Abenomics and the Japanese Economy

April 4, 2014

Kunio Okina

School of Government, Kyoto University

The Japanese economy before "Abenomics":The economy's continued stagnation since the early 1990s. (Japan's real GDP Growth Rate, source: reference a )

Japan's real GDP growth rate in the years before Abenomics is low and in decline. source: reference a

Even so, the GDP growth rate per worker comparable to that of the United States in 2000–2008. source: reference a

In addition, Japan’s unemployment rate (shown as a red line) is remarkably low compared to other developed countries (Source: reference b).

However, consumer price inflation declined by -0.3% on average from 1997 to 2010, an unusual occurrence among post-war advanced economies Source: reference a

Because of deflation, the BOJ introduced various unconventional policies that were later adopted by the Fed and other major central banks.

• Zero interest rate policy ( ZIRP: Feb 1999–Aug 2000) with Forward guidance

• Quantitative easing (QE: Mar 2001-Mar 2006)• Credit easing

• Outright purchase of ABCPs and ABSs• Equity purchase from financial institutions• CP repos

The long-term inflation expectation declined until the early 2000s, but anchored around 1% thereafter Source: reference a

However, as deflation has continued, the “Insufficiency” of the BOJ’s monetary policy has been sharply criticized by economists and politicians, including Mr. Abe.

“Inflation is always and everywhere a monetary phenomenon.”

—Milton Friedman

Is this aphorism also applicable to deflation?

Difficulty in fighting deflation is the so-called “liquidity trap”

In a liquidity trap, possible channels of monetary policy (quantitative easing) shift the IS curve. Unfortunately, they are all extremely unreliable.

1) Increasing asset prices (especially stock prices)

2) Lowering the real interest rate through increased expected inflation

3) Depreciating the currency

Beyond the narrowly defined monetary policy, Abe used two reliable ways to exit from the liquidity trap. The first is a reliable commitment to currency depreciation.

“The central bank makes a commitment to buy unlimited amounts of foreign currency at the exchange rate” (that is, at a devaluating level).

—Lars Svensson (“The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap” February 2001).

The effectiveness of the Svensson proposal was confirmed in 2011 by experimental policy in Switzerland.

• In 2011, Switzerland was troubled over the appreciation of the Swiss franc.

• Quantitative easing in August 2011 was huge but not effective.

• In September, The Swiss National Bank announced that it would sell unlimited amounts of the Swiss franc at a rate of 1.2 Euros.

Commitment stopped the appreciation of the Swiss franc immediately (The blue line shows Swiss francs/euros, the purple line indicates

the upper limit, and the arrow shows the start line of unlimited intervention, source: reference c).

Another “foolproof” way to exit from the liquidity trap is monetization with price level targeting.

“Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt—so that the tax cut is in effect financed by money creation.” Bernanke (May 31, 2003)

Under a price-level target, the increase in the money stock can be permanent

As seen in the case of Zimbabwe in 2008–2009, there is a risk that monetization will destroy fiscal discipline.

In 2012, Bernanke denied the possibility of future monetization in the United States.

“By buying securities, are you ‘monetizing the debt’? […]. No, that’s not what is happening, and that will not happen.”

—From Bernanke’s speech (October 1,2012)

“Abenomics” refers to the economic policies proposed by current Prime Minister Shinzo Abe before the December 2012 general election.

• Abe insisted that exiting from Japan’s long-lasting deflation and economic stagnation was an issue of the highest priority.

• It is said that Abe uses “three arrows”:First arrow: Aggressive monetary policySecond arrow: Flexible fiscal policyThird arrow: Growth strategy

But Abe jump-started the economy by devaluing the currency as proposed by Svensson.

• In a speech given on November 15, 2012, then-opposition party (LDP） leader Abe firmly committed to depreciating the yen

• After which the yen exchange rate began to fall sharply.

Abenomics began with a commitment to yen depreciation rather than “bold monetary policy (QQE).”

↓（Nov. 2012) ↓（QQE)

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Why was Abe so successful in depreciating the yen?Reason 1: Abe’s special position in Nov. 2012.

• Although it was certain that Abe would become the next prime minister, he was the leader of an opposition party at that time. Therefore,

• Mild opposition from other countries

• Strong impact to the market

Why was Abe so successful in depreciating the yen?Reason 2: Japan’s payment balance deteriorated sharply after the earthquake in March 2011. source: reference d

Why was Abe so successful in depreciating the yen?Reason 3: Global investors’ risk aversion has diminished since Draghi’s statement in July (The chart shows 10-year gov’t bond yields, source:

reference e).

Why is Abenomics so highly regarded in Japan? Stock prices rose parallel to the yen’s depreciation, which created optimism (The chart below shows the Nikkei Stock Average).

Despite the yen’s substantial depreciation, net exports have made a negative contribution to GDP growth, contrary to economists’ expectations. source: reference f f

But expansionary fiscal policy (the second arrow) has been undertaken and financed by QQE, as Bernanke proposed, which supported GDP growth in 2013.

s.a.; q/q % chg. Figures of components in real GDP indicate contributions to changes in GDP

1Q 2Q 3Q 4Q

Real GDP 1.1 1.0 0.2 0.2

Private demand 0.4 0.4 0.3 0.5

Public demand 0.3 0.5 0.4 0.2

Net Exports 0.4 0.1 -0.5 -0.5

The cost push caused by the yen’s depreciation has been the driving force behind CPI increases. source: reference g

What is QQE (the first arrow of Abenomics)?Its slogan is, “more than double”．source: reference g.

Why “more than double”? To change inflation expectations.

“The QQE aims at[…] drastically changing the market's and economic entities’ expectations, thereby working directly on raising inflation expectations.”

—From Kuroda's speech( December 25, 2013)

What had happened when the Fed began QE in December 12, 2012?

• The Fed’s new policy framework of monetary policy consists of two major pillars.

-The ｆirst is forward guidance regarding the ZIRP period.

-The second is large-scale asset purchasing (LSAP, QE).

The Fed plan required a completely unprecedented increase in reserve balance. source: reference h.

Bernanke denies any effect from the size of the balance sheet.

“We want to be sure that there’s no misunderstanding, that there’s no effect on inflation expectations from the size of our balance sheet.”

—From Bernanke’s press conference(December 12, 2012)

As Bernanke argued, inflation expectations in the United States continued to fall after LSAP (the chart shows the 10-year expected inflation, source: reference i).

How can we reconcile the BOJ’s view and the Fed’s view?

“What effect it will have on inflation depends very much on how Japanese households and firms change their inflation expectations.”

—Olivier Blanchard, research department counselor and director of IMF (April 29, 2013 by iMFdirect)

The motivation for the BOJ’s dramatic monetary expansion is thus largely to create a psychological shock

“If they revise them up, this will affect their wage and price decisions, and lead to higher inflation […]. But if they do not revise them, there is no reason to think that inflation will increase much.”

—Olivier Blanchard (April 29, 2013 by iMFdirect )

However, long-run inflation expectations have not changed substantially thus far (Quick Bond Monthly Survey: From

September 2013; the survey asked respondents to include the effects of the scheduled consumption tax hikes in 2014 and 2015. source :reference f).

The achievement of 2% inflation within two years will be difficult.

• Governor Kuroda indicated that the current large-scale purchasing of government bonds was not limited to two years.

• Governor Kuroda has continued to display a desire to shelve discussions about a QQE exit, and he has said, “It is too early to talk about an exit.”

What will the success of Abenomics bring? This will not become evident until the BOJ exits from QQE.

• The Achilles’ heel of Abenomics is its heavy reliance on “Monetization”, which is difficult to maintain once the inflation target is achieved.

Choosing financial repression or an inflation target is important, but it may not become a big issue until the exit.

• Until the 2% target is stably achieved, the continuation of large-scale government bond purchases is justified, even if no effects are seen.

• However, if the 2% target could be stably achieved, it would become difficult to justify the continuation of QQE.

The government debt-to-GDP ratio in Japan is highest among developed countries. Source: reference j

The IMF pointed out that Japan requires the largest consolidation effort (Required Changes in the Cyclically Adjusted Primary Balance

between 2011–2020. The red bars show expectations between 2011 and 2013 in % of GDP. source: reference k).

The Cabinet Office’s main scenario: the gradual decline of the government debt-to-GDP ratio (the red line presupposes the success of Abenomics; the blue line is an alternative source: reference l).

The Cabinet Office assumes that the potential growth rate increases rapidly and that the long-term interest rate will be lower than the nominal growth until 2017.

2012 2013 2014 2015 2016 2017

Nominal GDP growth rate (%) -0.2 2.5 3.3 3.4 3.8 3.4

Potential GDP growth rate (%) 0.9 0.7 0.9 1.2 1.4 1.7

CPI inflation rate (%) -0.3 0.7 3.2 2.6 2.8 2.0

Long-term interest rate (%) 0.8 0.7 1.0 2.1 2.4 2.8

How can we increase potential growth?“Growth strategy” (the third arrow)

• The Cabinet Office’s scenario presupposes that the growth of total factor productivity will be very strong.

• As strong as it was during the bubble period (the late 1980s).

Maximum deregulation is the most-used growth strategy, as Prime Minister Abe well knows.

• “Regulatory reform is the top prioritized issue of the Abe Cabinet. It is also a top priority in the growth strategy.”

—Abe’s speech on January 24, 2013.

• However, this is easier said than done.

Since the early 1980s, the long-term interest rate has been higher than the nominal growth rate (blue line: 10-year JGB

rate; red line: O/N call rate; black line: nominal GDP growth rate (3Q moving average. source; reference m)

The Cabinet Office’s scenario assumes a 2.8% long-term interest rate at FY2017. which implicitly supposes a strong financial repression effort by the BOJ. • The Taylor Rule for a policy rate is

i* = g* + p* + 0.5(p-p*) + 0.5y,

Where g* is the equilibrium real interest rate

p* is the inflation target

p is the actual inflation rate

y is the GDP gap

• If we use the Cabinet Office’s assumptions for FY2017,

g* = 1.7, p* = 2, p = 2.0, y = 0, and thus, i* = 3.7%.

Long term interest rate should be close to 5%?

Market participants tend to believe that the BOJ will have no choice but to accept financial repression.

• In this scenario, even if inflation exceeds the target, the BOJ will have to stabilize interest rates at a lower level

• It will be impossible to halt inflation overshooting when it occurs.

If the BOJ increases the policy rate, its balance sheet will be significantly impaired, and thus, government support will be needed. source: reference n

If the BOJ and the government intend to maintain the inflation target, preparations must be made.

• It is necessary for the government and the BOJ to prepare responses to maintain fiscal sustainability without ultra-low interest rates.

• The government must approve the BOJ's huge losses when it exits from QQE.

Is fiscal reconstruction the fourth arrow required for the success of Abenomics?

• However, this is a fairly dangerous for Mr. Abe.• The government and the BOJ may believe that financial repression is the second-best scenario for them.

• The pressing question is what scenario is most desirable for Japanese citizens – it may be one that Government and BOJ have avoided to discussing thus far.

Reference of source of figures

a) Shirakawa, Masaaki “Uniqueness or Similarity?--- Japan’s Post-Bubble Experience in Monetary Policy Studies --- ”, September 16, 2010http://www.boj.or.jp/en/announcements/press/koen_2010/data/ko1009c1.pdfb) Stelsel, David W. Comparing U.S. Unemployment to Nations Around the World, February 3, 2012 by CFA http://www.valeofinancial.com/2012/02/comparing-u-s-unemployment-to-nations-around-the-world/c) Ueno, Takeshi “Wagamichi wo iku suisu furan”, September10, 2012, http://www.nli-research.co.jp/report/nlri_report/2012/report120910.html,d) International Departmen t, Bank of Japan “ Japan's Balance of Payments for 2012”July 2013 ,http://www.boj.or.jp/en/research/brp/ron_2013/ron130724a.htm/e) Bank of Japan “ Financial System Report” April, 013,http://www.boj.or.jp/en/research/brp/fsr/data/fsr130417a.pdff) Bank of Japan “Monthly Report of Recent Economic and Financial Developments” March 2014, http://www.boj.or.jp/en/mopo/gp_2014/gp1403b.pdfg) Kuroda, Haruhiko “Overcoming Deflation and After” December 25, 2013,http://www.boj.or.jp/en/announcements/press/koen_2013/ko131225a.htm/h) Taylor, John “More Monetary Policy Uncertainty”, December 14, 2012 ,http://economicsone.com/2012/12/14/more-monetary-policy-uncertainty/

Reference of source of figures (continue)

i) Cleveland Fed “Estimates of Inflation Expectations”,February,2014 http://www.clevelandfed.org/research/data/inflation_expectations/

j) Ministry of Finance “Debt Management Report 2013”, https://www.mof.go.jp/english/jgbs/publication/debt_management_report/2013/index.html

k) International Monetary Fund “Fiscal Monitor 2013” ,http://www.imf.org/external/pubs/ft/fm/2013/01/pdf/fm1301.pdf

l) Cabinet Office “cyuu cyouki no keizai zaisei ni kannsuru shisan”, January 20,2014http://www5.cao.go.jp/keizai3/econome/h26chuuchouki.pdf

m) Fukao,Mitshuhiro “nihon no zaisei akaji no jiizoku kanousei”，June 2012, http://www.rieti.go.jp/jp/publications/dp/12j018.pdf

n) International Monetary Fund “UNCONVENTIONAL MONETARY POLICIES—RECENT EXPERIENCE AND PROSPECTS—BACKGROUND PAPER*”, April 18, 2013