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Three Broken Arrows

The Future of Abenomics After Re-election
Uwe Bott

December 14, 2014

When Shinzō Abe took over as Prime Minister of Japan following the general elections of December 2012, he promised to reinvigorate the Japanese economy which had been stuck in a rut for over two decades. He described his policy as having "three arrows": Structural reform, fiscal stimulus and monetary easing.

Two years later and in spite of Mr. Abe's landslide victory in snap elections today, his policies and their effects cruelly bring to mind the movie Groundhog Day. Mr. Abe might very well ask himself the question Bill Murray's movie character, Phil, did: "What, if there is no tomorrow? There wasn't one today".

Japan's situation is so desperate and all efforts to reform the economy seem so pointless because Japan has the worst demographics in the world. For example, fixing the "supply" side of the economy through structural reform may have little consequence in a country with chronically low demand. After all, the fastest growing age cohort are centenarians and over one-tenth of private homes are unoccupied, primarily because of ageing. The four graphs below from the U.S. Census Bureau show the dramatic differences in population pyramids between Japan and the United States in 2014 and projected for 2050.

Japan1.jpg            Japan2.jpg

Japan3.jpg           Japan4.jpg

That being said, structural reforms are desperately needed. Protectionism reigns in Japan, both in the industrial and agricultural sectors. Reforming these sectors would do less to jumpstart the economy but could prepare Japan for newly arising growth opportunities. A Trans-Pacific Partnership (TPP) Agreement with the United States, if concluded, could be such opportunity.

However, there is one area where addressing structural problems on the supply side may actually boost the economy now. By far the most sclerotic structure of the Japanese economy is its labor market. Restrictions make it nearly impossible for businesses to shed regular, highly-paid workers. This has created a two-tier labor market of regular, high-paying jobs and non-regular, low-paying jobs. In June 2014, it was estimated that 37% of all jobs fell into the latter category.

This hurts the country in two ways. Older workers make the majority of those with regular, high-paying jobs. But older workers also consume less. Younger people, on the other hand, are more often employed in low-paying, non-regular jobs. And, of course, younger people have a greater propensity to spend. Yet, in Japan they do not have the necessary income to consume more. As a result, domestic consumption is and remains depressed not only because of the country's demographics but also because of the structure of the labor market.

Loosening labor restrictions could help correcting this imbalance and enhance growth potential.  Yet, little has been done in spite of Mr. Abe's promises in that regard. With each election cycle, elderly voters with entrenched interests account for a greater share of the electorate making real reforms politically all that more difficult. Mr. Abe already toned down his public enthusiasm for structural reform in the run-up to the elections.

Japan's demographics cannot be altered, especially as there is no consensus to aggressively promote immigration. But there is another structural reform that actually could change Japan's growth equation. The graph below shows that labor participation rates of women between the ages of 25 and 54 in Japan are very low compared to other advanced countries with the exception of the United States, which has much better demographics than Japan as seen above.

Japan5.jpg

Source: The Labor Force Participation Rate Since 2007: Causes and Implications, U.S. Council of Economic Advisors, July 2014

In the Global Gender Gap Report published by the World Economic Forum in October 2014, Japan ranks 104th out of 142 countries, behind Tajikistan and Armenia. In the sub-score of "Economic Participation and Opportunity" it is in 102nd place. Some 60% of women leave the labor force after birth of their first child and women account for only 6% of management in Japanese businesses.

The Japanese demographic time bomb can be defused by radically increasing female labor participation. If Japan were able to raise labor participation rates of women to the levels of France, this would have a meaningful effect on the demand side of the economy as more income means more consumption.

Prime Minister Abe should be given credit for having recognized this and set very ambitious targets for 2020. He wants 55% of women to return to the labor force after child delivery and raise the percentage of women in management to 30%.

In some sense this is where the second arrow of Mr. Abe's reform comes in: Fiscal Stimulus. But too little of that stimulus has been targeted to provide more child-care centers and provide tax incentives for businesses to hire women. Instead, an extra $116 billion of public funds was largely earmarked towards projects such as disaster prevention and recovery.

What's worse, a fatal flaw of Mr. Abe's fiscal policies was to increase the country's consumption tax from 5% to 8% in April of this year. This tax increase led to a severe contraction of the economy amounting to 7.3% in the second quarter of 2014 and 1.6% in the third, ushering Japan back into recession again.

Just as Phil had a hard time suppressing his flaws in wooing his romantic interest, Japan has made the same fiscal-policy mistake before. After the stock market crash in 1990, the Japanese economy grew at a very modest 1.5% per annum between 1991 and 1997 because of somewhat accommodating fiscal and monetary policies. In spite of the economy's fragility, then-Prime Minister Ryutora Hashimoto decided to increase the country's consumption tax from 3% to 5% in April 1997. Then as now, this sucked the life out of the Japanese economy. It contracted by over 5% in the first quarter of 1998 and by over 3% in the second.

Undoubtedly, Japan's fiscal position and its debt burden are much worse today than in 1997. Public sector debt stands at 230% of GDP, by far the highest ratio among OECD countries.  And yet, increases in consumption taxes were the last thing the country needed at this point.

Faced with another recession and snap elections, Mr. Abe already announced that the next consumption tax increase, which was to take effect in October 2015, will be postponed until April 2017. In addition, there is word about more fiscal stimulus, including cash handouts.  

In the unforgettable words of the late U.S. baseball legend Yogi Berra, this too is "déjà vu all over again". Cash handouts have been tried before, in 1999 and 2009. Government-issued vouchers for taxpayers' consumption have no lasting effect on Japanese growth.  Money is fungible. At worst, taxpayers will use the vouchers to meet their recurring consumption needs and save their earned income without any impact on economic growth. At best, vouchers will jumpstart consumption for a quarter or two only to see it collapse, once they are withdrawn by the government.

Finally, the effectiveness of fiscal stimulus faces another unique challenge in Japan. Most countries, which apply Keynesian stimulus, are most successful if they invest public funds in their physical infrastructures. The massive Interstate Highway Program, designed under U.S. President Dwight Eisenhower in the 1950s, had a huge impact on U.S. economic growth and productivity for decades.

But Japan probably has the most advanced - and some will say gold-plated - public infrastructure in the world. After all, it has administered many programs of fiscal stimulus over the last 25 years in an effort to resuscitate the economy. These efforts failed to sustainably lift economic growth then because structural reform was lacking and monetary policy was not aggressive enough.

That takes us to Prime Minister Abe's third and final arrow: Monetary Easing. The Bank of Japan (BoJ) was very reluctant for much of the post-1990 period to use less orthodox tools of monetary policy. It stubbornly insisted that near-zero interest rates was all that it could do.

In contrast, the U.S. Federal Reserve responded quickly to the Great Recession of 2008 quadrupling its balance sheet. This aggressive quantitative easing is arguably the reason for the fact that the U.S. avoided the deflationary trap, returned to growth faster than any other advanced country and has more than recaptured the losses in real wealth of private households.  Japan's major stock index, on the other hand, never came even remotely close to its peak of December 1989 and currently stands at less than half its value of 25 years ago. Permanent negative real wealth effects like in Japan permanently depress domestic demand.

Under Prime Minister Abe, a new BoJ Governor, Haruhiko Kuroda, was installed.  He quickly pursued a policy dubbed qualitative and quantitative easing (QQE1). After the country fell back into recession in 2014, the BoJ launched a new version of the program named QQE2 on October 31, 2014. As a result of monetary expansion, the BoJ's balance sheet has more than doubled.

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The BoJ has set an inflation target of 2% but it has a hard time reaching that target, partly because deflationary expectations are deeply entrenched in Japan after 25 years. External factors have also played a role recently, especially steeply falling global commodity and energy prices.

It is also untested, whether aggressive quantitative easing when applied after such a long deflationary period can be as effective as the proactive actions of the U.S. Federal Reserve were. As a consequence, consensus over monetary policy in Japan is eroding. While all nine members of the Policy Board of the BoJ voted in favor of QQE1 in early 2013, the decision on QQE2 on October 31 was passed by a vote of 5:4.

Hence, Mr. Abe will enter his next term as Prime Minister with three broken arrows. Structural reform has been lackluster and failed so far to aggressively target structures that can offset the inescapable demographics. Fiscal stimulus has gone astray because of the contractionary effects of the consumption tax increase and monetary easing is struggling to meet its objective of reining in deflation, while losing internal support.

All that notwithstanding, Mr. Abe has no chance but to dust himself off after his electoral victory. He will need a new set of sharp arrows.  Maybe even more than one new set. To be sure, after trying again and again fighting against all odds, Phil did "get the girl" in Groundhog Day and there was a "tomorrow" after all. Enter content here

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