Economic trade offs: Japanese fiscal policy transmits to GDP growth rate

Japan has suffered years of persistent deflation, and needs expansionary policy to change that. But they also have the highest public debt of any of the developed countries, at just under 230%, and need contractionary policy to change that. How are they to manage such a difficult trade off?

Many students will have examined Abenomics, and Japan's "three arrows" of monetary policy, fiscal stimulus and structural reforms - to ensure long-term sustainable growth in the world's third-largest economy. This BBC article 'Abenomics, the objectives and the risks' sets those three strands of policy out very clearly. However, the dangers of trying simultaneously to deliver fiscal stimulus and to repay government debt are starkly illustrated in this morning's news that Japan has dipped into recession, with businesses cutting back spending by reducing inventories. The result has been that rather than the expected 2.2% annualised growth rate, GDP data for the third quarter shows shrinkage of 1.6%. This follows 7.3% drop in the second quarter, and severely limits the country's freedom to implement policies to cut down that debt. Part of the issue, reported in the FT, lies with qualitative measures such as real wage growth and inflation expectations, both of which are more sluggish than policy makers would like.

One factor blamed for the GDP falls is a reduction in consumption (60% of Japan's GDP) as a result of an increase in sales tax. The tax increase was legislated for two years ago, to be implemented in two stages; this approach was endorsed by the IMF and OECD as a good means of addressing the public debt issue. The first stage came in April with a rise from 5% to 8%, and data now shows that private consumption has been very weak in the third quarter. The second stage was due to raise the tax to 10% next April, but is now likely to be delayed by up to 18 months, which was allowed for in the legislation passed in 2012. It is crucial for the government to retain broad support from the people for the reforms they are implementing, and it is expected that Abe will call a snap election next month in order to prove that he has that support. Just as David Cameron warns the G20 of danger signs for the global economy, here is a stark example of factors which could destablise the fragile recovery.