No. 25 — June 30, 2000


Weekly Review

--- by Douglas Ostrom

Pundits around the world interpreted Japan's June 25 lower house election results as a wake-up call for the triparty coalition government. Judging by the reaction of financial markets to the large losses sustained by the Liberal Democratic Party and its partners, however, somebody must have pushed the snooze button on the political alarm clock. On the first day of trading following the elections, the Nikkei average of 225 stocks listed on the first section of the Tokyo Stock Exchange and the yen barely budged. The Nikkei, for example, was off a tiny 0.2 percent. That development was not an indication that the elections would have no effect on economic strategy. Instead, it was a sign that the policy impact was particularly hard to predict.

By conventional wisdom, the elections left the LDP even more dependent on its coalition partners, particularly the centrist New Komeito, although that party also suffered a setback. Since the New Komeito's strength comes from lower-income households and small businesses — constituencies that have been hard hit by Japan's decade-long economic downturn — party leaders presumably will push for still more fiscal stimulus as a sort of insurance policy against a relapse into recession. Conversely, since the two voting blocs have little to gain from restructuring initiatives that might, for example, reduce the ranks of small retailers, the New Komeito has scant reason to support the LDP in any such effort. In other words, the New Komeito's higher profile might be expected to increase the likelihood that the economic policy prescription written by the late Prime Minister Keizo Obuchi — fiscal stimulus with minimal structural reform — will remain in effect.

This reasoning, however, overlooks other aspects of the electoral outcome. Prime Minister Yoshiro Mori still is in charge, but the polls are being read as a personal rebuke that could threaten his position (see previous article). Given the perceived need for a fresh face and new ideas that focus on the long term and the luxury of time to pick someone other than the most obvious choice, the LDP powers-that-be could move to replace Mr. Mori with a prime minister who is less committed to Mr. Obuchi's economic strategy, which, in some characterizations, was geared to the just-held elections. Former LDP Secretary General Koichi Kato, for example, might fit the bill, although this choice would be unpopular with the New Komeito.

To a large extent, the counterpart to the LDP's electoral loss was the gain scored by the Democratic Party of Japan. In a move that left American analysts shaking their heads, recalling a similar pledge by Walter Mondale in the 1984 presidential campaign, the DPJ proposed boosting revenues from personal income taxes by lowering the minimum taxable amount. Unlike its U.S. namesake 16 years earlier, Japan's Democratic Party seemed to benefit from its identification with a tax hike, which suggests broad support for fiscal discipline.

In the DPJ's platform, a tax increase would be combined with spending cuts to trim the government's budget deficit, now the biggest in the world. While such a formula would be a body blow to the New Komeito and its low-income constituency, it dovetails neatly with Mr. Kato's emphasis on fiscal reform. The Ministry of Finance — always an important political player and even more so during a time of political uncertainty like the present — rarely sees a tax increase it does not like. The DPJ tax proposal would not distort economic incentives and, its political disadvantages notwithstanding, would be particularly attractive to MOF fiscal hawks.

This argument suggests at a minimum that the hands of those pushing for deficit reduction have been strengthened in both the opposition camp and the ruling party. The formation of an ad hoc coalition to press this agenda, possibly led by Mr. Kato and including elements of the LDP as well as DPJ legislators, is not out of the question; similar forces were behind the banking reform legislation approved in the fall of 1998. While the New Komeito would hate such a scenario, it likes the idea of early elections even less since it could lose additional seats.

The implications of this speculation are that the days of Obuchi-style fiscal stimulus could be numbered and that, in turn, the economy's expansion would be slower in the short to medium term. The payoff would come in the form of lower budget deficits and higher sustainable growth over the long run.

Partly for these reasons, analysts trying to guess the direction of monetary policy in Japan are rewriting their forecasts. The consensus going into the elections was that the Bank of Japan was increasingly eager to move away from its target of zero interest rates. In a newsletter dated two days before the polls, J.P. Morgan Securities Asia Ltd. Pte. put the chance of a rate hike at 40 percent by July 17 and at near certainty by yearend. The prospect of more restrictive tax and spending initiatives has raised the cost of a premature tightening of monetary policy, reducing these probabilities somewhat. Analysts will look for clues in the detailed minutes of the central bank's June 28 policy board meeting, which confirmed continuation of the goal of zero interest rates, and in public statements by BOJ Governor Masaru Hayami, who, prior to the elections, had suggested the possibility of an early rate hike.

Whether the results of the elections trigger a recalibration of fiscal or monetary policy, they cannot be read as a strong repudiation of existing economic strategies. Most analysts believe that the returns reinforced the reputation of Japanese voters as highly conservative, especially given the economy's current circumstances. Despite a decade of subpar performance that in other countries might have led to the accession of a dramatic and controversial figure like Great Britain's Margaret Thatcher, the electorate clearly avoided a call for anything approaching a revolution in economic policy. In particular, the likelihood of far-reaching structural reform, in which the role of the government in formal and informal regulation of the economy changes drastically, is about the same as it was before June 25. Put another way, the LDP leadership may have heard the wake-up call but not the alarm ringing.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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