Prime Minister Shinzo Abe began his second stint as Prime Minister by promising to jolt the Japanese economy out of its two decade-long slumber with a bold mix of monetary stimulus, and fiscal policy, and structural reform. However, his third “arrow” — structural reform — has not really come to fruition. Abe’s plan seems to have been to rely on more politically palatable fiscal and monetary expansion. He hoped that large, combined bouts of fiscal and monetary stimulus would mask Japanese structural problems and lead Japan to a recovery, bolstering his popularity in the process. However, good politics does not always translate to good economics. Two years on, his plan has largely failed and government officials have become increasingly anxious. The Prime Minister has two options moving forward: he can either try more of the same or take another, braver stab at structural reform.
Abe’s economic package, or “Abenomics” as it has became known, caught the attention of the world as an audacious and unorthodox plan to finally rid Japan of economic stagnation. However, it was not all that radical to begin with. For example, the Japanese government tried traditional Keynesian deficit spending throughout the 1990s to boost the economy – but to no avail. With a government debt-to-GDP ratio of approximately 240%, Japanese consumers know that any fiscal stimulus package is likely to be followed by government cuts or tax increases in the future to keep the national debt under control. When governments have high debt-to-GDP ratios, the multiplier effect of a fiscal stimulus generally gets smaller and smaller for this exact reason; it becomes difficult to convince consumers that a recovery is around the corner. Sure enough, in Abe’s case, a fiscal stimulus in 2013 was followed by an increase in the national sales tax in early 2014. Consumer spending slumped due to the rise in the consumption tax, offsetting the marginal gains from the fiscal stimulus a year ago.
The government also miscalculated the effects of the central bank’s massive quantitative easing program. Though the program intended to weaken the yen, which would make Japanese exports more competitive and lead to an export-led recovery, it failed to do so because most Japanese manufacturing companies produce their goods overseas. In recent years, the Japanese economy has become less reliant on exports and more service-oriented. Therefore, a weaker yen is not the silver bullet that it once may have been. The net effect of a weaker yen on the Japanese economy might actually be negative, as small- and medium-sized businesses will find it costlier to import raw materials. The government cannot simply rely on boosting exports to end stagnation, especially in the face of a fragile world economy.
The problems of the Japanese economy are not cyclical but structural in nature. The inflexible labor market and the lack of immigration have prevented any sustained recovery. Firms are unable to fire workers and are forced to hang onto them, however unproductive those workers may be. Some firms have even tried to force workers to leave by banishing them into special rooms and leaving them with nothing to do. Hanging onto excess workers has raised the cost of production for Japanese firms and has made them unwilling or unable to increase wages and salaries. As a result, wages have failed to keep up with inflation. This fall in real wages, combined with the rise in the consumption tax, has severely depressed domestic demand, making the prospect of a recovery extremely bleak. The fall in consumption has in turn dented business confidence. Companies are hoarding cash instead of investing in new equipment. The brief optimism that characterized the return of Shinzo Abe to the government’s helm has given way to widespread pessimism.
The problem of having one’s name attached to an economic program is that one is quick to receive the blame for its failure. Mr. Abe’s popularity, once the envy of leaders across the developed world, has dipped to its lowest point since he took office. In the face of falling approval ratings, he might be tempted to delay the second consumption tax hike or even implicitly pressure the central bank to embark on more QE. Both moves would be unwise. A delay in the consumption tax hike might alarm bond markets, while another round of QE will allow the government to shirk from much needed structural reform. Instead, the Prime Minister needs to expend some political capital and focus on tackling labor market rigidities by making it easier for firms to hire and fire workers, overhauling the social security system, and moving towards a more liberal immigration policy. Only then will Mr. Abe recover his reformist zeal.