CFE Advisory Board Member and Chief Global Economist at Deutsche Asset and Wealth Management, Josh Feinman, wrote the following commentary on the current US fiscal situation:
Japan: changing course?
For years, Japan has languished in the background of the global economy and financial markets, more a follower than a leader of key trends. Although it still boasts the world’s third largest economy, with a high standard of living and some first-rate export industries, Japan has been mired for so long in a stagnant, deflationary rut that it rarely garners much attention anymore — except as an example of what can go wrong in a wealthy, advanced economy, and as a potential warning to others. Indeed, after two “lost decades,” Japan has become a virtual emblem of inexorable decline. The contrast with the heady days of Japan’s spectacular performance in the decades following WWII, when the country was often in the spotlight, considered by many a model to be emulated and an economic rival to be feared, could hardly be more vivid.
Recently, though, Japan has begun to re-appear on the global radar screen, if only as a faint blip. The catalyst for the renewed interest in the country has been the election of Prime Minister Abe and the Liberal Democratic Party (LDP), who’ve pledged to reorient Japanese policy toward breaking the grip of deflation and restoring stronger growth. Structural reforms and fiscal stimulus are part of the agenda, but the main emphasis is on monetary policy. Here, the government has advocated that the Bank of Japan (BoJ) adopt a formal 2% target for inflation and initiate aggressive, open-ended asset purchases until that target is achieved. Perhaps most crucially, the government has just appointed new leaders at the BoJ who firmly believe that the central bank can and should end deflation. Financial markets have taken notice, with the stock market rallying and the yen losing ground since the fall, when investors first began to price in the likelihood of the election result.
But Japan has seen its share of false dawns before – times when policy initiatives were proffered, optimism was on the rise, and economic conditions seemed to be improving, only to peter out. Whether this time proves different depends most crucially on two questions: will policymakers really chart a new course of action and stick with it? And if they do, will it be effective? For the first time in ages, the answers may be “yes.”
There is no denying Japan’s long struggles. Since the early 1990s, the country’s real GDP has increased at a meager rate of only ¾% per year. And the country’s footprint on the global economy has steadily diminished over the past two decades; measured at market exchange rates, Japan’s economy has slipped from the second to the third largest in the world, and its share of world output has declined from a peak of around 18% in the mid-1990s to little more than 8% today (IMF estimates). Similarly, while its living standards remain high by broad international standards, and continue to increase incrementally, they’ve been slipping relative to many other countries. For example, Japan’s per capita GDP, valued at PPP exchange rates (which are better suited for comparing international living standards because they adjust for cross-country differences in costs of living), peaked at over 85% of US levels in the early 1990s but has declined to about 72% today.
Japan has also endured a persistent deflation. The GDP price index has fallen for 15 consecutive years (17 out of 18), at an average annual rate of just over 1%. This chronic deflation, coupled with the country’s paltry real growth, has left nominal GDP today lower than it was in the mid-1990s. And it has created a pervasive deflation psychology, as consumers and businesses widely expect the price level to fall and build those expectations into their planning. No other major nation has suffered such a long period of grinding deflation and feeble growth since the Great Depression.
What’s behind Japan’s woes? On the growth front, a big part of the problem seems structural, due to problems on the supply side of the economy. Estimates from the IMF and OECD suggest that Japan’s potential growth has slowed more or less continuously since the 1980s, to as low as ½% or so in recent years. Part of the reason is demographics. Japan’s working-age population began to slow in the 1990s, and by the end of that decade was in decline – a decline that has accelerated of late, recently exceeding 1% per annum. Worse, the changing age composition of Japan’s population may also be putting downward pressure on the country’s per capita growth. The share of Japan’s total population that is of working age has been falling since the late 1990s, and increasingly so in recent years, while the share that is elderly has been soaring. This shift has likely been depressing per-capita growth through several channels: directly, by reducing the size of the labor force that has to support a growing dependent population; and indirectly, as lower working-age population shares, and higher elderly shares, tend to reduce aggregate savings rates (because the elderly usually save less), constraining the pool of national savings available to finance capital investment and hence adversely impacting productivity and per-capita income.
Demographics are not the whole story. The chronic weakness in growth is also a residue of the excesses of the bubble years, which took a heavy toll on activity for years. Moreover, Japan’s labor markets and many of its industries – especially services, distribution, retailing, and agriculture – have long been considered over-regulated, insufficiently flexible, and excessively insulated from competition. Also, deflation itself may be impeding growth. Since nominal interest rates can’t fall below zero, expectations of falling prices imply that real interest rates have remained stubbornly high in Japan, even in the face of the global crisis of 2008-’09 and its aftermath, likely making the decline in aggregate demand steeper and more difficult to reverse in Japan than in countries not suffering deflation, where real rates have been able to fall more sharply. Deflation has also raised the real burden of Japan’s debts, and may be encouraging households and businesses to delay spending and investing because they anticipate lower prices in the future. And since workers tend to resist cuts in nominal wages, deflation makes it more difficult for real wages to decline in contracting industries, reducing the economy’s ability to transfer resources toward new growth areas, thus further impeding efficiency. To top it off, Japan was also hit hard by the global recession of 2008-’09, and its subsequent recovery was temporarily interrupted by the earthquake of 2011.
This may explain Japan’s growth struggles. But what’s causing deflation? Why has Japan been the only major economy to see its price level relentlessly decline? Although the recession of 2008-’09 opened up a sizable output gap in Japan, increasing unemployment, idling capacity, and likely putting downward pressure on prices, other countries were damaged just as badly (if not worse), yet avoided deflation. What’s more, Japan’s deflation began long before the Great Recession, and has persisted even when the economy was growing relatively briskly and was estimated to have been operating near or even above its potential, like 2004 through 2007. Deflation did seem to ease in that period – and again in the past year or so, as the economy has recovered – but it has never completely gone away. The strengthening of the yen, and the downward pressure this may have imparted on import prices, can’t explain it either. For one, imports are too small a share of Japan’s economy (only about 15%) to be the key to the inflation/deflation process. And the yen hasn’t even been rising consistently throughout Japan’s deflationary episode. If there’s any compelling causality here, it more likely runs from deflation to the stronger yen rather than the other way around. The persistent decline in Japan’s prices relative to those in its trading partners would naturally be expected to put upward pressure on the yen; otherwise, Japan’s products would become excessively cheap to foreigners, and foreign products might be priced entirely out of Japanese markets, creating unsustainable trade and capital flows.
At its core, deflation is a monetary phenomenon (and currency movements are one of its consequences). It is widely accepted that a central bank is able to control the price level over the long haul, so the persistence of deflation for such a long period in Japan ultimately reflects a failure of monetary policy. The BoJ has not been sufficiently accommodative, and the result is that deflation has become embedded in the fabric of Japan’s economy, built in to the expectations of households, firms, and investors in ways that have made it self-fulfilling.
What can be done?
Japan needs a multi-faceted approach. Structural reforms to boost potential growth, short-term fiscal stimulus to help boost the cyclical recovery and, most importantly, a more aggressive monetary policy aimed at breaking the deflation mentality. The new government has pledged actions on all these fronts. Ultimately, though, it’s a question of commitment and efficacy. Will they really adopt new policies and stay the course? And if so, will it work?
On the question of policy change and commitment, there is certainly reason to be skeptical. Japan has rolled out countless policy initiatives in the past, with limited success, either because the policies were insufficient to combat whatever headwinds the economy was facing at the time, or because they were not sustained long enough to finish the job (or both). It could surely happen again this time. After all, many of the country’s challenges are not easily remediable. There is little that can be done in the short-run, for example, to change the country’s demographic profile. Easing immigration rules would help, but for cultural reasons seems highly unlikely. Policies to encourage more women and older people to work would be beneficial too, and there has been some progress in these areas, but more rapid change is needed to mitigate the adverse effects of the country’s aging. There are other changes that Japan could adopt to help lift the country’s growth potential, like making labor markets more flexible, the tax code more efficient, and insulated industries more open to competition, but these reforms require overcoming strenuous social and political objections, so progress is likely to be modest.
Fiscal policy is also constrained, again more by politics than by economics. Although the country does have an enormous government debt outstanding, that debt is held almost exclusively internally, so the interest that will have to paid by future Japanese taxpayers will just go to future Japanese taxpayers. And the debt is all denominated in yen, the supply of which the BoJ can increase to buy the debt if need be, so the government never has to default. The government is having no trouble borrowing right now, and the country is still running current account surpluses, meaning that the private sector is saving sufficiently more than it invests not only to cover the government deficits but to accumulate assets abroad, adding to the country’s already positive net international investment position. Of course, if government debt continues to rise forever, it will eventually crowd out private, productive investment, making the country’s capital stock and overall economy smaller than it would otherwise be. So someday, the government will need to pare back its borrowing and trim its debt. But that day is not today. With the economy still struggling to recover from recession, there is little risk that government borrowing is crowding out much private investment now. On the contrary, some additional fiscal stimulus could be helpful, and the new government has talked of some fresh initiatives. But political concerns may limit their actions. In fact, a fiscal tightening is in the works for 2014 and 2015, when the consumption tax is scheduled to rise. Probably the best that can be hoped is that other measures will be taken to offset the impact of this tax hike and keep overall fiscal policy from tightening.
There is more room for maneuver on monetary policy. The BoJ has already followed the new government’s lead by adopting a formal 2% inflation target and agreeing to initiate an open-ended asset purchase program. A skeptic might argue, though, that there is less here than meets the eye. For one, the new 2% inflation target may not be that revolutionary given that the central bank already had a long-term inflation goal of “2% or less.” Also, the new asset purchases aren’t slated to begin until 2014, and even then are still planned to be concentrated at the short-end of the maturity spectrum, where they have the least ability to affect longer-term rates, and in amounts that will boost the BoJ’s net holdings only modestly.
Perhaps most importantly, policymakers at the central bank have been unwilling to take responsibility for deflation. Instead, they’ve persistently argued that deflation is mostly due to the country’s inadequate growth, so curing it will require the government to adopt policies to boost growth. This thinking is out of step with mainstream economics, which holds that over the medium- to longer-term, the price level is determined by monetary policy – full stop. That by influencing interest rates, financial conditions, the supply of money and credit, and inflation expectations, the central bank can get the inflation rate it wants, at least on average over time. Monetary policymakers can’t determine the economy’s real growth trend – that depends on things like demographics and productivity – but they can pin down inflation over time. Failing to accept that Japan’s deflation is largely a monetary phenomenon not only bucks mainstream economics, it’s also self-defeating. By denying that monetary policy can defeat deflation, the central bank has inadvertently been reinforcing the psychology that makes deflation harder to root out.
Fortunately, winds of change seem finally to be blowing at the BoJ. The biggest shift is the new leadership at the top. Signaling their commitment to fundamental reform, the Abe administration just nominated Haruhiko Kuroda to be governor of the BoJ, and Kikuo Iwata to be deputy governor. Both men have strongly advocated that the central bank pursue much more aggressive reflationary policies. Along those lines, the BoJ should first and foremost take ownership of the inflation process – publicly stress that it has the ability and willingness to end deflation and achieve the new 2% inflation target. Policymakers need to back that up with prompt, aggressive actions, including large and open-ended asset purchases to begin immediately, and preferably to be targeted toward the longer-end of the maturity spectrum and even branching beyond government bonds to private securities and foreign currency government bonds. The specifics are probably less important than the commitment to do “whatever it takes,” and to stay the course. Too often in the past, BoJ policymakers have taken tentative steps toward more forceful easing but then failed to follow through, undermining their credibility and ultimately making it harder to achieve their goals. The new leadership must break this vicious cycle.
Assuming they do, the question turns to efficacy: will it work? In principle, it should. Deflation ought to be correctable by concerted central bank action. When a central bank wants to generate inflation, it should be able to do so. After all, there is little practical limit to how large the BoJ can make its balance sheet, and how many yen it can effectively create. By buying bonds, the BoJ should help lower nominal interest rates, support risk assets, weaken the yen, and generally ease financial conditions. And if the whole package succeeds in boosting inflation expectations – i.e., if the BoJ’s 2% inflation target is credibly believed – that alone will help end deflation, not least by purging it out of people’s wage considerations, price decisions, and investment planning. Moreover, expectations of rising prices will help push down the real cost of borrowing (provided that BoJ bond purchases help restrain nominal rates), and this should foster more consumption and investment spending today, while also easing real debt burdens. Expectations of inflation might also encourage people to spend a bit more now, before prices rise later.
It all sounds fine in theory; but in practice it may prove more difficult. Japan has been stuck in deflation for so long that expectations of falling prices have become deeply embedded in all aspects of economic life – indeed, in the Japanese psyche. They may take time to overturn. Still, that just means the BoJ has to push harder for longer. In some ways, Japan could be an interesting test case of how difficult it is for a determined central bank to reverse a deflationary psychology. But if the BoJ has the will, there should be a way — not only to break deflation, but also to help support a cyclical recovery in the economy. Ending deflation might even boost trend growth a bit, though the kinds of structural reforms really needed on this front are largely beyond the purview of a central bank.
The leaders of Japan’s new government are pushing hard for fundamental reform. And the early indications, especially at the BoJ, are encouraging. It won’t be easy, though; Japan still faces formidable challenges that make a return to the pre-bubble glory days virtually impossible. And it will take time and perseverance by the central bank to end an entrenched deflation. But for the first time in years, there is a ray of hope in Japan.
Chief Global Economist
Deutsche Asset & Wealth Management