More on the failure of Abenomics

My contention has been that the first two arrows of Abenomics gave the Japanese economy a short window to bring the Japanese labour market back to full employment, re-ignite wage gains, and institute structural reforms. In my view, Abe has not used this window effectively and the stock market and economic gains of the beginning of 2013 are going to recede. Last month I predicted Abenomics would ‘fail’ as Japanese GDP growth slips below 0.5%. We are well on that path.

If one looks at the Japanese economy through the sectoral balances lens, it was clear that Abenomics would be a boon to GDP and corporate profits.

The shift toward greater government deficits was more important than the threats about the inflation target because that’s what increased GDP and moved currency exchange rates.

Using the sectoral balances approach to understand the impact of this policy is important. And despite the protests of investors like Hayman Capital’s Kyle Bass, bond vigilantes cannot unilaterally force a sovereign currency issuer into default. Nor can bond vigilantes force a sovereign currency issuer’s domestic interest rates up to onerous levels because the Japanese situation is all about policy rates, expected future policy rates, expected inflation and currency depreciation.

We have to remember that the central bank is the central government’s agent. In exigent circumstances fiscal and monetary policy unification will always occur, creating a consolidated central bank/treasury balance sheet style modus of operation. That’s what we see in Japan – and I believe will eventually see elsewhere.

When a country is trying to institute financial repression by keeping policy interest rates low while letting inflation rise, the currency is the release valve, something that can lead to current account deficits. This is what we have seen in Japan, as the country will record its first current account deficit since 1980.

So, that’s the setup here: Deficit spending increasing private surpluses and corporate profits, financial repression increasing inflation, lowering the exchange rate, and worsening the external balance – all very predictable. The question is what next?

When Abenomics was first instituted I had just written a piece on the importance of supply side problems. My view here is that running up deficits to reflate is a double-edged sword because, while it can goose GDP and increase profits,  in the absence of supply side efforts, it is really just loss socialization. Deficits without the supply side just gears up the government’s balance sheet and gears down corporate balance sheets. It’s just a transfer of wealth – unless you can take this all the way to full employment when household income and wage gains come into play.

I wrote the following in December 2012 then as Abenomics was introduced: 

“Personally, I remain sceptical about claims that Japan just needs to deficit spend until it reaches full capacity and inflation takes hold in order for it to turn the corner. I believe there are structural issues at play in Japan due to the changing demographics. The Japanese economy is aging quickly, and this suppresses consumer demand. Once the prop of deficit spending is removed, would Japanese consumer demand continue to grow robustly? That’s the long-term question. But what other choices do the Japanese have left? That’s a serious question because price deflation is killing the economy, interest rates have hit rock bottom and repeated cycles of quantitative easing have not yielded sustained results. The Japanese need growth.

[…]

“The bottom line here is that Japan’s government can continue to deficit spend for quite a while longer without economic Armageddon. But this does not necessarily ensure sustained economic growth even if the government kept at it until employment and industrial capacity reached their limits. Japan is in a deflation that is exacerbated by the demographic challenges of an aging society. Where and how this ends is anybody’s guess.”

What we see now, however, is that Abe is not willing to take it all the way to full employment, which would create wage gains. Yes, we have seen some incipient wage growth just in the last month. But Abe had already decided to raise taxes last fall, well before this growth came online. And Japan is nowhere near full employment now. Private sector employers are reluctant to raise wages. Even in the public sector, where government can help move toward full employment, there has been no public works boon. You are not going to get significant and lasting wage gains in Japan without full employment. And without wage gains, inflation is just a cost of living tax.

So Abenomics is a failure. And I believe the failure of Abenomics will cause the Japanese to eventually reach for wealth confiscation as a means of ‘fixing’ the situation in Japan.

Japan’s growth is slowing and its external balance is rising just as a consumption tax is about to come online, reducing deficits and sucking money out of the household sector. The result will be a decline in household disposable income, a decline in GDP growth, and a decline in corporate profits. This might improve the deficit. But if it induces a recession, it may increase the deficit. The scenario is bearish for Japanese equities and moderately bullish for JGBs.