Japan must put people before profits

An excess of corporate retained earnings over investment is the underlying explanation for Japanese woes. 'Abenomics' may not make any difference unless it lets the population enjoy more of this income.


Will Shinzo Abe, Japan’s new prime minister, rescue his country’s economy from two decades of lassitude? Or has 'Abenomics' launched a currency war and pushed Japan closer to hyperinflationary collapse? The plausible answer is: neither. The risk is that the policies of his government will fail to make a difference, in either direction.

What, then, is Abenomics? It has three elements: renewed fiscal stimulus; pressure on the Bank of Japan to agree a higher target for inflation; and still unspecified structural reforms. More precisely, as JPMorgan's Masaaki Kanno noted in the Financial Times, the government has announced a supplementary budget that will increase fiscal spending by 2 per cent of gross domestic product, raising the likely deficit to 11.5 per cent of GDP in 2013. Tokyo has also not only pushed the BoJ to finance this deficit, but has strong-armed it into accepting an inflation target of 2 per cent.

Will this set of measures transform Japan’s performance and, if so, in which direction? To answer this, we need to consider four aspects of the country’s economic record.

First, Japan has experienced prolonged deflation. Despite an official short-term interest rate of 0.5 per cent, or less, since October 1995, the GDP deflator (a broad measure of the price level) has declined by 17 per cent since early 1997.

Second, Japan has run persistent fiscal deficits. As a result, general government gross debt has risen from 66 per cent of GDP in 1991 to 237 per cent, while net debt has risen from 12 per cent to 135 per cent.

Yet, third, the yield on Japanese government bonds has collapsed from 7.9 per cent at the beginning of the 1990s to below 1 per cent now.

Fourth, contrary to widespread belief, economic performance has also not been so poor. The unemployment rate was only 4.1 per cent in November. GDP per hour worked (measured at purchasing power parity) has grown in line with that of the US since the early 1990s, although Japan is no longer closing the productivity gap with America.

Japan, then, is a warning, but also an encouragement, to other post-bubble, high-income economies. It is possible for a country with its own currency to combine reasonable growth with sustained deflation, soaring public debt and ultra-low short- and long-term interest rates for a very long time.

What, then, are the dangers? I see two, neither immediate: first, the opportunity for further 'catch-up growth' remains unexploited; second, at some point, the cost of government debt service is likely to become prohibitive and the alternatives will be default, either directly or via inflation. The later this adjustment happens, the bigger the challenge will be.

The persistent fiscal deficits and deflation are a puzzle. A standard explanation is that they are due to a mistake in monetary policy. If the central bank had avoided deflation, real interest rates could have been negative, making private investment and consumption stronger. I agree that this would have been helpful. But I disagree that deflation is the underlying cause of Japan’s ailment.

So what is that underlying cause? 'Excess private savings' is the answer or, more precisely, a huge structural excess of corporate gross retained earnings over investment, as Andrew Smithers of London-based Smithers & Co argues. A corporate sector structured for postwar catch-up growth became a black hole for demand, once the need for high investment disappeared in the 1980s. Policy makers responded with a bubble-induced boom in investment and then with fiscal deficits. In both periods the capital outflows also contributed to balancing demand and supply.

Easy monetary policy facilitated post-bubble deleveraging and, arguably, kept the yen lower than it would otherwise have been, promoting exports. But it was unable to raise investment enough to eliminate the huge corporate surpluses. The reason is that the private sector already invests too much. As Smithers notes: "Japan, with a falling population, invests 30 per cent more of its GDP than the US, where the population is rising.”

Given the imbalances in the Japanese economy and the vast bubble created during the 1980s to manage them, Japanese policy makers have done well. But the path they are on is unsustainable. What, then, might Abenomics deliver?

First, the weaker yen should help the economy, by promoting net exports. Yes, it is a beggar-my-neighbour devaluation. On balance, however, the policy will encourage more aggressive monetary policy elsewhere, which should be helpful to the world economy, if anything.

Second, raising inflationary expectations (if that actually happens) should lower real interest rates in the short run. That is good. But it could also destabilise inflation expectations. That is not good. It would have been an invaluable policy a decade ago. Today, with the huge debt overhang, it is still necessary but riskier, particularly if it confirms that monetary policy is under the full control of politicians.

Third, increasing the fiscal deficit will boost demand in the short run, which is certainly desirable: in the third quarter of last year, the economy was still 2.3 per cent below its level in the first quarter of 2008. But it is not going to remedy the structurally weak demand of the Japanese private sector.

So what more is to be done? The answer is: structural reforms focused on the weakness in private demand. Retained earnings have to be lowered, without equally reducing investment. The high levels of investment also need to be better employed. How might retained earnings be lowered? I see three possibilities: raising wages; forcing higher distributions to shareholders, via changes in corporate governance; and, finally, changing corporate taxation to encourage distribution of profits to shareholders and raise tax revenue. Smithers particularly emphasises the role of lowering currently excessive provisions for depreciation, which makes up the bulk of gross corporate savings.

The big danger is that Japan will persist in treating its longer-term structural problems as amenable to monetary and fiscal fixes. In the short run, the latter are necessary. But the key to a better-balanced economy is taking the vast surplus profits away from a corporate oligopoly that has proved unable to use them. Corporate financial surpluses that end up in vast fiscal liabilities must be trimmed. Let the public enjoy the income, instead.

Copyright The Financial Times Limited 2013.