Abenomics and Japan’s disastrous macro plans

Today’s commentary

Summary: Abenomics has been very successful in goosing the Japanese economy thus far. However, the question remains whether this success will be short-lived or durable. I believe it is likely to be short-lived because of the policy constraints that all countries face irrespective of whether they have fiat currency.

In the past year or so, I have decided to be more explicit about what I believe what are largely political constraints. And I think this is important in Japan. Having worked both in a policy position and in finance and banking, I am well aware of the political constraints that impinge on what academic economists sometimes think of as purely economic debates. For example, you might hear a lot of econ people saying something about fiat currency and deficits as if governments could simply ‘print money’ or run deficits until the economy reaches full employment. Frankly, that’s never going to happen in any large industrialized economy and I believe Japan shows you why.

I want to highlight just a few ideas from past posts on this and I have written a lot about Japan, so it has taken me a while to find the right posts here. But here are the key ideas in bullet point. Remember these points are applicable in the US, the UK, Australia, Canada or in any other fiat currency country where government doesn’t face a hard solvency constraint.

• Turning Japanese and understanding the consequence of policy half-measures (Apr 2009): “Even if economic and monetary policy have stimulative short-term consequences, it does not mean that the structural problems have disappeared. They are merely lurking underneath, waiting for the next downturn to re-assert themselves. Again, the Japanese scenario is a cautionary tale on this score.”
• Japan: stimulus without reform leads to a policy cul de sac (Nov 2009): “stimulus cannot be seen as a cure-all in an economy which lacks in domestic demand or in which debt burdens are high. I see this as a cautionary tale for The Europeans and Americans looking at stimulus as some magic bullet which will make structural problems disappear. “
• On Japan’s widowmaker trade and Reinhart and Rogoff (Apr 2013): “Take a cue from Japan. The lesson is not to stimulate and deficit spend like mad and hope this succeeds in reflating the economy. That’s just a risk shift onto the public balance sheet. And the Japanese experience shows that people are uncomfortable with these kinds of deficits and will always work to reduce them irrespective of the consequences. You need supply side fixes too.”

If you put those three bullets together what you see is that the origin of these crises is uniformly in private debt i.e. private agents ran up more debt than the encumbered assets could throw off in cash flow and so those debts had to be written down. The slow growth while this goes on comes from the lack of credit growth in the private sector as this process unfolds.

Invariably government intervenes and countries with fiat currencies are encouraged to dither and run up their sovereign debt burden via bailouts to special interests with political pull like the airline sector or the auto sector or the banking sector. These are bailouts and not high-return investments, meaning we should expect a period of slow growth in their wake because the policy is political and not based on improving productivity or investment returns.

At some point, the risk-shift onto the public balance sheet becomes deeply unpopular in many circles and deficit hawks take prominence in public policy. This will always happen. Count on it. And of course, because the previous public policy was not predicated on unwinding malinvestment but rather on goosing aggregate demand, you still have high private debt levels which become onerous when government cuts back and the huge demand from that sector of the economy leaves. The result is recession and renewed deleveraging and crisis.

This is what we are seeing in Japan right now for the 3rd or 4th time. Take a look at this article from last Friday on the plans to increase consumption taxes in order to close the deficit gap.

“Japan’s economy is steady at the moment and we should raise the tax as planned,” Hiroshi Yoshikawa, a University of Tokyo economist told reporters on Saturday as he left the last session of a week-long, government hearing that also featured business leaders and consumer advocates.

Prime Minister Shinzo Abe convened the panel to hear a wide range of views on whether to press ahead with a planned hike in the consumption tax to 8 percent from the current 5 percent in April. Unless Abe changes the plan, the sales tax will be raised to 10 percent in October 2015.

Advocates, including officials at the Ministry of Finance, say raising the tax would be an important first step in trying to lower public debt, which is the worst among industrialized countries at more than twice the size of Japan’s economy.

Abe is expected to make a decision in the next several weeks.

What will happen here is that the ‘miracle’ of Abenomics will be found to not be durable since none of the structural reforms have come online yet. Japan’s growth will weaken significantly, inflation expectations will plummet, nominal GDP will trend further down, the Yen will rise in value due to rising real interest rates and profits will take a hit. Abenomics will come unstuck.

This is disastrous.

The question is what the Japanese do next. They could try to default. Seriously. Now I don’t see default s a serious short-to-medium term option but over a three to five year time frame, it is something to consider as a political option. It is clear that the Japanese are unwilling to take the measures necessary to either durably boost nominal GDP (structural reform, immigration, etc). And it is also clear that politicians want to close the fiscal gap as soon as possible every time it opens up. And I believe the tension is so great here that Japan will always look to close the fiscal gap before a durable recovery based on long-term structural reforms is in place. This is where we are now headed.

The bright spot in the Abenomics experience is behind us. By 2014, I expect the weaknesses to begin in earnest.

P.S. – The right thing to do is to focus on policies that help in reducing private debt in the early stages of crisis and have government provide support to keep the economy afloat and to keep the economy closer to full employment despite the loss of the credit accelerator. That is not what has happened and doesn’t generally happen.