When I first studied macroeconomics for my MBA many years ago I remember thinking what elegance there was in the apparent simplicity of the model. A change in one component seemed to produce an equal and opposite reaction in its counterpart: increase demand and supply rushes in to fill the void; raise interest rates and prices go up while spending goes down.
Perhaps it is an easy model to understand badly. While interventions in the economy do produce the expected results in the short term, they also produce effects later on that are less well understood or planned for. Today’s fiscal and monetary policy makers also have the added complexity of working in a global marketplace and a global political arena where control of your own domestic affairs is an illusion.
With virtually every economy in the developed world currently struggling with the fallout from the global economic crisis of 2008 (plus the long-term results of many of their own domestic policies coming home to roost), Japan is drawing attention as an example of what disasters may lie ahead of many others – or is it? Opinion seems to be divided on the probable outcome of Prime Minister Shinzo Abe’s package of fiscal and monetary measures designed to lift the country out of over two decades of deflation.
Following the end of the Second World War, with the Yen having lost most of its value, Japan used low production costs and an obsessive commitment to manufacturing quality to build an export-driven economy. During the period 1955 to 1970 the country enjoyed economic growth rates averaging around 9.5% per annum, allowing it to build up huge trade surpluses.
Today’s fiscal and monetary policy makers also have the added complexity of working in a global marketplace and a global political arena where control of your own domestic affairs is an illusion
In 1971, partly to address the competitive threat of cheaper Japanese imports to its own economy, the US abandoned the gold standard, leading to floating exchange rates. Over the next few years the government of Japan tried to manage the value of the yen in foreign-exchange markets and two successive oil price shocks had the effect of lowering its value, so the country continued to be able to grow its exports, albeit at a slower rate. In 1985, however, France, West Germany, Japan, the US and the UK signed the Plaza Accord which agreed to devalue the US dollar in relation to the Japanese Yen and the German Deutsche Mark. As a consequence, the yen increased by as much as 51 percent over two years and Japanese economic growth fell significantly.
To offset the stronger yen, the Bank of Japan cut interest rates from five percent to 2.5 percent, fuelling a rapid increase in debt-funded investment which drove real estate prices into the stratosphere. Alarmed, authorities increased interest rates to above their earlier rate of five percent and the property boom collapsed – we all remember pictures of suited former Japanese business men cooking tea under the bridges of Tokyo in the early 1990s. Subsequent attempts to correct the problem with stimulus packages and a zero percent interest rate have failed to lift the country out of twenty years of deflation.
Yet even the latest economic statistics can give a confusing picture. Data released early in February showed that Japan’s economy experienced its third straight quarter of contraction to December 2012, shrinking by a worse-than-forecast annualised rate of 0.4 percent. Industrial output that had slowed following the shock of the 2011 earthquake fell a further 1.7 percent from October to November, again more than forecast by experts, and consumer prices fell another 0.1 percent.
Contrarily, 2012 also saw the Nikkei 225 stock average rise by around 23 percent and close on a four year high on February 6 2013. Despite over twenty years of deflation in the troubled economy, Japanese corporations have recorded five straight quarters of collective profit rises. This, in part, is why some experts are predicting that the country should not be written off. As Scott Callon at Ichigo Asset Management says, “Pound for pound, Japan is punching well above its weight.”
Band-aid or fix?
Re-elected for a second term by a population grown tired of the stagnating effects of deflation, Prime Minister Shinzo Abe has announced his latest measures in what is being dubbed ‘Abenomics’. His proposals include increased fiscal spending, radical quantitative easing, devaluing the yen, maintaining a zero interest rate and setting a two percent target inflation rate.
To achieve his objectives of quantitative easing and a two percent inflation rate he needs the cooperation of the Bank of Japan and he means business; earlier this year he issued veiled threats that if the BoJ does not meet his two percent inflation target he will revise a law guaranteeing the bank’s independence. The Governor of the Bank Masaaki Shirakawa, who disagreed with Abe’s policies, stepped down and has been replaced by Haruhiko Kuroda, described as being more ‘dovish’.
Response to Abe’s programme has been divided. The OECD is clearly bullish about the measures, declaring in its interim report on the outlook for the Group of Seven economies released in late March, “The prospect of more aggressive easing, with the Bank of Japan’s adoption of a two percent inflation target, has resulted in a 20 percent depreciation of the yen in real effective terms and a surge in equity prices. These have boosted the near-term growth and inflation outlook. This shift in stance and the effects of its announcement are welcome.”
Professor Richard Werner, whose career has included consulting to the Asian Development Bank and advising the Japanese Liberal Democratic Party’s Central Bank Reform Research Group, disagrees. “There has been too much talk about the exchange rate,” he says, “but this is a side-show. Japan has been in a 20 year recession not because the yen has been too strong, but because of lacking domestic demand.
“Raising the inflation target to two percent and then increasing bank reserves massively is not likely to achieve anything, as these measures ignore how the economy and the monetary system actually function,” he adds.
Werner, who originally proposed the concept of quantitative easing in the mid-1990s, claims the term is being misused by monetarists – and the BoJ – to describe reserve expansion. “The term was meant to refer to broad credit creation,” explains Werner.
“What is needed is an increase in the supply of money in circulation, not in bank reserves. This is true quantitative easing and it always works. We have clearly seen this in the US where bank credit has been growing by more than five percent for a while, delivering a full-blown recovery this year.”
One can see many similarities between Japan’s economic woes and the crises facing European countries currently struggling with massive debt loads and sluggish growth. Japanese government efforts to stimulate economic activity over the last twenty years led to spending that has outstripped tax revenues by a factor of two to one. The country now has a gross national debt of around 240 percent of GDP – the highest in the world, according to IMF estimates, although possibly Zimbabwe’s is higher.
But Japan has a couple of protective cushions that have thus far kept it from the ignominy of international rescue. One is the country’s massive trove of international assets built up during its period of large trade surpluses. Japan holds around $1trn in US Treasury bills along with around $3trn of other foreign assets making it the world’s largest net international creditor.
The other is the massive amount of personal savings built up by a thrifty society. Household savings rates have traditionally ranged between 15 and 23 percent and ninety percent of Japanese Government Bonds (JGBs) are held domestically. The high levels of government debt are sustainable because of its zero interest rate policy, which savers will accept because falling prices mean that they are actually receiving real rates of return. It is a delicate balance that hinges on maintaining stasis in all factors.
The all-important underlying demographics are changing, however. Prior to the 1990 property crash, Japan enjoyed unemployment rates as low as two to three percent; today they are nearer five percent, and the wages of those in work are falling. Workers no longer enjoy jobs for life, with over 30 percent of the labour force in part-time or contract positions.
While unemployment has increased, the population is both shrinking and aging. Experts forecast a 25 percent reduction in overall population by 2050 and an increase in the proportion of the population over 65 from 12 percent to 23 percent. Savings rates have declined to just three percent and pension funds are cashing in assets under management in order to pay out retirement benefits. For the first time, the amount of money being paid to retirees from savings exceeds the amount of new money that is going into savings funds.
Not everyone believes that all is lost for the Japanese economy. In fact, some are arguing that Japan has directly or indirectly taken the opportunity of what are referred to as the Lost Two Decades and used it to redefine economic success.
First, some interesting facts. Over the last two decades, while the US has increased its net overseas liabilities by $8trn, Japan has increased its net overseas assets by $3trn. The country’s health system is partly to blame for the aging society, having boosted life expectancy to four years longer than that enjoyed in the US, and unemployment, while high for Japan, is still about half of that in the US and is now falling.
Eamonn Fingleton of the New York Times has argued that “Japan has succeeded in delivering an increasingly affluent lifestyle to its people despite the financial crash. In the fullness of time, it is likely that this era will be viewed as an outstanding success story.”
Another bright spot is Japanese industry; its car industry has shown remarkable growth, with both Toyota and Nissan more than trebling sales between 1989 and 2012. Many household name corporations have been sitting out the difficult years paying off any outstanding debt and building reserves that they are now looking to use for overseas takeovers over the next few years.
Japanese firms also want to help the government kick-start the economy. A recent report from Nikkei said that Japanese retail giant FamilyMart has announced a plant to boost annual compensation by an average of 2.2 percent in an effort to help achieve Abe’s target of a two percent rise in consumer prices. Two other major retailers have announced similar plans, and two of the major automobile manufacturers are doing likewise.
But most people seem to have accepted that the growth rates of just under 10 percent enjoyed in the post war years, or even close to five percent experienced up to the property crash of 1990, will not be the norm in the future. In an interesting analysis, Brendan Barrett of the United Nations University points out that rather than becoming the economic and societal wreck one would expect of a country enduring two decades of deflation and recession, Japan may be defining a new model of economic success.
He cites the findings of the 2012 Inclusive Wealth Report, a new initiative from the International Human Dimensions Programme on Global Environmental Change. The Inclusive Wealth Index was set up as an alternative measure of success to the traditional economists’ measure of GDP, and over the period from 1990 to 2008, Japan apparently performed quite well.
“Japan depicts the most favourable situation,” say the report’s authors, “as it is experiencing wealth accumulation while at the same time increasing its natural capital stocks. This has been achieved primarily through investment in the forest sector. This position is also explained by a slower population growth rate in relation to other nations.”
Not surprising, then, that the Institute of Studies in Happiness, Economy and Society (ISHES) was set up in Japan in 2011. Founder Junko Edahiro argues in favour of a steady state rather than a growth-based economy, saying, “We live not for economic growth. We live for happiness in our daily lives and we hope generations to come can enjoy their happiness. Economies and societies should do something to serve this purpose and should take on different forms and structures if they fail to meet their goals.”
Work to be done
However, there is still the hard task of running the economy to be addressed and observers question whether the government has grasped the need to tackle fundamental structural issues.
Commenting on the release of lower-than-expected results from the last quarter of 2012, Economics Minister Akira Amari noted that while the economy was still showing some weakness, it was likely to resume moderate recovery helped by monetary easing, stimulus spending and an expected pick-up in global growth. Many argue that this blind faith in a package of measures that have already been tried and shown not to work is misplaced.
David Beim, from the Columbia Business School’s Centre on Japanese Economy and Business suggests that supporting industry is the best way forward. “Banks are not constrained by reserve requirements but by capital requirements and customer loan demand,” he says. “Monetary policy cannot alter these constraints. Fiscal policy (increase spending or lower taxes) can increase economic activity but only temporarily, as Japan has found out over the past 15 years. It adds to government debt as well.
“The only agents who can create real value-adding economic activity are private corporations, and they are influenced mainly by their own balance sheets and the state of demand for their products. The best thing the Abe government can do to stimulate growth is clear away the impediments to competition. Japan has far too many restrictions on doing business, most of which are designed to protect existing interests.”
Richard Werner’s solution to the immediate crisis is quick and to the point: “The fastest method to achieve a recovery in Japan at this stage is for the government to stop the issuance of government bonds entirely and instead fund itself entirely by borrowing from banks via loan contracts, to be paid out into the government’s accounts at the various banks. There would be full-blown recovery within nine months.”