November 17th, 2016

Abenomics rebooted?

by Emmanuel Martin When will Abenomics finally deliver? The economic policy […]

Team AEC

When will Abenomics finally deliver? The economic policy launched by Japanese Prime Minister Shinzo Abe back in April 2013 and lauded by many around the world at the time seems to have proved ineffective. Its idea was to extricate Japan from two decades of sluggish or negative growth and a deflationary spiral. Its “three arrows” consisted of aggressive monetary easing, more government spending and structural reforms.

In August 2016, after elections for Japan’s upper house of parliament bolstered the prime minister’s position, a research team from the International Monetary Fund published a call for Abenomics to be “reloaded” and intensified. They stressed the need for structural reforms, a reduction of fiscal imbalances and an effort to reinflate the economy, notably through “wage policy.” More or less at the same time, the government announced another stimulus package.

Magic wands

The first – monetary – arrow, based on quantitative easing (QE) and ultra-low or negative interest rates, is supposed to revive inflation but raises concerns among economists.

Some neo-monetarist economists say that QE in Japan has failed to sustain the expansion of totalmoney supply, an essential parameter for economic growth. They stress the difference between “state money” and “bank money” – with the latter accounting for the bigger chunk of total money supply. While state expenditure has kept the printing presses rolling at the central bank (QE), money creation by commercial banks has been very tight. This caution, spurred by tighter banking regulation and risk aversion, has kept the growth of total money supply relatively slow. Hence, Japan’s very low inflation rate and sluggish economy. In November, the Bank of Japan (BoJ) admitted that monetary measures alone may be powerless to nudge inflation back to the 2 percent target.

Focusing on interest rates can also be misleading, because ultra-low or negative borrowing costs can have distortive effects. They squeeze operating margins for commercial banks as the “flattened” curves for short- and long-term debt reduce the profitability of traditional financial mediation (borrowing short and lending long). The price of money is so low that its crucial function as the basic market signaling system has become meaningless.

At the same time, the BoJ, through its purchase programs of exchange-traded funds and real estate investment equities, has begun what some fear will amount to an incremental “nationalization” of the stock exchange. Such interventions generate serious market distortions that can cause misallocations of capital. Investors no longer make decisions on the basis of company performance, but on what they expect the central bank to do – thus weakening one of the market’s primary functions.

More traditional economists, while agreeing on the lack of total money growth and the difficulties of commercial banks, would recommend avoiding such expansionary monetary policies. The quasi-monetization of government debt and inflation targeting ultimately leads to what resembles a planned economy, albeit in very mild form. For example, both the government and the IMF are pushing for a variety of wage “control” that would require businesses to “comply or explain” their failure to meet government recommended pay increases (intended to boost consumption and economic growth.)

Feeling good

Economists are also arguing about the second arrow of Abenomics. The IMF has recognized that continuing to run fiscal imbalances with the national debt at 229 percent of gross domestic product could be dangerous, and advises raising the consumption tax. Nobel Prize winner and Keynesian economist Paul Krugman, meanwhile, recently complained that Japan has only fired the first, monetary arrow, and insisted that fiscal spending should increase and tax hikes be avoided.

Others maintain that the government needs to cut costs, downsize interventions and outsource public services. These measures would allow Japan to balance its budget without higher taxes, but would require introducing serious structural reforms – Abenomics’ third arrow.

For now the BoJ is taking up the slack with its quasi-monetization of government debt – and thus of spending. In September 2016, the government budgeted additional expenditures of some 3.3 trillion yen ($32 billion). Some experts worried that this marked the end of sound fiscal policy. As Dr. Stefan Lippert observed, Abenomics in practice has created a “feel-good economy” by firing off only the monetary and fiscal arrows. The third and most important arrow – structural reforms – has been kept firmly in the quiver.

Even today, two years after Mr. Abe made his first vague announcement of proposed structural measures, the follow-through has been disappointing. Labor market reform is still being discussed, including ways to increase the participation of women, elderly people and foreigners in the economy. But will “reloading” Abenomics actually mean firing the third arrow? Given the structure of Japanese society, one may doubt whether any serious changes will be implemented.

Institutional sclerosis

First, the demographic factor: Japan is getting old. One third of its people are over 65, which happens to be the average age of its farmers. The population has shrunk by 1 million over the past five years. Obviously, an aging society is not apt to be enthusiastic about change, especially when it comes to reforming the social system.

Here we should address an apparent paradox about Japanese society and change. The contribution of Japan’s leading companies to innovation, especially in the late 20th century, was enormous. Japanese capitalism revolutionized the manufacture of cars, audiovisual equipment, digital music and many other fields. Japanese companies have been agents of change in the world, disrupting many Western competitors. They have also benchmarked and absorbed into their own corporate cultures many Western technologies and practices.

Yet not all changes are created equal. To a large extent, Japan has developed through industrialization without total “Westernization” – or rather, total “Americanization” and its stress on constant social and economic transformation. At times it may seem that acceptable change in Japan is confined to technology. Like the traditional temples wedged between Tokyo’s ultramodern high-rises, many traditional cultural traits remain surprisingly intact. These include the core values of social harmony, stability and respect for hierarchy. As such, they can foster a certain inflexibility and reserve toward change, especially if it comes from outside.

Japan’s organizational and economic system, based on close cooperation between big government, bureaucracy and big business, both embodied and imposed a rigid framework, with high levels of social security and economic protectionism. This framework proved extremely helpful in the early phases of Japan’s economic takeoff, but for some time now seems to have become an obstacle to further development. The Japanese model was well-suited to the globalization of the 1960s, 1970s and 1980s, with its penchant for “managed innovation.” But it is less well adapted to the globalization of today, which is based on more decentralized innovative processes. The fact that even today many Japanese have had only one employer in their working lives is evidence of this.

Apart from culture, this resistance to change was probably nurtured by powerful vested interests. The close ties between shadowy conservative groups and mainstream political parties in Japan has no doubt contributed to this. Very much as described by the economist Mancur Olson, informal coalitions have skewed the rules of the political game in Japan to protect various kinds of rents. The result is often institutional sclerosis that hampers adaption to change. Ultimately, that can lead to economic stagnation and decline.

Dangerous dualism

Such processes are not peculiar to Japan. Countries like Greece, Italy or France have more or less followed a similar path. Very “protective” social systems cannot hide their nature for long.

The result is a dual system. In Japan, as in France, a gulf is widening between “insiders” who benefit from lifetime employment and social safety nets, and “outsiders” of the new precariat (more than a third of the working population) with low wages and insecure contracts. Between these two groups, there is not much left in the middle. The precariat’s low purchasing power contributes to the deflation plaguing many developed economies.

In such conditions, inequality is generated – not by a genuine free market system, but by institutional rigidities. Unconventional monetary policies might be aggravating the problem. Rather than kick-starting the country’s economy with a “stimulus,” their effect can actually be to favor certain sectors – the stock market and real estate investors. By penalizing savings with ultra-low interest rates, unconventional policies endanger banks by squeezing their margins and their future ability to lend, while discouraging households and small businesses from saving for future investment. By restricting opportunities and increasing uncertainty, such policies force households into a distorted short-termism.

An even bigger gap is created between outsiders and insiders on the labor market. The Japanese government and the IMF both want to address this dualism, especially by introducing new labor contracts that balance job security and wage increases. Such dualism is fertile ground for social resentment. Yet, in a country that venerates hierarchy and practices self-censorship about vested interests claiming to defend the “Japanese way,” social resentment could easily be deflected to foreign targets. Hence the rising tide of nationalist sentiment. Mr. Abe’s recent push to amend Japan’s “pacifist” constitution could be a sign that he plans to capitalize on such trends.

Reform or arm?

The question is whether Prime Minister Abe will have the courage to turn brave words on structural reforms into deeds. Since these reforms have been shelved for four years while the government has enjoyed comfortable majorities in both houses of parliament, it is hard to be optimistic in the near term. Japan’s demography and values make it unlikely that Mr. Abe will disturb voters’ habits. Meanwhile, the many open and hidden beneficiaries of Japan’s institutional sclerosis will push back against any radical turnaround. That leaves aggressive monetary easing as the preferred painkiller, to be invoked again as necessary in order to “buy time” for reforms that are regularly announced but almost never implemented.

The government may well decide to spend even more on defense, which would do double duty by promoting national security and creating jobs and even economic growth. North Korea and especially China are perceived as serious and growing threats. Regular incidents near the disputed Senkaku/Diaoyu Islands is fueling nationalist sentiment on both sides of the East China Sea. To some extent, there could be ominous parallels with the 1930s.

Yet China is now Japan’s leading trade partner, while Japan is China’s second largest. With such economic interests on both sides, “mutual destruction” seems quite irrational. However, the perceived Chinese threat could serve as a pretext to inflate Japan’s military-industrial complex – and further aggravate the country’s institutional and economic sclerosis.

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