September 11, 2020

Macro Series

Focus – Abenomics is found wanting

BY Russell Jones

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Report Contents

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  • The record of Abenomics is at best mixed, and at worst a chronicle of failure.
  • Overall growth potential is minimal, lowflation embedded, and vulnerability to shocks high.
  • Orthodox macro policy is now exhausted, and progress in structural reform has been sluggish.
  • Outright monetary finance may be employed in response to future traumas.
  • But the political, social, and cultural obstacles to supply-side renewal are substantial.
  • Others should study Japan’s travails in detail. Their turn may be next.

Regime change

Japan’s PM Shinzō Abe has resigned

Shinzō Abe, Japan’s longest-serving prime minister, and the beneficiary of three landslide general election victories, resigned on grounds of ill-health at the end of August. Mr. Abe assumed power towards the end of 2012, and immediately committed himself to ending the country’s 20-odd years of relative stagnation and increasingly embedded ‘lowflation’, if not a tendency for prices to fall. 1 Abenomics, as his economic strategy was termed, embodied three policy priorities, or ‘arrows’:

  1. Bold monetary reflation;
  2. Fiscal flexibility; and
  3. Accelerated structural reform.

Abenomics has dominated policy in Japan since 2012

Notwithstanding much hype about a fresh start for Japan, the new regime was in significant part evolutionary, rather than revolutionary. Successive Japanese governments had been applying similar, if more dilute, forms of the same medicine to the economy since the aftermath of the 1980s ‘Bubble Economy’.

Nevertheless, Abe’s departure from the political scene warrants an assessment of the success of his strategy, and an exploration of what might be coming next. This is important, not just to understand where Japan itself is at this extraordinary point in history, but because the country has for thirty years acted as something of a leading indicator for the policy challenges faced by other advanced economies. Increasingly, fears of Japanification have become all too commonplace, not least in Europe, but also, for example, in South Korea.

Patchy at best

The record is mixed at best, however

Regrettably, a review of Japan’s economic performance over the past eight years leads to disappointing conclusions about Abenomics. Its record is at best mixed, and at worst a chronicle of failure. The prime minister’s goals went unmet. Important opportunities more comprehensively to address Japan’s problems have been missed.

Focus - Abenomics is found wanting 1

Growth potential has continued to decline …

Real GDP growth remained a mere fraction of what it used to be in the pre-‘Bubble’ golden age, and has fallen far short of that of Japan’s major rivals. Growth potential has continued to wane in the context of a rapidly ageing and declining population, latterly dropping, on IMF reckoning, to just ½% a year, and leaving the economy vulnerable to shocks, and recession-prone.

… and despite some successes, many problems remain …

That said, digging a little deeper unearths some positive developments. Profitability has improved significantly, at least in large firms; and employment has been increasingly full, with the joblessness rate falling back to rates last seen in the early 1990s. In nominal terms, the economy has at last managed to exceed the previous peak established as far back as the end of 1997; in per capita terms, real GDP growth has since 2012 been broadly similar to that of the UK and France, if some way below that of Germany and the US; the burden of government debt had begun to stabilise, albeit at a level (close to 250% of GDP), normally associated with economies that have just experienced all-out war. And perhaps most important of all, Japan’s reputation for social stability has remained intact, when it has been breaking down in so many other places.

… and despite some successes, many problems remain …

On the other hand, the external surplus remains obstinately large at more than 3% of GDP. 2 Labour productivity, dragged down by an inefficient service sector, is just 60% of the US level, which is considered to be the ‘frontier’. 3 ICT investment has been flat since the Global Financial Crisis, and aggregate net investment has been similarly moribund; 4 bank profitability remains low; and at a mere 0.4% of GDP, net FDI inflows, which can be so important to technological advancement and market knowledge and access, are a mere one sixth of the OECD average.

… not least persistent ‘lowflation’ …

Turning to the vexed issue of lowflation, progress has been minimal. The 2% inflation target mandated by Mr. Abe just a month after his coming into office has proved persistently elusive.

Under the guidance of Governor Haruhiko Kuroda, and a succession of sympathetic policy board appointments by the government, the Bank of Japan has employed an increasingly unconventional approach to monetary reflation. This has progressed through increasingly large government bond purchases, to the buying of private sector assets, the imposition of a negative policy rate, explicit yield curve control focussed on 10-year maturities, 5 extensive funding for lending initiatives, and increasingly state-dependent forward guidance, culminating in a deliberate make-up approach to policy, similar to that recently embraced by the US Federal Reserve.

In the process, the central bank’s balance sheet has swollen to the equivalent of more than 100% of GDP – far in excess of those of the Fed, the ECB, or the Bank of England – and its actions have come to dominate both the JGB and the equity ETF markets, in the process deadening price signals, distorting resource allocation, and squeezing out activist investors – this at a time when the government was enjoying some success in improving corporate governance.

… even in the face of massive central bank balance sheet expansion

Nevertheless, despite these extraordinary interventions, and frequently strong risky-asset market performance, once changes in indirect taxes are stripped out, CPI inflation has averaged less than ½% a year during the Abenomics era. Moreover, troublingly, the historical record suggests that inflation tends to decline after a pandemic. 6

Focus - Abenomics is found wanting 2

In explaining the failures of Abenomics, it is necessary to examine the shortcomings of each of the three arrows.

Monetary shortcomings compounded

Inflation expectations and wage inflation have continued to sag

Where monetary policy is concerned, for all the unorthodoxies employed, inflation expectations, backward-looking and adaptive in nature, have steadfastly failed to converge on the government’s 2% target. And with that objective lacking credibility in the eyes of markets, households, and businesses, wage inflation has remained moribund, depressing income growth and final demand.

Neither has there been enough co-ordination of monetary policy with the two other arrows of the Abenomics regime.

… as monetary and fiscal policy have often bifurcated …

At least until the pandemic, monetary and fiscal policy have not been sufficiently dovetailed, and indeed have often been at cross-purposes. Nor has the government acted to underpin the monetary stance through sufficiently robust policies designed directly to raise wages, either in the public sector or more broadly.

While policymakers have introduced some targeted tax incentives for companies that pay higher rates of remuneration, and their rhetoric has aspired to higher wages, the minimum wage is aberrantly low for an advanced economy. More than a third of the workforce remain in poorly paid, short-term, and part-time contracts, where their

… and labour market dualism has endured

At the same time, the tax system is distorted such that married women are strongly incentivised to remain on the fringes of the workforce, if not out of it altogether. What is more, labour market dualism is further encouraged by aspects of the long-established ‘lifetime-employment system’ for regular workers. This puts a premium on employment stability at the expense of wage improvement, and it prioritises intra-firm job rotation and seniority-based wages, all of which reduce the incentive for employers to increase wages to attract workers from competitors.

Fiscal failings

High government debt has engendered fiscal conservatism

Turning to fiscal policy, even though total debt service costs in Japan have been negligible at less than ½% of GDP, over the course of the Abenomics era, Finance Ministry officials have been conservative. They have prioritised preventing a further significant increase in the public sector’s high burden of debt at a time when demographic changes are shrinking the tax base.

Indirect tax hikes have twice resulted in recession

The notion that, at near zero interest rates, efficient investment-driven fiscal expansion could pay for itself, if not actually reduce the debt ratio, has been treated with scepticism. Hence, any resort to fiscal stimulus has remained episodic and fleeting. Moreover, there have been two increases in the burden of indirect taxation, one in 2014, and one at the end of last year which, if understandable from the point of view of sustainably rebalancing the tax system and maintaining work incentives, have both resulted in the economy lapsing into recession. Finally, and perhaps most damning, until this year’s massive COVID-related fiscal package, the overall stance of budgetary policy had been tightened, by some five percentage points of potential GDP since 2012.

Focus - Abenomics is found wanting 3

Structural faults

Demographic trends warrant faster structural reform …

In an era when Japan’s unenviable demographic profile dominates all else – the population is projected to decline by some 25% over the coming 40 years, and the old-age dependency ratio to increase by a similar figure – it is in the area of structural reform that Abenomics’ failings have perhaps been greatest. Only by enhancing productivity, raising labour participation, and increasing inward migration can the demographic force be meaningfully counterbalanced.

Of course, there have been some successes, including the negotiation of important new trade deals with the EU, the US, and other Pacific economies, the liberalisation of the electricity market, and the gradual opening up of a particularly heavily protected agricultural sector.

… but progress has been patchy and halting

Progress elsewhere, however, has been limited. In addition to the shortcomings of labour market policy and the inertia injected into corporate governance reform and the release of the firms’ huge savings by the BOJ’s extensive ETF purchases, 8 Japan’s product markets, and in particular its service sector, are overburdened by high barriers to entry, and excessive regulation and bureaucracy.

At the same time, the constraints on foreign labour remain onerous; 9 childcare is still inadequate; the mandatory retirement age rights of firms are anachronistic when the population is ageing so rapidly; the economy is beset by low digitisation in the more sheltered industries; more incentives are needed to reduce energy consumption and address climate change; much healthcare and social care is inefficient and wasteful at a time when demand is surging and intergenerational equity is increasingly a burning issue; pension reform has been too timid; 10 there are insufficient alternative sources for SME finance beyond the banks, 11 and already-low FDI inflows are now threatened by new restrictions on certain security-related industries.

Japan at the crossroads

So, where does Japan go in the post-Abe era?

Despite an aggressive policy response to COVID …

No doubt, COVID-19 delivered another huge shock to the economy, including the postponement of this summer’s Tokyo Olympic games, which, even if the related infrastructure was already completed, has significantly reduced tourism revenues and consumer confidence. The economy, already in recession at the start of the year, contracted by a further 8% in Q2.

That said, the authorities have responded aggressively to the pandemic. In particular, the government set aside its budgetary conservatism, and delivered an unprecedented fiscal expansion, which, including measures announced around year-end, totalled some 21% of 2019 GDP. This extended to public investment, cash handouts to individuals and affected firms, deferred tax payments and social security contributions, and concessional loans.

The Bank of Japan, for its part, eschewed a further move of the policy rate into negative territory, and instead contented itself by further extending existing initiatives, lifting, for example, any predetermined limit on its bond purchases in the secondary market. This in effect guaranteed that the government could finance whatever support it saw fit to deliver to the economy at zero cost.

… recovery from a deep recession stands to be an extended process

Nevertheless, even if there is no second wave of the virus, real GDP is set to fall on average by some 6% this year, and in 2021 only partially recover the ground lost. What is more, it is difficult but to conclude that anything approaching conventional macroeconomic stabilisation policy has by now been more or less exhausted.

Even with debt service costs negligible, a gross debt burden on track to reach some 270% of GDP by the end of the year must represent a powerful psychological, if not practical, constraint on further orthodox fiscal stimulus.

Equally, aside from a more negative policy rate, embracing a more explicit form of inflation forecast targeting, or shifting its yield target from the 10-year area to the shorter-term maturities that are more important to firms and individuals, all of which are of questionable value, the BOJ has few remaining options. 12

A further shock may result in outright monetary finance

All this suggests that, in the event of another negative shock, Japan will have little choice but to cross the Rubicon and embrace outright monetary finance, just as it did in the 1930s, albeit with highly mixed results. 13 This could emerge in the form of ring-fenced programme of public investment, a round of cash handouts, or a repudiation of a certain proportion of the government’s outstanding liabilities to increase fiscal space, and deliver a permanent increase in the monetary base.14

Where structural reform is concerned, the deficiencies of recent years suggest that there is much more residual policy latitude, beginning with immigration, female participation, labour market dualism and deregulation, but also extending to FDI, the structure of the taxation system, agricultural subsidies, SME finance, and pensions, health, and social care. Indeed, the IMF has suggested that as much as 60% of the prospective 25% demography-driven fall in potential output over the next 40 years could be offset by structural reform. 15

… but structural reform is set to remain piecemeal

That said, Japanese society’s gerontocratic bias, and its underlying traits of misogyny and xenophobia continue to exert unfortunate influences on policy, and Mr. Abe’s potential successors as PM in the Liberal Democratic Party, not least Cabinet Secretary Yoshihide Suga, are a conservative bunch who have expressed little appetite for dramatic change. This could alter somewhat in the context of next year’s October general election but, overall, it seems likely that Japan’s policymakers are destined to continue to fight a flawed, and ultimately futile, rear guard action against the inexorable forces of the nation’s demographics.

Other countries should keep a close eye on Japan’s travails

In the process, while macro policy may embrace what is considered by many to be the ultimate taboo, reform will probably progress in piecemeal fashion. Real GDP will at some stage begin to fall persistently, but real GDP per capita will probably continue to expand. This represents a very unfamiliar set of circumstances that some other advanced economies will also have to get used to. The question is whether it will matter? After all, individuals’ living standards should continue to improve. But it will certainly throw up some political challenges. In this sense, Japan’s experiences will continue to provide lessons for all high-income OECD-country policymakers.

Watch fors

  • Little immediate significant change in Japan’s economic policy regime under its next PM.
  • Resort to direct monetary finance in the event of another major negative shock.
  • A continuation of piecemeal structural reforms.
  • Persistently falling real GDP, but rising real GDP per capita.
  • Other advanced economies following in Japan’s unfortunate footsteps.

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