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Abenomics: Now for the Hard Part

 
 

If Shinzo Abe wants wage increases, he should start by giving his media handlers a raise. Even before he became prime minister last year, Team Abe was doing a masterful job winning support for their man by taking a Reagan-era name and slapping it on a series of economic policies that have been touted in some form or another by successive Japanese governments for much of the last twenty years.

Now Abe is doing his part. With Thursday’s announcement by the Bank of Japan (BOJ) of unprecedented monetary easing under new governor Haruhiko Kuroda, Abenomics is making all prior Japanese economic policy look positively insipid by comparison. Through Kuroda, Abe has taken Japan into what is very much new territory.

Some of the weekend media coverage of the BOJ’s policy announcement seemed to see aggressive action as signaling Japan had finally joined some sort of quantitative easing club. But comparisons with Kuroda’s peers at the Fed and the Bank of England need caution; the treatment may be similar, but the underlying conditions are quite different. The United States and Britain have been nationalizing private-sector losses from the global financial crisis (GFC). The idea is that the cost of this will ultimately be foisted on to their publics via some combination of higher taxes, lower spending and inflation, ameliorated by higher growth as their economies return to an economic upcycle. You can criticize the policies—many do—but at least that path has been trodden before.

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Japan is different. Its banks didn’t suffer large losses during the GFC. Japan’s bubble was 20 years earlier, and those losses have already been nationalized. Rather, Japan is dealing with structural issues, mainly demographics and productivity. Until those issues are resolved—and structural problems need structural solutions, as Kuroda’s predecessors at the BOJ have been trying to tell everyone—Japan will not return to sustained economic growth, which makes the endgame of this massive easing much more uncertain than anything being tried overseas.

Fortunately, Abenomics does call for structural reforms, one of its “three arrows”—from the Japanese proverb “three arrows cannot be broken”—along with fiscal policy and monetary policy.

Of these three arrows, the least interesting is fiscal policy. Abe’s supplementary budget is certainly large, but Japan has done this many times before. Fiscal stimulus typically delivers a temporary uptick in growth, paid for with a rise in Japan’s government debt burden. It has never been sufficient on its own to return Japan to sustainable growth, and its only economic justification at this point is to offset the impact of more painful measures, such as an increase in the consumption (sales) tax. I emphasize “economic justification” because fiscal stimulus obviously has a political role, and Abe is looking to take back a majority in the Upper House elections expected in July.

The second arrow, monetary policy, has had its own problems. The BOJ has been a frequent target of criticism for its alleged timidity in this regard. Some of the criticism seems to benefit from 20-20 hindsight; Japan was, after all, a pioneer with the zero interest rate policy and quantitative easing, but it is true that the BOJ has had an unfortunate tendency to tighten too early.

More importantly, though, traditional monetary policy in Japan has always run into the same problem: even with scads of near-free money available, Japanese companies just don’t want to invest. Why would you, when a shrinking local market means you’re already overcapacity? Worse, the deflation caused by declining demand means that real interest rates in Japan turn out not to be so cheap after all.

So on one level, a monetary policy approach of once more, only this time with feeling, would seem to be just more of the same. But the BOJ has become increasingly unconventional in its choice of tools. What is remarkable about Friday’s announcement is the degree to which it is sidelining Japan’s financial sector, and injecting money directly into the economy. It is doing this by pledging to buy huge amounts of Japan government bonds (JGBs), including for the first time longer-term maturities, by lending directly to companies (with a target that will exceed the combined total of corporate lending by Japan’s commercial banks by roughly 50 percent over the next two years), and by making massive purchases of assets such as exchange traded funds and real estate investment trusts.

No wonder the announcement set markets afire. At the time of writing, the Nikkei was up about 2.4 percent and the yen had weakened roughly 5 percent. The weaker yen in particular will cheer Japanese exporters and those with overseas assets, even if it reduces the real incomes of everyone else.

A few observations on the announcement. First: What are Japanese banks supposed to do? As the Financial Times reports, they are being crowded out of both the JGB market and the commercial lending market. With few other domestic investments, we might expect a considerable spike in Japanese financial sector investment overseas. It is noteworthy that the BOJ on Friday indicated that it would not be buying any foreign bonds—it wants to avoid the accusation that it is intervening directly to weaken the yen. But forced capital flight from Japanese financial institutions could have the same effect.

Second, asset bubbles anybody? The BOJ may be hoping for a wealth effect, but that may come at the cost of steep private-sector losses in later years.

Third, Kuroda hopes that the threat of inflation will get Japanese spending again. But Japanese households are not exactly hoarding cash right now. While the average household does have substantial savings, the savings rate in 2012 was among the lowest in the OECD, a reflection of dissaving by aging households. The corporate sector, by contrast, is sitting on piles of cash, but will the possibility of inflation offset the lack of productive investment opportunities? Recent indicators showing weak machinery orders despite increased lending efforts underscore the problem. Expanding the monetary base is one thing, but when money velocity is at multi-decade lows, as it is in Japan, it may not have the intended effect.

Fourth, Kuroda insists he is not monetizing the national debt—the JGB buying is meant as a loan, not a gift. But the BOJ is now intending to buy the equivalent of all new JGB issues (and then some). That is important, because if bond yields were to spike with inflation, or the threat of inflation, then new bond issues will quickly become difficult for the Japanese government to service. When the BOJ is snapping up everything, though, yields need not rise. The trouble is that once you start doing that, you can’t stop. The government will either need radical fiscal reform or the debt will be monetized.

Which brings us back to structural reform, the third arrow in the Abenomics quiver. The touchstone issue here is the Trans-Pacific Partnership (TPP), a planned regional free trade zone. That’s because joining it would open some of Japan’s most hidebound sectors to overseas competition, acting as a kind of gaiatsu, or foreign pressure, on them to invest in productivity. This would have particular implications for Japan’s service sector, one of the largest in the world as a percentage of GDP but with lagging productivity. For all the Japanese government’s romancing of the nation’s manufacturers, the growth potential is in services, and would come in addition to the boon that TPP would represent for exporters. Some economists think the TPP could add 0.5 percentage points to Japanese GDP growth. But market-opening for Japan has always tripped up on staunch opposition from its economically tiny but politically powerful farm sector.

Farmers are a traditional support base for Abe’s Liberal Democratic Party, but to his enormous credit he appears willing to push the issue. (It is an irony that the LDP’s staunchest supporters—farmers and senior citizens living off savings—are the most likely losers if Abenomics works as advertised.) Particularly interesting are reports over the weekend that Japan has achieved a breakthrough in negotiations on a free trade deal with Australia, which had stalled on the same issues of agriculture. Although in Australia’s case a desire to lock in resources is at play, it suggests that Abe may feel good enough about his support levels to force at least compromise on the nation’s farmers.

Longer term, Japan either needs to increase its birthrate or rethink immigration. Abe is on the case here as well, it appears, announcing the creation of a task force (to report in May) that will consider measures such as loans to newlyweds and time off for women undergoing fertility treatment. Of course, even if Japan very quickly removes the tremendous opportunity costs that exist for Japanese women becoming mothers, the economic benefits won’t be seen for decades. In the meantime, Japan will need to encourage greater workforce participation and relax its tough immigration laws.

Without these structural reforms, Japan is on an unsustainable fiscal course, and Kuroda’s monetary policy innovation may simply mean that the dénouement is more spectacular, and exported in the form of a collapsed yen.

If Abe does manage to fire all three arrows though, then Japan may be able to navigate its way to some form of normality, with manageable pain, through sustainable growth, fiscal reconstruction, and then a paying down of the debt through a mix of taxes and inflation (and perhaps even an outright write-off by the BOJ).

Achieve that, then his unsavory nationalism and disastrous first term aside, Abe will be deservedly feted as the leader Japan has needed these past twenty years.

In short, Thursday’s announcement could herald the start of Japan’s revival or its collapse, depending on what action follows. Either way, the hard part is yet to come.

James Pach is publisher of The Diplomat.

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