More sizzle than steak: why the Abe economy will fail.

AuthorKatz, Richard

Abenomics, the popular term for the economic policies of new Japanese Prime Minister Shinzo Abe, is likely to fall far short of its goals of reviving long-term vitality in Japan, although it could succeed in providing a temporary and illusory lift to both the economy and Abe's Democratic Party. To provide a lasting revival, Japan needs a three-pronged approach of monetary stimulus, the right kind of fiscal stimulus, and structural reform. None of the three work without the other two. Abe, however, is focused only on the first two. With his party just back in power, he doesn't want any reforms that step on toes. As a result, Japan is more likely to do what it has repeatedly done after previous bouts of stimulus: fall back into lethargy as soon as the stimulus is withdrawn. Beyond that, political obstacles from the Ministry of Finance, the Bank of Japan, and some parts of the business community are already preventing Abe from even implementing many of his ideas on fiscal and monetary stimulus.

Japan could certainly use a strong pro-growth program of stimulus and reform. Its GDP is still 3 percent below the pre-recession peak of five years ago. In the fifteen years since 1997, per capita GDP has grown a dismal 0.46 percent per year, far below its potential. But going forward, even after the economy gets back to full capacity, many economists and policymakers estimate its medium-term potential growth rate as low as 0.5 percent per year.

In looking at the pros and cons of Abenomics, it would be helpful to start with the varying reactions from three prominent economists: Martin Feldstein, Adam Posen, and Paul Krugman.

THE FELDSTEIN FEAR, A FEAR SHARED BY SOME AT THE BOJ

In a January 18 op-ed in the Guardian, Martin Feldstein, formerly Ronald Reagan's chief economist, warned that Abe's emphasis on restoring inflation could actually make things worse. His concerns are shared by some within the Bank of Japan and the investment community.

"Seeking to boost economic growth, the authorities may soon destroy their one great advantage: the low rate of interest on government debt and private borrowing....[If Abe succeeds in achieving 2 percent inflation], investors will be willing to hold Japanese government bonds (JGBs) only if their nominal yield is significantly higher than it has been in the past....With a debt/GDP ratio of 230 percent, a four-percentage-point rise in borrowing costs would cause the annual deficit to double, to 20 percent of GDP."

Does that mean leaving Japan in its present deflationary situation is the lesser of the evils?

What Feldstein is claiming is that, if bond investors expect a 2 percent rise in inflation, then they will refuse to buy bonds unless they get a more or less equal 2 percent rise in interest rates. His critical assumption is that the Bank of Japan has no way to counter the investors' desire, and therefore no way to lower "real" (inflation-adjusted) rates.

Fortunately, real world data show this fear is unwarranted. During 2000-2012, for every l percentage point increase in inflation (or decrease in deflation), nominal rates on ten-year Japan government bonds went up, not 1 percentage point, but only 0.3 percentage points. The remaining 0.7 percentage points comprised a fall in the real interest rate (see Figure 1). In the past couple of months, despite higher inflation expectations, the Bank of Japan has successfully reduced the nominal rates on bonds in the one-year to ten-year range to record or near-record lows.

Once Japan has positive inflation, it should be able to emulate the U.S. Federal Reserve in pushing real interest rates into negative territory. As measured by inflation-indexed bonds known as TIPS (Treasury Inflation-Protected Securities), the Fed has engineered negative real rates on ten-year bonds since early 2012, and on five-year rates since early 2011.

A temporary period of negative real interest rates helps spur company and household purchases of interest-sensitive items, such as equipment, cars, and housing. And that would be the major benefit of reviving inflation in Japan. Since nominal rates cannot go below zero, a nation cannot have negative real rates unless there is positive inflation.

As for the impact on the high ratio of government debt to GDP, a critical factor in...

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