Author: Takatoshi Ito, University of Tokyo
Abenomics is Japanese Prime Minister Abe’s policy package consisting of three ‘arrows’: aggressive monetary easing, flexible fiscal policy, and growth strategies. Together, they are aimed at lifting Japan’s economy from chronic deflation and stagnation to a normal economy with 2 per cent inflation and strong growth. But will they succeed?
Abe’s first arrow hit on target. The Bank of Japan announced bold “quantitative and qualitative easing” measures on 4 April, doubling both the volume of long-term bond purchases per month and the average maturity of government bonds. Between the Diet’s dissolution, from 15 November 2012 to mid-April 2013, the yen depreciated against the US dollar by 20 per cent, and stock prices rose by 50 per cent. Consumption was boosted in the first and second quarters, and the profits of exporting firms improved dramatically, boosting share prices. In short, the first arrow is working beautifully.
The second arrow, released as the supplementary budget of the last fiscal year, increased government spending (mostly on infrastructure). Targeting the second quarter of this year, it is intended to be a short-term stimulus. Japan’s debt-to-GDP ratio, exceeding 200 per cent, is the worst among the OECD countries, with annual fiscal deficits of about 8 per cent over the last three years. So, the short-term stimulus has to be followed by a medium-term fiscal consolidation. Fortunately, a plan is in place, with the major parties having agreed to and passed legislation (in August 2012) raising the consumption tax rate from 5 to 8 per cent in April 2014, and then to 10 per cent in October 2015.
Thanks to the first and second arrows, the economy is firmly on the recovery path and ready for the third arrow: growth strategy.
But just as the third arrow is ready for release, Abe’s commitment to the already legislated consumption tax hike seems to be wavering. His personal economic advisers became opposed to the scheduled consumption tax hike. They argue that the deflationary economy is not strong enough to withstand the scheduled hike, favouring either a one-year delay in its implementation or a smoother implementation through 1 percentage-point increases each year for five years.
But the argument that the scheduled hike risks deflation and stagnation is not well supported by the data.The annualised quarterly growth rates of the first and second quarter this year were 4.1 per cent and 3.8 per cent, respectively (according to the revised estimates released on 9 September). Examining the contributing components, many analysts consider that growth will continue for at least several quarters. Given Japan’s potential growth rate is now estimated to be between 0.5–1 per cent, due to the declining working-age population, recent growth definitely shows a strong recovery.
It is unlikely that the tax hike will derail the economy from the expansionary path, barring an unexpected shock. Opponents argue that a tax rate hike necessarily causes a drop in consumption and broader aggregate demand, but this will be temporary. One aspect that is often ignored is that consumption drop post-rate hike follows a rush-to-buy demand pre-rate hike. If the 3 percentage-point hike is implemented as scheduled in April 2014, surge and decline between first- and second-quarter GDP can be smoothed by shifting outlays of government expenditure and/or the use of pinpoint subsidies for housing investment for the second quarter.
Opponents also often invoke the ‘lesson of 1997’ to challenge the view of temporary demand decline after the rate hike, reminding that the consumption tax increase in April 1997 from 3 to 5 per cent was followed by a large GDP drop in 1998. But this argument gives inadequate weight to the role of financial crises. The Asian financial crisis drastically depressed demand in Asia in the second half of 1997 and the first half of 1998. In November 1997, two large Japanese financial institutions, Hokkaido Takushoku Bank and Yamaichi Securities, as well as a mid-sized securities firm, failed rather suddenly despite earlier assurance by the finance minister that no big bank would fail. In 1998, two more large banks failed. The ‘Japan premium’ rose sharply, and the surviving banks were basically shut out from international financial markets. These events were Japan’s equivalent to the Lehman Brothers failure, and certainly not the result of a 2 per cent consumption tax increase in April 1997.
Apparent delay and indecision by Abe now risks losing critical reform momentum. A majority of market participants think that the scheduled tax hike will occur (a recent survey by the Abe cabinet also revealed that the overwhelming majority of business executives supported the scheduled tax hike), and reversal will send a strong negative shock to the financial markets in Tokyo. Foreign investors may see a retreat of Abenomics and unwind their positions, most likely causing yen appreciation and stock price decreases, basically wrecking the first arrow.
There are also major political problems associated with counter-proposals to implement 1 per cent increases over five years. A new law will need to be passed, and if it falls down a fiscal crisis in the form of sharp increases in the long-bond yield will be likely down the track. Forecasting such a risk, foreign investors will retreat. But even if new legislation eventually passes the Diet, the effort would be at the expense of realising the third arrow at next the Diet session.
The next 12 months will be crucial to Prime Minister Abe’s implementation of the growth strategy and the overall success of Abenomics. The clock is ticking and political capital is scarce. The time to release the third arrow is now. Coupled with this should be long-needed regulatory reform affecting agriculture, health care, education, foreign workers and energy, to incentivise market participants and lower production costs without lowering product and service quality.
Strong growth in the Japanese economy after two decades of stagnation will have positive spillover effects throughout East Asia. Economists, market participants, consumers and businesses are all waiting for an early end to the consumption tax debate and a swift release of Abe’s third arrow.
The decision that Tokyo will host the Olympic games in 2020 is very much welcomed. The Japanese might well remember that Australia introduced a 10 per cent GST (consumption tax) just several weeks prior to the Sydney Olympic Games of 2000. Japan may be able to further raise the consumption tax and finally solve the debt sustainability problem by 2020.
Takatoshi Ito is Professor of Economics and Dean of the Graduate School of Public Policy, University of Tokyo.