The title of this post might seem a bit strange, for several reasons:

1. The tax cut was widely blamed for causing a recession
2. I’m a libertarian that favors low taxes

In a first-best world I’d like to see the Japanese move toward the Singapore tax regime, which has much lower taxes that Japan. However, if the Japanese government insists on current levels of government spending, they really need to raise taxes. Not because they couldn’t keep on the current track for many years—they could. Rather the problem is that if Japan keeps borrowing money and rapidly increasing the ratio of debt to GDP, then they will become more and more susceptible to an economic shock, like higher interest rates. Financial crises always seem far off, until they are suddenly upon you.

The current government of Prime Minister Abe took power at the beginning of 2013, promising to boost economic growth and implement a 2% inflation target. They also promised to reduce the budget deficit, by raising the national sales tax in 2 steps. On April 1, 2014 they took the first step, raising the tax rate from 5% to 8%. The second increase from 8% to 10% was scheduled for later this year, but has been postponed to 2017. It should be moved up if possible.

In 2014, the American media reported that the April sales tax increase drove Japan into a recession. As you can see from the unemployment graph, that’s not true:

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Unemployment has been falling ever since Abe took office, and is now at fairly low levels, even by Japanese standards. Inflation increased, although the recent oil price collapse reduced it again (perhaps temporarily.) The total number of employed workers has been rising, despite a rapidly falling working age population. Stocks are soaring. In December 2014 the Japanese voters shrugged off the so-called “recession” and gave Abe a huge, overwhelming mandate.

The post-tax increase downturn was falsely labeled a recession for two reasons. First, most American reporters don’t know that Japan’s trend rate of economic growth is roughly zero, and hence positive and negative quarters are equally likely. And second, even with full 100% monetary offset (which occurred in this case) consumers will time purchases to avoid the tax increase. Thus GDP rose sharply in 2014 Q1, and then fell sharply in 2014 Q2. That’s simply a timing issue, and (as we can see from the Japanese unemployment rate) has no implications for the business cycle.

Again, I’d love to see Japan adopt a libertarian policy regime, but they aren’t going to do so. The Abe government is committed to a fairly high level of spending (by East Asian standards, not by European standards). But they are also blessed with one of the greatest central bankers in world history, Haruhiko Kuroda. They should take advantage of this opportunity by implementing the second tax increase as soon as possible. Unfortunately, they seem more interested in undercutting Kuroda:

AN EARLY strength of Abenomics, the plan of Shinzo Abe, the prime minister, to revive Japan’s economy, was the tight bond between Mr Abe and his handpicked central-bank governor, Haruhiko Kuroda. Former chiefs of the Bank of Japan had adopted a defeatist stance towards Japan’s deflationary morass. Mr Kuroda, the prime minister believed, was a champion of his desire to revitalise Japan in large part through unorthodox monetary loosening. In early 2013, soon after Mr Abe took office, the central bank duly launched a radical programme of quantitative easing.

But now the two men appear at loggerheads. The main point of contention is fiscal policy, which to date has been very loose, with a primary budget deficit (that is, excluding interest payments on debt) of 6.6% of GDP. Mr Kuroda (pictured) is making it clear that he does not believe Mr Abe is trying hard enough to bring the deficit down. The government, meanwhile, would prefer him to confine his remarks to the bank’s monetary remit.

A second and related difference is emerging over monetary easing itself. In the quest to rid Japan of deflation, Mr Kuroda promised whatever it took to push inflation up to 2%. The Bank of Japan may not be doing enough to achieve this. Prices are at a standstill. Yet the government appears to be signalling that a fresh bout of bond-buying might be too much of a good thing. Having ordained the inflation target, Mr Abe now appears to be undermining Mr Kuroda’s ability to reach it. . . .

To forestall further easing, some advisers even speak about changing the Bank of Japan’s 2% inflation target to a more modest one, of perhaps 1%.

Given their recent huge election victory, achieved with the new 2% inflation target, a drop to 1% could only be described as an “unforced error.”

If you think that you’ve now got Japan figured out (Abe hawk, Kuroda dove), think again. Just a few paragraphs later The Economist makes this bizarre claim:

Mr Abe has promised detailed plans in the summer for reducing future deficits. Swingeing cuts to social-security spending probably remain politically off-limits. Yet radical measures are needed. They will have to include getting elderly Japanese to pay more for their medical care. A health system that keeps too many people in hospital beds for too long needs to be overhauled. And the retirement age needs to be increased further. The most important test of the relationship between Mr Abe and Mr Kuroda will come if inflation picks up in earnest, at which point the central bank will begin to tighten its monetary policy. Mr Abe may insist on keeping the monetary taps open to safeguard growth. A premature falling out may only make that moment harder still.

As I keep saying, monetary policy failures are not about special interest politics. There is an almost mindboggling lack of understanding of monetary theory at the top levels of government. The entire world economy is resting on the hope that a few sane people like Haruhiko Kuroda can keep their head and keep NGDP chugging along while the rest of the political establishment careens recklessly from one extreme to the other.