It’s the first arrow of Abenomics that matters; What is really radical is the bold gamble to rid Japan of 15 years of deflation

November 13, 2013 5:26 pm

It’s the first arrow of Abenomics that matters

By David Pilling

What is really radical is the bold gamble to rid Japan of 15 years of deflation

Ayear after Shinzo Abe gave notice of his plan to restore Japan to economic vigour, the prime minister’s first arrow of massive monetary expansion is flying as swiftly as anyone could have dreamt. The yen is sharply down, the stock market up and consumer price inflation is edging towards 1 per cent, though there are doubts about how long the inflationary flame will flicker. In the first six months of this year the economy grew at an impressively fast annualised rate of 4 per cent. No one has seen anything like it in years.

The third arrow is a different matter. (We’ll pass over the second arrow of “flexible” fiscal policy since it involves an expansion, then a contraction of spending.) Arrow number three – structural reform – has been fired half-heartedly, if at all. And, the third arrow, says consensus, is what really counts. Without reform and deregulation to lift growth potential, Abenomics will peter out and the economy will be back to square one.

Contrary to consensus, however, Mr Abe’s third arrow is not the most important weapon in his quiver. That distinction belongs to arrow number one. To be clear, no one doubts that Japan needs to raise productivity through structural reform. What country does not? Yet what is really radical about Abenomics is the bold – some say reckless – gamble to rid the country of 15 years of deflation. For the first time, Japan has a central bank governor who says his institution can – and will – hit a specified inflation target. For years, the central bank has strongly suggested that it is powerless to do so. Japan’s salvation, it has said, lies in structural reform. The novelty of Abenomics, in other words, is to reclaim monetary policy.

Achieving 2 per cent inflation is no panacea. It could also be risky if bond yields rise uncontrollably, making debt harder to service. On its own, inflation will not address more fundamental issues about how to raise labour participation, how to improve corporate governance, how to liberate women or how to make Japan more open.

Banishing deflation, though, is a minimum requirement. Deflation has had a pernicious influence for nearly two decades. Past debts, notably the public one, have hung around in the system without the magic of rising prices to erode them. Deflation has caged animal spirits, dissuading banks from lending and companies or individuals from borrowing and investing. Prioritising structural reform over slaying deflation is like telling a man who has just collapsed from a heart attack that the priority is to get him on a fat-free diet.

There are counter arguments. One is that it is not a question of either/or. The first and third arrow can be deployed simultaneously. Mr Abe should fire now while he has political capital. Foreigners want to see signs of structural reform as proof that Mr Abe means business. That is why there has been so much disappointment about the watering down of plans to sell over-the-counter medicines on the internet. No one can seriously think that being able to order cold medicines with the click of a mouse is going to revive the economy. But investors put store in symbolism. If Mr Abe can’t take on risk-averse doctors and bricks-and-mortar pharmacists then what hope for broader reform?

The truth is that Mr Abe’s structural reforms are warmed over from previous administrations. The prime minister himself has stressed the importance of reform, but that is partly to divert attention from what Abenomics is really all about: printing money and devaluing the yen. A decade ago Prime Minister, Junichiro Koizumi was “slaughtering sacred cows” in the name of economic rejuvenation, though plenty of cows are still happily chewing the cud today. Mr Abe’s 94-page plan, replete with a 48-page road map and 37 subcomponents of industrial revitalisation, leaves no policy stone unturned. Sadly, neither does it present a grand vision.

Japan’s structural reform process has been frustratingly slow. But it would be wrong to say it has been fruitless. In the past decade, Japan has averaged real annual growth of 0.8 per cent. That is nothing to write home about. But it is no mean feat for an economy with a shrinking workforce and one that has had to contend with a global financial crisis, a devastating tsunami and the suspension of most of its nuclear power generation. To expect it to double real growth to 2 per cent, as Mr Abe’s plan calls for, is “pie in the sky”, says Paul Sheard, chief economist at Standard & Poor’s.

Could growth be substantially higher? That would require a more radical agenda than Mr Abe is contemplating. The status of women would need to be transformed. Japan would need to open more aggressively to immigration. That would not only increase labour inputs, but could also help to provide childcare for working mothers, and spark innovation and global connectivity. Since rising wages are key to sustainable inflation, there is a case for increasing the minimum wage. That, of course, would be the opposite of third-arrow deregulation. In fact, deregulation in general, which tends to increase competition, might run counter to Mr Abe’s reflationary aims.

No big push to transform Japanese society is likely. Mr Abe, a social conservative, is too nostalgic for the 19th century to shove Japan headlong in the 21st. Absent that, the fundamental task at hand is to banish deflation and get Japan on a more sustainable fiscal path. That will not solve all its problems. But it would be a vital first step. It is probably the best contribution Abenomics can make.