Goading growth from a Japanese bonsai

Lowy Interpreter

Just about everyone agrees that the Japanese economy has underperformed for over two decades. The astounding rise of China in the same period deepens the hurt. Prime Minister Abe has a three-pronged response: monetary expansion, fiscal stimulus and structural reform. Financial markets showed their support by sharply depreciating the yen and strengthening the share market even before the new prime minister took office, just on the promise of some action. Have the lost decades ended?

For monetary policy, the promise is 'more of the same' but 'this time, with feeling'. Inflation has consistently undershot the Bank of Japan's own objective of 1 per cent. Formalising the target and raising it to 2 per cent still runs up against the basic problem: how to create inflation?

For those brought up with the Milton Friedman doctrine that 'inflation is always and everywhere a monetary phenomenon', expanding the money supply will do the job. But the BoJ has tried this already. In fact it was the pioneer of now-fashionable quantitative easing beginning in 2001, filling the banks' balance sheets with surplus liquidity in the hope that they would expand their lending. After five years, the BoJ declared victory and retreated. There was a barely perceptible effect on interest rates and credit remained dormant until, eventually, there was a tiny stirring of economic growth in the mid-2000s.

Some argue that the BoJ was never enthusiastic enough to make QE work. Instead of the short-term government securities they bought, the BoJ is urged to buy private sector securities, directly encouraging businesses to expand. But most businesses have plenty of internally generated funds and spare productive capacity.

The selection process for the new BoJ governor (announced any day now; Haruhiko Kuroda is the front-runner) ensures that he will be a fully committed expansionist, whereas outgoing governor Masaaki Shirakawa has dragged his heels on QE and has been defeatist on boosting inflation. Textbook logic is on Shirakawa's side, but the depreciation in the yen since Abe's victory shows that the exchange rate can be shifted simply by the expectation of different policies.

Provided the magic doesn't wear off, the new regime may be able to keep the exchange rate around its current level, or even manage to depreciate it more without being accused of 'manipulation' by its Group of 20 partners. This would, by itself, be a useful stimulus. In the aftermath of the 2008 crisis, the yen appreciated by well over 20 per cent, making Japanese exporters less competitive. With this painful appreciation now reversed simply by the anticipation of Abenomics, the mere arrival of the new regime at the BoJ might, just possibly, be enough to inspire confidence and stir business out of its lethargy.

Prime Minister Abe has promised a fiscal stimulus of 2 per cent of GDP, though there is some double counting so the effect will be a bit smaller.

Fiscal stimulus has a more dependable expansionary impact than QE, but not everyone is enthusiastic. No one is arguing that this modest expenditure is the straw that will break the back of Japanese government debt, but it is a move in the wrong direction. Japanese debt is often quoted as being 230 per cent of GDP, but this is a gross figure and there are large official bond holdings (by the social security fund and the BoJ), so netting these out gives a less dramatic 120 per cent of GDP. While this is still high, the real concern is that it is projected to rise, with the International Monetary Fund arguing that at some stage Japan has to wind back its underlying budget deficit by around 10 per cent of GDP.

Japan is a lightly taxed country by international standards. The GST is 5 per cent compared with an international norm of nearly 20 per cent (although it is scheduled to rise over the next two years to 10 per cent). Thus this fiscal consolidation is not unachievable. But Japan does not have a lot of room (or time) to continue fiscal expansion. The government currently pays less than 1 per cent on its debt, but if debt concerns or higher inflation pushed this up to, say, 3 per cent, the budget would be in serious trouble (and bond holders would make a big capital loss).

That leaves the hardest area: structural reform and deregulation which would instill new dynamism into sclerotic sectors. No one doubts the potential for reform, but no politician knows how to do it while simultaneously getting re-elected. One way to package the necessary disruption might be for Japan to sign up to the Trans-Pacific Partnership, which requires participant countries to meet 'platinum standards' of openness for a wide range of behind-the-border regulations. Japan's thickets of protectionism (especially in agriculture) would, however, be difficult to penetrate.

Perhaps we shouldn't be too surprised, or too critical, about the current conjuncture if we recall just how much Japan has had to adapt in the past 25 years. It used to be the fastest-growing OECD economy, with an exchange rate that made exporting easy (300 yen to the dollar, compared with 90 now) and asset prices that promoted national pride and confidence. Remember when the grounds of the Imperial Palace were valued the same as the whole of California?

But that was then and this is now. It's hard to create a spirit of dynamism in an economy with few growth prospects, a shrinking labour force and a huge government debt. Demography has caught up with Japan, limiting flexibility and weighing down the social security system.

Tweaking monetary policy and another shot of fiscal stimulus aren't going to change much. Structural reform, the third element of Abenomics, is hard work. The alternative is more of the genteel stagnation of the past two decades. Even in the lost decades, per capita income crept up and unemployment remained low. Maybe that's not too bad, after all.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.