When a nation is engaged in a real policy debate – the kind we’re not having in the United States, because America’s right wing knows what it knows and never looks at evidence or admits mistakes – certain decisions take on significance that goes beyond their substantive importance because they are symbols of the broader direction that the country is heading.
So it is with Japan’s current plan to hike consumption taxes a second time. Not that this is a trivial decision in terms of its substance; it would be a fairly big deal in any case. But right now it has become something more: a sort of Rubicon for policy.
Let me admit that people I respect – like the economist Adam Posen and some officials at international organizations – believe that Shinzo Abe, Japan’s prime minister, should go through with the hike. But I strongly disagree.
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The funny thing is that both sides of this debate believe that it’s about credibility, but they differ on what kind of credibility is crucial at this moment. Right now Japan is struggling to escape from a deflationary trap. It desperately needs to convince the private sector that from here on out prices will rise, so that sitting on cash is a bad idea and debt won’t be so much of a burden. At the same time, Japan has a huge public debt and lousy demographics.
The pro-tax-hike side worries that if Japan doesn’t go through with the increase, it will lose fiscal credibility and that this will endanger the economy right now – basically, that the bond vigilantes will attack.
Why don’t I share this view? Partly because I don’t see how the supposed crisis of confidence is supposed to work. And, in fact, that was the point of my Mundell-Fleming lecture at the International Monetary Fund in Washington last year: When a country borrows in its own currency and doesn’t face inflationary pressure, it’s very hard to see how a Greek-style crisis is even possible (the lecture can be read here). The Bank of Japan controls short-term interest rates; long-term rates mainly reflect the expected short rates. Yes, investors could push the yen down, but that would be a good thing from Japan’s point of view. Mr. Posen has said that stocks could crash, but I don’t see why, if interest rates stay low and corporate Japan becomes more competitive thanks to a weaker yen.
Seriously: Tell me how this is supposed to work. In fact, tell me how a loss in fiscal confidence – fear that Japan might eventually monetize some of its debt – isn’t actually a positive development.
Meanwhile, it seems to me that Japan should be very, very afraid of losing momentum in the fight against deflation. Suppose that a second tax hike causes another downturn in real gross domestic product, as I predict it will. How likely is it that the Bank of Japan could come back after that and say “Trust us – this time we really will get inflation up to 2 percent in two years. No, really,” and still be believed? I’d argue that stalling the current drive would cause a fatal loss of credibility on the deflation front. And this would, by the way, do huge fiscal damage too.
Could I be wrong about all of this? Of course: Life is complicated, and as I said, people I respect are on the other side (although I really don’t understand their logic here). But it’s all about weighing the risks. Right now, the risk of losing anti-deflation credibility looks much worse than the risk of losing fiscal credibility.
Please don’t hike those taxes!