Reviving the Animal Spirits – A Strategy for Promoting Growth in Japan, a Commentary by Anoop Singh, Director of the Asia Pacific Department, International Monetary Fund

January 31, 2011

A Commentary by Anoop Singh, Director of the Asia Pacific Department, International Monetary Fund
Published originally in Japanese in Nihon Keizai Shimbun
January 31, 2011

Japan’s recovery in 2010 was brisk––faster than in the Unites States and Europe––but is beginning to moderate. A seemingly vigorous recovery a year ago started to slow in the final months of last year as the government’s eco-point program ended and exports leveled off due to an appreciation of the yen and uncertainty about the recovery in other regions, especially Europe. The IMF’s forecast released on January 25, 2011 predicts Japan’s GDP growth will slow from 4.3 percent in 2010 to 1.6 percent in 2011.

But a weak external environment and the expiration of stimulus alone cannot explain Japan’s slowing growth. While it is true that spillovers from the global financial crisis led to a sharp recession during 2008-2009, Japan’s lack of resilience has deep seated domestic roots. Lingering deflation and one of the highest public debt ratios internationally are constraining the speed at which Japan can recover from one of its deepest post-war recessions. Few countries have had to contend with such a challenging situation, especially with traditional monetary and fiscal policy tools largely exhausted. 

What can Japan do to revive its economic fortunes? Clearly, maintaining Japan’s edge as an exporter of high-quality consumer and high-technology capital goods remains a priority. In this regard, prospects for greater trade liberalization through the Transpacific Partnership are a promising avenue to support growth. But more importantly, Japan needs to rebalance its economy and create new business opportunities in its domestic economy. Almost 3 out of 4 employees produce goods and services for the domestic economy, but after a decade of low growth and mild deflation, investment in these sectors remains subdued. Population aging has failed to create vibrant new markets for medical equipment, services for the elderly, and related needs, with the risk that growth will stagnate as old industries decline. Regaining robust growth will require a revival of animal spirits by creating an environment, in which growth opportunities are quickly recognized and risk-taking is rewarded.1

Returning Japan to its past dynamism will entail a concerted policy effort. The government has already sketched a roadmap in its Growth and Fiscal Strategies adopted last June, and the Bank of Japan has embarked on a bold and innovative Comprehensive Monetary Easing policy. Building on these important steps, Japan needs to clarify the role of macroeconomic policies in supporting growth, design credible fiscal reforms, and stimulate corporate investment and household spending.

1. What should be the role of macro policies in supporting growth?

Fiscal and monetary policies can help cushion the fallout from the global crisis, but they alone cannot solve Japan’s underlying growth problem. Japan’s economy contracted more but also rebounded faster than any other G7 economy in 2009-10. Undoubtedly, determined action by the Bank of Japan and the government limited the negative spillovers of the global crisis by providing timely economic support and maintaining financial stability.

But macroeconomic policy, especially fiscal policy, is less effective in sustaining long-term growth. With public debt at unprecedented levels, new stimulus spending is becoming less potent, as households and businesses grow more concerned about the health of the public finances. Recent events in Europe have underscored that delays in addressing fiscal problems can have dire consequences. Japan has so far little difficulty in financing its deficit, but as retirees begin to draw down their assets, debt markets will need to look for new sources of financing, including overseas.

Hence, the room for supportive fiscal policies is constrained, shifting the focus to monetary policy to aid growth. But here too policy space is limited as interest rates are already near zero. In a bold move, the Bank of Japan has begun purchasing private and public assets to encourage more risk taking. This is a welcome step, but its success will greatly depend on whether it is part of a broader pro-growth agenda.

Should fiscal consolidation be part of growth enhancing strategy? The answer is yes. Reducing public debt now—albeit in a gradual way—can have significant growth payoffs in the medium-term. To be clear, these benefits would only accrue over time and in the short-run growth would be dampened. But the sacrifice of slower growth in the short-term to boost growth in the long-term may not be as large as often feared and could be mitigated if supported by reforms to enhance productivity in the economy. This is because determined efforts to reign in debt would reduce precautionary saving, especially among the young, and boost consumer and business confidence, thereby stimulating consumption and investment. The size of these effects depends on the design of fiscal adjustment and could rise with a more growth friendly tax system. In this respect, the government’s proposal to cut the corporate tax rate is welcome, but will need to be paired with a rise in the consumption tax to lower the public debt burden and underpin the social security system.

2. How to boost corporate investment in small enterprises and the service sector?

As Japan’s labor supply is shrinking, growth will increasingly depend on productivity gains and investment. Despite the recession, many Japanese businesses maintained healthy balance sheets and competitiveness. Yet, firms remain reluctant to spend. Business investment grew by only 3 percent in 2010 after falling 16 percent in 2009. New research explores the main deterrents for investment in Japan and finds that low profitability, limited access to external funding particularly in the SME sector, excess capacity in some sectors, and high economic uncertainty are key obstacles.

What can policy makers do to boost investment and technological innovation? First, they can lower corporate tax rates and extend loss carry-forward periods to raise returns on investment. Second, they can improve access to finance for small- and medium-sized enterprises, by promoting venture capital investment in innovative areas and more risk-based lending. The Bank of Japan’s new lending program to financial institutions is one example how such investment could be raised. Another is to encourage long-term investors, such as pension funds, to allocate a small share of their assets to venture capital investments. Such a strategy is common in other countries, such as Singapore, Korea, New Zealand and the United States, and has been credited with enhancing productivity growth.

3. How can households be encouraged to spend?

Japan’s share of private consumption in its national product remains below that of other G7 economies. The main reasons are slower productivity and wage growth, lower female labor force participation and a smaller share of non-wage income in total household income. Boosting income from labor and investments is therefore key to reviving household spending.

Here policymakers have various options. Japanese households’ rate of return on their savings is depressed by low dividend payouts by firms. One important reason is the extensive (albeit declining) cross-shareholdings among corporations and financial institutions. Encouraging a faster unwinding of such cross-shareholdings could increase share-holder compensation and encourage more risk-taking by investors, banks, and businesses.

To raise wage income through new jobs and higher productivity, Japan’s labor markets need to be more effective in channeling labor to new growth sectors. At 5 percent, Japan’s unemployment rate is low compared to other developed countries, but employment growth is more sluggish. For firms to create jobs in new growth sectors, a more flexible labor contract may be needed. Such a new contract would offer less protection at early stages of employment, hence encourage hiring, but increase job security over time as workers prove themselves on the job. It would also raise productivity by increasing incentives for training and narrow the current divide between regular and non-regular employment.

4. Putting it all together

Individually, the measures outlined here may not be enough to permanently raise growth. But combined under an overall strategy, they can create a pro-growth environment in which Japan’s animal spirits can come to life and flourish. With a still uncertain outlook for the global economy, Japan needs to focus on raising growth at home. In turn, the world needs a strong Japan to overcome the great recession. The government’s recent reform initiatives are a promising start. The task now is to push ahead with implementation of a broad pro-growth agenda.

1 In October 2010, the IMF invited a panel of academics and policy makers to discuss options on how to revive Japan’s “animal spirits”. Many of the ideas reflected in this column are based on new IMF research on Japan available for download at


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