Abenomics should take aim at structural reform

Andrew Smithers.
Financial News, a Dow Jones Company, 17th June 2013

A weak yen, a new governor of the Bank of Japan announcing a massive programme of quantitative easing, with the aim of ending deflation, and a rise of 2% of gross domestic product in government spending have caused a dramatic reassessment of Japan.

The initial response was very encouraging, with the stock market rising by 83% between October 12 last year and April 22, 2013. But since then concerns have surfaced, the stock market which had fallen back 15% by June 3 has since been volatile and the 10-year bond yield has risen from a low of 0.45% on April 4 this year to a high 0.94% on May 29, before retreating slightly.

The difference between the initial response and more recent volatility may reflect worries about the international reaction to the weak yen, concerns over the rise in the fiscal deficit or disquiet that inflation could set off a bond crisis.

The key, in my view, has been a massive gap between the rhetoric and the reality. The weakness of the yen is essential for Japan’s recovery and will have a short-term impact on inflation. The official rhetoric from parties including Japanese Prime Minister Shinzo Abe assumes a causal connection between Japan’s past two decades of deflation and an underperforming economy.

In reality, there is no connection and continuing inflation would be dangerous and unhelpful. At first, the claims that Japan was going to end its “period of deflationary stagnation” were largely taken at face value. This rhetoric was successful and the yen began to weaken sharply well before talk had turned into action. But with the arrival of both fiscal stimulus and more quantitative easing, the concerns of the thoughtful have started to rise.

Economists usually prefer low inflation to deflation. It allows real interest rates to become negative, a position assumed to stimulate demand. The main thrust of the argument is that business is encouraged to invest if capital is cheap.

But this is a very bad argument to apply to Japan, where domestic business investment is too high, being greater than in any other G5 country despite its falling population and thus slow growth. Japanese business has a structural savings’ surplus, which comes from a combination of excessively high allowances for depreciation and too much past investment.

Depreciation in company accounts is sufficient, on its own, to pay for 100% of the excessive level of domestic investment. As companies are unwilling to pay out 100% of their profits as dividends, the result is that companies run a large surplus of savings over investment and it is this surplus that depresses demand and, in order to avoid depression, introduces the need to be offset by the large fiscal deficit.

Abenomics aims to stimulate economic growth through higher business investment. If successful, this would provide some short-term help to the economy but make the longer-term problem worse.
There is no evidence that inflation will help consumption. Growth requires higher household incomes or lower savings. Inflation tends to push up prices faster than wages and thus depresses household real incomes. Savings rates have been falling steadily as inflation has turned to deflation. A strong stock market may be giving a boost to consumption, but it is a mistake to confuse this with the impact of inflation.

It is also argued that inflation will reduce the burden of the national debt, by increasing the rate of growth of nominal GDP. This would be true if we were looking at hyper-inflation. However, as the bond market’s response shows, moderate inflation may well make matters worse, not better, by pushing up bond yields’ rates even faster than inflation.

As Japan’s gross national debt is 214% of its GDP, rising interest costs can readily outpace any rise in nominal GDP. If the market starts to fear inflation, then bond prices will fall and, as Japanese banks are heavily invested in government bonds, this threatens to cause another financial crisis.

Worries about inflation causing a bond market crisis are made worse by the new fiscal stimulus. In 2012 Japan is estimated by the Organisation for Economic Co-operation and Development to have run a fiscal deficit of 9.9% of GDP. While this needs to fall, this must be done slowly and to have the decline matched by increased demand elsewhere, so that the tightening of fiscal policy does not push the economy into recession.

The usual case for an increase in the budget deficit is that it will stimulate the economy and produce a revival in the “animal spirits of entrepreneurs”. This assumes that the weakness in demand was the result of companies cutting back on their investment. But this argument cannot sensibly be applied to Japan, where companies invest too much rather than too little.

There is a parallel argument that households are saving too much because they fear for the future but, as they save very little, this assumption is not supported by the data. The case for fiscal stimulus depends on weakness of demand being temporary and cyclical, and in Japan it is structural. So long as the Japanese government, sadly egged on by many economists, continues to misunderstand this, it will have the wrong diagnosis and, as a result, the wrong treatment for its ills.

This year Japan is likely to have a reasonably strong economy. Exports should respond to the weakness of the yen, and construction to the rise in the budget deficit. Corporate profits will rise very sharply, which should support the stock market and help keep up confidence among consumers.

But, looking further ahead, the outlook is far from rosy. The key is whether the new government’s talk of structural reform will produce the essential change, which is to reduce both the level of depreciation allowances and the rate of corporation tax. At the moment the auguries are poor.