Why Abenomics will disappoint
The predominant concern of Shinzo Abe, Japan’s prime minister, is with the decline of his country’s economy relative to China’s. This explains “Abenomics”, which is aimed at economic revitalisation. Can it succeed? The answer is: yes – but only in part. It should be possible to end deflation. But a big upsurge in economic growth is unlikely.
Abenomics consists of “three arrows”. The first is a monetary policy aimed at eliminating deflation. The second is a flexible fiscal policy, aimed at supporting the Japanese economy in the short run and at fiscal stability in the long run. The third is structural reform, aimed at raising investment and trend growth.
Of the three arrows, the first is most likely to hit the target. In January the Bank of Japan adopted an explicit target of 2 per cent consumer price inflation. But it was only after the appointment of Haruhiko Kuroda, an outsider, as governor that a new approach was born. Under his leadership, the bank announced its ambitious programme of “quantitative and qualitative easing”, or QQE. The aim is to deliver the inflation target “at the earliest possible time, with a time horizon of about two years”. The central bank committed to doubling its holdings of Japanese government bonds over two years and more than doubling the average maturity of those holdings. Christina Romer of the University of California, Berkeley, former chair of the US Council of Economic Advisers, hailed this as a “regime shift”, comparable to America’s decision to go off the gold standard in April 1933.
As Mr Kuroda has argued in an interview with the Financial Times, the new policy is intended to affect the economy through reductions in interest rates, shifts towards holding riskier assets and higher inflation expectations. “We are half way,” Mr Kuroda claims. “The latest statistics show that the inflation rate has reached 0.9 per cent. But there is still a long way to go.”
A case can be made for optimism. First, evidence from bond markets and consumer surveys suggests that inflation expectations are rising. Second, excess capacity is probably very small: the BoJ judges that it is only 1.5 per cent of potential output, which is supported by the fact that unemployment is now about 4 per cent. Third, the economy is forecast to grow twice as fast as potential output over the next two years. That would eliminate excess capacity. Finally, the BoJ has made clear its determination to do whatever is needed to achieve inflation. A central bank can always reduce the value of the money it creates if it wants to. The risk is that, instead of stabilising at 2 per cent, inflation expectations rise far higher, forcing the BoJ to tighten (see charts).
Mr Kuroda also argues that positive expected inflation would promote economic activity. Real interest rates would be negative, encouraging households and companies to spend. If investment rose, so would the sustainable rate of economic growth. Moreover, if the private sector’s financial surplus (at 11 per cent of gross domestic product last year) were to fall sharply, the fiscal deficit could dwindle without damaging economic activity.
In these ways, then, the BoJ’s new strategy might promote a degree of economic revitalisation, though it also risks destabilising expectations of deflation, without reanchoring them at 2 per cent inflation. But monetary policy cannot eliminate the structural imbalances inside the economy or do much to raise underlying growth.
The government hopes to raise the trend rate of real economic growth to 2 per cent a year. This is not impossible. But it is very ambitious.
The population of working age is falling at a rate of about 0.7 per cent a year. The employment ratio, at 80 per cent for men aged 15-64 in 2012, is higher than in other big high-income economies. At 61 per cent for women, it is not far behind the US (62 per cent), the UK (66 per cent) and Germany (68 per cent). Yes, it would be possible to raise female participation further, but this would not transform the growth outlook.
To achieve the growth target, output per worker would have to rise at close to 2.5 per cent a year. No high-income economy achieved trend productivity growth so high between 1990 and 2012. True, Japan’s output per worker was only 71 per cent of US levels in 2012 (at purchasing power parity). Yet it is not far behind levels in other big high-income economies. Room for a productivity catch-up does exist, mainly in services. But this would demand a social and economic upheaval. The modest reforms under discussion will surely not achieve it.
Nor is what is under discussion relevant to dealing with Japan’s structural imbalances: excess private savings absorbed by huge fiscal deficits, which have then emerged as soaring levels of public sector debt. Indeed, the Japanese debate simply ignores the huge financial surpluses of the corporate sector and the low shares of household disposable incomes and consumption in GDP. So fiscal policy is aimed at raising taxes on consumption, which is now too low, and lowering taxation of corporate profits, which are too high.
Abenomics includes the usual list of “structural remedies”. But these are irrelevant to the real structural concerns. Andrew Smithers of Smithers & Co recommends lower depreciation allowances. Without a shift in incomes from corporate profits to households, the structural fiscal deficit cannot be eliminated, unless the current account surplus shifts into a gigantic surplus. It is bad enough that the eurozone is pursuing that strategy. Japan should not expect to do the same thing.
Supported by the new monetary policy, Japan is enjoying a cyclical upswing. Deflation may disappear. But hopes for faster trend economic growth are too optimistic and the discussion of structural obstacles too limited. Given its demography, Japan would do well to attain growth of 1-1.5 per cent a year. The country will be unable to combine economic dynamism with fiscal consolidation without a rise in consumption’s share in GDP. Since household savings rates are low, this can only happen if income is transferred from corporations. Nobody seems to be willing to recognise this challenge. It is assumed, instead, that Japan’s already excessive investment should rise still further. This is mistaken.
How, then, can the first year of Abenomics be assessed? As an early success, but a far from complete one.
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