Owning to the slowdown in the global economy, more and more nations are putting off fiscal reforms. Realizing planned fiscal rehabilitation becomes hard when economic growth falters. At the recent G20 meeting of finance ministers and central bankers, participants voiced fears that if concerned nations were to try to achieve their initial fiscal targets, the macro economy could succumb to shrinking equilibrium, with the result that fiscal restructuring plans could be shelved entirely. Of course, some degree of consideration for the economy is warranted.
But is the economic sluggishness due to cyclical factors or could it be that trend growth rates themselves are declining? If plans to rebuild state finances are predicated on formerly high trend growth rates, such programs could be hindered. While it is wrong to recklessly pursue fiscal rehabilitation that could harm the economy, putting off restructuring because of lacklustre growth, at a time when trend growth is falling, will only aggravate fiscal conditions. In this report, we will look at fiscal problems and declining trend growth due to the demographic onus.
For a couple of years now, I have repeatedly indicated that demographic change (ageing, falling birth rates) seems to be depressing trend growth rates in developed countries. When a nation’s working-age population grows at a slower rate or shrinks outright, it creates supply-side and demand-side constraints on corporate capital formation which weigh on that country’s trend growth rate. Specifically, on the supply side, a shrinking workforce leads to excessive capital stock, with the result that the reduced return on capital prompts corporations to curb capital investment. Many used to think that the negative impact of this contracting workforce could be offset by stepping up labor-saving investments to boost productivity, leading to increased capital stock that would somewhat shore up the trend growth rate. But as evident in Japan, the downturn in growth of the working-age population has coincided with a virtually proportional decline in capital stock growth. And from FY 2009 it seems that Japan’s net capital stock has entered a contraction phase.
Figure 1: Japanese Capital Stock (Trend) and Working Age Population Growth (% y-o-y)
Source: Cabinet Office, MIC, BNP Paribas
Figure 2: US Private Sector Capital Stock and Working Age Population (% y-o-y, HP Filter)
Source: Bureau of Economic Analysis, BNP Paribas
Declining Workforce Also Weighs on Trend Growth from the Demand Side
Meanwhile, demand-side factors also seem to strongly inhibit capital formation. A decline in the working-age population does not only imply a smaller workforce, it also means a reduced number of people in the prime of life, the most active time for earning income and consuming. Facing lacklustre sales due to the chronically thinning ranks of consumers, companies naturally are pessimistic about the domestic market and this constrains their local capital investment. These past several years, such bleak prospects for domestic demand have caused more and more companies, both manufacturing and non-manufacturing, to look abroad for business development.1 Hence, the most aggressive investment has all been overseas. Incidentally, the mechanism of “reduced working-age population growth > reduced capital formation growth” is described as a long-term theory, but, while not widely known, this same phenomenon has recently been observed in the US.
Downshifting Trend Growth Threatens to Undermine the Social Welfare System
The downshifting of trend growth due to productive population decline threatens to undermine the Japan’s social welfare system and public finances. It goes without saying that a decline in the working-age population means reduced tax receipts as well as social welfare premium payments. Meanwhile, rapid social ageing causes social welfare benefits (pensions, healthcare, nursing, etc.) to escalate. But because premiums paid into the system cannot keep up with benefits being paid out, the difference must be made up from the government’s tax coffers, resulting in chronic massive transfers of tax money. Since these transfers increase every year, while tax revenue does not pick up, the difference must be covered by deficit spending (Japanese Government Bond issuance). In other words, Japan’s social welfare systems operate on budget deficits that fuel the public debt. Given this very abnormal situation, social welfare and state finances must be quickly rebuilt to operate in a low growth economy.
Lavish Social Welfare Systems Set Up During the Demographic Bonus
The current social welfare systems were largely completed around 1973 in the waning days of Japan’s era of high growth. At the time, the booming economy ensured ample tax receipts and the growing population ensured ample social welfare premium payments, while the relatively small pool of elderly receiving benefits ensured the nation’s finances were also ample. Convinced that such conditions would go on forever, the social welfare systems were designed to provide lavish benefits. Looking back, it is clear that the robust expansion was the product of population growth, the demographic bonus, and that the huge tax revenue posted each year should have been set aside for when the demographic bonus would turn into a demographic onus. But such ideas did not occur to anyone back then, instead the tax windfall from the demographic bonus period was entirely directed toward spending.
Needed Reforms Were Put Off During Period of Intermediate Growth
When the high-growth era ended and Japan shifted to an medium-growth economy, at the very least we should have prepared for the coming demographic onus by reforming social welfare systems and fiscal administration. But no one realized the economy was shifting to a lower trend growth rate because of productive population decline, with the result that much-needed social welfare and fiscal reforms were largely put off.2
Figure 3: Elderly Population and Social Welfare Benefits (CY)
Source: Cabinet Office, BNP Paribas
Figure 4: Japan’s Real GDP (% y-o-y)
Source: Cabinet Office, BNP Paribas
When Productive Population Started Declining, Defects in Social Welfare Became Apparent
The productive population started declining from the 1990s, ushering in an era of low growth. While the defects in the social welfare systems and fiscal administration became apparent at that juncture, most still had no inkling that changing demographics were causing trend growth to fall. Low growth of the 1990s was widely deemed to be due to the Non-Performing Loans (NPLs) from the “bubble economy” of the late 1980s. While it is a fact that the NPL mess weighed on trend growth via the dysfunctional financial system (including the 1997 financial crisis), trend growth did not revive even after these problems were resolved, as productive population decline became a distinct factor reducing trend growth from the mid-1990s. From the 2000s, meanwhile, it was widely felt that deflation was the main reason for low growth – While overcoming deflation is certainly very important, it is hard to believe that that alone will revive Japan’s trend growth.
Drop in Trend Growth is Still Not Admitted
Although reforms to make the social welfare systems and fiscal administration sustainable in a low-growth economy are of the utmost importance, many people (the “growth first” camp) still believe that, prior to these painful reforms, the authorities first need to bolster the growth rate with discretionary macro stabilization (monetary easing, fiscal stimulus). For such discretionary policies to work, one must assume that the economic slowdown is due to cyclical factors, not the downshifting of trend growth. Despite the economy averaging no more than almost 1% growth these past twenty years, those clamouring for macro stabilization still cannot face the truth that trend growth has declined.
Society Cannot Accept the Downshifting of Trend Growth
This inability to admit reality after twenty years is truly astounding. These people apparently only consider the economy’s performance during the peak of expansion phases, while ignoring that business cycles also have inevitable slowdowns. But looking at the response of US and European policymakers to their recently burst bubbles, it has become apparent how hard it is for a society to accept a downshifting of trend growth.
Lavish Fiscal Spending Structures Tend to be Created During Credit Bubbles
In any event, the inability to face reality contributes in various ways to deteriorating fiscal conditions. For starters, when trend growth downshifts, fluctuations in the macro economy become severe, including the formation/bursting of credit bubbles. To most people, the collapse of credit bubbles is deemed to reflect the downshifting of trend growth. While there certainly is such an aspect, the primary causality could actually be the other way around, namely downshifting of trend growth engenders bubbles. In other words, when trend growth declines, bubbles occur precisely because the return on capital falls. The way this works is as follows: in the final stages of a demographic bonus period, investment projects with high profitability become few and far between because an investment boom usually continues alongside the demographic bonus. Those projects still remaining tend to be real estate-related investments (property financing from perspective of financial institutions) whose returns are dependent on rising real estate prices. It is the activation of such investments that inflate bubbles.3 The strong tax receipts enjoyed during such bubble-driven robust growth encourages the adoption of loose fiscal policy, whose lavish spending structure after the bubble bursts can only be sustained with constant deficit spending.
Figure 5: Working Age Population (Age 15-64/population, %)
Source: United Nations, BNP Paribas
Figure 6: Combined Central and Local Government Debt (% of GDP, FY)
Source: Cabinet Office, MOF, BNP Paribas
Expansionary Fiscal Policies Continue When Downshifting of Trend Growth is Not Admitted
While trend growth downshifts gradually, what most people remember is the robust growth rate enjoyed during the bubble. Hence the slowdown seen today is deemed momentary or cyclical, and trend growth is not deemed to have weakened at all. What is really necessary at this juncture are structural policies designed to bolster trend growth, like deregulation and cleaning up the bubble’s aftermath (excessive debts, overcapacity). But because the economic sluggishness is mistakenly deemed to be cyclical, the authorities tend only to adopt discretionary policies to shore up the economy, while needed structural policies are put on hold until after the economy revives. Even if the economy picks up while fiscal stimulus is being implemented, growth will weaken again once the effects of the stimulus wear off. What remains is just the same low trend growth rate and an even bigger public debt.
West is Following Path Taken by Japan
Due to the fact that Japanese society in the early 2000s could not accept the reality of lower trend growth (many still do not), the nation’s lavish spending policies have continued. This is also true in the West, where fiscal policy was pursued to the limit in the years following the bursting of the credit bubbles, after which aggressive monetary easing has become the sole pursuit. The West seems to be following the same path that Japan took.
Real Reason for Global Slowdown from Mid-2011
Slower growth evident around the world from mid-2011 is due in part to the fading impact of the monetary and fiscal stimulus adopted after the Lehman shock. With trend growth having declined, the growth rates these economies return to, once the stimulus ends, is their low trend growth. But the inability to accept this fact is why fiscal restructuring programs are increasingly being shelved.
Will Stimulants Again be Administered?
If growth remains weak, perhaps those nations lucky enough not to succumb to fiscal crises will start mulling more misguided policies like lavish fiscal spending as a kind of stimulant. Here in Japan, lawmakers from both the ruling Democratic Party of Japan (DPJ) and opposition Liberal Democratic Party (LDP) are already calling for more stimulus. But while such stimulants may provide a momentary jolt, administering them cannot go on forever. The “growth first” response evident in so many countries today seems to be a systemic error observed when trend growth is distorted.
Higher Inflation Rate Could Cause Interest Payment Burden to Outpace Tax Revenue
Incidentally, those that admit Japan’s trend growth has declined are calling for aggressive monetary easing to raise the inflation rate and thereby increase tax revenue. While it certainly could be possible to increase tax receipts if the inflation rate were elevated, these people forget that if inflation rises, spending will also increase. For example, if long-term interest rates were to rise alongside inflation, the government’s interest burden will also escalate. Even if interest rates do not match inflation (something that cannot be guaranteed), the fact that Japan’s public debt has swollen to 200% of GDP means there is a risk that the interest payments on the debt could outpace tax revenue.
Higher Inflation Will Also Cause Primary Balance Expenditures to Increase
Additionally, though not widely known, primary balance expenditures, especially social welfare benefits, would also likely escalate with higher inflation. In Japan’s social welfare systems, benefits are indexed to wage and price growth, with the result that improvement in the income level of working-age households automatically translates into a higher level of social welfare benefits for retirees. As a result, if inflation picks up, retirees’ benefits, after a certain time lag, will increase, causing primary balance expenditures to also grow. In 2005, the authorities tried to curb this by introducing macro indexing to the public pension system, but these reforms have only somewhat reduced benefit increases arising from wage and price growth. Thus, if inflation were to rise, given the existing systems and the political clout of vested interests, healthcare and nursing costs will certainly escalate. Policies designed to bolster inflation and growth will not work without concurrent reforms to rein in expenditures.
Figure 7: Household Saving Rate Without Effect of Ageing (CY, %)
Source: Cabinet Office, MIC, BNP Paribas
Reverse Mechanism of Unstable Social Welfare Impairing Growth
So far we have described how declining trend growth undermines social welfare systems, but in Japan and other developed nations the reverse seems to be occurring. According to research by Carmen Reinhart and Kenneth Rogoff, economic growth rates are adversely affected when the public debt exceeds 90% of GDP, for even without succumbing to an outright fiscal crisis, households and businesses will curb spending on concerns over increased future burdens. This is the so-called non-Keynesian effect, and, as pointed out in earlier reports, there is evidence of this effect hampering trend growth in Japan.
Working-Age Population Curbs Consumption on Anxieties About Social Welfare’s Soundness
For example, Japan’s household savings rate has been steadily falling due to societal ageing. But if we exclude the effects of ageing, the savings rate has been trending higher. What this suggests is that the working-age population is saving more and spending less out of concern for both the sustainability of social welfare systems and the future burden of repaying Japan’s public debt. What’s more, if we look at the trend of the savings rates for population segments, the rate for the productive population is clearly rising. Needless to say, curtailed spending by this population group weighs on corporate growth expectations, leading to curbs on capital formation that also hamper trend growth.
Significant Adverse Effects Already Exist
While some might argue that the subdued tone of Japanese Government Bond (JGB) yields is proof that the public debt is not yet adversely affecting the macro economy, we maintain that the growth rate is being substantially impaired by the restraints on spending by households and businesses. In fact, it would be more correct to understand the low level of JGB yields as being the result of curbed spending by the private sector (i.e. savings are being channelled to finance JGBs).
Reforming Social Welfare and State Finances is a Growth Strategy
The view that growth must be revived before undertaking painful reforms of social welfare is very deep-seated. While it certainly is important to pursue proper growth strategies (deregulation, etc.), if the economy’s weakness is due to trend growth downshifting because of the instability of social welfare and financial administration systems created during Japan’s demographic bonus, it stands to reason that making these systems sustainable in the era of demographic onus ought to be deemed a growth strategy.
Figure 8: Age Based Savings Rate (Positive Rate of Working Households, %)
Source: MIC, BNP Paribas
1 Needless to say, the income incurred from capital accumulation abroad does act to underpin Japan’s trend growth.
2 An exception was the consumption tax, begun in 1989 to cope with future societal ageing.
3 During the demographic bonus, the growing workforce makes capital stock relatively rare, resulting in higher returns on capital that foster aggressive investment. During the demographic onus, this mechanism works in reverse.