The macroeconomic policy in Japan in the 1990s swung from fiscal expansion to fiscal consolidation and conversely. The efforts to restore soundness of public finance culminated in the Fiscal Structural Reform Act of 1997, which articulated several fiscal targets in the medium-term perspective. The act was however suspended after only a year due to economic slowdown, which threatened politicians with the possibility that fiscal consolidation might deteriorate the Japanese economy further. During the past decade, a number of economic packages to stimulate the return of the economy to a self-sustaining growth path totalled over 130 trillion yen in terms of project cost base.2 However, the Japanese economy has not recovered. As a result, these discretionary fiscal policies made the fiscal balance dramatically worse and accumulated government debt to over 140% of GDP in 2002. The new government under Prime Minister J. Koizumi was formed in April 2001. The government put structural reforms at the top of the agenda and included the fiscal consolidation plan to achieve a primary balance surplus in the early 2010s. While Japan is moving into an ageing society more rapidly than other countries, there is increasing pressure to restore public finances over the medium term. However, downside risk in the Japanese economy has been increasing since the middle of 2002 mainly due to serious deflationary pressure. Halting deflation is urgent in the short term for restoring economic growth. Japan is thus faced with considerable difficulties in achieving both the short-term objective of economic recovery and the medium-term objective of fiscal consolidation. In addition, Japan is in the extraordinary situation where there has been little incentive to enforce fiscal consolidation because huge domestic savings can finance huge government deficit, keeping the coupon rate of a ten-year Japanese Government bond to less than 1%...