Japan – the challenges facing the new LDP leader – Part 2

October 9, 2025
bill
Japan
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This is a second part of an as yet unknown total, where I investigate possible new policy agendas, which are designed to meet the challenges that Japan is facing in the immediate period and the years to come. This is also in the context of the elevation of Ms Takaichi to the LDP presidency and soon Prime Minister. She has suggested that her policy agenda will shift somewhat from the current government position, in the sense that she wants lower interest rates, while the majority of economists want higher, and she is advocating further fiscal expansion, while the mainstream want austerity. In the first part I examined the inflation issue in Japan, which suggests that the mainstream view that rates have to rise is misguided. Today, I am considering the scope for fiscal expansion.

The series so far;

1. Japan – the challenges facing the new LDP leader (October 6, 2025).

2. Japan – the challenges facing the new LDP leader – Part 2 (October 9, 2025).

Ms Takaichi is an advocate of Abenomics, which was defined by a commitment to robust fiscal activism and low interest rates, with the Bank of Japan keeping government bond yields close to zero via its massive bond-buying program.

Last year, the new leader told the Bank of Japan that it was “stupid to raise interest rates now” and she has consistently articulated a view that interest rates should not be used as a counter-stabilising policy tool (Source).

One of her current advisors is a colleague of mine at the University and we have published several articles and books together.

As a result, the policy advice is fairly consistent with Modern Monetary Theory (MMT), although she is also getting input from mainstream economists.

But the combination of stable low interest rates (that is, de prioritising monetary policy as a tool to control the economic cycle) and a commitment to use bold fiscal policy interventions to achieve full employment and material prosperity is clearly more MMT than an expression mainstream New Keynesian orthodoxy.

The other interesting aspect of her approach is captured by her statement at the press conference upon taking on the LDP leadership:

The government should take responsibility for monetary policy … (the government) … should communicate closely with the BOJ.

Over the last week, there has not been a lot of commentary focused on this aspect of her approach, but as I signalled in Monday’s post, this challenges one of the shibboleths of mainstream New Keynesian thinking, which has led us all to believe that ‘central bank independence’ is non-negotiable and requires no political influence on monetary policy.

I have considered this issue before in these posts among others:

1. The central bank independence myth continues (March 2, 2020).

2. Censorship, the central bank independence ruse and Groupthink (February 19, 2018).

3. The sham of central bank independence (December 23, 2014).

4. Central bank independence – another faux agenda (May 26, 2010).

5. Senior mainstream economist now admits central banks are not as independent as many believe (June 3, 2024).

The point is that the independence narrative was part of the depoliticisation agenda accompanying the neoliberal takeover of government.

It allowed elected governments to shift the blame for interest rate increases (and the political fall-out) away from itself by claiming that the monetary policy authority was ‘independent’ from government and so on.

Of course, there is no independence.

The elected government typically appoints the senior officials of the central bank so the appointments are political and the history of the RBA board confirms that clearly.

More importantly, the central bank and the treasury departments for each nation must communicate on a daily basis because fiscal decisions have implications for the liquidity in the system, which, in turn influences the state of the reserves that banks hold in their accounts at the central bank, which, in turn, determines what the central bank does in order to manage that liquidity to ensure it is consistent with their current monetary policy stance.

If that all sounds like gobbledygook then I urge you to go back and read some of the posts I have linked to above to get the more detailed explanation which will clear it all up for you.

The bottom line is that at the operational level there can be no independence between the central bank and the treasury – both macroeconomic policy arms are part of the consolidated government sector and must work together for policy consistency to occur.

The interesting point though is that Ms Takaichi is coming out openly about this and making it clear that monetary policy should be the responsibility of the elected government and not handed over to unelected and largely unaccountable technocrats.

That is a marked departure from the orthodoxy.

Where I depart with Ms Takaichi’s stated goals are that she seeks to:

… prioritize economic growth.

I have written before about how Japan should lead the world in showing us how to achieve a sustainable degrowth trajectory while still ensuring the material needs of its citizens are met.

For example:

1. Degrowth and Japan – a shift in government strategy towards business failure? (July 17, 2024).

2. Japanese government investing heavily in technologies to help its population age (October 21, 2024).

With an ageing population, a resistance to large-scale immigration, there are now significant constraints appearing in the labour market in terms of available skills etc.

As I have noted before, over 70 per cent of SMEs, which dominate the economy, are owned by those who on average are over 70 years age.

And there is a resistance to selling those businesses on the open market when the owner gets too old to run them – in favour of passing them down within the family.

However, increasingly the children do not want to carry on the family business tradition and so the businesses close when the ageing owner is done.

So rather than fight against the demographic reality, which is on-going and difficult to reverse within the dominant culture, it would be more sensible to develop a degrowth strategy.

Even if we did not hold that degrowth predilection, it remains to ask just how much capacity there is within the current productive resource availability to accommodate significant economic growth anyway.

I ask that question because to advocate increasing the fiscal deficit implies that the government thinks there is real resource space available to absorb the increased nominal spending without provoking demand-pull inflationary pressures.

So I am doing some research on that question and this is the first take on the available evidence.

I will write more about this topic as my research expands.

The Bank of Japan publishes a quarterly time series – Output Gap and Potential Growth Rate – and the latest data came out on October 3, 2025.

This data provides some evidence we can draw upon to help us determine the ‘growth space’ available to the Japanese government.

The technical paper underlying this data is – Methodology for Estimating Output Gap and Potential Growth Rate: An Update (published May 31, 2017).

I won’t go into the technical details but I have written about the deficiencies of conventional output gap methodology.

For example:

1. The NAIRU/Output gap scam reprise (February 27, 2019).

2. The NAIRU/Output gap scam (February 26, 2019).

3. The dreaded NAIRU is still about! (April 16, 2009).

4. NAIRU mantra prevents good macroeconomic policy (November 19, 2010).

5. Structural deficits – the great con job! (May 15, 2009).

6. Structural deficits and automatic stabilisers (November 29, 2009).

My own PhD work was, in part, about this exact issue and my work as a 4th year student at the University of Melbourne (1978) was, in part, about these issues.

The idea of an output gap is conceptually sound – it is pretty clear that we can conceptualise some potential output level beyond which the productive system cannot squeeze any more real output without extra resource capacity being added (capital, labour, land, etc).

The measure of current production is clear enough although measures of GDP are deficient for what they include (for example, pollution) and exclude (for example, home production).

It is also fairly easy to understand the concept of a macroeconomic equilibrium unemployment level where the conflicting distributional nominal income claims between workers, capital and government are consistent, albeit for a transitory period, with the real output available for distribution.

My PhD (and early publications) were, in part, about theorising and operationalising this idea with a path-dependent system.

However, as they say, the devil is in the detail.

We know that ideology distorts the measurement process and the empirical expression of theoretical concepts.

Let me explain.

The Bank of Japan writes that:

The output gap is the economic measure of the difference between total demand as an actual output of an economy and average supply capacity, smoothed out for the business cycle — namely potential GDP – … in the goods and services market of the nation. The potential growth rate is the annual rate of change in potential GDP. In factor markets, the output gap expresses the differential between the labor and capital utilization rates and their average past levels. The potential growth rate is the sum of the average growth of labor input and capital input, and the efficiency with which these factors are used, namely total factor productivity (TFP).

Taken at face value, this is uncontroversial, although the absence of any biophysical aspect on the conceptualisation of potential GDP growth rates is a serious and known deficiency.

But, essentially, the output gap concept is easy to understand.

The problem is that ‘potential GDP’ is not easily measurable and requires us to take a stand on what constitutes full capacity utilisation of labour and capital.

This is where ideology enters the picture.

What constitutes full employment of labour?

In the context of the maximum output that might be squeezed out it must mean having everyone working up to their desired hours.

However, that is not the way the mainstream define full employment.

They consider the Non-Accelerating-Inflation-Rate-of-Unemployment (NAIRU) which is conceptually the unemployment rate where inflation is stable.

It is unobservable and the estimates using statistical means are highly dependent on the assumptions and approach taken.

As I have noted many times before, the statistical accuracy for the known NAIRU estimates is notoriously poor, with wide standard errors – such that they are basically useless for pinpointing some specific full employment level.

Moreover, they are typically biased upwards, meaning that the mainstream depiction of full employment associates much higher unemployment rates with that state than the approach that I take.

The Bank of Japan’s approach is relatively orthodox, initially based on estimating what they call the Labour Input Gap and the Capital Input Gap.

They then come up with a weighted measure of these gaps to define a total output gap.

Then using actual GDP figures derived from the National Accounts, they can subsequently estimate the potential GDP.

Why?

The output gap is defined in simple algebra as:

You don’t need to be a mathematician to be able to work with this definition.

If actual GDP is 100 and potential GDP is 120, then the formula gives:

Output gap = (100 – 120)/120 = -0.166666667 or in percentage terms -16.7 per cent.

That would be a very large output gap.

The Bank of Japan defines the Labour Input as:

The Bank’s potential Labour Input measure uses the same expression “which smooths out the
business cycle”.

What does that mean?

I won’t go into the technical stuff but basically they use statistical tools to calculate a trend and assume this is the full capacity measure.

The difference between this ‘trend’ input measure and the actual measure is the Labour Input gap.

It is problematic because the trend may not correspond with an employment level that satisfies the desire for working hours of the available labour force.

They similarly calculate a Capital Input gap based on the difference between actual capacity utilisation rates and average utilisation rates.

There are all sorts of measurement problems faced in doing that.

But for now, we just assume these estimates have some degree of applicability to the real world.

The fact that the Bank of Japan and the Ministry of Finance use these estimates of the output gap in designing economic policy is a good reason for considering them, notwithstanding my concerns.

They are likely to underestimate the Labour Input gap, which means we can consider them for argument sake, to define the smallest gap – with the reality lying above their estimates.

The latest data came out last week (October 3, 2025).

Here is a graph showing the Labour Input gap, the Capital Input gap, and the total output gap between the March-quarter 1985 and the June-quarter 2025.

As at the June-quarter 2025, the Bank estimates an output gap of -0.32 per cent – relatively small.

They estimate the Labour Input gap to be +0.47 per cent, which means the available labour force is working over their trend potential.

They estimate the Capital Input gap to be -0.79 per cent, which means current capital utilisation is below its longer term average utilisation.

So their estimate of a small output gap is based on the idea that the economy could extract more output out of capital stock by working it harder.

So according to these estimates, there is some scope for increasing actual GDP growth using increased net government spending, before tax offsets might be considered.

The question though is how to do that with the labour capacity already well above potential?

I am exploring that question next.

And the context is that there is now a growing antagonism across the political divide for the consumption tax.

I am told that Ms Takaichi is sympathetic to the argument that this tax could be reduced.