Could Abenomics succeed?

Last Updated: Fri, Jun 28, 2013 21:10 hrs

More than 20 years have passed since 1991, when Japan's real estate and stock market bubbles burst. This triggered a period of slow growth, rising debt ratios, an appreciating yen and price deflation, conditions that have persisted until recently.

For much of that time, Japan's travails were regarded as a curiosity, of apparently little consequence to others in the advanced world. Its numerous efforts to escape from its malaise met with condescension, pity and incomprehension from outsiders. By the end of the 1990s, it became increasingly difficult to remember that this was the rival that the Americans had widely expected would challenge the United States for global economic dominance. China's accession to the World Trade Organisation in 2001 provided the context for that nation's export-driven boom, which ultimately led it to surpass Japan's economy in size within a decade.

While Japan's famous social discipline has largely survived (powerfully demonstrated at the time of the Great North-East earthquake and tsunami in 2011), prolonged mediocre economic performance has had a profound impact on national morale and politics, and has bred widening distrust by the public in the competence of the ruling elite. The lifetime employment model that had characterised post-war Japan has begun to fray, replaced by widespread part-time and temporary employment, and the return of vagrancy and homelessness.

The era of prime minister Junichiro Koizumi (2001-2006) promised a break with Japan's faction-ridden and relatively colourless politics, but even his strong personality and personal charisma did not prove decisive. A fed-up Japanese electorate finally threw out the discredited Liberal Democratic Party (LDP) after a nearly unbroken reign since World War II, and flirted with the opposition Democratic Party of Japan. But this too ended badly, triggering early elections that returned Mr Abe and the LDP to power late in 2012.

Given this demoralisation, Mr Abe moved quickly and decisively to articulate his programme of economic revival, and has done a masterful job of selling this to the public. Drawing upon medieval Japanese imagery, he has presented his government's programme as three arrows: monetary, fiscal and structural reform. Of these, the monetary arrow was launched first and has already had visible consequences, as discussed more fully below. The fiscal arrow has also been launched, in a marked break from the finance ministry's long-standing concern with Japan's high gross public debt. The third arrow, of structural reform, is being kept in reserve until after elections to the Upper House of the Japanese Diet next month. However a symbolic down payment has been made by the Abe government in its joining trade negotiations under the Trans-Pacific Partnership, the topic of one of my earlier columns.

Mr Abe's monetary programme is based on the assumption that, for growth to revive, the public must be convinced that deflation has ended. In order to change expectations, he has pushed the Bank of Japan to adopt a formal annual inflation target of two per cent. By contrast, the average consumer price level in 2012 was about three per cent below that in 2000. This mandate is being implemented by a new governor (a former senior finance ministry official who had been appointed president of the Asian Development Bank by Mr Abe) known to be in favour of radical monetary action. Soon after his appointment, the new governor announced a massive programme of quantitative easing: buying government bonds on a huge scale so as to double the size of the monetary base (essentially the central bank's balance sheet) over the next two years.

Since the programme was launched in April, Japanese financial markets and economic indicators have bounced around, but the broad movements have been supportive of the government's goals. The most immediate and volatile indicator has been the yen, which initially depreciated sharply against the dollar before rebounding part-way. In sympathy with the yen, the stock market sprang to life, reflecting improved competitiveness and earnings expectations of Japanese corporations. Less positively, though not entirely unexpectedly, yields on government bonds rose, a source of worry for the government itself given its huge stock of outstanding debt and for the balance sheets of Japanese banks that are major holders of these bonds.

An obvious question is why this was not tried before. The answer seems to be a fundamentally different assessment of risks and rewards between the outgoing dispensation of the central bank (and its political masters) and the present one. These differences are on at least two counts. The first is the importance attached to mild deflation, of the kind that Japan has been experiencing, which is very far from being the much more feared deflationary spiral. The Abe government seems to believe that even mild deflation encourages postponement of consumption since consumers assume that future prices will be lower than current ones. Its predecessor was more concerned that, given weak labour markets, wages would not rise to compensate for rising inflation, thereby depressing consumption. The recent experience of the United Kingdom suggests that this is not an idle concern. The second difference is almost certainly connected with prospects for government debt. As already noted, there is a delicate issue of sequencing involved: if yields rise before inflation and growth kick in, this could complicate fiscal management and threaten Japan with something it has so far avoided, which is a sovereign debt crisis.

So Mr Abe has chosen to gamble. Certainly India would wish that his gamble succeeds, because the politics of Asia would be transformed by a vibrant, growing Japan, and India's relations with Japan have been growing steadily warmer. But in contrast to the past, Japan's latest experiment is now not being ignored, but is instead being studied intently by other advanced democracies in Europe. These too are facing the toxic mix of asset price collapses, weak banks and high public debt that Japan has struggled with for 20 years, while some at least have equally unfavourable demographics and an increasing aversion to immigration. Where Japan has an unused reservoir of labour in its women, Europe has it in its youth. So from being a beacon for developing Asia in the 30 years from 1960 to 1990, it is not entirely fanciful to think that if Mr Abe succeeds, Japan could light the way for Europe over the next 10 years.

The writer is chief economist, Shell International.
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