Economic Policy Measures in Response to Oil and Food Price Hikes

Takatoshi ITO (Professor, University of Tokyo)

It has now become evident that Japan's economy is heading into a recession. There seem to be various causes for this downturn, but clearly main ones are cost increases and consumption decreases due to sharp rises in the prices of food and energy related goods. Price increases in crude oil and food have two important implications on the Japanese economy.

First, it means global relative price changes, that is, resource prices tend to increase relative to the prices of other goods and services. Second, it means "income transfers" from those countries that are scarce in resources such as Japan to those countries that can produce crude oil, food and other resources. For example, the amount of oil that Japan used to import in exchange for one Toyota vehicle can now be imported for two Toyota vehicles, making Japan in a more disadvantaged position due to the lack of resources (which means deteriorating terms of trade and decreasing income for Japan as a whole).

Then, what to do in terms of economic policy? If the economy is stimulated through fiscal and monetary policy measures, inflation will surely accelerate, while production might not increase due to various supply constraints. If, on the other hand, monetary tightening measures are adopted to curb inflation, investment and housing demand will certainly decline, leading to a further downward movement in the economy. At any rate, we are now in a very difficult position to decide on fiscal and monetary policies.

Certain policy measures are obviously inappropriate. First, income subsidies to compensate for the value losses of wages and pensions due to inflation would only aggravate inflation through its "second-round effects." Price regulations and inflation-adjusted subsidies should also be avoided, because those measures would distort necessary relative price changes in the market. Third, expansions in public investment budget to cover cost inflation might well violate a criterion of judging whether to proceed with a project based on the cost-benefit analysis.

Clearly desirable policy measures from the medium and long term viewpoint, if not effective in the short term, are as follows. First, we should adopt policy measures to encourage Japan's supply structure to adapt to a new relative price system in the global economy. More concretely, policies should be directed toward alternative energy developments and energy cost reductions, where Japan's energy saving technologies might well contribute to income growth through exports of their patents and licenses.

Second, a bold measure for agricultural reform should be taken to transform sufferings from increases in food and cattle feed prices into a kind of opportunities: for example, abolishing "production adjustment" (policy encouragement of idling rice paddies) will increase agricultural output. At the same time, in order to prevent income decreases due to increased production, productivity improvements with higher value-added must be achieved through business consolidation and better branding in Japanese agriculture.

Third, we should proceed with a growth strategy so as to emphasize Japan's strengths. For example, new wealth could be created through better management for higher returns on 15 billion dollars of household assets and 1.5 billion dollars of public pension reserve funds. Also, a new institution may be needed to provide proper rewards to excellent human resources in Japan amid globalization.

In conclusion, what we need now is an economic policy package to minimize the degree of economic downturn in the short term, while avoiding the waste of limited fiscal and economic resources and, at the same time, encouraging a desirable structural reform in the medium and long term.

(The original Japanese article appeared in the August 30, 2008 issue of Weekly Toyo Keizai)