Abenomics’s first two arrows helped boost aggregate demand, but masked problems missed by Abe’s unfired, double-edged third arrow of politically sensitive structural reform.
In a snap election last Sunday, Japanese Prime Minister Shinzo Abe consolidated his already strong public support for Abenomics: monetary easing, fiscal stimulus and structural reform aimed at ending the Lost Decade(s) of slow economic growth.
Two ‘arrows’ of monetary easing and fiscal stimulus were released within weeks of Abe’s inauguration. Fiscal funds injected demand into the economy that then increased incomes, which further boosted aggregate demand through the multiplier effect. For a similar outcome, monetary stimulus like quantitative easing reduced interest rates to encourage investment and consumption.
This might counter the dwindling workforce and increasing dependency ratio caused by a rapidly ageing population by encouraging a consumption driven economy, increasing investment since firms benefit from higher sales through the accelerator effect.
However, fiscal stimulus continues adding to public debt, which towers at 240% of GDP. An attempt to reduce this in April by hiking the sales tax led to a recession because already fragile consumption stumbled further, replaying the events of a similar tax rise in 1997.
Abe called the snap election to delay the next incremental tax rise to avoid worsening the ‘paradox of thrift’ – when households save a higher proportion of their income, but this fall in consumption reduces aggregate demand and thus incomes so much that net savings in the economy decreases.
Moreover, monetary policy is limited in its power since a marginal cut in rates near zero, the liquidity trap, has little effect. While the real economy is barely growing, rising financial asset prices are benefitting rich asset owners’ savings.
While imperfect, these inflationary policy tools helped sustain a recovery, but masked problems missed by Abe’s double-edged third arrow of long run, politically sensitive structural reform. These boost the productive capacity of the economy in inefficient markets that close of competition to protect vested interests and cultural norms.
Agriculture, healthcare, energy and other sectors benefit from a lack of competition, mostly through protectionist tariffs and subsidies. Liberalizing these areas would encourage competition, but might put unskilled workers out of jobs and so add to the welfare fiscal burden.
Another potential supply side shakeup could be smoothening labor market imperfections i.e. immigration policies, female employment (currently discouraged by the tax code) and working practices like corporate governance principles. This would improve workers’ skills and ease hiring processes so encourage employment.
These structural reforms may initially have a contractionary effect on those reliant on policies that give them an unfair competitive edge such as elderly farmers and corporate bureaucrats.
However, this would shift income from corporate reserves to household spending. These policies are necessary to promote long run growth and will have a lower negative impact the earlier they are implemented since vested interests become more entrenched over time.
Lower interest rates from monetary easing would lead to a depreciation of the yen as investors divert savings to higher yielding nations. Although this would increase demand for exports, it would only be a temporary competitive boost that may spark other central banks to do the same – as China’s did – in a ‘currency war’. Moreover, a depreciation of the yen would increase the import price of energy, which is a major cost of living for households.
Abenomics’s first two arrows helped boost aggregate demand. This impact will only lead to sustained growth if the third arrow of structural reform is fired. While painful in the short run, this shot is the best course of action to finally obtain the “virtuous cycle” of rising prices, wages, consumption and production.
Abe's victory confirms that the nation is rightly ready for this brave political step.