Abenomics cure for Japan must be wiser and braver

by Clive Crook


Japan’s new prime minister, Shinzo Abe, is proposing a bold departure for his country’s economy. He’s mostly right. Japan continues to underperform, and bad macroeconomic policy has been the main reason. Abenomics isn’t riskless or easy, however. The government will have to be wise as well as brave.

Abe advocates what he calls a “three arrows” approach to expansionary policy: monetary, fiscal and structural. On two of the three, change is under way. He has pressured the Bank of Japan to end deflation by adopting a new inflation target and forthright quantitative easing.

He has announced a supplementary budget that will further increase the government deficit. As yet, the supply-side part of the program is vague.

Last month the BOJ answered Abe’s demands by adopting a 2 percent inflation target in place of its de facto target of 1 percent. It also promised to buy assets more aggressively. For the moment, attention has shifted to the appointment of the next governor of the central bank. A nominee could be announced next week. Abe should bolster the policy shift by putting a like- minded radical in the job.

The prime minister also favors renewed fiscal stimulus. The supplementary budget may be just the start. Japan’s gross public debt stands at about 220 percent of gross domestic product. Net of government holdings, the figure is about 130 percent.

That’s high, however you measure it. Yet the yield on Japanese government bonds remains low, suggesting no investor anxiety about the government’s solvency. Less than 10 percent of the debt is held by foreigners, Japan has a high savings rate, and by international standards, taxes and government spending are modest (leaving untapped fiscal space for servicing debt). For all these reasons, there’s little risk of a sudden fiscal calamity.

Even so, Abe would be wise to keep the emphasis on monetary stimulus.

A skeptic might ask, hasn’t Japanese monetary policy been loose for some time already? Looking at nominal interest rates, you would think so. And the central bank has bought assets, too. How can monetary policy be to blame if these measures have failed to stimulate demand? The problem must lie elsewhere.

Not necessarily. With prices falling, real interest rates have been higher than nominal rates. Also, the BOJ’s efforts have been timid. Its quantitative easing has been confined to short-term assets, which are almost equivalent to cash. Switching them for actual cash (bigger balances held at the central bank) doesn’t do much. To work, easing has to involve longer-term assets, as has been the case with such programs in the U.S. and the U.K.

The BOJ’s commentaries on its actions have been self-defeating. Its inflation target was too low, and it compounded that mistake by saying that objective would probably be undershot. Add the reliance on an impotent form of QE, and it’s unsurprising that the strategy hasn’t worked.

Abe’s right. The BOJ needed, first, a higher inflation target and, second, a perceived determination to hit it, whatever it takes. Despite the apparent realignment of the central bank’s policy with Abe’s, this new approach won’t be fully in place until the next BOJ governor supports it wholeheartedly — and acts on his words.

A different objection to stronger monetary stimulus is that it constitutes a declaration of currency war. Too much is made of this, though, admittedly, Abe is partly to blame. Monetary stimulus does tend to depreciate the currency. In Japan’s case, this is a desirable side effect — but a side effect nonetheless.

If the primary goal is to increase domestic demand, the policy isn’t unneighborly. Faster Japanese growth is in everyone’s interest. If domestic demand is growing, other countries can take a change in the currency in stride. A policy that makes depreciating the currency its primary goal is different. That invites retaliation, and can start a cycle that descends into beggar-thy-neighbor competitive devaluation, leaving everybody worse off.

Abe is muddled on this vital distinction. His party’s election manifesto said weakening the yen was a top priority in its own right. At a meeting in Moscow last weekend, Japan’s finance minister told his Group of Seven counterparts that he would clear up such misunderstandings.

Good idea.

Sensitivity on the currency war point, you might think, argues for greater reliance on fiscal policy. Not a good idea.

As Adam Posen, the president of the Peterson Institute for International Economics, has argued, most recently at a seminar last week, that fiscal stimulus is no longer such an attractive option for Japan.

The danger isn’t imminent fiscal meltdown — that’s unlikely for the reasons mentioned above. It’s that years of heavy public borrowing have stuffed Japan’s banks with public debt, which is squeezing out lending to the private sector. Another problem is the mounting cost of debt service, despite low interest rates, which is serving to crowd out public investment, too. Fiscal stimulus, Posen argues, shouldn’t be deployed indefinitely. Japan needs a plan to contain and reduce its public debt.

No such reservations apply to supply-side economic reforms — Abe’s third arrow. This approach ought to be pursued with as much enthusiasm as effective monetary stimulus. Abe has an early opportunity to advance this goal. On Friday he met U.S. President Barack Obama in Washington. One item on their agenda was Japan’s participation in the proposed Trans-Pacific Partnership. The trade pact plans to include 11 nations; it would have 13 if Japan and South Korea decide to join.

There’s strong resistance to the idea in Japan, because it might require economic reforms in sensitive areas, especially rice farming. The need to build momentum for those reforms is exactly why Japan should commit to take part in the pact as soon as possible. Let’s see how much of a radical Abe really is.

Clive Crook is a Bloomberg View columnist. The opinions expressed here are his own.