Emergency Planning for a Fiscal Meltdown
The European sovereign debt crisis shows no sign of abating. The situation escalated in May after the results of elections in Greece and France placed those nations' fiscal austerity commitments in jeopardy. On the eve of a Greek ballot scheduled for June 17, Greece's withdrawal from the eurozone was looming as a distinct possibility. The result was a massive decline in the value of the euro and in stock market prices worldwide. Meanwhile, Spain's borrowing costs rose to new highs after one of the nation's top banks requested a government bailout.
In Europe, market movements galvanized leaders of the European Union, key European governments, and organizations like the International Monetary Fund to formulate policy measures and force commitments from Greece, Italy, Portugal, and Spain. The election results in Greece and France were in large part a popular backlash against decisions reached through such a political process. The Greek and French governments had adopted sweeping economic policies without holding a national debate, let alone building a consensus, and they paid the price.
These developments have cast into sharp relief the limitations of democratic government, particularly the slow pace of decision making. And as the crisis has spread from one country to another, observers around the world have begun asking whether democracy is capable of meeting the challenges of our time. World markets move at a pace that leaves the democratic process in the dust, and as governments resort to undemocratic policymaking processes in an attempt to keep up, voter resentment builds, raising the risk of a political backlash.
The time lag between the markets and the democratic decision-making process is one potent argument for advance planning to deal with a Japanese debt crisis that has yet to arise. Taking the time before a crisis occurs to deliberate and secure political support for a response plan is one way to reconcile the imperatives of democracy with those of the marketplace. But another important reason to prepare for such eventuality is that a timely announcement of countermeasures that already have the nation's support could well be sufficient to head off a full-blown crisis before it materializes.
Lessons from Japan's "Unanticipated" Nuclear Disaster
The ratio of public debt to gross domestic product has reached monumental proportions in Japan, and almost all economic estimates agree that, without a decisive change in course, the debt will only continue to balloon. Given Japan's persistent deflationary climate, it may be hard for the average Japanese citizen to accept the idea that the nation's government finances are spiraling out of control. Yet most economists agree that at some point within the next few decades—and possibly even within the next few years—Japan could suddenly find itself in the midst of a sovereign debt crisis similar to that facing Greece.
A sovereign debt crisis is a situation with serious financial and economic repercussions. Bond prices plummet, the government's fund-raising mechanism ceases to function, inflation rises steeply, the value of the national currency plummets, and unemployment soars. As we have seen in the case of Greece, the economic, political, and social costs are likely to be huge, and in the final analysis, it is the people who pay the price. What can we do to prepare for such a disaster?
If we have learned anything from the March 2011 nuclear accident it is the need to think about the "unthinkable." Because neither the government nor the power industry had envisioned such a disaster and its aftermath, they were unable to respond rapidly, and their delays led to unnecessary suffering and confusion. Moreover, prompt action to deal with a fiscal crisis could be even more difficult owing to the complex procedures mandated by law and the need to marshal support for a tough course of action in the face of various competing interests and conflicting opinions. To dismiss such a scenario as unthinkable would be to ignore the lessons of Fukushima. Denying the possibility of a crisis—making it taboo even to discuss the possibility—in order to maintain a false sense of security among the people actually exposes the public to greater risk.
Needless to say, preventing such a crisis by implementing fiscal reforms now would cost the nation far less than managing a debt crisis after it has arisen. Clearly, Japan's policymakers should do everything in their power to prevent a debt crisis farther down the road. But planning in advance for such a contingency is extremely important from a policy standpoint.
Having such a plan in place is also an important means of preventing a developing crisis from escalating into a full-blown emergency. Psychological forces in the marketplace can make fears of a financial meltdown self-fulfilling. A single event or report can spread panic among market players, triggering a massive selloff leading to a bond market crash. In such a case the government could find itself facing insolvency regardless of the nation's economic fundamentals. One important way of averting a panic is to secure the nation's support in advance for a debt-crisis response plan.
When a debt crisis develops, it tends to escalate quite rapidly. From a policy standpoint, it is essential to respond to the crisis at the earliest stages to prevent the situation from progressing past the point of no return. With this in mind, the government needs to plan its response in two separate phases, one corresponding to the earliest stages of a crisis and the other a full-blown fiscal emergency. In the following, we discuss the key policy objectives and considerations that need to be addressed when planning the government response at both stages.
Early Response to a Developing Crisis
The first key to effective crisis planning is to establish the conditions under which the response plan would go into effect and ensure that everyone involved understands and accepts those criteria. A prior understanding regarding these criteria would facilitate a rapid early response in the event of a debt crisis by eliminating the need for protracted consultations at various levels to secure approval for implementation. And rapid implementation could make all the difference when it comes to calming jittery markets.
With regard to the criteria for action, aggregate indicators may be more appropriate than simple quantitative triggers. It will be necessary to reach a common understanding among key policymakers and officials as to the thresholds for a "developing crisis" in such key indicators as the following.
- Long-term interest rates: What level (expressed as a percentage), persisting over what period of time, should be taken as signaling a developing crisis?
- Long-term government cash-flow forecast: What is the threshold level—based on a previously agreed method of calculation—for declaring a developing crisis?
Point 1: Preemptive Action in a Developing Crisis
While immediate stopgap measures, such as recapitalization of domestic financial institutions, are an important component of any early debt-crisis response, the central goal must be restoring the markets' confidence in the nation's fiscal sustainability. For this, the government must promptly demonstrate its commitment to fiscal rehabilitation by announcing an ironclad commitment to two basic policies: (1) major cuts in spending, including social security expenditures, and (2) major increases in revenue, primarily by means of the consumption tax. Without restoring the conditions for issuing bonds from a position of long-term fiscal sustainability, the government cannot ultimately regain the markets' confidence, and the crisis will at some point reignite.
Further, to prevent an escalation of a crisis during the early stages, the government must move as quickly as possible to outline a concrete fiscal rehabilitation plan that the markets see as viable. For this purpose, it needs to deliberate the substance of such a policy well in advance and draw up a blueprint for fiscal rehabilitation that clearly specifies where, when, and by how much the government intends to curtail spending.
The need to specify cuts in advance is particularly important from the standpoint of social security policy. When it comes to social spending cuts, the prime target should unquestionably be pension benefits, but attacking livelihood support and other welfare benefits would be the politically safe route to take. If forced to decide in the midst of a crisis, government leaders may be inclined to make cuts that are politically expedient but negatively impact the welfare of our society.
Point 2: Propping Up Local Economies
During the early stages of a debt crisis, when government bond prices are falling, regional financial institutions—local banks, so-called shinkin banks, and credit unions—will most likely be the first to feel a serious impact. Local institutions not only lack the sheer mass of larger nationwide banks but are geographically constrained in their operations as well. As a percentage of their total assets, these local banks are less heavily invested in government bonds than the so-called megabanks, but because corporate bond holdings occupy such a large share of their portfolio, soaring interest rates and falling bond prices would cut deeply into their assets.
Faced with eroding assets, local financial institutions would tighten credit, making it difficult for small businesses to raise cash and remain solvent. This would be devastating for regional economies. Since cushioning the impact on local economies is likely to emerge as a key political issue in the event of a crash in government bond prices, the government should plan such measures in advance, with the following points in mind.
- Emergency recapitalization of local financial institutions will be needed to prevent or mitigate a credit crunch. The government should draw up a detailed plan to minimize the impact of a debt crisis on local economies, including decision-making procedures for approval of capital infusions and similar measures.
- To mitigate the negative impact on the cash flow of small businesses, the government should establish other credit mechanisms to supplement the role of local financial institutions, such as public organizations that offer micro-financing to small and very small businesses and publicly held local investment funds that offer equity financing.
Response to a Full-Blown Crisis
In a full-blown debt crisis, confidence falls to the point where the government's cash flow is jeopardized—the situation Greece was facing in 2011. For example, when repeated government bond offerings fail to attract sufficient subscribers, the government finds itself hard-pressed to raise the cash needed to maintain services and meet its obligations.
Point 3: Funding the Government in a Full-Blown Debt Crisis
In a situation in which the government finds itself unable to raise cash through the normal channel of bond issues, it must resort to emergency measures to secure the funds needed to keep functioning smoothly. Policymakers need to anticipate such a contingency and identify steps to be taken in cooperation with the Bank of Japan, including emergency legislation and budget cuts, with particular attention to the following:
- Identifying in advance the procedural hurdles to action by the Bank of Japan to ease government cash flow (legislative action, Diet resolutions, Policy Board decisions, etc.,) and formulating measures to facilitate quick action in the event of an emergency.
- Targeting and prioritizing budget programs to be suspended or curtailed in the event that the government must cut budget spending on an emergency basis or implement large-scale budget cuts.
Point 4: Measures to Contain a Full-Blown Crisis (Preventing a Financial Meltdown)
The government should also formulate measures to minimize chaos in the financial markets and the real economy in the event of a full-blown debt crisis. The focus here should be measures to ensure that the effect of the debt crisis on private banks with extensive holdings of Japanese government bonds does not precipitate a financial meltdown.
With this in mind, the government needs to plan appropriate measures in advance, keeping in mind the following questions: What steps can the government take within the confines of the laws governing the financial industry and accounting practice? What steps should the government and the Bank of Japan take to stabilize the financial markets?
At the present time, Japan's net foreign assets exceed 250 trillion yen, but as our public debt accumulates at an ever faster pace over the next decade, our overseas assets are likely to dwindle rapidly. If Japan were to find itself a net debtor nation with a sovereign debt crisis on its hands, its financial institutions, private industry, and government would all face a critical shortage of foreign currency. In such a case, the nation could find itself cut off from international financial markets and hard-pressed to secure adequate supplies of food and vital resources. This is another contingency for which policymakers must prepare in advance.
Point 5: Restoring the Market's Confidence through Fiscal Rehabilitation
To restore market confidence, the government will need to implement a policy package that signals a strong commitment to fiscal rehabilitation. The substance of this program is the same as that discussed under Point 1 as part of the early response, but in the event of a full-fledged crisis, the government would have to commit itself to an accelerated timetable. To ensure that the government can stabilize its finances quickly through prompt implementation of spending cuts and tax hikes, policymakers should prepare an "express timetable" for accelerated implementation of the fiscal rehabilitation plan discussed under Point 1.
Point 6: Ultra Long Term Economic and Social Reforms
Stabilization of government finances is a necessary condition for sustainable economic and social development. But in the long run, such sustainable development will require structural reform at every level. Given the outlook for a long-term demographic shift to a hyper-aged society—leading ultimately to the "piggyback" situation of one unproductive elderly person for every productive working-age citizen—surely two of our top priorities should be technological innovation for improved elder care and a shift in our industrial emphasis toward goods and services oriented to the needs of a rapidly aging society. In addition, the government must tackle the challenge of boosting the fertility rate so as to stabilize the population over the long term.
To accelerate the aforementioned technological progress and industrial shift, the government must set appropriate policy priorities and focus its resources accordingly, while at the same time pursuing the regulatory and structural reforms needed to hasten the replacement of the social and industrial structure.
In the event of a developing or full-blown debt crisis, the government must be able to present such a reform plan for the nation's approval and move toward implementation without undue delay. This means preparing a basic roadmap for reform before such a crisis strikes.
A Crisis Is No Time for Debate
The foregoing is a summary of the issues that policymakers need to begin deliberating now in order to ensure that the nation is adequately prepared in the event of a debt crisis. The time to discuss and debate such matters is not after a crisis has arrived on one's doorstep. Just as with evacuation drills, advance planning for a debt crisis would facilitate a rapid, automatic response, freeing officials from the need to spend precious time securing approval for each measure. In the case of sovereign debt, moreover, having such a plan could actually prevent an emerging crisis from snowballing into national insolvency.
It is imperative that Japan's policymakers stop treating the subject of a sovereign debt crisis as taboo and begin formulating procedures—predicated on a practical understanding of our systems and the policy tools at our disposal—to deal with such an eventuality.
For this purpose it is not sufficient to hold closed-door deliberations among a select group of finance officials and committee members. Because the effect of a sovereign debt crisis on the real economy and the lives of ordinary people is pervasive and profound, and because close bipartisan cooperation is of the essence in dealing with a national crisis, any response plan must have broad-based national support crossing party lines. In a crisis situation, there is simply no time to gauge and shape public opinion via the democratic process.
In addition to the obvious expedient of thought experiments by policymakers inside of government, it would be highly advisable to seek nonpartisan recommendations from experts in the private sector on the kinds of measures required in the event of a fiscal crisis. With such deliberations and recommendations as a starting point, the government can build a public consensus for a decisive emergency response. Having witnessed the ongoing chaos of the European debt crisis, we are convinced that contingency planning is critical to this nation's future.