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Assessing Abenomics as Formerly Japan-Specific Issues Spread to Other Developed Economies

Akinari Horii [Profile]


While acknowledging the partial success of Abenomics, former Bank of Japan Assistant Governor Akinari Horii warns of the possible dangers of BOJ debt monetization. Financial uncertainty in Japan could also have wider global ramifications.

Secular stagnation, the threat of deflation, public debt overhang . . . A number of the world’s developed economies are facing these challenges nine years after the global financial crisis broke out in European money markets in summer 2007. They are well known, though, to many Japanese, whose economy has faced them over roughly a quarter-century now, a period often referred to as “Japan’s lost decades.”

In the past Japan’s economic malaise was considered to be unique. Some pundits attributed it to Japan’s aging and declining population and others to its egalitarian society, which “hammers down the stake that sticks out,” thereby penalizing innovation. Now that the economic malaise appears not so unique to Japan, however, it is worth revisiting what went wrong during the lost decades and examining what Japan is now trying to do under the name of Abenomics in order to end the malaise.

Japan’s Lost Decades

Huge bubbles burst in the Japanese real-estate and equity markets in 1990, ushering in the lost decades, when economic growth was lackluster at best and negative at times. Deflation emerged in the late 1990s amid a series of bankruptcies of large financial companies, and in the 2000s a deflationary equilibrium was established in Japan’s economy. Under mild deflation, real interest rates were kept high, putting upward pressure on the yen. In these circumstances savings in cash, bank deposits, and government bonds were encouraged while equity, real estate, and other riskier investments discouraged. As a consequence, risk-asset prices were depressed while bond prices rose; leverage remained low in the private sector, while government financing was so easy in nominal terms that Japan accumulated the world’s highest level of government debt.

During the lost decades, expansionary monetary and fiscal policy was tried on a number of occasions, but failed to engineer growth robust and lasting enough to halt deflation. In the 1990s, or the first decade after the bubbles burst, the Japanese banking system was full of nonperforming assets whose value had plummeted with the collapse of real-estate and equity prices. Banks were then busy deleveraging their positions, thus limiting the multiplier effects of monetary easing and fiscal stimulus. Because the government preferred quicker expansionary effects on economic growth, the focus was on things like new roads where few cars were running and new ports where there were few ships to harbor, rather than on productive infrastructure in congested areas where residents had to be persuaded to leave through time-consuming negotiations. Cynically speaking, Japan was obviously not as efficient as China in this regard.

During this period, structural policy was applied to the labor market with the view to increasing wage flexibility downward. Ironically enough, wage flexibility became an important element for the deflationary equilibrium, where lower wages and prices fed each other while it eased pressures on unemployment.

After the banking system restored its health in the first half of the 2000s, there were incipient indications of stronger economic growth and the end of deflation in Japan under the influences of global credit bubbles, which covered the US housing market, European debt market, and emerging economies, as well as the yen carry trade in foreign exchange markets. In 2007 the global bubbles burst, throwing Japan’s economy into a renewed deflation. During the following several years, monetary policy was less easy in Japan than in the US, which entailed upward pressures on the yen in the market. Once again, Japan’s economy stayed in a deflationary equilibrium. Risk taking continued to be penalized, thereby stifling technological innovation as well as needed reorganization of industries.

From a Deflationary to an Inflationary Equilibrium

Abenomics was launched in late 2012 to break down this deflationary equilibrium and to achieve a new equilibrium in Japan’s economy of sustainable growth with 2% annual inflation. Abenomics consists of three arrows: aggressive monetary policy, flexible fiscal policy, and growth-oriented structural policy. Their elements oppose the deflationary equilibrium factors, i.e., low real interest rates; a weaker yen; more investment in equity, real estate, and other risk assets; higher prices of those risk assets; and more risk taking in the private sector, all of which is to stimulate innovation and resource reallocation. Structural policy is now aimed at raising both wages and labor-market participation in contrast to the past.

Abenomics has been successful on all these scores, but only to a half extent. For example, Japan’s CPI inflation rate has moved up from negative to positive, but not yet to 2%. The labor market has become as tight as it was in the bubble period a quarter of a century ago, while corporate profitability reached its highest ever level, in terms of earning per sales as well as per equity, before dropping back a little on account of the yen’s steep appreciation in early 2016. Nonetheless, there has been no strong inflation pressure in both the labor and product markets.

In these circumstances the Bank of Japan has stepped up monetary easing while the government has expanded its spending further. Monetary policy operations have taken the form of huge purchases of government bonds at low or even negative interest rates, which appear to be paralyzing both the sense of fiscal cost on the part of politicians and the market function as a signal of future risks.

Is a Soft Landing Likely?

Public debt amounts to 250% of GDP in Japan, by far the largest burden in the world. Even if government financial assets are netted out, the debt to GDP is as high as 130%. The BOJ had bought up 36% of the government bonds outstanding by mid-2016, and by doing so, it created a monetary base equivalent to 80% of Japan’s annual GDP. The comparable numbers for the United States and the euro area are 20% each. The massive liquidity supply has suppressed interest rates in the market, over both the short and long terms. In view of long-term bond yields at zero or negative rates, the market has in fact lost the signaling function.

This is not surprising. History has shown a number of times how myopic the market is. For example, as hindsight makes clear, before the collapse of Lehman Brothers and the near-default of Greece, their bond prices were grossly overpriced. The market’s confidence in borrowers can be comparable to treaties for Charles de Gaulle, who said, “Treaties, you see, are like roses and young girls; they last while they last.”

Government debt monetization by the central bank is fundamentally inconsistent with public confidence in the central bank that maintains the integrity of money. An examination of historical precedents of public debt monetization in the United States, Europe, and Japan confirms that there are indeed few successful soft landings. Most of the earlier episodes ended up with hyperinflation, some accompanied by political disorder.

The present size of Japanese debt accumulation, as well as the weight of central bank financing, indicates a potential shock in the making. Zero or negative long-term interest rates are incompatible with sustainable economic growth with 2% inflation. Whenever the market expects the latter soon to come about, it will likely become unsettled, with abrupt rises in bond yields and high volatility. Because of the globalized nature of financial markets, a shock in Japanese financial markets could prompt dislocations in other markets where government debt is accumulated—indeed, anywhere in the world.

(Banner photo: Bank of Japan Governor Haruhiko Kuroda at a Tokyo press conference following a meeting to discuss economic and financial policies on August 2, 2016. © Jiji. Names in this article are listed in Western order, per the wishes of the author.)

  • [2016.10.14]

Special advisor and a member of the board, the Canon Institute for Global Studies, a research think tank in Tokyo. Joined the Bank of Japan in 1974 after graduating from the University of Tokyo. During his three-decade career at the BOJ, also worked at the Bank for International Settlements in Basel, Switzerland, Japan’s Ministry of Finance, and the Institute for International Policy Studies in Tokyo. In 2006 he was appointed assistant governor of the BOJ, stepping down in June 2010. Since July 2010, he has been at his current position.

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