Chart 1: Economic Support Packages Since 1990 (Gov. Expenditure Basis, JPY Trillion)
Source: MOF, Cabinet Office, BNP Paribas
The Abe administration has hit the ground running, outlining a three-pronged approach (“three arrows for growth”) for reinvigorating the economy, consisting of a bold monetary policy, a flexible fiscal policy and a growth strategy to stimulate private investment. While the speed and vigor of the new regime is certainly impressive, as Abe tries to demonstrate strong leadership utilizing the new Headquarters for Japan’s Economic Revival and the reinstated Council on Economic and Fiscal Policy, one wonders if the policy direction is really correct. After all, Japan is saddled with very complex problems, and whether most of these problems can be resolved at one stroke like the administration contends is questionable. We worry that the aggressive monetary and fiscal measures advocated by Abe are not just pork-barrel policies geared toward the Upper House election in July. Discretionary monetary and fiscal policies might give the economy a momentary jolt, but the effects do not last, leaving the trend growth rate unaffected.
Of course, discretionary monetary and fiscal measures can be a tactic for buying time to allow growth strategies to work in elevating trend growth.1 Past administrations also incorporated such measures into their policy packages. But the growth strategies of the new government seem to include both good and bad, and some of the specific programs reported so far sound like pork-barrel policies that benefit specific sectors. Such favourable treatment for select companies can actually impair trend growth by preventing competition. In this report, we will consider the kind of policies the new regime ought to implement.
Looking first at macro stabilization policies, discretionary fiscal policies essentially consume future income by expanding the public debt (i.e.,increased borrowing). As for discretionary monetary policy, its effect, when there is one, is essentially derived from the front loading of future demand for immediate consumption. But because the zero bound has greatly reduced the effect of monetary policy, the actual role has been limited to neutralizing appreciating pressures on the yen and to curbing upward pressures on long-term interest rates resulting from increased fiscal spending.
Chart 2: Nominal GDP and Cost of Capital to Government (FY, %)
Source: Cabinet Office, BNP Paribas
Increased fiscal spending can certainly inflate nominal growth while it is being implemented. Since Japan’s trend growth rate has declined to under 0.5% and because the output gap is no longer that wide, deflation could be overcome if aggressive fiscal stimulus were continued. But once the effects of the stimulus fade, the economy will just revert to its slow growth rate, making it clear that the low trend growth rate never changed at all.2 What will remain, however, is the public debt that has grown even larger (= increasing the probability of fiscal meltdown). Even if deflation ends, it would be premature to automatically think trend growth has revived. In the 1990s, many also thought (incorrectly) that high growth would return once the Japan’s Non-Performing Loan (NPL) mess was resolved.
The Government Seems to Be Focusing on Fiscal Stimulus
After the landslide Lower House election win, the focus of the Liberal Democratic Party (LDP) with regard to discretionary macro stabilization policy seem to have shifted from monetary easing to fiscal stimulus. Seeing how monetary easing alone has had little effect in sparking aggregate demand, it is now felt that fiscal stimulus is necessary to deliver inflated nominal growth ahead of the upcoming Upper House election. That is why the regime on 15 January approved an extra budget worth JPY 13.1 trillion, the largest emergency economic stimulus package on record, excluding the measures adopted after the Lehman shock.
Risk That Fiscal Stimulus Will Be Repeated
This kind of massive stimulus might be acceptable to many, so long as it is a one-off measure. But there is a risk that it will be repeated (we view the stimulus package as inappropriate because Japan cannot afford such lavish spending). Even if the economy enjoys a stimulus-driven boost in 2013, it will be worse off for it in 2014 when the effects of that stimulus fade and consumer spending also falls in reaction to the spending binge ahead of the April 2014 consumption tax hike. Consequently, won’t the government adopt more fiscal stimulus to stave off reduced growth in 2014, and thereby keep the October 2015 consumption tax hike from being shelved? Won’t this have to be repeated in 2015, when there will be another post tax hike pullback in consumption weighing on the economy?
Japan is Addicted to Fiscal Stimulus
Since no one at this juncture really feels the cost of the government’s fiscal stimulus so long as yields on government bonds are held down by aggressive monetary easing, there is a real risk that the expansionary spending could be continued. In fact, because the economy suffers whenever stimulus is withdrawn, people have come to demand that these policies continue. As a result, since late 2012 I have started to fear that Japan might be dependent on stimulus like a drug addict. The optimism and exhilaration accompanying rising stock prices are not a reflection of stronger growth expectations, just the rush experienced after an addiction has been fed. Even if policies acting on expectations are important, the effects will not last so long as the policies lack a firm foundation.
Chart 3: Share of Developed Countries With Dynamic Inefficiency Conditions (23 OECD Countries)
Source: EcoWin, BNP Paribas
Chart 4: Japan’s Real GDP (%)
Source: Cabinet Office, BNP Paribas
Nominal Interest Rate Has Been Historically Higher Than Nominal Growth Rate
If expansionary fiscal policies continue, it is possible that inflationary pressures could rise alongside elevated nominal growth. But what would that mean for the long-term interest rate? In Japan since the 1980s, the yield on government bonds (government’s cost of capital) has generally exceeded the nominal growth rate. So if the growth rate were to rise, upward pressures on nominal interest rate (bond yields) would increase.
Risk Premium is Extremely Low
For example, assuming that the equilibrium real interest rate (per capital trend growth rate) is slightly above 1%, the long-term interest rate could conceivably climb into the 3% range if the risk premium and 2% inflation are priced in. Currently, the risk premium is extremely low because it is widely felt that inflation and the long-term interest rate will not rise. But once burned, investors will start demanding a risk premium.3 With Japan’s public debt already swollen to 200% of GDP, if the long-term interest rate were to rise, there is a risk that Japan could succumb to a fiscal crisis as the snowballing cost of interest payments on the debt would necessitate larger fiscal deficits that further aggravate the debt. Even if tax receipts were to pick up thanks to economic growth, it would not be enough.
Bank of Japan (BOJ) Has to Walk a Fine Line Between Price Stability and Financial System Stability
It goes without saying that the BOJ will be expected to undertake aggressive easing to prevent interest rates from rising. For if long-term rates were to climb, BOJ would be pressed to purchase massive amounts of government debt so as to stave off a financial crisis owing to the huge volume of JGBs held by Japan’s financial institutions. Initially, the BOJ might have the upper hand in holding interest rates down. But aggressive easing to maintain JGB prices clearly won’t work after inflationary expectations have been generated. When monetary policy is incorporated into the government’s debt management, the central bank has to walk a fine line between price stability and financial system stability.
Policies to Ward Off a Fiscal Crisis Could Create a Bubble
Of course, a fiscal crisis might not come soon. Between 1988 and 1990, the nominal interest rate broke with its historical trend and fell below the nominal growth rate, resulting in the inflating of a huge credit bubble. So if policy is used to forcibly push the nominal interest rate below the growth rate, Japan could experience another bubble. In the recent past, when nominal interest rates fell below nominal GDP growth rates in more than 50% of OECD nations — namely in 2000, 2004, 2005 and 2006 — bubbles (IT bubble, housing/credit bubbles) were inflated. Thus, policies to ward off a fiscal crisis could end up creating new financial imbalances (bubbles).
Neglecting the “Minimax” Principle?
Seeing how trend growth has greatly declined, the Japanese economy probably does not have the strength to clean up the aftermath of another burst bubble. Consequently, we are taking a big risk whether we pursue the path toward a potential bubble or the path toward fiscal meltdown. Of course, it could be argued that the long-term interest rate might not easily turn northbound, even if the debt continues growing, so long as investors continue to direct their money toward “safe” assets like JGBs. That said, policies that expose the economy to even the slightest risk of fiscal collapse or a bubble should be avoided. When faced with uncertainties, the “minimax” principle should be the cornerstone of all economic policymaking. Unfortunately, the selection of policies in Japan seems closer to high-stakes gambling.
Chart 5: Real Effective Exchange Rate – JPY – (Jan.1986=100)
Source: BOJ, BNP Paribas
Chart 6: Comparison of GDP Deflation With and Without Effects of Changing Terms of Trade (SA, Q1 2000=100)
Source: Cabinet Office, BNP Paribas
True Role of Central Banks
Because central banks are entrusted with the job of issuing that special kind of liability called money, financing the government’s deficit spending can lead to serious outcomes like fiscal crisis or bubble formation. To avoid this, the wisdom of history has taught us to make central banks independent from politics. Whether BOJ Law needs to be revised or not, the fact of the matter is that legal hermeneutics are being used to water down Japan’s central banking system in practice.4 Of course, a circumspect Abe regime might be skillful in the way it does this.5 But once the system has been compromised, politicians seeking to further test the system’s limits are sure to appear, confident that a magic wand exists. Regardless of the kind of statesmen our democracies might elect, independent central banking should remain a systemic safeguard against bad outcomes.
Quick-Acting Remedies For Reviving Trend Growth Do Not Exist
We are also apprehensive about Abe’s growth strategies. While steps must certainly be taken to raise trend growth, it takes time before slow and steady efforts in this connection start to bear fruit. Past administrations also pushed growth strategies to bolster trend growth, but significant achievements did not necessarily follow. It could be argued that sufficient efforts were not exerted, but whatever the case, fast-acting remedies for reviving trend growth do not exist.6 It would be wrong to simply resign ourselves to low growth, but we should also not entertain excessive hopes for the government’s growth strategies.
Royal Road of Growth Strategies Is Deregulation
As indicated in earlier reports, the royal road of growth strategies is simply deregulation, reducing government meddling in the economy. The source of sustainable growth is the freedom to discover and innovate, which results in higher returns on capital, thereby fostering capital formation. This cannot be achieved by expanding the sphere of state influence. The royal road to economic growth involves reducing as much as possible government interference so that free enterprise can blossom. Participation in Trans-Pacific Partnership (TPP), therefore, is not just a means for tapping into robust overseas demand, it is also a package of needed regulatory reform and so should be the top priority in terms of growth strategies.
Does the Government Have the Experience or Know How to Discover And Nurture Growth Industries?
Meanwhile, the new Headquarters for Japan’s Economic Revival is charged with devising microeconomic policies to create new growth fields. But we have suspicions that the organization might just end up furthering the interests of established corporations. Discovering growth sectors or companies that can supply consumers with the goods and services they crave is the job of the market and consumers. Past industrial policy shows that the industries that the government deemed to be growth sectors usually end up as declining sectors because public support effectively isolates them from the discipline imposed by the market. Conversely, companies capable of standing on their own without government support are those born out of the fierce competition of a free and open market. The government needs to understand that it does not have business experience or know how to discover or nurture growth industries. There is also talk about setting up public/private funds to promote investment into new growth areas. But when the state gets involved in supplying risk money, the market’s ability to identifying growth companies is impaired by moral hazard.7
Chart 7: Capital Stock (Trend) and Working Age Population Growth (% y-o-y)
Source: Cabinet Office, MIC, BNP Paribas
Merely Supporting Established Businesses Is Not a Growth Strategy
What is more, we need to realize that a pro-business policy is completely different from policies that merely support established businesses. To bolster trend growth, struggling companies that are no longer viable must be allowed to fail and new players must be allowed to enter the market. This is the only way to rejuvenate Japan’s industrial sector. Keeping weak companies on life support via tax breaks and subsidies not only ties up labor and physical capital, thereby impeding the emergence of growth companies, but it also weighs on trend growth. Stock prices might rally when companies get financial backing by the government, but this does not necessarily mean improved trend growth.
Effects And Side Effects of Weak-Yen Policies
Moving on to currency policy, it goes without saying that policies to depreciate the yen would be effective in alleviating the deflationary pressures afflicting Japan. Thanks to the yen’s weakness, Japan was able to enjoy an export-led recovery in the first half of the 2000s. But effective policies also have big side effects, and reconciling the two is not easy. Because the yen’s super weak tone continued even after the crisis in the 2000s passed, sectors like consumer electronics, despite losing competitiveness due to the catch-up of the emerging economies, markedly beefed up domestic production capacity, with the result that they are now saddled with excessive capital stock. Hence, the harsh environment these manufacturers face today is not only a product of the yen’s stronger tone after the Lehman shock, it also reflects the capacity glut built up on the mistaken belief that the yen would stay super weak. Weak yen policies are difficult to manage.
Would Weak-Yen Policies Be Feasible?
Before delving into the pluses and minuses of a weak-yen policy, we must address the problem of feasibility in terms of currency diplomacy. Weak-yen policies were possible in the mid-2000s because the global economy was strong, so other nations tolerated it. These days, however, growth is on the decline for both the emerging and developed economies, so these nations look to overseas demand to make up for weak demand at home. It is very doubtful if the Obama administration would tolerate weak-yen policies, especially given its objective of doubling US exports. Of course, if Abe were to convince Obama to allow policies to weaken the yen, that would be a major success in currency diplomacy for Japan.8
Disseminated Side Effects Of A Weak-Yen Policy
Moving on to another side effect of weak-yen policy, while currency depreciation is a boon to exporters, it is a bane to importers. By absorbing deflationary pressures and stimulating exports, a weak yen has positive macroeconomic effects. But it also greatly affects the distribution of income via changes in the terms of trade. For example, by raising import prices, yen depreciation ultimately robs consumers of some of their real purchasing power. While this could be offset if the enhanced export growth leads to increased wages, that did not happen during the previous export-led recovery, despite its protracted nature.
Owing To Deteriorating Terms Of Trade, Households Did Not Benefit During the Previous Recovery
That the GDP deflator continued to fall throughout the recovery in the 2000s was not only because of chronic price decline but also deteriorating terms of trade due to soaring commodity prices and the yen’s weak tone. Thus, while the weak yen fueled an export-led recovery that greatly benefited corporate Japan, especially big manufacturers, households were largely bypassed by the recovery, as wages did not grow and real purchasing power declined with deteriorating terms of trade.
“Redistributing Wealth Amid Economic Contraction” Versus “Income Disparities From Deteriorating Terms of Trade”
The Abe administration has slammed the policy of Democratic Party of Japan (DPJ)-led governments as focusing on “redistribution policies that lead to a diminishing equilibrium.” Such criticism is not entirely wrong inasmuch as many at the previous administrations were concerned more with redistributing income rather than expanding the economy. What is interesting, however, is that the DPJ began its trek toward power by running as the antithesis of Koizumi-Abe regimes of 2002~2007. The DPJ, then the largest opposition party, not only rejected Koizumi’s structural reform agenda, but it also criticized the polarization of society between big business, which benefited from the weak-yen fuelled export boom, and households, whose real purchasing power was declining. Now if the new Abe regime succeeds in implementing policies to weaken the yen, will the DPJ again start hammering the government on income disparities resulting from deteriorating terms of trade?
Is Abe Aware of the Side Effects of His Policy Agenda?
Perhaps the prime minister, aware of the side effects of his policy agenda, will move to forestall criticism over wealth disparities by toning down his structural reforms and playing up his tax reforms that target the wealthy (raising the maximum income and inheritance tax rates) and aim at job and wage growth (tax breaks for companies that raise wages). Even the public works-centered spending binge might be touted as reducing income gap between the cities and countryside. Incidentally, income disparities was a major theme of South Korea’s presidential election in December, as the government of outgoing President Lee Myung-bak embraced a policy mix (currency depreciation and structural reforms, including free trade agreement with US) that made chaebols rich on booming exports, while households saw their spending eroded by deteriorating terms of trade. While it is too early to say what Abe’s true colors will be, one wonders if he will take a page from Lee’s playbook.
Challenges For the New Regime
In closing, we would briefly like to touch on the policies Japan ought to adopt. The nation’s average growth rate has declined from 4.6% in the 1980s to 1.1% in the 1990s and then to 0.8% in the 2000s. At this rate, growth in the 2010s could slip below 0.5%. Rather than blaming policy failure, we have argued that the Japanese people need to acknowledge the reality that trend growth itself has weakened. Without innovation, the return on capital will continue declining alongside Japan’s shrinking workforce, thereby causing capital formation to stall to the detriment of trend growth.
Policies To Deal With Shrinking Workforce Are Essential
Since the shrinking workforce (from ageing, falling birth rates) is one factor behind the reduced growth, Japan needs to beef up the workforce by making fuller use of the elderly and women. Women, in particular, represent a great loss to Japan’s human capital formation as many women suspend their careers to raise families. Creating systems that allow women to maintain their careers would not only benefit the companies and individuals involved, it would also be good for the overall economy by enhancing average productivity. Thought could also be given to immigration policy.
Promoting Capital Exports Could Be an Effective Policy
If the return on capital is declining at home, promoting the export of capital to areas with high returns would be effective. The Abe regime has, in fact, touted all of these measures, including steps to beef up the workforce, and we hope the regime will vigorously pursue these policies. The lack of innovation to somewhat offset the negative impact of a shrinking workforce is a very big problem, but this can be addressed by pursuing regulatory reform, including participation in TPP.
Stoking the Illusion That Discretionary Monetary And Fiscal Policies Can Forestall Burdens on the Electorate is Wrong
While advancing growth strategies, Japan also needs to make its social welfare and tax systems more suited for a low-growth economy (i.e., the comprehensive reform of social security and fiscal affairs). Currently, premiums alone cannot cover the cost of social welfare, as elderly on the receiving end increase in number (graying of society) and the productive population on the paying end decrease (declining birth rate), with the result that the escalating cost of running these systems must be financed with budget deficits that compound the public debt. As things now stand, social security and fiscal affairs will collapse in the absence of much needed reforms that include both tax hikes and reduced benefits. Stoking the illusion that discretionary monetary and fiscal policies can forestall burdens on the electorate is wrong.
1As contended by policymakers the world over, monetary and fiscal stimulus aims at buying time and these policies cannot resolve structural problems. Resolving problems by elevating growth, the “growing out” approach, won’t succeed unless trend growth is sufficiently strong.
2 In fact, prolonging extreme monetary and fiscal policies can actually reduce trend growth by distorting the allocation of income and resources.
3 This is why government bond yields in Greece, Spain and Portugal, which had previously been as low as Germany’s, surged after the sovereign debt crisis.
4 We cannot help but think that adventurism, rather than conservatism, is influencing monetary policy today.
5 If the Abe regime plays its cards right, perhaps central bank independence will globally deemed no longer necessary. While we feel that would be imprudent, it would be very interesting to see such a grand experiment unfold.
6 If the lack of results was due to insufficient efforts, could that be because people were complacent with the momentary economic jolt from monetary and fiscal stimulus and so lost their ardor for carrying our growth strategies. When economic conditions improve, rather than deeming it to be a good opportunity for reforms, people are increasingly satisfied with the situation, with the result that reform lose urgency. Judging from comments at New Year’s gatherings of business leaders, it seems that complacency could be sprouting again.
7 The principal–agent problem was one factor behind the US investment banking bubble in the 2000s, as banks undertook excessive risk taking in pursuit of high returns, confident that any losses would be passed on to others.
8 But whether the American Automobile Policy Council would tolerate this is another matter.