if the central bank does not agree to carry out his inflation-promoting agenda. Unless he is derailed in this effort, we will be able to see a clear test of this prescription.

It is also worth noting one other way in which Japan is already a model. The deficit chicken hawks that dominate Washington policy debates are warning us that financial markets will panic if we don’t soon get our debt under control, with investors fleeing the dollar and interest rates soaring. Japan’s ratio of debt to GDP of 240 percent is more than twice that of the United States, yet the interest rate on long-term government bonds is hovering near 1.0 percent and the government’s main concern is that the yen is over-valued.

If Abe is allowed to carry through his policy and it proves successful, it will provide a great example for the United States, Europe, and other regions still suffering the effects of the economic collapse in 2008. Of course these countries have not always been able or willing to learn lessons from other experiments.

The eurozone countries proved that deficit reduction in the middle of a downturn leads to recessions and higher unemployment, just as textbook Keynesianism predicted. The United Kingdom provided an even better proof of the Keynesian model since it did it to itself in the context of a country with its economy that was not suffering from a crisis of confidence.

In spite of the overwhelming evidence that these examples provide of the foolishness of deficit reduction in the middle of downturn, austerity remains very much in fashion in elite Washington circles. If our leaders can’t learn from other countries’ failures, there is still the hope that they make be able to learn from success.

If Abe carries through his Keynesian agenda and manages to restore Japan to a healthy growth path perhaps it will put an end to austerity economics in the United States. As President Bush always used to say, “is our leaders learning?”

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy and False Profits: Recoverying From the Bubble Economy.

This article originally appeared on Al Jazeera.