Tax Hike in Japan to test fight against Deflation

The Japanese government has been proactive in its battle with deflation but higher consumption taxes will show how much progress has actually been made

There is a big test coming up for the Prime Minister of Japan, Shinzo Abe, and his own brand of economic policies which have been labelled “Abenomics”.  Abe has launched a range of aggressive measures to end deflation and get the Japanese economy moving again.  However, a rise in the consumption tax from 5% to 8% in April will provide a thorough examination of the economic recovery in Japan.  The results will matter not only for the long-suffering Japanese citizens but may also provide crucial lessons on how to combat the growing threat of deflation.

Economic Policy - could do better

A report card for Japan's Prime Minister might see him get an “A” for effort but a “C” for execution.  Abe has had a busy first year in power and has attracted plaudits for his three arrows of economic policy encompassing fiscal stimulus, monetary easing, and structural reforms.  This has translated into 10.3 trillion yen (or around US$100 billion) in extra government spending and the Japanese central bank aiming to double the money supply over a two year period.

Hopes were buoyed as the Japanese economy perked up in early 2013 while the stock market in Japan was one of the best performers last year.  Unfortunately, Abenomics did not live up to the hype with economic growth slowing and many investors selling their Japanese shares in 2014.  The shortfall against expectations has been due to an unwillingness to push through the reforms which are key to getting the economy moving again.

Your Neighbourhood Economist had always been sceptical about the outlook for the reforms as Abe is a conservative in a political party which is known as a bastion of old-school traditions in Japan.  The Japanese government is not alone in using expansionary monetary policy as a shortcut to improving the economy.  Yet, two decades of stagnation show that there is no easy route to scoring good marks where the economy in Japan is concerned.

Economic recovery put to the test

The hike in the consumption tax (which has been on the cards for decades) is a move to sort out the government finances but threatens the goal of defeating deflation.  Consumer prices have begun to edge upwards but this depends on the central bank in Japan continuing to print a torrent of new yen notes.  Rising prices are a novelty in Japan after decades of deflation with the higher consumption tax set to bump prices up a further notch.

It is not clear whether Japan is ready for this real-life lesson on the effects of inflation.  Many companies in Japan are not yet convinced that inflation has taken hold with some even lowering prices to absorb the higher taxes.  As a result, wage gains have been timid despite the government's efforts to bully Japanese firms into paying their workers more.  Inflation without higher wages is even worse than deflation as consumers increasingly feel the pinch.  The increase in consumption tax could exacerbate this trend and depress spending.

Little to learn

A poor showing in economic policy in Japan will seldom make the news elsewhere but it does not bode well as other places look set to face a similar set of problems.  The causes of deflation in Japan are becoming more prevalent in Europe – high government debts, an ageing population, a stagnating economy, and companies struggling amid globalization.

Lessons learnt in Japan could be applied elsewhere.  Yet, successes have been few and far between.  Japan does not make a good case study for fiscal stimulus (more due to problems within Japan rather than problems with the idea of a stimulus).  Neither has monetary policy had much impact with an increase in the supply of money only having a limited effect on inflation (due to the link between money supply and inflation being weaker than assumed).  Europe is instead contemplating negative interest rates which is something that Japan has not tried.

Too much inflation will drag down the grades of central banks but deflation could earn them a fail.  Part of the reason is that deflation has been seen as a cause of the malaise of the Japanese economy (even though deflation is more likely just a symptom).  If the Japanese economy could return to being the star pupil it was in the 1980s, deflation would no longer come with such a bad reputation.

Quantitative Easing – Get to the chopper!

What do you do when the economy needs a fiscal stimulus but there is no money for it?

Central banks have an ever expanding range in their toolkit to choose from to fix their individual economies but none of them seem to have worked so far.  This may be because they lack the right tool for the job.  In this case, the right tool is likely to be a large hammer in the form of a substantial fiscal stimulus but this is the preserve of governments who, at this point in time, are saddled with too much debt.  Yet, there is a way in which central banks could use monetary policy to act like a fiscal stimulus and generate the boost to demand that the global economy desperately needs.

Even new monetary policies are falling short

Economists thought we had it figured out.  Simply control the money supply by setting interest rates and it will be possible to ride out any booms and busts.  However, the weak recovery following the global financial crisis has shattered this belief.  Even manipulating the money supply using newly contrived measures such as quantitative easing has been less fruitful than hoped as well as creating unexpected problems. 

Quantitative easing has relied on a convoluted process where central banks create cash in order to buy bonds which frees up money for use elsewhere.  The problem has been that there is little demand for money in the actual economy as businesses are not keen to borrow as a result of the weak underlying economy.  Instead, what is needed is an instrument for inserting money straight into the economy.  This is because, rather than just cheap credit, companies need greater revenues from stronger sales in order to encourage investment and jump-start the economy again.

A fiscal stimulus fits the bill and has been tried already but only in small doses.  The key spanner in the works in this case has been high levels of government debt.  Before the crisis, politicians everywhere were almost as amped up as bankers and government finances were managed as if the boom time would continue forever.  The results have left us short of workable options to bolster the sluggish global economy.

Using Monetary Policy like a Fiscal Stimulus 

It may sound like a strange solution, but if monetary policy is not working and higher government spending is not possible, central banks could use their money-printing capacities to engineer a fiscal stimulus.  Rather than using freshly printed cash to buy bonds, central banks could just give it away.  Or, to use an analogy that economists like to use, drop money from a helicopter. 

Central banks operate the valves which control the supply of money, which is already being expanded on a temporary basis using quantitative easing.  The helicopter idea is a much more direct approach than shovelling money at the bond market.  Recipients of the cash would be free to spend it as they please, thus injecting money into the actual economy and creating a bonus for firms.  

The cash would not actually be in in the form of notes or coins but could be paid as a cheque or straight into the bank accounts of tax payers.  It strikes at the core of the main problem in the economy, a shortage of demand, allowing for more rapid results and less distortion compared to having surplus cash in the financial system.

The main drawback of this seemingly too-good-to-be-true policy is worries about inflation.  This is also the biggest obstacle as inflation is the primary concern of the central banks that would need to print the cash to be distributed.  It is the belief of many economists that it is the discipline of central banks which has kept inflation down over the past few decades.  Any sign that central banks might allow for more inflation is thought to push prices into a perilous upward spiral.  Yet, inflation is no longer the threat it once was and would not become an issue until the economic recovery was well under way.

Just like any handyman, economists have their favourite tools and are sometimes loath to admit that there might be a better option.  Unfortunately, it may just be a step too far for central banks to overcome their fear of inflation and leave the safety of familiar ground despite the extra firepower on offer.

Japan – Don’t hold your breath

Hopes are high that Japan might be set for an economic reboot but a deeper look at the new policies and politicians involved suggests otherwise.

Your Neighbourhood Economist was once an optimist regarding the prospects for the economy in Japan after having lived there for nine years.  A nascent recovery in the seemingly morbid Japanese economy always seemed to be just around the corner.  It seems as if the economy in Japan is at another possible turning point with a string of new policies that could just do the trick.  The newish Prime Minister has taken on board some bold policies and optimism abounds, but after having been disappointed in the past, Your Neighbourhood Economist is not getting carried away and thinks that another let-down is the more likely outcome.

The despairing state of the Japanese economy is so bad that it makes the Eurozone crisis look like a day out at the beach (where many Europeans will be in August).  Not only is the government debt equal to around 230% of GDP (which makes Greece seem not so bad) but close to half of what the government spends each year is made up from borrowing.  Japan is still dealing with the consequences of perhaps the largest property bubble in history which burst in the late 1980s, but prices for property are still falling over two decades later and share prices are still only around a third of their peak in 1990.  To make things worse, Japan is also in the grip of deflation (falling prices) which typically stops consumers from spending and firms from investing.

Any optimism may seem surprising faced with such problems but the election of a new LDP government headed by Shinzo Abe has sparked hopes of a turnaround.  Abe has prompted a raft of new policies (referred to as the three arrows) encompassing monetary and fiscal policy combined with reforms.  The first two of the arrows have already been unleashed – a 10.3 trillion yen (US$116 billion) stimulus package (fiscal policy) and plans to double the money supply over two years (monetary policy).  The third arrow involves key reforms necessary to revive the economy but only piecemeal policies have been released so far leaving Your Neighbourhood Economist worried that the first two arrows won’t amount to much while the critical reforms will be stifled.

The best policy response to a temporary drop in demand is typically an increase in government spending to make up for the shortfall and keep the economy ticking over.  But this prescription for a fiscal stimulus has been tried over and over in Japan with little avail as the problems are beyond being fixed in this way (for more, see When Keynesian Policies won't work).  Neither does the doubling of the money supply hold much promise.  As shown in other countries with loose monetary policy, companies and consumers have shown that they would much rather pay back debt or hoard extra cash rather than spend or invest it.  So the extra funds from the central bank will only probably show up in the bank accounts and only a small portion of it will likely feed through to the real economy (see Why is the economy still stuck? for more on the poor track record of monetary policy).  An expansive monetary policy tends to be a favoured policy option for governments that are looking for a way to avoid unpopular but crucial measures to shore up the economy (for more detail, see Perils of doing too much).

The best hope for the Japanese economy is the reforms in the third arrow such as joining in on the new Pacific free trade agreement which would open up the economy to more competition from overseas.  The reforms are needed to cut through regulation in many areas which stifle innovation to the benefit of vested interests who resist any changes to this harmful regulation.  This is the nature of politics everywhere but the problem is more pervasive in Japan due to a culture that prizes consensus where making changes in the face of opposition is frowned upon.  The extent to which the Prime Minister is willing to go up against the vested interests is as yet unclear.  The reforms announced in June which were supposed to provide initial targets of the third arrow were disappointing.  While the announcement came at a crucial time ahead of elections (which the ruling LDP party won a sweeping victory), the signs are not good. 

The LDP gets the bulk of its support from the vested interests who oppose reforms and has little impetus to rebel against its support base considering that the main opposition party is in disarray.  The LDP has pushed ahead with reforms in the past – most notably under the leadership of Junichiro Koizumi who was Prime Minister between 2001 and 2006.  But Koizumi was a maverick from outside of the party mainstream while Abe is a party stalwart who has already had an unimpressive spell as Prime Minister.  Abe does not seem to be a true believer in the need for reforms as Koizumi was and Abe’s main focus instead seems to be changing the constitution to increase the military might of Japan.  So while it is high time for a turnaround in the fortunes, it does not look like any amount of arrows will slay the beasts sucking the life out of the Japanese economy.

Time to rethink inflation?

Inflation has been made into a bit of a monster by economists but does inflation deserve its bad name?

Inflation is seemingly innocuous and a bit boring. Prices go up over time without hardly anybody noticing or being able to do anything.  But the experiences of stagflation, when the economy stagnated but inflation was stubbornly high in the 1970s, made inflation public enemy number one for economists.  Even though the global financial crisis has shown that there are far worse gremlins lurking in the economy, worries about inflation are hardwired into the way economists look at the world.  Does inflation still matter or should central banks be keeping their eyes out for something else?

Inflation has been targeted by policy makers since the 1970s when economies in the West were plagued by high inflation and slow economic growth amid the effects of the oil shocks.  Inflation became a central part of a downward economic spiral – rising prices for consumer products due to oil being more costly prompted unions to demand higher pay which pushed up the costs for firms, to which they responded with increasing the prices of their goods. The negative impact of rising prices and wage increases in combination with the higher cost of oil devastated the economy and created a link between economic stagnation and inflation – hence the term “stagflation”.  A turnaround came on the back of the unions losing their power to influence wage negotiations after standoffs with Margaret Thatcher in the UK and Ronald Regan in the US.  But inflation is the boogie man than has given a generation of economists nightmares.

The trauma of stagflation was powerful enough for politicians to give up control of monetary policy to independent banks which was seen as the best means by which to keep the beast of inflation in its cage.  This policy has been successful in that inflation has remained subdued over the past two decades with expectations of low inflation translating into only incremental increases in wages.  This new policy was aided by the development of China as source of cheap labour and an exporter of low cost goods which limited increases in both prices and wages.  Despite achieving what it set out to do, the new policy framework also created new problems.

Central banks have focused on slaying the beast that is inflation but choose to ignore higher prices in other areas such as assets like houses or stocks.  Higher prices for assets have the potential to develop into asset price bubbles which when popped can have a devastating effect as shown by the global financial crisis.  Whether it be because asset price bubbles are not always easy to spot and this would create considerable subjectivity in policy making, central banks have typically shied away from acting to prevent the build-up of asset price bubbles.  Inflation in terms of prices of consumer goods is easier to measure and develop a consensus on the correct policy measures but this may be a case of slaying one dragon only to let a bigger one roam free.

Your Neighbourhood Economist would argue that inflation is not the scourge that it once was.  Relentless increases in wages as in the 1970s are not likely to occur as unions do not have anywhere near the same power as before and also because competition from workers in China and elsewhere means that average wages in Western countries have hardly seen any increases at all.  So the past lessons from stagflation do not seem so pertinent any more.  The global financial crisis occurred at a time of low inflation but following a period of excessive lending by banks spurred on by low interest rates set by central banks.

This does not mean that inflation is something that should be let loose again.  Rising prices eat away at what workers can afford to purchase with their wages and they will be able to buy less with their savings that are stashed away if prices are increasing.  Inflation in one country also increases the costs used to produce goods in that country and makes it less competitive relative to goods made elsewhere.  But to have monetary policy revolve around something that has only a minimal effect on the overall economy is out-of-date and potentially hazardous.  Inflation may also be a route to salvation for Western countries buried under high levels of debt – it is easier to pay back loans if wages and tax revenues are increasing (for more on inflation as a power for good, see What's up with inflation?).  It will take a lot for economists to admit that they have gotten side-tracked by an infatuation with inflation, but the aftermath of a near economic collapse seems as good a time as any to do so.

The perils of doing too much

Central banks have been recruited to stave off economic disaster but they may have been forced into overplaying their hand.

The global financial crisis has propelled central banks into prominent roles in fighting off recession while politicians have been slow to act.  Being the last remaining stalwart against economic disaster, central banks had to go further and do more than would have ever been previously conceivable due to their limited range of policies.  Even though the efforts of central banks have some effect in keeping the global economy afloat, the jury is still out with regard to the distortions left behind by the actions of central banks as well as their new roles as backstops for the global economy.

Most central banks have been given independence over the past few decades due to the notion that this will aid them in their central goal of reigning in inflation.  The theory behind this is that politicians would be tempted to use the tools of monetary policy – setting interest rates and the level of money supply – to boost economic growth and their re-election chances to the long term detriment of the economy.  So independent economists at central banks were given the reigns of monetary policy and a target for inflation of typically around 2% to ensure that a safe pair of hands would be in charge.  The typical cycle of monetary policy involved interest rates rising during periods of strong economic expansion to keep lending in check while a weaker economy prompted cuts to interest rates in order to make borrowing easier. 

The global financial crisis that struck in 2008 involved what could be deemed to be a perfect storm.  Politicians had got caught up in the bubbly state of the economy and government spending got out of hand backed by tax revenues that were later found to be just a temporary fill-up.  This was not just confined to a few countries but the Bush administration in the US, the Labour government in Britain, and many countries in Europe were running large budget deficits at a time when common sense would have suggested putting money away during the good times.  So when the banks got themselves into trouble and required help from tax payers, government finances were already stretched and there was nothing left in the coffers to bail out the economy. 

A crisis of confidence hit the global economy with spending by consumers and investment by companies being cut back due to the chronic uncertainty of whether the banking sector was going to collapse.  Your Neighbourhood Economist would argue, with a good dose of hindsight, that the typical Keynesian policies of an increase in government spending would have been the best response to the global slowdown with government making up for the shortfall in demand from elsewhere.  Government spending could have made up for the shortfall in demand, but the mismanagement of government finances meant that this option was not available.

Monetary policy was always going to be a struggle (a bit of hindsight coming in useful here too) as the activities of the central banks during recessions, such as boosting lending, are generally transmitted through the financial system.  Yet, banks everywhere were fighting for their own survival instead of being concerned about the tinkering of central banks in the background.  The weak translation of monetary policy into positive effects on the actual economy has resulted in the extent of the actions of the central banks having to be ramped up to have an effect.  The most obvious example of this is the recent announcement by the Japanese central bank that it plans to double the money supply in Japan which would be beyond belief even just a few years ago (for more, see All bets are ON). 

Even though the worst seems to be over, central banks are still in a difficult situation in terms of getting out of the role of being the guarantors of the economy.  The massive scale of their involvement in the economy will make an orderly retreat fiendishly difficult due to possible economic hiccups in the future and uncertainty over how the economy will respond.  Even if this Herculean task is pulled off with minimal problems, a new precedent has been set where central banks will now ride to the rescue if the economy goes bad. 

This situation is made worse by politicians who have shown themselves to only look short-term in their focus when dealing with such problems as the Eurozone crisis in Europe or the fiscal cliff in the US.  The expanding responsibilities of central banks may find them overextending themselves to the detriment of the good work they have achieved so far such as keeping a lid on inflation.  Central banks have overachieved during the global financial crisis considering their initial remit but should not have to be relied on to save the day.  Economists are not meant to be super heroes.

When Keynesian Policies won’t work

Japan is set to try yet another fiscal stimulus but this is more about politics than following the ideas of Keynes.

Keynesian policies has made a dramatic return after been shunned as a viable policy option.  Firms and households have reined in their spending due to uncertainty over the future while banks cut back on lending after the global financial crisis.  The resulting slump in demand has opened up a role for governments to fill the gap in spending which is the core premise of Keynesian economics.  But this government action is only ever meant to be a stopgap to boost demand until normal economic conditions resume.

So a stimulus package after an economy has been stagnating for two decades is beyond what Keynes would proscribe.  But this is what the government in Japan is set to embark on.  As well as a likely waste of money, the extra government spending is also a worry considering the high level of public debt in Japan and previous stimulus policies which have resulted in a glut of public works being carried out leaving Japan with lots of roads and bridges which are hardly used.  But worst of all, it is used as an excuse to put off reforms needed to rejuvenate the economy and may doom Japan to another decade of missed opportunities for economic revival.     

The newly elected government, head by the new Prime Minister Shinzo Abe, released plans this month for a stimulus package worth 10.3 trillion yen (US$116 billion).  Abe has also bullied the Bank of Japan into lifting the target for inflation from 1% to 2% as part of a push toward more aggressive policy to get the country out of deflation.  But this is the same prescription that has been administered before in Japan and the outcome will probably be the same too – a short term boost bought with more debt.  To add to this, the Liberal Democratic Party (LDP) which Abe heads does not have the best track record.  Its previous numerous stimulus packages have been more notable for extending the LDP’s hold on power through building needless infrastructure in remote regions to secure votes.  The LDP maintained its stranglehold on Japan for over 50 years of almost uninterrupted rule and was only voted out of government in 2009 despite presiding over two decades of economic stagnation following the bursting of one of the largest ever asset bubbles at the end of the 1980s. 

The LDP is expert at looking as if it is doing something while not actually dealing with the core problems, but even more perversely, it is making things worse by adding to Japan’s mountain of debt.  Government debt in Japan which reached 237% of GDP in 2012 – the highest among developed countries.  Government debt is still increasing at a rapid rate with a budget deficit of 10% in 2012.  Japan’s only saving grace is that it is mostly Japanese banks buying government bonds and Japanese savers have tolerated the meagre returns which banks have been able to offer up as a result.  So Japan has been saved from a debt crisis like that which has plagued Europe but it has also allowed politicians to put off making the necessary changes and ballooning debt must eventually have consequences such as higher interest rates which may trigger bigger problems. 

The persistent sluggishness of the Japanese economy suggests that it is not a shortfall of demand that can be fixed by a fiscal shot in the arm but changes need to be made to help the economy work better.  For a country that relies heavily on exporting, it is relatively closed off to imports which reduces competition and results in higher costs for households and businesses.  Japan has many global firms but it is also a tough place to start a business.  Wages and prices also need to be able to move so the economy can adapt to new circumstances.  Change in Japan will not come from the policies enforced top-down but need to bubble up from below through the activities of individuals and start-ups and the government just need to put in place the reforms to make this happen.  Yet, there are few signs of this happening even after an economic slump lasting over two decades.  It is a scary look into the future for leaders in Europe.