Don't declare victory for Abenomics yet

With the yen's falling to below ¥100/$1 for the first time since 2009 and the Nikkei’s posting five-year highs, analysts have begun declaring victory for the Abe administration’s campaign against deflation and slow growth. Paul Krugman, the intellectual godfather of Abenomics, has not quite begun his victory dance yet, but he is optimistic that under President Kuroda Haruhiko the Bank of Japan has credibly signaled that it will continue monetary expansion until it reaches its 2% inflation target.

But it is far too early to draw conclusions about the success of Abenomics — given that deflation continues — and there remain a number of unanswered questions surrounding the Abe government’s economic program.

Ultimately, the success of an economic program must be measured not just in terms of corporate balance sheets, but also in the economic wellbeing of average citizens. If wages remain stagnant or if Japan experiences a jobless recovery, can Abenomics be declared a success? What will Abenomics mean for the Japanese worker? As a New York Times article by Hiroko Tabuchi and Graham Bowley suggests, it remains to be seen whether monetary stimulus will translate into wage hikes or higher employment — though the government is trying to encourage corporations to hire more workers and raise wages. It may also depend on whether the government is able to reverse the rise of Japan’s non-regular workforce, the short-term contract workers who enjoy few benefits, little to no job security, and virtually no opportunities for advancement. Non-regular workers comprise between a third and a half of the labor force, and as the government acknowledges, the non-regular sector constitutes a tremendous waste of human capital.

However, without a plan to overhaul the Japanese labor market, the danger exists that exhortations to raise wages will result in corporations’ raising wages for regular workers but maintaining or cutting low wages for non-regular workers, thereby deepening the inequality that exists between regular and non-regular workers. The Abe government and the LDP are not blind to this problem — last month, for example, LDP Vice President Komura Masahiko said (jp) that more had to be done to improve the status of non-regular workers and provide equal pay for equal work — but thus far it is not clear how the government plans to resolve it. (For more discussion of the problems in Japan's labor market, see here.)

The same goes for gender balance in the labor force. Noah Smith (a onetime guest blogger here) has identified how underutilized women are in the Japanese labor force, and expressed his hopes that the Abe government will act to increase female participation in the workforce. Abe has, to his credit, said the right things about gender equality.In his 19 April speech at the Japanese National Press Club (jp), Abe spoke of gender equality as not a social policy issue, but as a central piece of his growth strategy. The reality is, however, that we just don’t know what he will be able to do to change the role of women in the economy. Pretty much the only specific proposal Abe mentioned in his speech was the proposal to increase the number of women in corporate management positions, but that proposal affects a fairly small number of women. Abe is not the first politician to pledge to do something about gender inequality — for the past decade Japan has had a cabinet-level minister of state for gender equality — but we still don’t know what Abe will do to succeed where previous governments have failed.

Reforming the labor market is part of the so-called “third arrow” of the Abe program, the Abe government’s growth strategy. Once again, Abe’s rhetoric is at least encouraging — talk about public-private partnerships to move Japan from inefficient to high-value-added sectors — but until the government’s detailed plans are released in June, it is difficult to say anything conclusive about whether the Abe government will succeed at transforming Japan’s economy. It is worth noting that the Abe government is not the Koizumi government redux: whereas Koizumi talked of moving from the public sector to the private sector, in his speech last month Abe stressed the role of government in promoting growth in new sectors, industrial policy for the new century, with all the risks that come with efforts by government to pick winners. 

Abenomics (and the latest round of quantitative easing in the US) has raised fears of currency wars breaking out between Japan and its competitors. The effects of the BOJ’s stimulus program are already being felt outside of Japan. South Korea’s central bank has already moved to cut rates in light of the ongoing decline of the yen against the won, as did Australia’s central bank earlier this week. European exporters — especially Germany’s — are feeling the pain from the yen’s decline against the euro. Of course, no government will admit that a currency war is afoot, but if other governments engage in competitive devaluation with Japan the benefits to Japanese exporters from a weaker yen will be muted (if they aren’t already muted). Though the G7 finance ministers' meeting in the UK this weekend did not necessarily single out Japan for criticism, the fact that the meeting was held does suggest that Japan's policies are under close scrutiny abroad. 

There are also lingering questions about Japan’s fiscal situation. With the BOJ stepping in to buy government bonds, the Japanese government will continue to be able to borrow without having to worry about rising interest rates. But the risks of Japan’s ever-growing debt remain — and if the BOJ has in fact succeeded at convincing market actors that it is committed to raise inflation, there is the risk that it will be unable to control inflation once it has met its target, hastening the day when interest payments will rise and break the government’s budget. The government is in a race against time. It needs to trigger sustainable long-term growth that can raise tax revenue before interest rates rise. The Abe government has indicated if economic conditions are still sluggish, it will delay the consumption tax increase passed under the Noda government, thereby postponing a useful means of closing the government’s annual deficit of 10% of GDP.

Finally, the question of Japan’s demographics looms over the debate about Abenomics. Edward Hugh offers a sobering account of how demographics may forestall the Abe government’s program. Hugh basically asks whether Japan has experienced a prolonged balance-sheet recession and is in a liquidity trap, as argued by Krugman, Richard Koo, and others, or whether Japan’s persistent demand shortfall is the result of a “shrinking population trap.” Hugh is skeptical that either fiscal or monetary policy will fix Japan’s economy and that the government’s monetary policy experiment risks triggering capital flight as elderly Japanese investors seek higher returns elsewhere. Hugh’s post is lengthy and I cannot do it justice with a short summary, but it should be taken into account when deciding whether Abenomics has succeeded.

The point is that it is impossible to know whether Abenomics has succeeded until we actually see the whole program put into action. Generating inflation is, as the Abe government says, just one arrow in a comprehensive plan to rejuvenate Japan’s economy. Stock market gains and a weaker yen may be helpful indicators but they should not be mistaken for signs for change in the real economy. Similarly, promising rhetoric about reform is encouraging, but after decades during which many Japanese politicians have talked a lot about reform but failed to follow through, it seems that a “wait-and-see” attitude is still appropriate. 

Abe probably has about as favorable a political environment as a Japanese prime minister could ask for — dysfunctional opposition parties, few challengers within the LDP, and high public approval ratings — suggesting that he may well be able to follow through on his ambitious agenda. That being said, if Abe cannot reverse Japan's economic woes even with all of these factors working in his favor, I have to wonder if anyone can.

Mr. Kan's Third Way

The Third Way has, belatedly, arrived in Japan.

The style of politics popular in advanced industrial democracies during the 1990s among center-left leaders keen to reconcile their left-wing parties to the rise of neo-liberalism and the onset of austerity after the 1970s had heretofore failed to surface in Tokyo. But with the ascendancy of Kan Naoto, Third Way politics may get another lease on life in Japan.

In his maiden policy speech as prime minister on 11 June, Kan explicitly spoke of a "third way" to the reconstruction of the Japanese economy. Rejecting the first way, what he identifies as the ideology of the construction state (shared prosperity through public works), and the second way, "extreme market fundamentalism" focused on supply side reform at the expense of public welfare, Kan proposed a third way that would target the budget deficits that he says have produced ongoing stagnation and eroded confidence in the social security system. In short, he is trying to break what I've described elsewhere as an impossible trinity of deficit reduction, renewed, balanced, and low-carbon-emitting growth, and robust welfare provision.

What follows is a set of policies intended to create a "Strong Economy," "Strong Government Finances," and "Strong Social Security." 

His proposals on the first point are a reiteration of the DPJ's prevailing position on the economy: the need to balance external and domestic demand, to be realized through a combination of intra-Asian trade, tourism, Green technology, and support for families and the elderly.

On the second point, Kan alluded to the specter of Greece — an allusion that will be repeated in other times and places in the coming years — to make the case for aggressively attacking Japan's bloated national debt with efforts to cut wasteful spending and fundamental tax reform, which would undoubtedly include a consumption tax increase. Naturally he appealed to the LDP to cooperate with the government on this issue.

Finally he turned to social security, identifying a secure social security system as critical for economic growth. Effectively he argued that a shaky social security system in an aging society triggers hoarding on the part of middle-aged and senior citizens concerned about their well-being in retirement.

The similarities with the Third Way politics of Blair and Clinton are not accidental. Kan, a veteran of Japan's reformist, pragmatic left, is at once trying to unleash and humanize Japanese capitalism. He praises Koizumi's supply-side reforms for promoting the restructuring of Japanese businesses, but despairs of their impact upon Japanese society in the form of unemployment and persistent deflation.

While Kan arguably speaks more fluently about economic policy than any prime minister since Koizumi — his speech was largely free of the airy fairy rhetoric that characterized Hatoyama's pronouncements — it is difficult to see Kan's Third Way having any more success than the Anglo-American Third Way, which in retrospect seemed to do little more than promote the Casino Capitalism that produced the financial crisis that has arguably wiped out whatever gains were made to the state's role in welfare provision and plunged both countries ever deeper into debt. The point is not that Kan is foolish for trying to reconcile what appear to me at least as irreconcilable political goals: the political environment demands that the government addresses all three, not least the problems in the social security system. Instead, it seems likely that over time Kan will be forced to focus on one goal at the expense of the others — and that the privileged goal will be deficit reduction.

Even without Kan's embrace, it is likely that deficit reduction would become the government's primary goal with Greece serving as "focusing event," with Kan's government full of deficit hawks, and with the finance ministry still a potent force in policymaking. But with Kan himself having embraced the issue in strong terms, there appears to be little doubt that his government will prioritize deficit reduction above all else, to the point of the DPJ's including a pledge to increase the consumption tax in its manifesto for next month's upper house election (perhaps not a bad move politically with a Yomiuri poll showing sixty-six percent support for a consumption tax increase). Kan has also stated that within the month his government will establish 2020 as a goal for restoring the government's primary balance to surplus.

The question, however, is whether deficit reduction will lead to sustainable growth and secure social security spending. For example, I find it difficult to believe that the government will able to promote greater domestic demand, let alone sustain existing domestic demand while taxing consumption at higher levels. Deficit reduction is undoubtedly valuable in its own right, it's just difficult to see how the Kan government will be able to make good on the totality of its economic program. Can the government really cut enough waste and raise enough tax revenue to shrink its deficits while expanding programs to promote economic growth?

I think that the pursuit of deficit reduction will have implications for Japan's foreign and security policies. The first challenge, however, is figuring out exactly what has changed: Yomuiri sees a new realism in the DPJ's latest manifesto (discussed here at Twisting Flowers), but the reality is that apart from the new government's emphasis on rebuilding relations with the US and the call for defense transparency in China, the DPJ is putting in words what it has already been doing since taking power, especially in its focus on stronger bilateral ties with South Korea, Australia, and India. And really, the Hatoyama government was not nearly as soft on China — or as opposed to the US-Japan alliance — as the contemporary wisdom in Washington held.

Moreover, the Kan government's overtures to the US can be overstated: even the formulation of support for the alliance voiced in Kan's address last week was more like former LDP Prime Minister Fukuda Yasuo's, in which the alliance is viewed largely in terms of its role in providing stability in Asia, than the vision of the alliance as resting on a foundation of shared values and dedicated to the promotion of democracy in the region. Like Fukuda, Kan recognizes that stable, constructive relations with Japan's neighbors, China most of all, are essential, and that the US-Japan alliance is valuable insofar as it contributes to Japan's Asia policy aims.

But in the Kan government's unflinching support for last month's agreement on Futenma, the new government is clearly interested in bolstering the US pillar of Japan's foreign policy. What I wonder is whether the DPJ's renewed interest in the security relationship is a function of its focus on deficit reduction. As the government looks to reduce spending, DPJ officials may increasingly be coming to the realization that austerity combined with regional uncertainty means that for the foreseeable future Japan will be dependent on US deterrent power. While the new government is quietly hedging against the possibility that the US commitment to Asia might weaken through its focus on bilateral cooperation with regional powers and its growing acceptance of the need to loosen restrictions on arms exports (which would lower the cost of bolstering Japanese's own conventional capabilities), the DPJ clearly accepts that for the foreseeable future it will be necessary to maintain a constructive security partnership with the US, even if the party continues to hope for an "equal" partnership.

It is open to debate whether austerity is leading the Kan government into a more enthusiastic embrace of the US (or even whether the embrace is more or less enthusiastic than the Hatoyama government's or any LDP government's for that matter). The DPJ may simply be free or cheap riding irrespective of concerns about austerity in the future. Or it may sincerely believe that the status quo is more or less the best option for Japan when it comes to coping with the rise of China.

However, I think the proposal to relax the three arms-exporting principles is a sign that the DPJ is sensitive to the costs of defending Japan and, therefore, that while the alliance may provide the most cost-effective means of national defense (provided measures are introduced to lessen the domestic political costs of US bases on Japanese soil), the government should look for ways to reduce the costs of Japan's providing its own defense in due time.

In short, at home and abroad the DPJ is performing balancing acts, pursuing multiple and at times conflicting goals that require flexibility on the part of the government — precisely the reason why Ozawa and other politicians have called for a stronger Westminster-style executive over the past two decades. Whether the government will be up to these challenges even with reform remains to be seen.

Two crises

In the comments section of this recent post, I have been accused of overstating Japanese decline and understating the US decline.

I have actually said very little about the economic crisis in the US — and what I have said about Japan is not particularly new. For the most part I have simply updated an argument that I have made since the early days of this blog to take new circumstances into account: Japan is in the midst of systemic, secular decline, akin to the bakumatsu, the end of the Tokugawa shogunate in the mid-nineteenth century. I am far from alone in making this argument; Ozawa Ichiro himself is fond of making it, with the implication that he and the DPJ will be the instrument of Japan's restoration. (Among foreign observers, Michael Zielenziger has made a similar argument.) Japan's decline long predates the current financial crisis. It arguably goes back to the bursting of the bubble and the onset of the "lost decade." The decline has institutional causes, demographic causes, and leadership causes, but these factors all add up to an unmistakable and precipitous drop in the state of the Japanese economy, the post-2001 "boom" notwithstanding.

The current crisis has served merely to illustrate just how fragile the post-2001 "recovery" was and just how little the Japanese economy has changed. As an article in this week's Economist notes, "In the long run, what Japan needs is as clear as it has always been: less dependence on export-led manufacturers, more productive and internationally minded service companies, and a more flexible workforce that welcomes women, older workers and immigrants...For the time being, where the world economy goes, so goes Japan." The Koizumi revolution was still-born. Structural reform was left incomplete before Mr. Koizumi departed. Even worse, Mr. Koizumi failed to destroy the old LDP. He dealt it what may ultimately prove to be a mortal blow, but in the short term he gave the party enough of a boost to ensure that a largely unchanged LDP would continue to hold power during this critical period. But not only did Mr. Koizumi serve to prolong the life of the LDP, he also dealt the DPJ a serious blow. Not only did he steal the opposition party's better ideas, but he also served to draw reformist candidates to the LDP. With Mr. Koizumi as party leader running as an LDP candidate was palpable for young, idealistic reformers. By doing so, Mr. Koizumi deprived the DPJ of candidates who would naturally belong to the DPJ's reform wing. The DPJ's leadership crisis can at least partially be laid at the feet of Mr. Koizumi. The young reformers — now orphaned in the LDP by Mr. Koizumi — may yet leave, but I think that when we assess the impact of Mr. Koizumi's tenure, we must consider this line of reasoning as one of the negative consequences. As a result, Japan now has a ruling party which in the three years since the last general election has turned its back on structural reform (and paying down the debt) and an opposition party that is not nearly as reformist as it could be.

Is it really necessary to spell out again the crisis facing Japan today? The dying regions? The bleak demographic outlook? The national debt? It is hard to overstate the impact of Japan's national debt problem. According to this list, Japan ranks third in the world in debt/GDP ratio at 170%, behind Zimbabwe and Lebanon. The next highest G8 country is Italy, in seventh place at 104%. The numbers will change somewhat in light of various stimulus packages in response to the crisis, but in Japan's case it will only get worse. Granted, the US has a major debt problem of its own, which barring drastic action in the coming years will only worsen. But the US has one important advantage that Japan doesn't have: the dollar remains the world's reserve currency. Despite the crisis, governments and investors are still willing to hold US dollars. This doesn't mean that the US can avoid adjustment (more on this momentarily), but it does give the US government more room for maneuver. Japan's situation is not hopeless — as an anonymous commentator to my earlier post notes (scroll to the bottom), Japan's debt/GDP ratio includes prefectural debt and most of it is held domestically, which gives the government a cushion that the US government may not necessary have.

The consequences of Japan's debt are clear. The government is trapped. How will it revive economic growth, foot the bill for a greater portion of welfare provisions (effectively building a welfare state), and cut its debt to more sustainable levels so that it will be able to do more for its retiring baby boomers? Japan is not alone in this dilemma, but it is feeling the pain particularly acutely.

What about the US?

First, let me say that US elites have been no less incompetent (ideological, short-sighted, arrogant, etc.) than their Japanese counterparts. The biggest difference is that Japanese elites have had years to correct their mistakes. Say what you will about President-elect Obama, but at least American voters had the good sense not to reward the Republican Party with another presidential term. I've seen few signs that the Democratic Party is any better equipped to deal with the crisis, but at least the Republican Party has been sentenced to some time in the wilderness, which one hopes it will use productively.

I have no doubt that this crisis is dire, and that the US has yet to hit bottom. There is still the risk that the recession will become a depression. It is still unclear whether the banking crisis has passed. The Paulson Treasury appears to have mishandled the bailout package.

And then there are the structural problems. To say that America has been living beyond its means is a gross understatement — America has been living as if the very idea of limits didn't exist. No limits to energy consumption. No limits to the US government's ability — by means of its unrivaled military — to reshape the world and provide extended security for the American people. At the same time, the US has neglected its infrastructure, its health care and pensions systems, and, most important for future growth, its education system. Above and beyond these serious problems, Americans and their government have acted as if there were no limit in the rest of the world's demand for US debt.

Americans are now learning the meaning of limits. The question, as Paul Krugman notes, is what the post-crisis economy will look like. He looks at the balance of consumer spending, nonresidential investment, residential investment, government purchases, and net exports and concludes that a smaller trade deficit should step in for lower consumper spending, which means that the US may become more dependent on exports than it has been in the past. Meanwhile, as Niall Ferguson argued in Monday's Washington Post, central to this transformation will be the US relationship with China, a relationship Ferguson describes with the unfortunate word "Chimerica."

"In essence," Ferguson argues, "we need the Chinese to be supportive of U.S. monetary easing and fiscal stimulus by doing more of the same themselves. There needs to be agreement on a gradual reduction of the Chimerican imbalance via increased U.S. exports and increased Chinese imports. The alternative — a sudden reduction of the imbalance via lower U.S. imports and lower Chinese exports — would be horrible.

"There also needs to be an agreement to avoid a rout in the dollar market and the bond market, which is what will happen if the Chinese stop buying U.S. government bonds, the amount of which is now set to increase massively."

The very word Chimerica undoubtedly keeps Japanese officials awake at night, as it captures what has long been the worst nightmare of many Japanese elites: ever closer cooperation between Washington and Beijing. The thought of the economic crisis bringing the US and China closer together, perhaps under the watch of Secretary of State Hillary Clinton, is surely causing a spike in the blood pressure of certain Japanese. (That said, Ferguson does not mention that Japan holds more US treasuries than China, meaning that surely US-Japan bilateral negotiations are no less necessary thank US-China negotiations.) (Correction: As of September, China became the largest holder of US treasuries.)

The adjustment will undoubtedly be painful, particularly for my generation — the so-called millennial generation — which has known only good times (indeed, perhaps the most prosperous period in human history). But America still has, to use Aso Taro's favorite phrase, "latent power," starting with comparably favorable demographics. Interdependence also works in America's favor, as it may have plenty of help from other governments in shifting to a more sustainable footing. The rest of the world still catches America's flu.

Ultimately it is foolish to argue that one country's problems are worse than another's. The developed countries have their collective back to the wall, and not for the first time does the world run the risk of watching an age of unprecedented prosperity collapse into an "era of fear." (It is worth revisiting a Tony Judt essay to which I linked nearly a year ago.) Japan's and America's problems are both severe, but different. For the past two decades, Japan has fallen from a great height, and barring adjustments, it may have further to fall. The US may yet experience a similar decline.

Finally, I must repeat what I said in the comments to the earlier post: I do not celebrate Japan's decline. I lament it, and wish its leaders had done more sooner — and failing that, I wish that they be held responsible for their failures. I don't believe that Mr. Aso is wrong to believe in Japan's latent power, and hope that the government finds a way to release the energy of the Japanese people.