‘Abenomics’ needs reform

by Mamoru Ishida

“Abenomics” has made a good start. Thanks to the expansionary monetary policy and the fiscal expenditures, the Japanese economy has resumed growth.

However, it is an upswing phase of a normal business cycle and, as such, it will not necessarily lead to the sustainable economic growth and consolidation of government’s debt, the twin objectives of Abenomics.

An important feature of Abenomics is its over-reliance on monetary policy. Prominent monetarists in Prime Minister Shinzo Abe’s economics team have argued over a decade that since deflation is a monetary phenomenon, it can be cured by monetary policy.

When it was proved that the zero interest rate and quantitative easing since 2001 failed to cure the deflation, they concluded that the Bank of Japan’s expansionary monetary policy was not expansionary enough. Hence they have brought an even more expansionary QQE (quantitative and qualitative monetary easing) into Abenomics.

They don’t seem to notice the structural stagnation of advanced economies. To explain it, former U.S. Treasury Secretary Lawrence Summers quotes Alvin H. Hansen, who asserted in the 1930s that the U.S. economy was in secular [long-term] stagnation, because consumption was largely saturated and investment opportunities were largely exhausted.

During the Japanese bubble of the 1980s and the U.S. bubble prior to the 2008 crisis, general prices remained stable. It was a sign of “chronic demand shortfall.” As the natural rate of interest (the interest rate that realizes full employment) is significantly below zero, even zero interest rate is too high. Paul Krugman calls it a “liquidity trap” situation. It is not a temporary state of affairs now, but “the new normal.”

Bank of Japan Gov. Haruhiko Kuroda has been attempting to reduce the real interest rate (nominal interest rate minus inflation) below zero by engineering a 2 percent price rise so that investment activities are stimulated. At the same time, he intends to keep the interest rate low by purchasing government bonds to an unprecedented degree.

I would point out that his QQE has inherent risks that could defeat the objectives of Abenomics, which are sustainable economic growth and consolidation of the government’s debts.

First, inflation is bound to lead to higher interest rates. BOJ policy board member Takehiro Sato said in February, “It is highly possible that the long-term interest rate could rise well before the exit of QQE.” When it does, it would increase interest payments on government debt and could seriously hamper consolidation of government debt.

Interest payments in fiscal 2014 are already ¥10 trillion, accounting for 10.6 percent of expenditures at the historically lowest interest rate of 1.2 percent.

Second, QQE could give rise to a bubble. I define bubble as the euphoria of using up future demand now at an unsustainable magnitude.

Interestingly Kikuo Iwata, BOJ vice governor, reportedly said deflation is a state of “contraction of aggregate demand resulting from deferring expenditure to the future.” We could probably regard QQE as an attempt to turn both the deferred demand and the future demand into current effective demand. This could go on for a while, but it would eventually end up in a new bubble.

Carmen Reinhart and Kenneth Rogoff studied bubbles and financial crises that took place in 66 countries over eight centuries and found a certain pattern of boom and bust. A surge in credit fuels asset market boom and overall euphoria in the pre-crisis decade. The unwinding process following the crisis is of comparable magnitude and lasts a full decade.

In the longer run, we can discern a 70-year-long wave stretching from the devastation of World War II to reconstruction, global economic growth and, finally, the great bubble and the 2008 financial crisis.

Population decline could worsen Japan’s predicament. Paul Krugman refers to Paul Samuelson’s proposition that the natural rate of interest equals the rate of population growth, adding the “reality is a lot more complicated than that, but I don’t think it’s foolish to guess that the decline in population growth has reduced the natural real rate of interest by something like an equal amount.” He goes on to say that Japan’s shrinking working-age population is probably a major factor in its secular stagnation.

Japan’s structural problem requires structural reforms. That is what Abenomics should be all about.

Abe should be applauded for presenting a comprehensive program to revive the Japanese economy. Because it is a medium-to-long-term national project, his historical mission is to create and leave to succeeding administrations the conditions for sustainable growth and fiscal consolidation.

The possibilities of either a premature rise in interest rates or another bubble have to be minimized.

Abenomics’ over-reliance on monetary policy has to be rectified, and the role of monetary policy in its growth strategy must be redefined before it is too late. Japan has little time to waste.

Mamoru Ishida, an adviser to Itochu Corp., is a visiting professor at China’s University of International Business and Economics and at Wuhan University.