Volume 4, no. 10, October 2016
Author: Kazuo Ueda, The University of Tokyo
In an attempt to combat deflation, the Japanese government recently announced a fiscal policy package exceeding 28 trillion yen. The Bank of Japan (BoJ) joined the effort by easing monetary policy further on 29 July. This comes after more than three years of Abenomics. It is almost an acknowledgement that the stimulus so far has failed to work.
Relative to the 2 per cent inflation target, the actual consumer price index (CPI) inflation rate (excluding energy and foods) is running at 0.4 per cent as of June 2016. This is despite an almost tripling of the monetary base over the past three years. The growth rate of real GDP averaged a meagre 0.7 per cent over the 2013–15 period. Worse still, labour productivity growth remains stagnant.
Demographic trends undoubtedly present the most serious long-term challenge to Japan.
Demographic trends undoubtedly present the most serious long-term challenge for the country. Given Japan’s reluctance to accept large-scale immigration, the average Japanese person will have to work more efficiently to raise output. But the rigidity of the labour market poses a major obstacle to achieving this end. Without more flexible movement of workers within and across firms, attempts at reforming corporate governance will have limited efficacy.
To be fair, the Japanese labour market has become more flexible over the past two decades with the increase in the number of non-regular workers, who now represent close to 40 per cent of the market. This is one reason why the unemployment rate has not increased significantly despite two decades of stagnation.
The increase in non-regular workers has generated a serious income inequality problem, fattening the lower end of the income distribution. At the same time, unlike in the United States, the rich have not been getting richer. Technological developments have instead seen a small number of talented individuals play pivotal roles in productivity enhancement and earn controversially high incomes. Japan’s income distribution pattern suggests that both the merits and demerits of new economies are largely absent, thanks to labour market rigidity and broader cultural factors.
Japan needs specific plans to develop young talent and to effectively use both core and non-core workers. The Abe government must go beyond simply focusing on mitigating the pain of non-core workers and address the inefficiency of the core labour market.
The absence of solid growth prospects and the mountain of existing government debt also produce a fairly gloomy outlook for fiscal sustainability.
The absence of solid growth prospects and the mountain of existing government debt also produce a fairly gloomy outlook for fiscal sustainability. Japan needs to increase taxes substantially and constrain social security spending in order to reduce the government debt-to-GDP ratio. To this end, the consumption tax rate alone will have to almost triple to at least 20–25 per cent from the current 8 per cent. Currently, neither of these options appears politically feasible.
The absence of a realistic plan to ensure fiscal sustainability has produced huge uncertainties concerning future social security benefits and taxes, which negatively affect consumption. The long period of near-zero inflation has generated significant inertia in inflation expectations.
Long-term structural problems and the legacy of two decades of stagnation have become obstacles for effective monetary easing under Abenomics. Easier monetary policies have stimulated asset prices occasionally, but have had limited effect on output and prices.
The BoJ seems to be reaching its limits.
Worse still, the BoJ seems to be reaching its limits. It now owns more than one-third of the Japanese government bond (JGB) market, and this is expected to increase to almost half by the end of 2017. The functioning of the market has deteriorated significantly. It is unclear how long the bank can keep buying JGBs at the current pace.
Reflecting these quantitative easing difficulties, the BoJ made a highly unpopular decision to lower the interest rate on bank reserves into negative territory in January. Given the effective zero lower bound on bank deposit rates, declines in bank lending rates as a result of sharp declines in market interest rates have lowered net interest margins to the point where banks’ traditional business—taking deposits and lending them out—is no longer profitable.
The BoJ could ease further by buying more JGBs or by lowering the rate on bank reserves in the near term, but this would likely only bring forward the day of reckoning.
Popular discussions of Japan’s monetary policy have shifted to the possible use of so-called ‘helicopter money’.
Given the technical limits of quantitative easing and negative interest rates, popular discussions of Japan’s monetary policy have shifted to the possible use of so-called ‘helicopter money’. Proposals vary, but realistically this must mean fiscal expansion for a sustained period.
The recently announced fiscal package is believed to be a stimulus of around 1 per cent of GDP in the near term. More extreme proposals of helicopter money have been raised, such as a large-scale swapping of JGBs held by the BoJ for zero coupon perpetuities. But this would effectively deprive the BoJ of its power to tighten monetary policy when necessary.
The joint stimulus will most likely be insufficient to raise inflation to the target. Yet if inflation does increase significantly, it may aggravate the fiscal situation. Higher inflation rates will allow the BoJ to taper JGB purchases and raise short-term interest rates. JGB yields could increase by more than inflation and the outlook for fiscal sustainability could worsen sharply.
The longer-term economic problems facing Japan are formidable but there is some cause for optimism. In the near term, a more solid expansion in the global economy, especially in the United States and Asia, would relieve pressure on the yen and the BoJ. In the medium term, a 2 per cent inflation rate, if achieved, could animate business spirits and trigger a substantial rise in investment and growth. But for now we will just have to wait and see.
About the author
Kazuo Ueda is Professor of Economics, The University of Tokyo.