Tuesday, September 23, 2014

Will lack of tax hikes crash the Japanese economy?

Adam Posen thinks that if Abe fails to follow through on his pledge to hike taxes, the Japanese stock market will crash:
Posen’s fear, outlined in an interview in his office last week, is that Abe reneges on a plan to raise Japan’s consumption tax to 10 percent, from the 8 percent level it was boosted to in April. If that happens, prepare for international investors to dump Japanese stocks and the yen, says the former U.K. central banker. 
“If Prime Minister Abe decides to postpone, let alone cancel, he runs a real risk of crashing the stock market,” said Posen... 
To Posen, delaying the tax measure would test the patience of international investors who have backed Abe’s efforts to both propel his economy from 15 years of deflation and restore fiscal order to a nation where government debt now tops 240 percent of gross domestic product.
This is interesting, because most people are saying the exact opposite. Most people are blaming the recent Japanese sales tax hike (from 5% to 8%) for the severe contraction of GDP in the second quarter.

I always thought that was a little weird. Why should a 3% tax hike crush Japanese GDP when a similar-sized tax hike in America a year earlier failed to put much of a dent in growth? Why is the Japanese economy so fragile to tax hikes? Neither Econ 101 theories of deadweight loss nor Econ 102 Keynesian theories have much insight, and the calibrated DSGE models I've seen don't predict an effect nearly so big.

OK, but now let's take Posen's totally opposite contention. Will delays in tax hikes really cause a collapse in investor confidence that crashes the Nikkei? It seems possible, certainly. After all, Japan can get rid of its debt in three ways - default, monetize, or consolidate. The more it starts to appear that consolidation is politically impossible, the more it starts to look like monetization is inevitable.

That could cause the marginal Nikkei investor (who is probably not Japanese) to bolt. But will monetization be bad for stocks? As interest rates go to zero, the present discounted value of stocks explodes. As long as inflation remains subdued, monetization is good for stocks, not bad.

So what Posen is saying is essentially that debt monetization will lead international investors to fear hyperinflation - which really does kill stocks. I'm very, very suspicious of this, because I think it's just a fact that no one really knows why or when hyperinflation happens. It's always possible that investors could get scared of hyperinflation and bolt.

But suppose Japan's debt were half of what it is. Wouldn't it still be the case that investors could get scared of monetization-induced hyperinflation and bolt at any moment? What level of debt and monetization is reassuring to investors, and what level is scary? Posen has no evidence to support his contention that Japan is near a tipping point. But does anyone have evidence? Can anyone?


  1. Everything is fine and dandy until somebody imposes price controls:


  2. Berholz put the limits at something like debt over 80% of GNP and spending over 1.5 times taxes.

    I think Japan is in the early stages of the hyperinflation feedback loop:

    1. Anonymous7:54 PM

      Zimbabwe! Zimbabwe! Zimbabwe!

  3. Brian Romanchuk just posted on this at Bond Economics

    A MMT View On The Theory Of Hyperinflations

  4. This is exactly the kind of hypervetilation that was occurring back in 2010 in the US. It was bogus then and it's bogus now.

  5. At least where I live (Okinawa), the 3% tax hike was actually more like a 10% hike in typical prices for super-visible consumer goods (restaurant bills, vending machines, etc... stuff you see every day). I chalked this up to delayed price hikes that should've happened when the currency was devalued, but didn't happen for whatever reason. This was probably more of a psychological effect than actual inflation, since most other things (energy, etc) had already shifted in price. Just one possible explanation for why a 3% consumption tax hike might be associated with an outsized drop in consumption. It's not just a 3% hike in prices, but a 3% hike in prices combined with a long lag in passing the 20% yen devaluation onto consumers.

    Other possible changes:
    1) The tax increase was accompanied with basically every store, vending machine, etc being plastered with notes apologizing for price increases, while price increases over the previous 1.5 years after yen devaluation weren't advertised
    2) Before the tax increase, the 5% sales tax was silently added to basically every bill. Now, there's a line listing the 8% tax (and, annoyingly, an increase in the use of 1 yen coins). Big-ticket items (at stores and online) now have separate prices listed for before and after tax. Maybe this has some nudge effect on consumer behavior?

    1. Here's some experimental results that are half-relevant to my last question - http://www.nber.org/papers/w13330 - although this compares behavior when tax is included on the price tag vs. when it is added at the register. In Japan now, it's more of a comparison to having 1 tax-inclusive number on the price tag vs. having 2 numbers (pre- and post-tax). A few stores (Starbucks for one) have smartly switched to only listing the pretax price and adding tax at the register. According to the model in this paper, that's expected to increase sales 4%... perhaps the Japanese economy could be transiently rescued if everyone copied Starbucks.

    2. Anonymous11:30 PM

      The same story is true in Tokyo - the prices of a lot of everyday goods have finally burst through the 100 en or 1000 en barrier.

      But the other point to make is that there's a lot intertemporal substitution in these figures about gdp. People knew that the tax hike was going and in the last months before it occurred car showrooms and electric goods stores were crazily busy. The upshot was a sharp rise in gdp prior to the hike and a sharp fall afterwards. In fact as a teaching tool for intertemporal substitution its' been perfect.

    3. Ditto on the last point here. Even when we had one-day sales-tax holidays in the states I didn't see so much activity as there was here for avoiding the 3% hike... both by consumers and as an advertising theme for retailers. On the plus side, I got a great deal on underwater camera gear that the shop wanted to move before the tax hit.

  6. The mere fact that Adam Posen has accepted the bribes offered by Pete Peterson - sorry I meant "been made president of the Peterson Institute" - is a good enough reason to ignore him.

  7. Calibrated DSGE models are typically calibrated in such a way so that fiscal policy has no effect. As such, it is not a surprise that they would not predict anything.

    The tax hike causes a direct shock to the price level, which is highly visible, and affects everyone. They also hit an economy that was already not growing very fast. In the U.S., the tax hike only slowed an economy that is still had momentum coming out of recession. Also, the US tax hikes are less visible, which reduces their psychological impact.

  8. Anonymous9:26 AM

    When I read the title, I thought this would be another funny and sarcastic post by Noah. But it's serious! Will the lack of a tax hike destroy an economy suffering from such a lack of demand that a 0.5% ten year bond yield still doesn't produce inflation?!

    Maybe it's a stealth joke by Noah. He pretends he is serious so the rest of us think more deeply?

    What happened the last time Japan increased taxes? Did that make the economy better or worse?

  9. A tax hike that will constrain demand is going to stimulate the Japanese economy? Whatcha smokin', Noah?

  10. Hyperinflation occurs when there is a collapse in productivity. IN particular, a collapse in high value exports which shored up the domestic currency. Domestic currency collapses; so hyperinflation.
    But the black market premium on domestic currency also causes hyperinflation.
    Plus other causes.
    Price controls empty the shops. Everything goes onto the parallel market as happened in Zimbabwe. Think Walmart with nothing on the shelves. I mean nothing. But the goods that would normally be sold there were being sold on the parallel market.

    1. Anonymous7:55 PM

      Zimbabwe! Benghazi!!!

    2. The Japanese just don't do hyperinflation. I would say that it is impossible for it to happen there. Although, never say never. But can't see it happening.
      My eyesight really struggles with the prove your not a robot thing.

    3. Hyperinflation in Japan? I don't thinks so. IMO Europe is at this same way like Japan. Low inflation and stagnation in economy. EBC will give same injection of money but I don't believe that's enough.

    4. Japan did hyperinflation after WWII. Not that long ago really, but long enough that the people who lived through it as adults are all retired and out of power. So new batch of foolish people can print too much money.

  11. I am so happy to read this. This is the kind of manual that needs to be given and not the random misinformation that's at the other blogs. Thanks for sharing this.

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  12. Anonymous12:14 AM

    I find it hard to believe that anyone can be concerned about hyperinflation in Japan given any normal investment horizon. Let's try angling for inflation, yeah?

    Moderate inflation and low real interest rates strikes me as perfectly awesome for stocks. Earnings tick up every year and you don't even have to do anything. It's like free money for people who take a little risk with their savings.

    1. Hyperinflation is like an avalanche. It can go from holding still to very rapid in a very short time.


  13. Anonymous7:09 AM

    "Japan can get rid of its debt in three ways - default, monetize, or consolidate."

    There is a fourth way - financial repression.

  14. I think the story (for example in the linked article) is that a pre-announced tax hike has short term effects quite different from the Keynesian multiplier. The multiplier is for non-distortionary taxes. The story in the linked article is that the announced increase was distortionary.

    Things suddenly cost 3% more on an announced date. I don't believe in rational expectations, but you don't have to assume amazing forecasting skill to guess that people will react if they are told that they can save if they buy now now now. The story is that Japanese people shifted purchases of durables forward to avoid the extra 3%. That would cause high demand in the recent past (1st quarter) and low demand in the second quarter.

    There is ample evidence that tax changes have large effects on the timing of transactions (I am thinking of realizations of capital gains in the USA just around pre-announced shifts in the capital gains tax rate).

    The points are two. 1) If this is a shift of demand back a few days then both the 1st quarter bump and the 2nd quarter decline won't last. 2) Standard macro models have a lot of simplifications -- one often is ignoring the incentive effects of taxes.

  15. Anonymous6:31 AM

    Japan has wind assets and fertile soil. they can make electricity. do not panic. any other discourse is hot air

  16. ooops. Two big misses. Getting sloppy.

    The foreign investor fears depreciation, not hyperinflation. I personally don't think depreciation is such a threat, and I surely don't see any big trigger here. Hyperinflation in Japan is unthinkable, exactly nobody in the markets fears that. Besides, monetization of old debts does not necessarily cause inflation; steadily increasing nominal public spending does, whether funded by printing bonds or printing money makes little difference.

    Also, there's an obvious, enormous difference between a 3% consumption tax hike and a 3 point hike in the top marginal income tax rate, especially if the latter is mostly dodged.