Abenomics came to the scene two years ago and contained hope that it would be able to lift Japan out of its seemingly endless slumber, plagued by some of the worst demographic developments in the world, low growth, and mild deflation.
Mind you, Japan was never really in as bad a shape as many people had it, referring to the post 1989 bubble years as "lost decades." Growth on a per head basis has been as good or better compared to the EU and US.
Despite an implosion of several bubbles (stocks, land, real estate) three times the relative size of the 1929 and 2008 bubbles in the US, and years of crippling bad debts at banks, unemployment never even came close to double digits, which is why we called Japan sort of a miracle, rather than suffering from lost decades.
What kept Japan alive, despite incredible headwinds of:
- Crippling wealth destruction from falling asset prices leading to severe company deleveraging.
- Mountains of bad debt leading banks to greatly curtail lending (and you have to understand that banks are way more central to company finance compared to the US).
- Adverse demographics, a rapidly aging and shrinking population.
Below you see how severe the corporate deleveraging actually was.
For instance, bank lending went down a whopping 37% between 1998 and 2011, despite rather aggressive monetary policy with QE between 2001 and 2006. The latter seems to have arrested an acceleration of deflation but it hasn't gotten Japan out of it.
However, what compensated for the private (mainly corporate) deleveraging was public releveraging. The public sector didn't even use all generated private sector savings, despite large public deficits.
The deleveraging private sector moved into such a huge surplus that Japan was still saving as a nation, as it testified by the continued substantial current account surplus.
While this seems an object lesson to handle the collapse of an asset bubble, even one that was three times the relative size of those in the US (1929 and 2008), Japan has committed grave errors, although their expansionary fiscal stance certainly isn't one of them:
- Monetary policy was slow to react, and this let deflation slip into the system, which has been extremely hard to root out from the economy.
- Banks were slow to deal with their enormous bad debt problem.
While banks did much better in the new century, it is especially the deflation problem that has Japan still in limbo. Note for instance that nominal GDP has actually been shrinking for a good part of the period:
And a shrinking nominal GDP is basically a disaster for debt dynamics (ask the peripheral countries in the eurozone, when in doubt). The large deficits and declining nominal GDP certainly took their toll:
These developments seem to have left Japan between a rock and a hard place. Here is where Abenomics came in in 2013, with a concerted effort to try to reflate the Japanese economy and get it out of deflation once and for all.
It is loosely based on the successful reflation program of Finance Minister Korekiyo Takahashi in the early 1930s, which got Japan out of its depression. Abenomics consisted of three 'arrows':
- Monetary stimulus
- Fiscal stimulus
- Structural reforms
This was off to a promising start, especially as the yen fell quite dramatically, boosting exports and inflation, which is basically just what the doctor ordered. The main force operating was the shift in expectations in combination with a large QE program.
But then the authorities resorted to fiscal retrenchment in an effort to rein in the ballooning public debt, and this proved premature, and hence counterproductive. Indeed, this lesson should have been learned from the 1997 debacle, when the then Prime Minister Hashimoto also prematurely embarked on a sales tax hike which snuffed out the recovery.
And now the second policy mistake seems to be in order with the negative rates which looks like it has produced a strong reversal of the yen. Below you see first the significant weakening of the yen in the wake of Abenomics announcements, but from well over 120 yen per dollar the yen has reverted the last couple of weeks to just above 110.
So what does Japan do now? Here is where it gets interesting, as Japan has been a sort of laboratory for post-bubble policies. It suffered from the implosion of asset bubbles and subsequent deleveraging and deflation, and it has been throwing in an interesting mix of policies to deal with the aftermath.
Some of that highly successful (public releveraging is exactly what is warranted), but others not so, like lack of decisive action early on with deflation and bad debts, and some fiscal retrenchment mistakes (1997 and 2014).
Since the negative rates seem to have backfired, there are little obvious things that Japan can do to revive growth and inflation, necessary to get the public debt under control.
Helicopters to the rescue?
Japan could embark on a (fairly limited) amount of so called helicopter money, instead of having the BoJ (the Bank of Japan) inject money into the financial system, which is supposed to work through bringing interest rates down which is supposed to spur lending and move people into more risky assets.
The truth is that with interest rates already rock bottom, there is little traction here, most of the success of Abenomics simply worked by lowering the yen but that also has petered out and reversed.
Helicopter money entails central banks to inject money directly into the 'veins of the economy,' rather than taking the detour through the financial system where it has limited effects and increasingly worrying side-effects.
The idea, or at least the term helicopter money comes from no less than Milton Friedman, although the idea circulated in Chicago university long before him. In its basic form, there are two varieties, getting money straight into the hands of governments or households:
- The central bank financing the public sector directly, rather than the latter having to issue debt on the markets.
- The central bank (more likely another government agency) crediting household accounts.
If the problem is insufficient demand and all other options have been exhausted then helicopter money could be a viable option.
In a way, Japan is already embarking on this. Here is Lord Turner, former UK financial regulator and one of the most forceful advocates of helicopter money (The Telegraph):
He calls Japan's move to issue government debt at a rate of 40 trillion yen, while the central bank expands its balance sheet at a rate of 80 trillion yen a year, "a de facto debt monetisation".
"You are effectively replacing government debt with central bank money," says Lord Turner. "It would be better for authorities to publish a statement, laying out the rules and assuring the world it is not too much."
This is, of course, not without risk. But those that warned five years ago against QE leading to debt monetization and currency debasement, predicting accelerating inflation and bond market crashes have been proven profoundly wrong, at least so far.
Which is actually rather illuminating, as the amount of monetary fireworks has already exceeded most people's imagination, but basically only the US doesn't seem to need further expansion.
But even in the US there are complaints about the nature of the recovery, although that seems mostly an issue of wage growth (or rather, the lack of it). Nobody can argue that private sector job creation hasn't been brisk (even if more than a few try).
So the US doesn't need helicopter money and in the eurozone there are too many complications (legal and institutional) despite a very creative ECB president, which leaves Japan as the prime laboratory.
We think, on balance the upside outweighs the risk, basically because there is significant risk of doing nothing or too little.
Japan is facing strong headwinds from demographics, hasn't escaped deflation, which is wreaking havoc on its debt dynamics, and as the sales tax hike in 2014 shows, it can't tighten fiscal policy without consequences for the economy.
The private sector generates a chronic savings surplus; demographics and the lack of inflation itself probably the most important forces behind that.
A yen devaluation could break this cycle, but for the hard money men it must be a mystery why despite 80 trillion yen a month in debt monetization and at least some negative interest rates, the yen is still seen as a bit of a safe haven.
Japan is still one of the most interesting economic laboratories in the world, and very relevant as well as the ailments of bad demographics, lowflation or even deflation, and bad debt dynamics are never far away from other still prosperous countries.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.