In-depth Abenomics: A Midterm Evaluation
How Can Trend Growth Be Revived?

Kōno Ryūtarō [Profile]

[2015.02.17] Read in: 日本語 | FRANÇAIS | Русский |

Raising Japan’s trend growth rate will require the steady implementation of growth strategies, the third arrow in the Abenomics quiver. But policies touted as growth strategies often serve only to protect established businesses, obstructing the entrance of innovative rivals and actually impairing trend growth. The main shortcoming of Abenomics is the shelving of social welfare reform. If welfare costs continue to accelerate, capital formation will stagnate and trend growth could turn negative.

As Japan’s trend (potential) growth rate declined, the economy’s high performance in fiscal 2013 reduced slack, meaning that growth strategies are needed now more than ever. According to my analysis, the trend growth rate has recently declined close to zero—or, to be precise, to around 0.3% from fiscal 2010 to 2012. The economy’s robust 2.1% expansion in fiscal 2013 was largely due to the Abe Shinzō administration’s aggressive fiscal spending, exceeding 2% of GDP, and the front-loading of demand before the April 2014 consumption tax hike.

With the economic growth rate almost eight times that of the trend growth rate, Japan saw rapid reductions in idle capacity, surplus labor, and other slack in the economy, with the result that corporations began complaining about labor and production capacity shortages in spring 2014. While aggregate demand has certainly been deficient over the past 20 years, the concurrent decline in the trend growth rate lowered the economy’s supply capacity. Now full employment is fast approaching. The reason that real exports remain lackluster currently, despite the substantial depreciation of the yen in real terms, is, in fact, due more to supply constraints than to softness in the global economy.

Of the three arrows in the Abenomics quiver, the one exhibiting the greatest impact right now is the second arrow of fiscal policy. Of course, the first arrow of aggressive monetary easing is also having an effect by neutralizing the upward pressure on interest rates from Abe’s aggressive fiscal spending. The main driver of growth, though, has been fiscal policy, with monetary easing playing an accessory role. But fiscal stimulus, which essentially only brings forward future income for immediate consumption, does not create new value added.

What this means is that even if fiscal stimulus continues, there will be no improvement in trend growth—only the amassing of public debt that increases the probability of fiscal collapse. The key to reviving trend growth is found in the third arrow of growth strategies alone. With the effects of the first two arrows of discretionary macrostabilization steadily fading as full employment approaches, the third arrow of growth strategies is becoming more important than ever.

Fiscal Restraint Would Foster Private Sector Investment

Manpower shortages have become a serious problem not only for the construction sector but also for other labor-intensive industries, such as retailing and restaurants. Labor bottlenecks in construction are impeding private spending in that sector, and the inability to secure personnel is compelling some big retailers to cut back on capital spending. Normally, when the government ramps up fiscal spending, market interest rates rise and start constraining, or crowding out, private-sector investment. But in Japan these days, the Bank of Japan’s aggressive buying of long-term Japanese Government Bonds has suppressed the long-term interest rate, with the result that crowding out has appeared first in the labor market, reflecting the squeeze put on manpower by Abe’s aggressive public investment. Given this situation, a shift toward more conservative fiscal policy could actually foster private investment. In other words, in the current environment, where the slack has largely disappeared, fiscal restraint could work as a growth strategy.

Trend growth is floundering in part due to the decline in the working-age population. But another reason is that domestic capital stock has stopped growing due to a fall in net domestic investment since fiscal 2009. Japan is no longer undertaking sufficient domestic investment to cover the depreciation of capital. Although capital investment increased in fiscal 2013, and will likely grow in both fiscal 2014 and fiscal 2015, the gains will probably only be enough to arrest the decline in net capital stock. The government hopes to elevate trend growth to 2%; but it would be unwise to have high hopes about growth strategies quickly delivering big results, given the fact that both net capital stock and the working-age population continue to drop. In any event, it will require a considerable amount of time for growth strategies to bear fruit.

Some argue that Japan needs to stimulate capital investment by steering real interest rates lower. But fostering investments that would only materialize due to negative real interest rates would be counterproductive, reinforcing Japan’s sluggish return on capital or natural rate of interest. Reviving the return on capital should be the aim of all growth strategies, as this will lead to higher total factor productivity growth and facilitate profitable capital formation, thereby resulting in enhanced trend growth.

Needed: Promarket, Not Probusiness, Policies

So what policies are appropriate (or inappropriate) for growth strategies? It goes without saying that the “royal road” of growth strategies is deregulation. Deregulation to foster free enterprise will facilitate the private sector innovation and creativity needed to bolster productivity growth. The problem is that all too often policies that are touted as growth strategies actually only serve the interests of established businesses. Owing to the antibusiness tilt of the previous Democratic Party of Japan–led governments, the probusiness stance taken by the Abe regime is widely welcomed. But policies that benefit established businesses can actually hurt trend growth by raising barriers to block innovative rivals from entering the market. What Japan needs are promarket policies that open markets to newcomers rather than probusiness policies that protect the status quo. One reason Japan’s TFP growth has been slow to revive is that government intervention in the private sector has continued to expand on the pretext of countering economic sluggishness.

It is also a big mistake to perpetuate export-based growth strategies. I suspect that the prime minister still adheres to the old mercantilist mindset that sees currency depreciation to boost real exports as the key to economic growth. But with the collapse of the Bretton Woods system in the early 1970s, export-based growth strategies are no longer effective. In fact, such policies are harmful to Japan’s trend growth, as they lock labor and other economic resources into the manufacturing sector, thereby preventing resources from shifting to nonmanufacturers and depriving potential growth sectors of the resources they need. And manufacturers, the beneficiaries of these policies, find themselves saddled with excessive payrolls and excessive capital stock that suppress profitability. In the mid-2000s, dramatic yen depreciation stoked real export growth and strengthened domestic production capacity. As is evident from the subsequent plight of the consumer electronics industry, though, the nation only ended up with a huge glut of unprofitable capital stock.

Behind Japan’s Deteriorating Terms of Trade

Japan’s approach to exports needs to be reconsidered. In the mid-2000s, Japan’s real gross domestic income, calculated by adding trading gains to real gross domestic product, did not improve commensurate with export-driven real GDP growth, as soaring commodity prices, led by crude oil, and the impact of yen depreciation caused the country’s terms of trade to sharply deteriorate. Germany, on the other hand, did not experience this deterioration in its terms of trade, as the strong euro neutralized part of the commodity price rise and higher import prices were passed through to export prices. Germany’s industrial structure has shifted to the production of high-end goods, which have easy cost pass-through. To avoid deteriorating terms of trade, Japan also needs to shift to manufacturing high-end products that command higher prices, and to achieve this, it needs to boost productivity growth. This means that Japanese manufacturers, with their relatively high wages, must give up trying to compete head-to-head with same-segment producers in emerging economies.

A further question is why real wages have remained stagnant since the 1990s. Real wages can be broadly separated into labor productivity growth, the terms of trade, and labor’s share. In the 1990s, the main culprit for lackluster real wages was the sharp decline in productivity. Since the 2000s, the main cause has been deteriorating terms of trade and the decline in labor’s share. So long as productivity growth remains weak, Japan will be unable to create high-end, higher-priced products, and improvement in real wages will also be impossible. Depending on currency depreciation to make real exports competitive is tantamount to boosting exports by relying on inexpensive, nonregular labor. If things continue as they are, nominal wages will revive with the end of deflation, but real wages will remain stagnant because of the lack of improvement of productivity growth. Because full employment is drawing ever nearer, a weak yen has less merit. Consequently, we need to give up the old export-based growth strategies that relied on currency depreciation and shift to a supply structure where the merits of a strong yen can be enjoyed. This would be an effective growth strategy.

The Main Shortcoming of Abenomics

Before closing, I would like to touch on the biggest shortcoming of Abenomics. Namely, by touting the undeniable need to defeat deflation and restore economic vitality, Abenomics has effectively sidelined other more pressing problems from public debate. Those problems are Japan’s ballooning public debt and the insolvent social welfare systems fueling it. Created during the era of high growth, Japan’s lavish social welfare systems became unsustainable in the 1990s, when elderly recipients started increasing in number, while the productive population on the paying end steadily shrank. To keep the systems afloat, the government has to pump in public money, which, given the sluggishness of tax revenue, means these systems operate on the premise of chronic budget deficits. The government is slated to implement the second phase of the consumption tax hike in April 2017, raising it to 10%. Even so, the tax coffers will still fall short of the soaring cost of social welfare. According to my simulations, if nothing is done to rein in social welfare costs, even raising the consumption tax to the 25% level will not produce a sustainable surplus in the primary balance. The only solution is to stop social welfare costs from accelerating.

From the perspective of growth strategies, stopping the acceleration of social welfare costs is, in fact, extremely important. This is not only because tax hikes to secure revenue for social welfare will distort the allocation of resources. Another cause is that net national savings have declined to zero since 2009 because the government’s saving position (figure 2), a result of accelerating social welfare costs, completely uses up net private savings, leaving nothing for capital formation. If nothing is done to stop social welfare costs from escalating, net national savings will turn negative, even if taxes are raised to cover social welfare. While continued tax hikes might stop the debt from expanding for the time being, it would only transfer net private savings to the government’s (dis)savings, leaving net domestic savings to continue trending lower into negative territory. If so, trend growth will eventually fall below zero on the widespread reduction of capital stock. Arresting the growth of social welfare costs will help to stop trend growth from decelerating.

What reforms can quickly be implemented to rein in social welfare costs? The minimum reforms needed with respect to the pension system include raising the pensionable age to 70, fully applying the macro-indexing slide (currently suspended because of deflation), and ending the preferential tax treatment that pension income enjoys. With regard to healthcare and nursing care, there is a need to increase out-of-pocket expenses, particularly for noncritical medical services. (When users mistakenly assume the actual costs are low, the result is excessive demand.) Given the advanced level of medical treatment, it is hard for public health insurance to cover all illnesses, so some services should be provided by private-sector insurance. This could also be part of a growth strategy.

(Originally written in Japanese based on a July 2014 speech given by the author at the National Bureau of Economic Research and published on November 7, 2014. Banner photo: Elderly and other patients wait for calculation of medical expenses in a hospital waiting room. © Jiji.)

  • [2015.02.17]

Head of economic research and chief economist at BNP Paribas Japan. Born in 1964. Graduated from Yokohama National University with a degree in economics. Before taking his current position in 2000, worked for companies including Sumitomo Bank (now Sumitomo Mitsui Banking Corporation), Daiwa International Capital Management (now Daiwa SB Investments), and Dai-ichi Life Research Institute. Coauthor of Tettei bunseki: Abenomikusu (A Thorough Analysis of Abenomics). Other works include Enyasu saisei: Seichō e no michisuji (Renewed Yen Depreciation: A Pathway to Growth).

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