Japan needs inflation, and more inflation than the 0.5 per cent achieved with its quantitative easing programme. The need is not for the usual countercyclical reasons, even if the economy is flirting with technical recession. Rather, the country needs meaningful positive inflation for reasons of fiscal stability. Public debt, even on a net basis, is very high at 160 per cent of gross domestic product. Even a small adverse shock could cause unsustainable debt dynamics — such as debt service payments spiralling up to consume much of the government budget.
In circumstances like those facing Japan today, positive inflation can contribute to fiscal stabilisation as a form of taxation. Together with low nominal rates provided by the Bank of Japan, it would lead to negative real rates and reduce debt. No debt reduction is pain free. Debt holders would suffer but, under our proposal, the average taxpayers would in effect recoup the cumulative 15-20 per cent of GDP that they transferred to bond holders by deflation in the last 20 years. Reducing the public debt burden would in this gentle and general manner also ease the way for other reforms.
Together, Abenomics and the BoJ’s commitment to a 2 per cent inflation target were intended to encourage a virtuous cycle from positive inflation to wage increases to greater consumption and so on. The central bank’s large-scale asset purchases (Y80tn a month of Japanese government bonds) have helped: inflation has fluctuated between 0.5 and 1.0 per cent, an improvement over the deflation of the preceding two decades, and the yen has declined in two stages to Y120-plus to the dollar.
But that decline has proved insufficient to start an inflation cycle in the face of falling energy prices and the recent Chinese slowdown. Nominal wages rose only a little more than 1 per cent in 2014 and 2015. For the average Japanese investor and consumer, inflation expectations have not budged.
Japan needs to jump-start a wage-price spiral of the sort feared from the 1970s, but that Abenomics rightly aspired to after 20 years of deflation. Such a cycle should be started by increasing nominal wages by 5 to 10 per cent in 2016. Tripartite bargaining is practised in Japan — i.e., annual nationwide wage negotiations for the unionised part of the Japanese labour force with government participation. A third of the country’s workers are covered by these bargains, and many more (including management) have their wage adjustments set accordingly. Even part-time worker pay is correlated with this process. Such bargaining with government input can push wages up, just as in the past it has kept them down. In the 2014 and 2015 wage rounds, the Abe administration publicly advocated a rise in wages but did little else.
The government should force the issue. It should go well beyond its recent minimal minimum wage increase in both scope of workers and size of raise and require annual wage indexation (of at least 3 per cent). Even before those measures pass the Diet, the administration should raise wages in government contracts and regulated sectors. Finally, Shinzo Abe should delay any Diet vote on the promised permanent cut in corporate taxes until companies raise wages across Japan — if companies come through, then tax credits for wage increases can be added in following years.
The point is not to redistribute income from business to labour. If anything, employers and other price setters should be encouraged to pass on the increased costs from wages to consumer prices, and try to maintain their profit margins. The BoJ should maintain QE to accommodate this general price and wage increase until the cycle takes hold over a three-year period. This means replacing the current 2 per cent inflation target with something much higher — such as 5 to 10 per cent — for several years. This would be unlikely to cause accelerating double-digit inflation, but if it did, the BoJ could easily stop that spiral. In parallel, the central bank should also aim for an exchange rate depreciation proportional to inflation, so as to keep the real exchange rate roughly constant.
Obviously, the higher the rate of inflation, the faster the government debt reduction in real terms, but also the higher the distortion costs to the economy. We believe that a 5-10 per cent inflation rate for a few years would decrease net debt by 8 to 16 per cent of GDP per year and sustainably raise inflation expectations without causing major distortions. Some may object that such inflation will raise nominal interest rates sooner or later. But the BoJ can without doubt keep nominal interest rates low until later. When inflation is high enough, or begins to accelerate beyond the desirable level, the central bank can then increase nominal rates. Fiscal consolidation by budget cutting or tax increases alone, absent inflation, would be likely to make the deficit larger rather than smaller in the short run (as happened with European austerity).
We see our proposal as a fair and efficient redistribution from Japanese bondholders, who got a windfall from prolonged deflation, to the rest of the economy. This is not an approach open to all countries; it clearly cannot be used for example by countries that operate under that fixed exchange rates. Neither would it be feasible for debtor economies saddled with uncompetitive unit labour costs, such as Greece. But for Japan, stuck in a near-deflation regime, inflationary nominal wage increases can go far in restoring fiscal sustainability.
This article was co-written by Olivier Blanchard, C. Fred Bergsten Senior Fellow at the Peterson Institute for International Economics, and Adam Posen, President of the Peterson Institute
Get alerts on Adam Posen when a new story is published