#246 Highs & Lows

The Nikkei Rises, What Distinguishes Policy Conditions from Policy Problems, and A Grand Bargain for Cooperative Federalism.

Global Policy Watch: A New High For Japan

Global policy issues relevant to India

— RSJ

There was tremendous euphoria across trading desks in Tokyo this Thursday. The Nikkei 225 index finally, finally surpassed its 1989 peak of 39,900 as a bunch of chip-making stocks and others like Advantest rode the AI (and Nvidia) boom to levels not seen since that year of the spectacular asset bubble collapse. Yeah, if you entered a Japanese index fund back in 1989, you will finally be making money this week in nominal terms. Of course, accounting for inflation, you will still be down some 20-odd percent. There are a few reasons to believe that Japan might have turned some kind of a corner here at some psychological level. I’m not a psychologist - between Sigmund and Lucian, I favour the latter Freud - so, I’m not sure if I should ignore the sluggish Q4 GDP data and the trillion and half dollars of cash that the Japanese households still hoard because they don’t believe in the prospects of their equity market. Regardless, it is a useful and strange milestone to reflect on a few things. What went wrong for Japan in the intervening 34 years, and could it have been avoided? What lessons does it hold for other economies? 

It is difficult to imagine today the kind of hold Japan had over the world’s imagination in the mid-80s. It was the byword for technology advancement, it had cracked the code for creating a continuous improvement mindset among its workers, its government and industry worked in tandem to power the economy, more than half the top 20 companies by market cap were Japanese, people were enrolling into zen Buddhism classes, wannabe poets were writing haikus, karaoke parlours were sprouting everywhere, and manga, video games and kaiju were catching the fancy of the young in the developed world. Jack Welch was learning kaizen and Six Sigma from Toyota; Sony was buying out Columbia; Nintendo was cool, and Japanese cars and dealerships were everywhere. The future was Japan.

And yet, it all went sideways. And like in all such stories, there was bad luck, poor economics and hubris involved.

Let me start with hubris first. That year in 1989, unauthorised prints of an essay titled ‘The Japan that can say no: Why Japan will be first among equals’, written by Shintaro Isihara, minister of transport and a kind of an ideologue of the ruling LDP, and Akio Morita, the legendary founder of Sony, started doing the rounds in Washington. The essay was what you might call a humblebrag today with chapters like ‘America lacks business creativity’, ‘Japan, a country where each person is highly creative’, ‘America looks 10 minutes ahead: Japan looks 10 years ahead, ‘Let us think about the role Japan should play in the world’ etc. You get the drift. These weren’t isolated ideas of two mavericks at that time in Japan. Both Ishihara and Morito represented mainstream thinking of how Japan saw itself then. A rising economic superpower ready to teach others how to run their business and society. A true Vishwaguru. 

Here’s an extract from the essay to illustrate this thinking (this is Morito writing):

“I delivered a speech in Chicago entitled ‘Ten Minutes vs Ten Years’. I stated that we Japanese plan and develop our business strategies ten years ahead. When I asked an American money trader ‘how far ahead do you plan…. one week?’ The reply was ‘no, no … ten minutes.’ He was moving money through a computer, targeting the fate of that transaction ten minutes later. So, as I told the Americans, we are focusing on business ten years in advance, while you seem to be concerned only with profits ten minutes from now. At that rate, you may well never be able to compete with us.

A ten-minute profit cycle economy does not permit companies to invest in long term development. There are some exceptions, such as IBM, AT&T, DuPont and some others. But they do not represent the mainstream of American business nowadays. Gradually but surely, American business is shifting towards a symbol economy. In addition, it seems fashionable to call the service industry the ‘futuristic third wave’ and information and intelligence is the business of the future. But these produce nothing.”

Hindsight is 20:20 and all that, but I will say even back in 1989, it would have taken remarkable self-confidence and ignorance to dismiss ‘information and intelligence’. I mean, how much more wrong could he have been? American businesses may or may not plan for ten years, but their ‘system’ allows for the Schumpeterian cycle of creative destruction and regeneration. That’s more than enough to ensure companies may come and go, but the broader economy continues to forge ahead. 

Morito has more to reveal on his and, possibly, the broader Japanese industry’s lack of appreciation of what it takes for an industry to grow:

“Recently I said, ‘America is supposedly the number one industrial country in the world. Why don’t you have a Department of Industry?”

You don’t need a department of Industry, really. No Department of Industry would help create the cycle of destruction and creation that the U.S. industry saw in the 1990s. 

And lastly, this:

“I had the opportunity to visit Washington D.C. in April a year ago, and was surprised at the very hostile atmosphere. It was only five days after Congress passed the resolution condemning Japan on the semiconductor issue. I met some of my old friends, senators and congressmen, who with subtle smiles admitted that racial considerations or more directly, racial prejudice, played a role in US-Japan relations.

… It is my firm conviction that the roots of the US-Japan friction lie in the soil of racial prejudice. American racial prejudice is based on cultural belief that the modern era is the creation of the white race, including Americans. If Americans were ever to be made aware of the presence of a real Japanese culture in the Azuchi-Momoyama period, they may develop some respect for Japanese cultural history. Unfortunately, the present American education system does not teach children the value of other cultures. In the period noted above, there were over 20,000 ‘terakoya’ schools all over Japan. No other nation had such an extensive schooling system at such an early point in their history. During the Edo period, even farmers and peasants were able to read and write at least one or two thousand characters, including hiragana and katakana. Japan already at that time had a complete postal network called hikyaku as far as the southernmost end of Kyushu. Documents and information of various kinds were available in libraries in many cities and towns.

It is important that they (Americans) face the situation aware of the historical context, seeing that the reality is that the power in the world, including economic power, is shifting gradually from West to East.”

It is good to lecture others on racial prejudice and their social issues when you are convinced you have them sorted in your society. 34 years later, Japan still lags behind most developed economies in the participation of women in the labour force and how open it is to immigration. These prejudices have had real ramifications on Japan over the years, and they will continue to be a drag. Making unsubstantiated claims about a glorious past and using them to claim moral superiority and virtuousness is pure hubris and eventually sets you on the road to disaster. It is a lesson for any rising economic giant. 

That apart, it is a good occasion to revisit what went wrong with Japan structurally. I have written about this in the past. 

Krugman, in 1998, argued the lost decade of the 90s was because of monetary policy failure. He believed the Bank of Japan (BoJ) should have publicly taken a high inflation target that would have avoided deflation and prevented interest rates from going down to zero. Of course, this is supported by theory. A higher inflation target anchors inflation expectation at a higher number, and this increased expectation, in turn, leads to higher inflation because of the forward-looking aspect of the aggregate supply equation. Further, the increase in inflation expectation would reduce the real interest rate because it takes time for the nominal interest rate to reach its long-term level. In the short-term, this reduced real interest rate stimulates growth which in turn increases inflation. A kind of a virtuous cycle sets in.

Anyway, this wasn’t done by BoJ. The other option was to reduce the interest rate to zero quickly and provide substantial monetary stimulus quickly to check loss in output. A combination of a high inflation target (as suggested by Krugman) and monetary easing policy could have possibly worked.

Between 2001 and 06, the BoJ went on a quantitative easing overdrive, purchasing long-term Japanese government bonds. After the global financial crisis of 2008-09, the BoJ extended this programme to purchase private sector financial assets, including corporate bonds, ETFs (therefore equity in private companies), and CPs and invest in real estate investment trusts (REITs). This impacted financial markets, with stock markets rising, bond yields falling, and corporate bond issuances increasing. But this expansionary policy came at a cost. The debt to GDP ratio, which was around 60 per cent in the 90s, went up to 240 per cent by 2012. However, none of these measures moved the needle on inflation. It is possible a higher purchase of private risky assets like corporate bonds and commercial paper instead of government bond would have spurred growth and raised inflation expectations. But that was not to be.

Separately, the lack of coordination between monetary and fiscal policies hurt the economy. There were multiple increases in taxes to balance the budget while the monetary policy was working to increase consumption sentiments. Lastly, there was a lack of clear communication to manage expectations among the public about long-term inflation, interest rates or growth. A forward-looking guidance by the central bank on these parameters provides assurance to market participants more so when the financial system is weakened by high NPAs and general risk aversion. A recent example of this was seen when the US Fed indicated it will purchase corporate bonds as part of its stimulus during the pandemic. The planned purchase announcement itself did the trick in raising bond prices before the Fed actually bought a single one of them.

Shinzo Abe and BoJ Chairman Haruhiko Kuroda assimilated the learnings from the lost quarter-century to formulate the ‘three arrows’ of the Abenomics in 2013. Abenomics wasn’t a radically new construct but in bringing the three arrows together, setting targets for them and then communicating it clearly indicated Abe meant business. Japan needed to be jolted into a path of recovery and this was the way to do it. The primary objective of the 3 arrows was to ‘warm up’ the economy to an extent that spurs demand and gets the investment cycle going. On that count, it failed, though it is seeing higher inflation and wage hikes simultaneously now. 

Structural reforms didn’t cut to the key issues confronting Japanese society – an ageing population leading to a fall in total factor productivity, a disappointed younger generation carrying the burden through levies and taxes on income, strong hierarchical working style stymieing innovation and a reluctance to embrace large scale immigration to get out of this rut (an advantage so far for the US).

I guess with China not attracting foreign investors as much, the ‘China+1’ helping out Japan too, and some psychological barrier being breached with this level, this time might be a bit different. But the broader lessons of what Japan got wrong in 1989 are useful for any nation beginning to believe it’s destined for greatness.

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A Framework A Week: When Do Conditions Become Problems?

Tools for thinking about public policy

— Pranay Kotasthane

This week, I returned to reading a seminal work of public policy, John Kingdon’s Agendas, Alternatives, and Public Policies. This book proposes that the window for policy change is thrown open only when three different streams merge — the problem stream, the policy (solution) stream, and the political stream.

But in this edition, I will zoom in on one framework that is crucial to understanding why some problems rise up the government agenda, while most others are lost in the dungeon where government files decay patiently.

In his book, Kingdon distinguishes conditions and problems. Conditions are situations we hate, but we put up with them anyway. For instance, bad weather, the poor air quality in most Indian cities, or the poor law and order situation. Such conditions come to be defined as problems only when we realise something must be done about them. And this conversion of a condition to a problem can happen, according to Kingdon, in three ways.

One is when the condition violates a core value of an important interest group. In such cases, the mismatch between the observed conditions and the deeply held value manufactures a problem definition. This is why there is a tendency to create positive rights by those seeking a bigger State. Once a lack of something is positioned as a right, the hope is that every violation becomes an infraction of a core value and, hence, can float up as a problem. Of course, this strategy involves heavy coercion, and I’ll not discuss that aspect for now. Another example is how the current dispensation converted a condition called “temple destruction by invaders several centuries ago” into a live problem definition.

In contrast, a chronic condition that hasn’t come to be seen as a violation of core values are the predictable droughts that happen with irregular regularity.

The second route for conditions to become problems is through comparisons. Relative decline vis-a-vis an adversary or competitor does help. Indices often serve this political purpose, creating the illusion that an ambiguous phenomenon can be precisely converted into a number, pitting countries, cities, or states against each other.

A third way (and this is a terrific insight) is to think deeply about the problem category for a particular condition. The category in which the problem is positioned has a disproportionate impact. This example from the book is self-explanatory:

“During the 1970s, handicapped activists agitated for and eventually won statutory language and regulatory interpretations which mandated retrofitting of existing subway systems for elevators and other devices that would make public transit accessible. Transit operators and even many handicapped people themselves argued that the handicapped could be transported more cheaply and more conveniently around urban areas with dial-a-ride service or in subsidized taxis. The issue turned on how one classified the problem. If it was defined as a civil rights issue, then equal access to subways was called for because separate is not equal. On the other hand, if it was a transportation issue, then equal access was not necessary and other solutions were appropriate. The category into which the issue was placed made a tremendous difference.” (Agendas, Alternatives, and Public Policies)

These three factors, values, comparisons, and categories, are useful for change agents who want to convert chronic public policy conditions into powerful problem definitions.

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India Policy Watch: Making Cooperative Federalism a Reality

Policy issues relevant to India

— Pranay Kotasthane

When I think about India’s governance challenges from the lens of complexity, federalism jumps at me as the one true leverage point that can resolve many other wicked problems. India is too big and too diverse to be governed by one entity in the capital, however good it may be. Given this supreme potential of federalism, there is a need for a grand compact between India’s union, state, and local governments. Instead of thinking of piecemeal solutions, we need to think of a package of measures that moves India’s federalism to a new equilibrium.

There’s now also an opportunity to change the status quo. As we wrote in edition #215, the delimitation of Lok Sabha constituencies offers a once-in-a-century chance for a grand bargain to correct several problems with Indian federalism. I have argued earlier that there’s no moral or constitutional case to oppose delimitation. This debate is about relative power and not principles. So, delimitation should be seen as a part of a package that does several things simultaneously to balance competing interests. Perhaps, this package needs to have six elements.

First, a jump in the vertical devolution of resources to state governments. All federalism debates focus narrowly on horizontal devolution, i.e., the formula for sharing resources between states. But the real solution lies in increasing vertical devolution, i.e. how the tax resources are split between the Union government and all states as a whole. If the Union government keeps less money to itself, all states stand to gain together. Moreover, the union government should agree to a clause that any money raised through cesses and surcharges should be made a part of the divisible pool of resources shared with states. My colleague Sarthak Pradhan and I have an article on this topic in last Sunday’s Times of India.

Second, the position of the governor should be abolished. There’s no reason for an agent of the Union government to mind the States in an India that’s in the Information Age. Former Union Home Secretary Madhav Godbole in his book India - A Federal Union of States, meticulously explains how the powers vested in the governor can be handed over to other democratic institutions while abolishing the post itself.

Third, states must commit to removing inter-state migration barriers. Like in China and the US, India’s growth will be lopsided. Some states will have more opportunities than others. Making people access these opportunities should be a common goal. Chinmay Tumbe has proposed an Inter-State Migration Council for addressing concerns and coordinating policies related to migration.

Fourth, codify revenue powers for local governments. Our states are too big to discover citizen preferences. Only local governments can come to our rescue. We need additional ‘lists’ in the seventh schedule of the constitution to clearly delineate the revenue-generating powers of local governments.

The Goods and Services Tax (GST) framework should be amended to include a third component dedicated to local governments, without increasing the overall tax rate. This would directly channel resources to municipal bodies and panchayats.

Of the three dimensions of decentralisation—fiscal, administrative, and political—local governments fare worst from a fiscal angle. Thus, strengthening state finance commissions is an urgent necessity. In this regard, Dr Vijay Kelkar has a precise suggestion:

“This means that the State Finance Commissions will also need to be strengthened in terms of their mandate, and their recommendations should receive acceptance similar to the Central Finance Commission. This can be achieved by amending (i) Article 266 of the Constitution to include a consolidated fund for Municipalities and Panchayats and (ii) Articles 243H and 243X to ensure that revenue allocated by the Central and State Finance Commissions to Municipalities and Panchayats do not form part of the consolidated fund of the State and instead the funds flow directly to the consolidated fund created at the local level.”

Fifth, the state of UP must be divided. Just like the disproportionate power of a commercial entity is considered a market failure, one state having disproportionate power in a federation is a major political failure.

Finally, Indian states need a voice in the Union legislature and the Union executive. The former can be achieved by restoring the Rajya Sabha’s position as a council of States. For the latter, there is currently no arm of the Union executive that takes the long-term well-being of states into account. To fill this gap, Dr Kelkar suggests that the NITI Aayog should be allocated to give grants to states. In essence, he suggests that the NITI Aayog adopt the role that the Planning Commission of India played in inter-government bargaining and negotiations. The other alternative is to proliferate the GST Council model in multiple areas, where significant issues are dealt with by empowered ministers from states and union governments without resorting to political grandstanding.

Are there other elements you believe should be part of this grand bargain? Drop a comment below.

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HomeWork

1. [Book] Dr Madhav Godbole’s India - A Federal Union of States is a terrific read for anyone trying to understand Indian federalism. Godbole was a former Union Home Secretary, and his book gives the topic a scholarly treatment grounded in reality.

2. [Paper] Dr Vijay Kelkar’s BPR Vithal Memorial Lecture on “Towards Strengthening India’s Cooperative Federalism: Initiatives for Multi-level Governance Reforms” has many ideas for resolving India’s multi-level governance problems.

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