The limits of Japan’s Abenomics

This is my Perspective column from this week’s Fund Strategy magazine.

A hard landing in China is uppermost in the minds of equity fund managers and second is fear at the failure of Japan’s experiment in Abenomics, with monetary expansion a central plank

While the prospect of “tapering” by America’s Federal Reserve has prompted much anxiety it is far from the most pressing concern for global equity fund managers. According to the most recent monthly survey by Bank of America Merrill Lynch it ranks way down the list.

It may be that equity managers have high confidence in the Fed’s abilities. It could also be that bond managers, who were not covered in the survey, are more worried by tapering than their equity-based colleagues. In any case equity managers have more pressing concerns than the Fed’s performance. A hard landing in China prompts the most concern while worries about the eurozone, although subsiding, remain

However, this article will tackle the second most feared risk: a failure of Japan’s experiment in “Abenomics”. This is linked to the discussion of Fed tapering as both have a bearing on the amount of liquidity circulating in the global economy. While the American authorities are signaling the possibility of monetary tightening a central plank of Abenomics is monetary expansion.

Abenomics, as those who follow Japan will know, is named after Japan’s prime minister: Shinzo Abe. When he came into office in December he made it clear that he would implement an extensive economic reform programme. Since then he has announced a plan with three elements, or arrows as he prefers to call them.

In relation to monetary policy it involves a 2% inflation target and a commitment to doubling Japan’s monetary base over two years. He has appointed Haruhiko Kuroda, a former head of the Asian Development Bank, to lead the Bank of Japan in implementing this part of the initiative.

The assumption behind such monetary measures is that Japan is stuck in a liquidity trap. Essentially consumers are reluctant to buy goods that are likely to become cheaper in the future. From this perspective deflation is one of the main causes of Japan’s economic malaise.

Abe’s second arrow is aimed at fiscal policy. He has announced a substantial stimulus package of public investment measures.

More recently he has announced a structural reform programme to promote economic growth. This is an amorphous package with many elements including boosting farm incomes, encouraging tourism, increasing foreign direct investment and boosting capital investment.

Abenomics, especially its monetary component, has received widespread plaudits from foreign experts. Those who could be broadly identified as Keynesians – such as Paul Krugman, Adam Posen and Joseph Stiglitz – have been particularly supportive.

This is hardly surprising since, although Abe belongs to the conservative Liberal Democratic Party, his views are in line with Keynesian thinking. Indeed as far back as 1999, in the first edition of his The Return of Depression Economics, Krugman pioneered the idea that Japan was suffering from a liquidity trap. In a sense Abenomics, particularly its monetary component, is built on this assumption.

Unfortunately it is misplaced. Krugman’s argument is essentially a circular one in which he confuses a symptom of Japan’s economic atrophy – falling prices – with its cause. He fails to properly consider the structural reasons for the country’s economic malaise. In particular its failure to promote economic restructuring.

In a sense Krugman and other Keynesians have played a role in persuading Japan to pursue a more ambitious version of Fed policy. Shoring up asset prices is mistakenly seen as a way of turning the economic cycle back to growth. The possibility of a more deep-seated crisis is ruled out.

As for an expansionary fiscal policy, Japan has tried it many times before. That explains why the IMF estimates Japan’s gross government debt at 245% of GDP this year compared with an advanced country average of 109%. Building infrastructure is fine in principle but Japan has a fair share of railways lines leading to nowhere as well as other redundant facilities.

The key to Japan overcoming its financial lethargy lies in structural reform. Not just increasing business investment, which is higher than in the other large developed economies, but making it more effective.

Yet whether Abe’s government will take the necessary measures to encourage corporate restructuring is questionable. He is after all the leader of a party for all but a few years since its foundation in 1955. For almost a quarter of a century, since the onset of the crisis, it has consistently failed to take decisive action on the economy.

From a global perspective it looks likely that Japan will continue its experiment in monetary expansion for a while. It may boost economic growth in the short-term although it is unlikely to have a durable impact. In the meantime, perhaps early next year, America is likely to start turning down the money tap.

The main western economies have kept themselves afloat on cheap money for decades. Not just since the emergence of the latest crisis in about 2008 but since the 1980s.

Japan has rejoined this experiment although its actions are not as novel as much of the commentary suggests. It has tried fiscal stimulus before as well as monetary expansion.

Such measures may help alleviate problems in the short-term but in the longer term they are likely to make matters worse.