Lesson for Europe: Mr.Abe´s Gamble

26.05.18 Publication:

All politicians need luck, especially in their early months in office. So the lucky star has certainly shone on Japan’s new prime minister, Shinzo Abe. Even he could not have expected that immediately after he introduced a dramatic change in economic policy—known in Japan universally as “Abenomics”—his country would show the fastest growth of all the rich countries, of 0.9% in the first three months of 2013 or 3.5% if expressed at an annual rate. Yet note this: if Japan had been a member of the euro-zone his recipe of Abenomics would be enough to have had Japan thrown out or at least reprimanded. So he is lucky that it isn’t.

There is an apt saying that is often heard both in economics and in financial markets: “if something looks too good to be true, then it is usually false”. That is partly appropriate for Abenomics and this seemingly miraculous, convention-defying Japanese growth. It is really too soon to give credit for the growth to Mr Abe’s new policies. Japanese quarterly GDP figures have often been confusingly volatile, compared with those in Europe and the US. Yet there are good reasons to be optimistic, and for Europe to learn some lessons from Japan.

Mr Abe’s Liberal Democratic Party won its landslide majority in Japan’s general election just on December 16th, barely two weeks before the first quarter of 2013 began. Only a true magician could make a difference that quickly. No economic levers—fiscal, monetary or regulatory—can have an effect so rapidly. The real test of Abenomics, which consists of a small fiscal stimulus, a massive monetary expansion, and a promise of liberalizing reforms in the economy, will come in the second half of 2013 and especially during 2014.

Even so, it is already clear that Mr Abe’s policies have changed the atmosphere in Japan from pessimism to optimism, from despair and disillusionment to hope. The latest statistics, combined with a boom in the Tokyo stockmarket, will add to that positive feeling. And optimism can have a real economic effect, if it translates into companies deciding to spend more of the cash they have been hoarding on new offices, factories, equipment and employees, and if households decide also to save less from their incomes and spend more.

In the latest quarter, the figures show some of that effect taking place in consumer spending, but not much in business investment. The trouble is that, like in Italy, Japanese households’ incomes have been declining in recent years and their once famously high rate of saving has plummeted. So until and unless more jobs are created and incomes actually rise, there is not much scope for consumer spending to keep on driving economic growth. The real hope has to be that business investment will revive.

This is where Japan may, as the year progresses, offer some lessons for Europe. Just as Japanese companies over the past 15 years or so have tended to reduce their debts and hoard cash, so European companies have been doing the same during the past five years. One motive—deflation, ie falling prices, which make debt burdens costlier to repay—has been present in Japan but so far absent in Europe. But the other—extreme uncertainty about the solvency of the financial system and the future course of the economy—has been shared. So is the broader problem of the government holding a huge burden of public debt.

Abenomics, the main thrust of which so far has been a change in the leadership and policies of the central bank, the Bank of Japan, towards a very aggressive programme of expanding the money supply, has already boosted exporting companies’ profits because it has led to a 20% fall in the value of the Japanese yen. The hope is that this cheaper yen will next boost their capital investment too. But the bigger hope is that by making companies confident that economic growth is reviving it will encourage domestic companies to invest more too, which would guarantee that growth would indeed revive. That will also depend on Mr Abe’s promises of liberalizing reforms being turned into reality.

The theory behind this strategy is that the real solution to Japan’s vast public debt burden has to be economic growth rather than higher taxes or cuts in public spending. The recent rapid fall in America’s federal budget deficit, thanks to quite strong US economic growth, bears this out. The Japanese plan is to use this combination of vast monetary expansion and some fiscal expansion to create a virtuous cycle of accelerating growth, rising tax revenues and falling budget deficits, just as is happening in America.

It is a big gamble. Japan’s public debt is not just large: it really is enormous, at 240% of GDP in gross terms (nearly double Italy’s) and about 140% in net terms once debts owed by one branch of government to another are taken into account. The cost of financing that debt has remained extraordinarily low even as the debt has grown, because it has been almost entirely financed domestically (90%+ of government bonds are held by Japanese) and because deflation has made bond lenders content to accept very low yields.

So the danger is that if bond markets become afraid of inflation, and afraid that the government debt could get harder to finance, so the cost of that borrowing could rise in the markets, raising borrowing costs for private companies too. That might throttle the economic recovery.

Yet it is a gamble that is surely worth taking, and it might well work. Economic growth needs to revive first, ahead of any rise in inflation, generating the rising tax revenues that would reduce Japanese government borrowing. As 2013 goes on, and as the eurozone recession gets longer, so pressure will increase in the eurozone for Europe to take a similar gamble. If Mr Abe’s luck holds, it will make it likelier that once she has been successfully re-elected in September, Chancellor Angela Merkel might think of following the Japanese model too. Next stop, Merkelomics?