1. What is the likely outcome of the next general election?
The Democratic Party of Japan (DPJ) is likely to win an outright majority. Low popularity of the current ruling party, the Liberal Democratic Party (LDP), is the key factor, but policy disarray in the LDP is also important, along with the weak economy. The main risk to this scenario is geopolitical, in particular disruptions on the Korean peninsula, which would highlight the defense expertise of the LDP.
2. What will be the post-election political and policy dynamics?
An outright majority for the DPJ in the Lower House could trigger several changes elsewhere. In the Upper House, where the DPJ has only cobbled together ad hoc majorities on specific issues, the DPJ might want to form an alliance with some other party, e.g., the Komeito, which has more than enough seats to form a stable majority coalition with the DPJ there. In the LDP, recriminations over the loss of power could trigger a split into pro-reform and anti-reform camps. In the DPJ itself, the challenges of governing could deepen policy splits inside the party, especially over foreign policy.
3. Where will the DPJ take Japan?
The DPJ is a center-left party. It will focus first on hot-button issues like civil service reform, pension reform and medical reform in a small number of target ministries, most likely the Ministry of Health, Labor and Welfare, the Ministry of Agriculture and the Ministry of Land and Transportation. It will also address social issues such as stagnating wages and inadequate labor protection rules, child-care allowances, health access and pension reliability. It has said clearly that it will not raise the consumption tax for several years.
4. How united are the DPJ leaders and the rank-and-file on policy issues?
The DPJ agrees on many issues, but is deeply divided on some, and silent on others. On privatization, the senior leaders wish to abolish many agencies, but may try to reverse postal reform; indeed, a key part of the DPJ support base lies with public sector unions. On the environment, the green lobby in the DPJ wants strict CO2 reduction goals, but key party officials and auto union supporters of the DPJ oppose such goals. On foreign policy, many members decry the US-centric foreign policy of the country, while others regard this policy as the cornerstone of national security. Investors will only increase confidence in a new government if these disagreements are settled, and action taken with pro-growth results.
5. How will the DPJ pay for the extra spending that it wants? What is its position on deficit reduction?
The DPJ is proposing about JPY20 trillion of new spending. It claims to have found funding from cuts of wasteful spending, tax enhancements and sales of government assets. Even if these claims are correct, however, there is no provision in the DPJ plan for deficit reduction. Hence, for investor confidence in a DPJ government to emerge, a credible strategy to reduce deficits will be needed.
This matter is NOT an election issue because the LDP has not produced a credible deficit reduction policy either. Moreover, any such strategy would require productivity enhancements and/or structural reforms that are large enough to offset the negative demand impact of fiscal deficit reductions. Such enhancements and structural reforms, however, require harsh political battles with vested interests, and thus will be difficult to implement, regardless of which party is in power.
6. What should investors look for as signs of change - for better or worse?
The key sign of change, whether positive or negative, will come from the personnel decisions made by a DPJ government. The crucial Cabinet posts will be Welfare, Finance, Agriculture, Trade/Industry, Internal Affairs and Communications, Land & Transport, and Administrative Reform. In the DPJ party, the key post will be Policy Affairs Chairman. Investors will be encouraged if pro-growth people take these posts, and disappointed if not.
What's New: Change of Government
Japan is likely to have a change of government by the early autumn, the first such change since the early 1990s. Investors are naturally interested in the implications of such a change.
We believe that the Democratic Party of Japan (DPJ) is likely to win an outright majority in the Lower House in the coming general election. The next general election could come as early as August 2, but in any event must be held by October 18 at the latest. With very little time to recover in public opinion polls and with a great deal of internal dissention, the ruling LDP is unlikely to do well. Indeed, my top-down election model suggests that the DPJ will win 248 seats, an outright majority.
However, even a clear victory in the Lower House will immediately raise a new issue: The Upper House, which does not see its next election until July 2010, will remain without any single party in majority. A coalition would remain necessary.
The DPJ is already the top party in the Upper House, but does not have an outright majority. Rather, it has cobbled together a complex coalition in the Upper House, but this coalition is hard to manage. Depending on the outcome of both the Tokyo Assembly election (July 12) and then on the outcome of the general election, the DPJ may choose new partners in trying to form a working majority in the Upper House.
The Upcoming General Election: DPJ Victory Likely
Such an outcome would have important implications for policy. First, the Lower House would no longer have the ability to override Upper House legislation, since a two-thirds majority in the Lower House is necessary to do so. Currently, the LDP and its partner, Komeito, have such a super-majority. However, it is extremely unlikely that a DPJ victory would be large enough to form a coalition with any other party and achieve a two-thirds margin.
Second, with no two-thirds majority in the Lower House, legislation will require full approval in the Upper House, in order to become law. Currently, the DPJ has 109 seats in the Upper House (for which the next election comes only in July 2010). Thus, the bargaining power of relatively small groups of Upper House members will rise. Any group or party that could bring 13 or more members into a coalition with the DPJ would give that coalition the 122 or more seats needed to pass legislation.
Third, the now-ruling LDP would be left in the cold. Its first reaction would likely be to attempt to discredit the DPJ government. The LDP used similar tactics in 1993 when it lost power briefly to the Hosokawa government. However, the LDP's own internal problems imply the possibility that a splinter group will bolt and form a new party. If such a splinter party garnered enough Upper House members to make a working coalition with the DPJ possible, then the incentive to do so would be strong. In light of the popularity of the DPJ, and the unpopularity of the LDP, there is an incentive for LDP Upper House members to join such a splinter party, particularly since the next Upper House election is not far away - July 2010.
We illustrate the potential outcomes in the Upper House, in the wake of a DPJ victory in the Lower House. For example, the Komeito, which is currently in coalition with the LDP, has 21 seats in the Upper House. Were they to join a coalition with the DPJ, the new coalition would have 130 seats, quite enough for a stable government. Alternatively, an LDP splinter group of 9, combined with some small groups currently effectively allied with the DPJ, could generate such a majority as well.
For investors, the key point will be to examine the strength of the DPJ outcome in the Lower House, and then watch coalition movements in the Upper House, to see whether a more stable, policy-coherent government can form.
Who Are the Democrats?
The next significant issue is the policy stance of the DPJ. Just like the LDP and like most large parties, the DPJ includes a very broad spectrum of opinions. However, the particular problem in the DPJ is that the breadth of opinion extends over both key policy areas, economics and foreign policy.
One group in the DPJ represents the combination of no use of the SDF abroad (i.e., dovish foreign policy) and a large role for the public sector in resource allocation. While individual stances of different politicians differ, this group is often associated with DPJ representatives with a background in public sector unions (e.g., Mr. Koshiishi, from the Japan Teachers' Association). A second group favors less public sector involvement in the economy, but a more active role for Japan in foreign policy, albeit restricted by tight rules on when Japan might use the SDF force abroad. This group is represented by Mr. Ozawa (former Party President) and by Mr. Hatoyama (current Party President). A third group favors even less role for the public sector in resource allocation (e.g., aggressive privatization of government entities, outsourcing of public services) and looser conditions on use of the SDF (e.g., Mr. Maehara, also a former party president).
Many Japanese voters wonder how such differing views can coexist in the same party. However, there are enough areas of agreement to form a party and to propose action. For investors, the key areas of DPJ agreement are:
Civil service reform and regional government reform appear to be merely political issues at first glance, but nothing could be further from the reality. Both agendas will require a significant improvement of e-government; both will release large numbers of workers for redeployment in other key areas (e.g., nursing care).
Agricultural reform: Productivity in Japanese agriculture is extremely low. Legal changes to allow farm consolidation could create opportunities for corporate farming (for both food sector companies and trading companies). Restructuring of the agricultural distribution system would also imply new business opportunities. Such changes are essential if the DPJ is to fulfill its promise to raise agricultural self-sufficiency.
Postal privatization: Investors will look for signals about the true philosophy of the DPJ in the way that the DPJ approaches this issue. Depending on the eventual Upper House coalition, the DPJ may reverse privatization or may become more aggressive.
Consumer protection rules will expand under the DPJ, at a pace faster than would have happened with the LDP. The extra burden for companies will be an issue.
Consumption tax: The DPJ leadership has stated clearly that it will not raise the consumption tax until government spending waste is eliminated. Investors are likely to welcome this stance.
Monetary policy: The DPJ has no clear stance on monetary policy. There could be disruptive impact if senior leaders call for rate hikes in order to improve the income of depositors. Such calls are likely to be short-lived, however, since the DPJ's constituency includes many small business borrowers.
Productivity policy: Japan cannot achieve both fiscal reform and stable living standards without accelerated productivity gains. Few DPJ members have emphasized the need for productivity acceleration. Hence, there is potential upside surprise for investors should the pro-growth group in the DPJ take important posts.
Fiscal consolidation: The DPJ has no plans on deficit reduction. It claims to have found JPY20 trillion of savings and funding from various sources, but wishes to use that entire amount for new spending. Investors will see no improvement from the LDP, unless the DPJ frames a credible deficit reduction policy.
Fiscal Policy and Deficit Reduction
The DPJ has taken an aggressive stance on cutting waste, and has identified categories and government operating procedures to revamp. However, it also has several areas where it believes spending should be expanded, such as childcare allowances. The DPJ has identified about JPY20 trillion of such spending. To its credit, it understands the need to avoid further increases of Japan's already large fiscal deficits and debt/GDP ratio. However, the DPJ's outline plan for how to pay for extra spending has been controversial.
The DPJ outline targets revenue increases of JPY8.2 trillion. Details are sketchy, but the DPJ has identified a list of special tax benefits that could be abolished. There is always uncertainty over whether abolishing such measures will actually lead to the expected revenue recovery. In addition, profits from special accounts of the government are a component of this item. The DPJ focuses most on profits from the special account for foreign exchange reserves; this account borrows at short-term rates from the market and invests in US Treasuries, which this account has acquired over the years in foreign exchange intervention. Some of these profits from this account are already transferred to the government as revenue, but the DPJ wants to increase this transfer.
The DPJ also sees room for direct spending cuts. One large item would be cuts of tax transfers to regional governments. The DPJ is concerned that much waste at the local government level occurs because funding is easily available from the central government. Reducing the amount of transfers (while at the same time removing the many strings attached) would reduce waste. The DPJ has also proposed cutting the total compensation budget for national civil servants. Although some senior civil servants are underpaid, there are many central government officials who are posted to regional governments, and effectively duplicate functions of regional counterparts. The DPJ also believes that ending amakudari, the system of bureaucrats taking jobs in government affiliates after retirement from the ministries, would save significant sums.
Finally, the DPJ is advocating asset sales and use of hidden reserves in government special accounts - a policy first proposed by the pro-reform group in the LDP.
While the DPJ plan is an important contribution to the debate on fiscal policy, some questions remain. First, there are concerns about whether the cost savings and spending cuts will in fact materialize in the amounts the DPJ hopes. Second, the plan appears to mix both one-shot asset draw-downs and recurring sources of funding, while the extra spending is all in categories that recur. Since the spending is virtually certain to materialize while the funding (whether recurring on one-shot) might not, there is naturally a concern that bond issuance may in the end rise as a result of the DPJ proposals.
A more important point is the absence of deficit reduction as a goal. True, the recent performance of the LDP sets no standard for fiscal rectitude. However, no DPJ document lists deficit reduction as a major goal of policy. Indeed, there seems to be little discussion of the matter within the party. While the DPJ deserves credit for recognizing the need to fund new spending initiatives, investors are unlikely to feel comfortable with a DPJ government until a credible strategy for deficit reduction is proposed, legislated and implemented.
Signposts for Investors
It is clearly too early to get excited about the implications of a DPJ government, either positive or negative. There remains too much uncertainty on how strong its legislative power will be, what it will actually do, the timing and prioritization of actions, how it will pay for new initiatives, etc. Thus, in the eyes of most investors, the prudent approach is to wait for more information. The cost of waiting is not high, particularly in light of weak economic indicators such as the recent BoJ Tankan results in Japan and the disappointing June employment data in the US. But what information will become available, and on what time line?
The first key data point will likely be the results of the Tokyo Prefectural Assembly election, on July 12. The LDP is widely expected to take a serious blow; more important, however, will be the outcome for the LDP's coalition partner, the Komeito. If the Komeito does badly, then it will likely blame its association with the LDP. Such an outcome would increase the likelihood that the Komeito dissolves its coalition with the LDP, and uses its significant seat count in the Upper House to switch to a coalition with the DPJ - with which the Komeito agrees on many welfare issues.
The second key data point will be the micro results of the general election, which could come as early as August 2 or as late as October 18. In addition to the number of seats garnered by each party, there are other important points.
a) Will there be a rejection of long-serving Diet members in favor of newcomers?
b) What will happen to the balance of pro- and anti-reform forces inside the LDP? Should the pro-reform forces take the upper hand, they could use the opportunity to redefine and focus the party philosophy, while the DPJ remains troubled by a broad range of supporters. Should the anti-reform forces in the LDP take the upper hand, the likelihood of a splinter party would grow.
c) What will happen to the small left-wing parties, such as the Social Democratic Party (seven seats) and the Communist Party (nine seats), and the small right-wing parties such as the People's New Party (seven seats)? Should these small parties lose seats in the Lower House election, their credibility as ongoing partners in coalition with the DPJ in the Upper House would drop.
The third key data point will be the personnel decisions in the new government. If the DPJ forms the new government, it will be important to gauge the philosophies, expertise and aggressiveness of those taking key Cabinet posts for the economics-related ministries. These key economic ministries are a) Ministry of Health, Labor and Welfare; b) Ministry of Finance; c) Ministry of Agriculture; d) Ministry of Internal Affairs and Communications; d) Ministry of Land &Transportation; and e) Ministry of Economics, Trade and Industry.
If the DPJ appoints Cabinet ministers for these agencies who are expert, aggressive and growth-focused, then the likelihood of actual implementation of policies will rise. If appointments focus on other members of the party, then investors could be disappointed. Many of the DPJ Diet members are not well known outside of political circles, however, and so investors will need time to understand the true colors of the new players.
At this point, at least four DPJ Diet members are worth watching, as bellwethers on where the DPJ will go with policy. These four are (in descending order of age) Yoshihiko Noda, Akira Nagatsuma, Seiji Maehara and Keiichiro Asao. See Appendix in the full report for details on the policies views of these Diet members, along with others from the full spectrum of DPJ Diet members.
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America's Fiscal Train Wreck
July 06, 2009
By Richard Berner | New York
America's long-awaited fiscal train wreck is now underway. Depending on policy actions taken now and over the next few years, federal deficits will likely average as much as 6% of GDP through 2019, contributing to a jump in debt held by the public to as high as 82% of GDP by then - a doubling over the next decade. Worse, barring aggressive policy actions, deficits and debt will rise even more sharply thereafter as entitlement spending accelerates relative to GDP. Keeping entitlement promises would require unsustainable borrowing, taxes or both, severely testing the credibility of our policies and hurting our long-term ability to finance investment and sustain growth. And soaring debt will force up real interest rates, reducing capital and productivity and boosting debt service. Not only will those factors steadily lower our standard of living, but they will imperil economic and financial stability.
Familiar challenges. Sound familiar? Warning about these challenges has long been a staple for economists. Five years ago, for example, I summarized my concerns about our coming fiscal problems, along with the interplay among them and unexpected longevity, inadequate thrift and saving infrastructure, mediocre education outcomes, and inadequate energy policy (see America's Long-Term Challenges, May 21 and May 24, 2004). I was merely the latest in a long line of alarmists; for example, Pete Peterson famously noted more than 20 years ago that "America has let its infrastructure crumble, its foreign markets decline, its productivity dwindle, its savings evaporate, and its budget and borrowing burgeon. And now the day of reckoning is at hand" (see "The Morning After," Atlantic Monthly, October 1987). The Congressional Budget Office (CBO) has since 1997 - under directors from both sides of the aisle - carefully laid out ever-more depressing fiscal scenarios in its annual Long Term Budget Outlook, the latest of which appeared last week.
The problem, ironically, is that the day of reckoning hasn't come. This has seriously undermined doomsayers' credibility and, more importantly, it has made the electorate and elected officials complacent about the threat from unsustainable fiscal policies. Some even proclaimed that "deficits don't matter."
Fast forward to today. Yet the last five years have brought our ever-distant fiscal crisis rapidly forward. Some of the deterioration is obviously cyclical: Courtesy of the financial crisis and recession, aggressive fiscal stimulus, and ongoing military outlays, the federal deficit has ballooned to US$1.8 trillion or 13% of GDP in fiscal 2009. But the bulk of the threat is structural: The fiscal stimulus package included spending increases with minimal bang for the buck, leaving more debt than growth. In its FY2010 budget, the administration proposes to extend several tax cuts enacted in 2001 and 2003, provide relief from the alternative minimum tax, and increase both mandatory and discretionary spending compared with current law. Most important, by 2019 the full force of rising entitlement outlays and debt service will begin to hit the budget. No rosy growth scenario will provide sufficient resources to meet all the claims on future federal revenue. And while tax hikes or a broader tax base will likely be part of the solution, the real cure is to curb the growth of entitlement spending.
Against that backdrop, voters and politicians are nervous: Two recent polls suggest that Americans are more worried about deficits than healthcare by a ratio of 2:1. But despite voters' deficit anxiety, near-term action to reduce long-term deficits seems highly unlikely for two reasons. First, no one wants to endanger a still-fragile economy by raising revenues or cutting spending until they are sure of economic recovery. Second, while there is no shortage of fiscal scolds inside the Beltway, the political will to change popular entitlement programs is still absent.
Healthcare the main culprit. Analysis of those programs makes it easy to see why. The rise in federal healthcare outlays under Medicare and Medicaid is the main long-term factor boosting deficits. These popular programs create a safety net for the elderly and disadvantaged that has been a band-aid for our flawed system of financing healthcare.
The base is already large: In 2010, some 100 million Americans will be enrolled in Medicare, Medicaid and SCHIP (the State Children's Health Insurance Program), and outlays amount to 5% of GDP. Longer term, Medicare enrollment will rise significantly as the population ages. More importantly, future per capita cost growth for both programs is well in excess of per capita GDP, meaning that outlays for these three programs will double to 10% of GDP by 2035 and nearly double again by 2080. Translated into budget outcomes, according to CBO, these programs will account for virtually all of the likely growth in primary federal spending - total spending less interest on debt held by the public - in relation to GDP, and thus all the likely expansion of the deficit and debt. In contrast, social security cost increases will play a relatively minor supporting role.
There is no lack of options to alter the unsustainable path for Medicare and Medicaid outlays. At the end of 2008, for example, CBO analyzed 115 of them, any handful of which could significantly slow the growth of spending or find the means to pay for it. To name two: Raising the age of eligibility for Medicare by two years (to 67) starting in 2014 would save US$85 billion by 2019. Limiting the tax exclusion for employment-based health insurance to amounts below the 75th percentile for such premiums and doing the same for health-insurance deductibles for the self employed would net US$452 billion over 2009-18. Note that the second option would raise additional revenue, but would not address burgeoning entitlement spending. Yet the prospects for actually adopting any of these measures are dim. There is no serious discussion in Washington of, or appetite for, curbing eligibility for federal health programs. Nor, more important, is there the will to rein in the growth of per capita costs.
Meanwhile, the current healthcare reform effort aims at the apparently conflicting goals of curbing costs and increasing access and quality. In the long run, those goals may turn out to be complementary. But in the near term, politics likely dictate that increasing access will take priority over cutting costs. And increasing access to today's health options will be expensive. For example, preliminary CBO estimates of Subtitles A through D of Title I of the proposed "Affordable Health Choices Act" indicate that expanding access to health insurance for 39 million Americans by granting subsidies will cost US$1 trillion over the next decade. Proposals to cut costs may yet emerge to fulfill the president's requirement that any healthcare reform be deficit-neutral. But political agreement will be hard to come by; witness the storm of opposition to a "public insurance plan" when the outline for any such plan is still vague. Thus, in the short-to-intermediate term, increasing access first means bigger deficits are likely. Pundits are describing the president's ability to deliver a healthcare reform package that improves Americans' lives and contains costs as a defining moment for his leadership. As I see it, it is also a bellwether for our willingness to tackle our fiscal challenges.
Deficit disorder. America's now chronically rising deficit will almost surely expand debt beyond the appetite of global investors to hold it without significant concessions in the form of higher interest rates or a big enough decline in the dollar to make it look cheap, or both. Soaring deficits and debt imply higher real interest rates. That hasn't happened in the current recession, of course, because of the weakness in private credit demands resulting from the collapse of corporate external financing needs and the deleveraging of the American consumer. But rates likely will rise significantly when recovery begins to lift private credit demands. Standard estimates suggest that a 20-point sustained increase in debt/GDP - what we will experience between 2008 and 2010 - will boost real rates by 70-110bp.
But many question whether rising deficits and debt will have significant longer-term market consequences. Optimists cite the example of Japan, where massive deficits boosted government debt to 160% of GDP with apparently no effect on interest rates. The comparison is not apt for two reasons. First, Japan's lost deflationary decade pulled down nominal yields, but there were serious consequences for real yields. Real 10-year JGB yields averaged 1.7% over that period, much higher than the 30bp of annual real growth experienced in Japan. Indeed, my colleague Robert Feldman points out that this positive gap between real rates and real growth clearly boosted Japan's deficits and debt unsustainably (see Fiscal Reform and the r-g Problem, June 17, 2005). Second, Japan's massive current account surplus, which averaged 3% of GDP, means that Japan has no need to rely on foreign saving inflows.
In contrast, America's budget deficits are worsening our persistent internal and external saving-investment imbalances. Our chronic external deficit has shrunk to 2.9% of GDP in recession, but rebounding oil prices and imports suggest it will grow in recovery. Even a coming sea change in consumer behavior and the incipient rise in our personal saving rate to 7-10% of disposable income (5-8% of GDP) won't be enough to offset federal dissaving. State and local governments are awash in red ink, now more than 1% of GDP and growing. Consequently, we still need sizeable inflows of saving from abroad to finance federal deficits.
Fiscal credibility deteriorating. Some are concerned that our reckless fiscal policy will trigger a downgrade of the US sovereign debt rating, making the financing of our burgeoning deficits more difficult. While worries that the US will default on its debt are illogical, global investors and officials are concerned about the credibility and the sustainability of our fiscal policies. So am I. They fear that we will adopt policies that will undermine the dollar and the domestic value of dollar-denominated assets through a combination of risk premiums and inflation. I worry about that too, although such policies probably would be accidental rather than deliberate. As a result, interest rates may have to rise significantly to compensate investors, including reserve portfolio managers and sovereign wealth funds, for such dangers. While the dollar will for now retain its reserve-currency status, such concerns put it at risk.
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