(UNTITLED)

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP86T01017R000606740001-7
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 10
• Document Creation Date: January 12, 2017
• Document Release Date: April 21, 2011
• Sequence Number: 1
• Publication Date: October 22, 1986
• Content Type: MEMO

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Central Intelligence Agency
DIRECTORATE OF INTELLIGENCE
22 October 1986
The Effectiveness of Japanese Fiscal Policy: The View
From Tokyo
Summary
Tokyo is committed to fiscal austerity, but continued sluggish
economic growth is certain to heat up the debate over whether to use
government spending and taxing policies to stimulate the economy. In
our judgment, a fiscal policy shift would not only increase Japanese real
GNP growth--by 2.5 percentage points if Tokyo boosted government
spending by 10 percent--but would also raise the level of imports in the
process. In addition to its direct effect on foreign purchases, more vibrant
domestic demand would slow the current decline in wholesale prices and
thus help US firms maintain the competitive position afforded by the
recent yen appreciation. Japanese economists as well as the political
leadership, however, are less convinced than we that fiscal stimulus would
reduce their trade surplus. We believe Tokyo's pessimism about the
effectiveness of a policy shift, along with concerns about the long-term
costs of deficit financing, make it unlikely that Japan will discard its tight
This memorandum was prepared by Office of East Asian Analysis.
Information available as of 22 October 1986 was used in its preparation. Comments and
queries are welcome and may be directed to the Chief, Japan Branch, Northeast Asia
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The Looming Fiscal Debate
The sluggish Japanese economy and recommendations from Washington to
reflate are rekindling the debate in Tokyo over whether to stimulate the economy with
increases in government spending or tax cuts. The near certainty that economic growth
will fail to meet Tokyo's 4-percent growth target for the fiscal year ending next March is
inducin some
to encourage the Nakasone government to alter,
at least for now, its austere fiscal stance (see figure 1).
In our judgment, the outcome of the debate will depend on how Tokyo evaluates
several factors: the effectiveness of a bond-financed increase in government spending
or cut in taxes in pulling the economy out of its doldrums; whether such action would
ease trade tensions with Washington; how many long-term economic problems would
be caused by the policy shift; and, most important, whether the current economic
deterioration is serious enough to require a boost in government spending to maintain
The Short-Term Impact of Fiscal Policy...
On the Production of Goods and Services. Virtually all the key economic
policymakers in Tokyo agree that an increase in government spending or a tax cut
financed by the sale of government bonds will, in the short-term, boost the production
of goods and services.
We believe there is ample evidence to support this judgment. Simulations
conducted with our econometric model of Japan suggest that a sustained 10-percent
increase in government spending--$35 billion roughly split between government
consumption and public investment--would boost real economic growth by 2.5
percentage points in the first year and 1 percentage point in the second year (see figure
2). A study conducted by the OECD last year came to a similar conclusion. In that
report, the effect on Japan's growth of a boost in government expenditures was higher
than the average for similar simulations conducted on the other Big Seven
countries--the United States, Great Britain, France, West Germany, Italy, and Canada
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Figure 1
Japan: Growth in Real Government Spending
12 1
-6
1977 1978 1979 1980 1981 1982 1983 1984 1985
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Figure 2
Japan: Effect on Real GNP of a Sustained
10-Percent Increase in Government Spending*
lqtr 2qtr - 3qtr
1987
4gtr
lqtr
2qtr 3qtr
1988
4qtr
?SImulatlon assumes that s endin Increase be ins in first
quarter of 1987?
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On the Current Account Balance. Despite the effectiveness of fiscal policy in
boosting real economic growth in the short term, economic policymakers in Tokyo claim
that faster growth would do little to reduce the country's large trade surplus. Indeed,
EPA Director General Kondo made this argument publicly at the recent GATT talks in
Uruguay. Both the Finance Ministry and the EPA argue that higher Japanese growth has
a minimal effect on commodity imports, which currently constitute 55 percent of
Japanese overseas purchases. Even that limited effect is further reduced because the
Japanese economy is moving away from industries that are heavy users of energy and
other raw materials, such as steel, nonferrous metals, and petrochemicals.
Japanese Government economists support their judgment on the relationship
between the current account and fiscal policy with data produced by large economic
models.2 The EPA model, for example, shows that a 10-percent increase in government
spending would reduce the trade surplus by only $4.5 billion. According to these
calculations, GNP growth would have to increase by more than 6 percentage points to
achieve even a $10 billion cut in the trade surplus. For its part, the Ministry of Finance
calculates that a 10-percent increase in government spending would boost imports by
only $2 billion and that a $30 billion cut in taxes--one-third of present income
taxes--would increase imports by only $700 million.
Although our model and OECD studies produce similar results--a 10-percent
boost in spending in our model reduces Japan's current account surplus by $8 billion in
the first year and an additional $6 billion the second year (see figure 3)--the figures, in
our view, substantially understate the effect on the current account of domestic
economic growth induced by fiscal policy. Experience with our own large-scale
macroeconomic model of Japan leads us to believe that although the Japanese models
probably yield fairly accurate estimates of the effect of a demand stimulus on imports,
they are likely to fail to capture two important results from a fiscal policy shift that will
First, the models do not account for the fact that increasing domestic demand
boosts the return to investments in nonexport-related industries. Consequently, their
forecasts understate the drop in exports as investment shifts away from export
industries and toward products geared to domestic sales.3 Second, the models fail to
accommodate the dynamic interrelationship between the domestic economy, its effect
2 Both the EPA and the Ministry of Finance maintain large economic models. These
models consist of several hundred equations and are designed to mimic the behavior
of the economy.
In contrast, as Japan's domestic demand slowed in the 1970s and the early 1980s,
firms looked to export markets to maintain sales. Indeed, 30 percent of Japan's
investment spending during the 1980s has been export related, according to
estimates made by the US Embassy. This investment paid off well. Nearly a third of
the increase in manufacturing sales by Japanese firms from 1974 to 1985 was
accounted for by exports, so that the share of exports in total sales increased from
less than 20 percent in 1974 to 26 percent last year, according to Japanese
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Figure 3
Japan: Effect on the Current Account
Surplus of a Sustained 10-Percent Increase
in Government Spending*
Q -1.5
C_ 2
vm
lqtr 2gtr 3qtr
1987
4gtr
lqtr
2gtr 3qtr
1988
4qtr
*Simulation assumes that spending increase begins in first
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on exchange rates, and the consequences in trade. Most economists contend that more
robust domestic demand is necessary for yen appreciation to begin correcting the trade
imbalance. Without an increase in domestic demand, we believe even the gains thus
far--export volume has declined since early this year, while import volume is up
sharply--could erode.
In some respects, this adjustment process is already occurring. Failure to
stimulate the economy could lead to price reductions that would go far in restoring the
competitive position Japan enjoyed before the yen appreciation. Wholesale prices of
domestic goods, which have fallen for 17 consecutive months, are now declining at an
annual rate of over 10 percent. An increase in domestic demand would decrease their
slide and contribute to maintaining the competitive position gained by US firms after the
appreciation.
Long-Term Problems
While Japanese policymakers agree that a large government role in the economy
can provide short-term stimulus, they are equally convinced that in the long run it leads
to numerous economic problems. They believe, for example, that a bond-financed fiscal
expansion increases inflation and interest rates, thereby discouraging domestic
investment and reducing potential real production. A recent statement by Director
General Umezawa of the Finance Ministry Tax Bureau, who suggested that expansionary
fiscal policy actually reduces economic growth, typifies this perception. Indeed, many of
the individuals and organizations who are in positions to influence fiscal poilcy--such as
close advisers to Nakasone and the Finance Ministry--appear to be the most concerned
about the long-term implications of adopting a policy of fiscal expansion. Last month's
$23 billion economic stimulus package demonstrates their views in action.
Implementation details have yet to be announced, but it appears that only small
amounts of new funds will be involved, making the effect on growth minimal.
A study by the OECD suggests that Tokyo's concerns about the long-term effects
of fiscal stimulus may be valid. OECD simulations show that long-term interest
rates--an important determinant of the cost of capital for private investment--increase
sharply in Japan following a bond-financed increase in government spending. Indeed,
the OECD study suggests that interest rates rise more in Japan than in the other Big
Seven countries for a similar increase in government spending.
We suspect that the narrow and tightly regulated government bond market
accounts for these results. Government bonds are sold primarily to a syndicate of
Japanese banks, who must hold the bonds for at least one year before resale. This
restriction and tax considerations make these bonds relatively unattractive investments
to banks. With financial liberalization increasing their options, syndicate members have
been demanding higher interest rates as compensation for large purchases of new
government bond issues.
In addition, many Japanese Government bureaucrats--particularly in the Finance
Ministry--argue that over the long term increased spending financed with bonds will
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limit Tokyo's ability to use fiscal policy to react to emergencies, such as fundin relief
after a natural disaster or countering the effects of a full-fledged recession.
Pressures for Change
Taken together, these long-term concerns have formed the basis for Tokyo's
policy of fiscal austerity, but a growing number of Japanese officials are arguing that
Tokyo should reverse that policy and stimulate the economy. They apparently believe
that the current economic slowdown is serious enough to warrant acceptance of some
longer term costs.
A supporting chorus is evident from some Japanese economists who question
the government's traditional contention that a large deficit is a tax on future
generations. They draw a sharp distinction between spending on government
consumption and spending on public investment. Their argument points out that
bond-financed increases in public investment, such as bridge and road construction, will
benefit future generations, who should thus share some of the costs of these projects.
Moreover, such investments--unlike consumption spending--earn a return that can be
used to pay off the debt.
Given the prospects that Japanese economic growth will continue to weaken in
the months ahead, calls for fiscal stimulation will probably receive greater attention at
senior political levels, where Finance Minister Miyazawa will be a key player.F
Miyazawa has publicly expressed interest in using an
expansionary fiscal policy to offset the negative aspects of yen appreciation. If this in
fact is Miyazawa's personal policy preference, and not just a political posture adopted to
distance himself from the Prime Minister, then he could develop into an important voice
in favor of increased spending. Moreover, Miyazawa has a compelling reason to become
more active on the policy front in the months ahead; as one of the ruling party's three
.new leaders," he is a potential candidate to succeed Nakasone as LDP president and
thus as prime minister, but at this point more poorly positioned in the leadership race
than some of his main competitors. Still, without support from elsewhere in the LDP for
his policy views, Miyazawa will face an uphill battle to get the Finance Ministry to
reverse field on a tight budget policy that has now been in place for nearly a decade.
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SUBJECT: The Effectiveness of Japanese Fiscal Policy: The View From Tokyo
Distribution:
1 - Joseph Massey, USTR
Donald Gregg, Office of the Vice President
Thomas Hubbard, Department of State
William Brooks, Department of State
Chuck Kartman, Department of State
Marshall Casse, Department of State
Rea Brazeal, Department of State
Nicholas Riegg, Department of State
Allen Wallis, Department of State
James Kelley, Staff Member NSC
Cdr. (Ret.) James Auer, DOD/ISA/EAP
DIA/DB-2D
Defense Intelligence Agency
Defense Intelligence Agency
Stephen Danzansky, National Security Council
Louis Pugliariesi, National Security Council
Bruce Smart, Department of Commerce
H.P. Goldfield, Department of Commerce
Byron Jackson, Department of Commerce
Allen Lenz, Department of Commerce
Mel Searles, Department of Commerce
Maureen Smith, Department of Commerce
David Mulford, Department of Treasury
Robert Cornell, Department of Treasury
Doug Mulholland, Department of Treasury
Robert Fauver, Department of Treasury
Richard Woodworth, Department of Treasury
National Security Agency
David Germany, Council of Economic Advisers
Central Intelligence Agency
1 - Director, DCI/DDCI Executive Staff
1 - N I O/EA
1 - NIO/Economics
1 - C/EA
1 - OGI/IIC/PI
1 - OEA/NEA/Korea Branch
1 - OEA/NEA/STI Branch
1 - OEA/NEA Division
1 - OEA/China Division
1 - OEA/SEA Division
1 - D/C)EA
1 - C/Production/OEA
1 - FBIS Analysis Group
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1 - DDI
1 - Senior Review Panel
1 - PDB Staff
1 - C/PES
1 - CPAS/ILS
5 - CPAS/IMC/CB
1 - Branch
1 - LDA
1 - NIC/AG
1 - DDO/EA Division
1 - DDO/EA
2 - Author
1 - Chrono
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