Published in Newsweek Japan 7/1/2014
Is Prime Minister Abe starting to regret using that hoary old tale about the three arrows to describe his reflationary economic programme? The first, remember, is supposed to represent aggressive monetary easing, the second expansionary fiscal policy, the third ill-defined structural reforms.
No doubt it seemed like good politics at the time. Triads have a way of lodging themselves into the consciousness and also have a pleasing symmetry, with no element having precedence over the others. Hence the three musketeers, the third man and the Holy Trinity. Likewise, Japan’s three famous sights, three famous gardens and three sacred jewels.
The third arrow struck a chord because it told people what they wanted to hear – that government can push a button and remake economic and social reality. As ever, such projects sound grand in the abstract, but less appealing when your own vital interests are at stake. No surprise, then, that progress proved difficult when airy generalities had to be converted into negotiations about specifics
The key proposition of Abenomics is much simpler. Unlike the failed policies of his predecessors, it promises to get the macro-economic settings right – meaning monetary and fiscal policy. The rest can be left for company managements, consumers and investors to decide for themselves.
If all goes well, rising asset markets will reverse Japan’s two decades of balance sheet recession and enable an exit from deflationary stagnation. A return to growth would end Japan’s marginalization and greatly strengthen its geopolitical position. In other words, the stakes could hardly be higher.
These are still early days, but the progress so far has been remarkable. Thanks to the decline in the yen, corporate Japan has become much more competitive and profits have soared to an all-time high. Bankruptcies have fallen to the lowest level in twenty two years.
The street-level economy is doing better too. Consumer confidence is hovering at the highest levels this century and the labour market has been steadily tightening. With the ratio of job offers to applicants nearing parity, there is a good chance that wages will soon start to rise across the board.
Crucially, the capitalization of the Japanese stock market has risen by a hundred and fifty trillion yen – the largest ever yearly increase. Real estate prices are on the move too. This massive improvement in the national balance sheet is the big story of the year, not the supposed failure of the third arrow.
To stick with the triad principle, there are three key reasons why the government should concentrate its energies on fiscal and monetary policy.
First, the third arrow obsession is a hangover from the failed policies of the past, specifically the “big-boned” reform of the Koizumi era and the hard money orientation of the Shirakawa Bank of Japan. Then the conventional wisdom was that Japan’s most serious problem was supply-side inefficiency. A programme of Thatcher-style deregulation and privatization, it was assumed, would be enough to put the economy back on its feet.
The aftermath of the Lehman shock showed the diagnosis was wrong. Despite the widely applauded initiatives of the Koizumi administration, Japan proved the most vulnerable of all the developed economies, suffering a huge 8% hit to GDP. Large-scale monetary and fiscal stimulus was obviously needed, but the reform-obsessed policy-makers just sat there twiddling their thumbs
Taken individually, many of the Koizumi reforms were useful and necessary. But their net effect was deflationary – as you would expect since the role models were the inflation-plagued Anglo-Saxon economies of the 1980s. The same can be said for some of the labour market reforms that have been discussed this year.
Second, the third arrow talk puts Japan in a different category from other countries. When the whole world except for Japan was booming, it did look as if Japan’s problems were unique. Now, though, nearly all the developed countries are struggling to deal with the severe post-bubble crisis of growth and jobs. Needless to say, we do not hear President Obama or Prime Minister Cameron being grilled about their third arrow reforms. The debate is entirely about monetary and fiscal policy, as it should be.
Lastly, all the hype drove expectations way too high, allowing political rivals and the nay-saying media to concentrate on meaningless “disappointments”. Hence the absurd fuss about the omission of twenty three medicines from the ten thousand now allowed to be sold online.
The reality is that in complex modern democracies there are limits to what governments can achieve in terms of changing ingrained cultural practices and habits of thought. Prime Minister Abe cannot magically transform your hikikomori son into a suave globe-trotting entrepreneur with fluent English. He cannot force husbands to do more housework or turn Sony into Apple or give Japanese institutional investors the acumen of a Warren Buffet. He cannot even sweet-talk the corporate sector into paying higher wages. That depends on the supply-and-demand balance for labour in the economy as whole – which is indeed moving in a favourable direction.
Revolutionary change is not going to happen. You have to work with what you’ve got. Even so, changes to incentives can lead to changes in behaviour that become significant over time. One example is the government’s plan to make fifty percent of corporate entertainment expenses tax deductible. Over the past twenty years, companies have cut their entertainment budgets by more than half and even the Ginza has lost its glitz. If this new form of targeted Keynesianism works, better times are ahead for one of the glories of Japanese civilization.
Another example is the introduction of NISAs, UK-style tax-free savings accounts, which should encourage the flow of household savings into the stock market – potentially setting off a virtuous circle of increasing wealth and greater spending power.
The big picture is that exiting deflation should have the effect of penalizing inertia and rewarding risk-takers and optimists. Japanese people have tended to stereotype themselves as modest, cautious introverts, but that was far from the case during the bubble years. Even amongst ordinary people, speculation and luxury spending were rampant, as was exhibitionism at Juliana’s disco and hubris amongst Japanese intellectuals. It was the long years of deflationary stagnation that created today’s risk-averse, hundred yen shop mindset. That should now be ending, like the long bear market in stocks.
The key question for the year ahead is not whether the third arrow hits its targets, but whether arrows one and two have been fired with enough power. The Bank of Japan’s monetary easing is of vast scale, but few economists believe that the target of 2% inflation is achievable within the designated two year period. Even in the United States, after five years of aggressive quantitative easing the Fed’s favourite measure of inflation is barely over 1%. The situation in the Eurozone is similar.
Worse, the government has gone ahead with the consumption tax hike, which will take around eight trillion yen out of the economy. Stimulating capital spending while reducing the purchasing power of consumers is deflationary and threatens the high support ratings on which Prime Minister Abe depends.
In other words, year two of Abenomics is likely to be a bumpier ride than year one. Fortunately, though, there are few constraints on more policy action. Expect to see a second round of QE in the spring, probably including large-scale purchases of stocks and real estate investment trusts by the Bank of Japan. If the spring wage settlements are disappointing, the government should consider raising the minimum wage. A loosening of fiscal policy is needed too – aimed at putting money in people’s pockets, rather than capital investment.
To overcome the deflationary mindset, in 2014 Japan needs to say sayonara to hundred yen shops and get back to the Ginza.