During the past 17 years, Japan has experienced sizable deflation; for example, the GDP price deflator declined on average by about 1% per year since 1995, and it declined during the past couple of years by 2% per year. Since many wages and other prices cannot be adjusted downward very easily, deflation tends to distort labor and other markets. To end deflation and stimulate the Japanese economy, Prime Minister Shinzo Abe has introduced a set of policies called “Abenomics”.
These policies have “three arrows”: massive fiscal stimulus, aggressive monetary policy a la the Federal Reserve’s QE’s 1-3, and improved competitiveness of the Japanese economy. It will take many years to greatly improve the competitiveness of the Japanese economy, so for the next few years Abenomics has to rely only on fiscal stimulus and aggressive monetary policy.
Given that Japan’s ratio of debt to GDP is already the highest in the world at almost 2 to 1, Japan can hardly do much more in the way of fiscal stimulus without creating an even larger debt burden. The debt/GDP ratio has reached such a high level because fiscal stimulus was the main weapon used to try to jumpstart the Japanese economy during the 1990s and early part of this century. This policy was basically a failure since large fiscal deficits did not prevent the Japanese economy from growing slowly, and they did not prevent consumer and asset prices from consistently falling.
Short-term interest rates in Japan have hovered near a zero nominal rate during the past 20 years, partly because of the fiscal and other efforts to stimulate the Japanese economy. Long-term nominal rates have also been quite low. Abenomics wants the Central Bank of Japan to start purchasing bonds and other assets on a large scale with the intent of both lowering real long-term interest rates further, and greatly increasing bank lending and the money supply. Increased bank lending and a greater money supply would likely end the many years of deflation and cause prices to rise, with a goal of a 2 per cent annual increase in prices.
The hope is that lower long-term interest rates and greater availability of credit will also stimulate investment and innovation, and thereby increase the growth rate of the Japanese economy on a sustained basis. Lower real interest rates are also expected to reduce the value of the yen in international markets by making Japanese bonds and other assets less attractive to world investors. A lower real value of the yen-that is, lower after adjustment for the increase in Japanese prices-would increase consumer demand in other countries for Japanese exports.
Will Abenomics, and its main manifestation in more aggressive buying of assets by the Bank of Japan, succeed in increasing the economy’s growth rate? Japan is trying to copy the Fed’s large-scale asset purchases in the Fed’s efforts to limit damage from the financial crisis, and get the American economy rolling again. The Fed’s actions have had 3 stages: QE1, introduced during the early days of the crisis, attempted to prevent the American economy from slipping into a very serious depression. QE2 and QE3 were implemented after the American economy was in a major recession, and they were designed to reduce unemployment and increase the growth rate of American GDP.
Most economists, including myself, believe that QE1 was extremely important in providing liquidity to the American banking system at a time when liquidity was in scarce supply. But I have many doubts about the efficacy of QE2 and QE3 that further increased bank reserves, and lowered long-term interest rates even further. Although the evidence on the effects of these Fed actions is not conclusive, despite the aggressive actions the recovery of the American economy has been slower than in any previous recession. More than 4 years after the crisis erupted, unemployment is still about 7 1/2 % (compared to under 5% before the crisis), and the growth rate of GDP is still far below its long-term growth path.
Japan is not in a financial crisis, so the success of QE1 in providing liquidity to banks is not very relevant. Expansive monetary policy by Japan is likely to end its deflation and lead to price increases. That is the good news. The bad news is that the evidence so far on QE2 and QE3 is not reassuring that Abenomics’ monetary loosening will significantly raise the long term growth rate of Japan’s real GDP.