Can 'Abenomics' pull Japan out of the mire?

ECONOMICS:Will Shinzo Abe, Japan’s new prime minister, rescue his country’s economy from two decades of lassitude? Or has “Abenomics” launched a currency war and pushed Japan closer to hyperinflationary collapse? The plausible answer is: neither. The risk is that the policies of his government will fail to make a difference.

What, then, is Abenomics? It has three elements: renewed fiscal stimulus; pressure on the Bank of Japan to agree a higher target for inflation; and unspecified structural reforms.

More precisely, as JP Morgan’s Masaaki Kanno noted in the Financial Times, the government has announced a supplementary budget that will increase fiscal spending by 2 per cent of gross domestic product, raising the likely deficit to 11.5 per cent of GDP this year. Tokyo has also not only pushed the BoJ to finance this deficit, but has strong-armed it into accepting an inflation target of 2 per cent.

Will this set of measures transform Japan’s performance and, if so, in which direction? To answer this, we need to consider four aspects of the country’s economic record.

First, Japan has experienced prolonged deflation. Despite an official short-term interest rate of 0.5 per cent or less since October 1995, the GDP deflator (a broad measure of the price level) has declined by 17 per cent since early 1997.

Second, Japan has run persistent fiscal deficits. As a result, general government gross debt has risen from 66 per cent of GDP in 1991 to 237 per cent, while net debt has risen from 12 per cent to 135 per cent.

Yet, third, the yield on Japanese government bonds has collapsed from 7.9 per cent at the beginning of the 1990s to below 1 per cent now.

Fourth, contrary to widespread belief, economic performance has also not been so poor. The unemployment rate was only 4.1 per cent in November. GDP per hour worked (measured at purchasing power parity) has grown in line with that of the US since the early 1990s, although Japan is no longer closing the productivity gap with America.

Post-bubble economies

Japan, then, is a warning, but also an encouragement, to other post-bubble, high-income economies. It is possible for a country with its own currency to combine reasonable growth with sustained deflation, soaring public debt and ultra-low short- and long-term interest rates for a very long time.

What, then, are the dangers? I see two: first, the opportunity for further “catch-up growth” remains unexploited; second, at some point the cost of government debt service is likely to become prohibitive and the alternatives will be default, either directly or via inflation. The later this adjustment happens, the bigger the challenge will be.

The persistent fiscal deficits and deflation are a puzzle. A standard explanation is that they are due to a mistake in monetary policy. If the central bank had avoided deflation, real interest rates could have been negative, making private investment and consumption stronger. I agree that this would have been helpful. But I disagree that deflation is the underlying cause of Japan’s ailment.

So what is that underlying cause? “Excess private savings” is the answer or, more precisely, a huge structural excess of corporate gross retained earnings over investment, as Andrew Smithers of London-based Smithers Co argues.