To the surprise of many, Japan has pushed itself into another bad recession in the last two quarters of this year. An economic recession is defined as a negative growth rate in two consecutive quarters.
This is exactly what happened to Japan when economic growth was negative 7.3 percent in the second quarter and was negative 1.6 percent in the third quarter, instead of an expected positive growth of 2 percent for the third quarter. This unpleasant surprise is hard to take, particularly after this country has undertaken aggressive quantitative easing since the end of 2012 and increased fiscal spending.
But in April 2014, the expansionist Japanese Prime Minster Shinzo Abe made a big mistake by increasing the sales tax from 5 percent to 8 percent; he also announced that he would levy another tax increase to make the rate go up to 10 percent. This fiscal austerity may not be recommended by any student who took Econ 202 (Principles of Macroeconomics) anywhere in the world.
Japan has been trying to emerge from a deflationary recession, but upon a few signs of economic recovery it could not wait to embark on this crippling austerity. A sales tax increase of this magnitude — and under the circumstances of prolonged recession and deflation — severely crimps consumer spending, which constitutes 60 percent of gross domestic product (close to 70 percent in the United States).
The United States made a similar mistake in 1936-1937 when President Franklin Roosevelt increased undistributed profits tax and also made spending cuts, causing the economy to go back to recession after the grave years spent going through the Great Depression that began in 1929.
By the spring of 1937, U.S. wages, production and profits had regained their 1929 level but unemployment remained elevated — although lower than the 25 percent that prevailed in 1929. Unemployment jumped from 14.3 percent in 1937 to 19.0 percent in 1938 and industrial production plunged by 30 percent. This recession lasted for 13 months.
We can understand Japan’s concerns about its very high debt-to-GDP ratio, which comes to about 200 percent. This is the highest percentage in the 34-member-country Organisation for Economic Co-operation and Development. But this woe is not a pressing short-term problem and it can wait, as they say in the AT&T advertisement.
There was no exigent reason to raise the tax rate by 3 percent in April and announce a planned increase by 2 more percentage points in 2015. Most of Japan’s debt is in yen and not in a foreign currency.
On the other hand, Greece, which has had a terrible fiscal crisis, has its debt in euro, which is not its domestic currency. Japan can monetize its domestic debt by printing yen; Greece cannot. Moreover, what Japan really needs now is a demand boost more than supply side reforms because it does not have high unemployment and high inflation to prefer the supply side.
Japan’s new recession also came at the wrong time for the United States and the rest of the world. It should directly and negatively impact American exports to Japan. The world’s third-largest economy was the fourth-largest trading partner for the U.S. last year after Canada, Mexico and China.
Japan’s recession would appreciate the value of the U.S. dollar, which means lower American prices at home at a time when the U.S. is feared to be slipping into deflation. It may affect Japan’s quantitative easing and its positive impact on the U.S. stock market. Japan is also a large buyer of U.S. Treasury securities.
It owns more than one trillion dollars of those securities. It buys them because of their low default risk and also to keep its yen more competitive with respect to the U.S. dollar and other currencies. The objective is to increase Japanese exports. A prolonged recession in Japan can thus affect U.S. interest rates and appreciate the dollar further. The Japanese recession will also affect Japan’s exports to other countries in East Asia, particularly China.
This important episode tells us that policymakers at the highest level should have some minimum competence in economics and they should also have competent economic advisers. Economic mistakes are devastating mistakes.
Shawkat Hammoudeh is an economics professor at Drexel University. He can be contacted at [email protected].