Question – where next for Japan

An inquiry from a reader prompts Your Neighbourhood Economist to look into the prospects for Japan

There has been another knock at the door of Your Neighbourhood Economist, with a reader what I thought Japan should be doing in the short and medium term?  The question arrived just days before another big policy development in Japan with the central bank ramping up its monetary policy.  This is the latest attempt by policy makers in Japan to resurrect an economy that has been languishing for decades.  To get an idea of what Japan should be doing, we need to start with what went wrong and why Japan has not made much progress.

What is not going right?

Japan got itself into trouble in the 1980s with the spectacular collapse of a financial bubble from which it has never recovered.  Property prices have fallen almost every year for two decades while prices for consumer goods have been inching lower for almost as long.  Japan has repeatedly tried to use fiscal stimulus but higher government spending has been unable to mask deeper problems with the economy.  Along with numerous roads and bridges which are hardly used, the main result of these rescue attempts has been a ballooning amount of government debt which only adds to Japan’s woes.

Monetary policy has been adopted recently as the potential saviour in the fight against what has been deemed as the main problem – deflation.  Falling prices were seen as prompting consumers to hold off spending and preventing companies from investing.  With this in mind, the central bank in Japan announced plans to double the money supply in early 2013.  But the policy of pumping more money into the economy was based on the false logic that deflation was a problem rather than just the symptom of a weak economy.  Instead, it is likely the case that deflation persists because prices rises had gotten out of hand in the past and need to fall back to appropriate levels.

Fix-up job not working

The result of this monetary policy has been as Your Neighbourhood Economist might have expected with just a brief and temporary boost to inflation.  Prices for consumer goods cannot rise consistently if consumers themselves do not get a similar rise in pay.  Higher wages in Japan seem unlikely as a declining population hurts aggregate demand and Japanese firms invest more overseas than domestically.  Yet, rather than change tact, Japan’s central bank has opted for more of the same. 

This involves the Bank of Japan aiming for an even larger boost to the money supply in Japan with annual purchases of 80 trillion yen (US$720 billion or £450 billion) in government bonds.  The timing of the new policy comes as the Japanese economy is faltering under the added weight of a tax hike designed to fix the government’s finances.  Japan has gotten itself deeper and deeper into trouble and seems likely to be an example of what not to do in terms of fiscal and monetary policy.   

Where to from here

The best option left to the Japanese government is to reform the economy so as to increase competition and improve efficiency.  There is substantial domestic opposition to reforms even within the current government headed by Prime Minister Shinzo Abe who included reforms as one of his key policies.  An easy way to sidestep domestic politics would be to jump on-board to plans for the Trans-Pacific Partnership (TPP).  This is a free trade agreement with the United States, Australia, Mexico, Chile, and other countries around the Pacific Rim.

Left to themselves, Japan will probably continue to stagnated due to the stifling effects of its consensus style of politics which make it tough to come up with reforms that keep everyone happy.  As such, Japan has a history of positive change only coming when imposed from the outside and this free trade agreement looks likely to follow this trend.  Greater competition from foreigners will help lower costs of business and create impetus for freeing up businesses in Japan from a host of restricting rules.  Facing up to the outside world looks like the best way to inject life back into a Japanese economy that has been slowly decaying for years.