Japan Reaches a Keynesian Cul-de-Sac; Japan hurtles toward fiscal cliff as money printing can’t make up for an economy’s decrepitude.

WEDNESDAY, APRIL 2, 2014

Japan Reaches a Keynesian Cul-de-Sac

By RANDALL W. FORSYTH | MORE ARTICLES BY AUTHOR

Japan hurtles toward fiscal cliff as money printing can’t make up for an economy’s decrepitude.

The calendar read April 1, but instead of a day of pranks, Tuesday was the day Japan goes over its own fiscal cliff. So says Carl Weinberg, chief economist at High Frequency Economics.

That’s because Japan imposed a massive increase its national sales tax, to 8% from 5%, on April 1, which is the first day of the fiscal year there. But instead of April Fool’s Day, it might better be called the Japanese version of Groundhog Day.

As in the now-classic 1993 film by the late Harold Ramis, Japan seems determined to relive its massive blunder of 1997. That year, the nation also hiked the sales tax, to 5% from 3%, and turned an unsteady economic recovery back into recession.

In a report colorfully entitled, “Japan’s Sales Tax Hike: Anatomy of a Murder,” Weinberg writes the nation’s gross domestic product is set up to crash in the current quarter — after a spending spree to beat the sales-tax increase. Over time, he estimates real GDP will be lowered by 1% while consumer prices will be increased by 1% by the tax increase.

At the same time of the sales-tax hike, other fiscal stimuli under “Abenomics” will expire, exerting a further drag on the economy. Even so, the higher sales tax doesn’t come close to curing Japan’s fiscal problem.

“We estimate that this increase in the sales tax accomplishes less than one-fifth of the adjustment in public-sector finances necessary to stabilize the debt-to-GDP ratio, which is approaching 300%,” Weinberg writes. “Even so, economic growth will take a big hit in the second quarter because of the tax hike, and at least some momentum gained from the massive fiscal stimulus of Abenomics will be lost.”

Abenomics might be described as Keynes on steroids. The Bank of Japan was to double the size of its balance sheet, to expand the money supply and depreciate the yen. Fiscal policy was to run full tilt stimulative, while structural reforms were supposed to boost the growth potential of the economy. All to pull Japan out of the deflationary rut in which it has been mired since the bursting of the credit, real estate and financial bubble in 1990.

Initially, the steroids did boost performance, especially of Japanese stocks. In 2013, the equity market returned 54.8% in local-currency terms; the depreciation of the yen lowered the returns in dollars to 27.35%, however.

In the first quarter, the advance reversed. Japanese stocks lost 7.38% in yen terms and 5.47% in dollar terms, as the Japanese currency appreciated slightly.

It would appear the monetary printing press has lost its power to boost Japanese stock prices. Part of that could be the equity market’s anticipation of the impact of the sales-tax increase.

But structural changes in Japan’s economy have complicated the Bank of Japan’s task of stimulating the economy. So write Citi economists Kiichi Murashima and Naoki Iizuka in the bank’s Japan Economics Weekly.

Inflation in Japan has become much more sensitive to the depreciation of the yen because of the penetration of imports. The weaker yen, as a result, sharply reduces households’ purchasing power.

At the same time, the weak yen isn’t having the salutary effect on exports, as textbooks would have one believe.

Japanese companies already have moved so much production offshore during the long years of the super-strong yen. That means a cheaper currency isn’t inducing manufacturers to return to Japan from their overseas facilities, to which they are committed. Most of the Toyotas, Nissans and Subarus Americans buy are assembled in the States, which isn’t going to swing on the basis of the yen-dollar rate.

At the same time, Japanese consumers are switching to global brands after years of hidebound loyalty to domestic makers. As with the rest of the world, they’re buying iPhones or Android phones from South Korean brands, many of which are made in China.

As a result, the Citi economists estimate a 10% depreciation in the yen worsens Japan’s trade balance by 1.5 trillion yen ($14.4 billion.) Again, that’s the opposite of the textbook prediction; that currency depreciation produces trade surpluses.

This suggests Japan is in danger of reaching a Keynesian cul-de-sac. Printing more money to depreciate the yen isn’t having the positive effect of boosting exports but is reducing households’ purchasing power. Accumulated government debt is forcing tax hikes on a weak economy and limits the scope of fiscal policy.

Underlying all this is Japan’s well-known demographic plight of an aging and shrinking population. That means a falling workforce to produce income to support pensioners.

In the end, money printing and government borrowing cannot make up for a shrinking work force in an economy in which producers have moved offshore. That is the conundrum facing Abenomics.