Is Abenomics Working? by Filipe R. Costa

by Filipe R. Costa

Japan shocked the world last Monday when its Q3 GDP numbers were released, confirming that the country is now in a triple dip recession. This came despite the Abenomic efforts aimed at reflating the economy and creating growth. While the consensus was pointing towards GDP growth of near 2% (on a year-on-year basis), the real numbers came in at -1.6%. These were shockingly below the worst of the expectations, putting the country in its third technical recession in less than four years.

After 25 years of zombified growth, Prime Minister Shinzo Abe convinced everyone that he could wake up the Japanese economy and push growth to the 2% level through the “three arrows plan”, which consisted of: 1) flexible fiscal policy, 2) loose monetary policy, and 3) longer-term reforms.

From the very beginning Abe seduced the Bank of Japan into bold monetary action. Early in 2013, the central bank announced a 60-70 trillion yen asset purchase program aimed at quickly increasing the bank’s balance sheet and at pushing consumption and inflation higher. The yen reacted very well to the Abenomics plan and start depreciating against all major currencies, allowing Japan to export its deflation and increase its net exports.

But, while the monetary side of the plan seems executable, as the government can always issue new debt if the central bank can’t find any outstanding to purchase, the budgetary side of it seems concerning. This is because it is a clear incentive for the central government to increase its already huge debt pile. Abe wants to boost economic conditions through monetary and fiscal stimulus but he also needs to cut government debt. The current debt levels stand above one quadrillion yen and surpass 200% of GDP.

How can Abe deal with this double need? The answer is that he simply can’t! He needs to pick one at a time.

In Paul Krugman’s view, Abe should approve more fiscal stimulus for GDP to gain momentum, finance the extra expenses through new debt issues, and hope the future generations can pay for it. In fewer words: he should kick the can down the generations. The fathers spend today, the sons (eventually) pay tomorrow!

But with the population ageing in Japan we have no reason to believe that future generations can really manage to pay for the rising expenses. At this pace, debt will either have to get a haircut or be given a haircut in the future. Did I repeat myself? That’s because there’s only one way to pay for the debt, and that is to cut on its value, either through a default (unlikely) or through inflation. In either case someone will lose the money and it’s up to the government to decide between the bondholders and the whole population (keeping in mind that the second option redistributes wealth from the poor to the rich).

The fiscal situation in Japan is concerning, in particular if we consider the fact that the population is ageing, which is pressing up government spending and contributing to a decline in revenues. To change the current route Abe will need to push for its third arrow of intervention, which involve longer-term reforms. But those reforms take too much time and effort to unfold and to start showing results. Until now nothing (or near nothing) has been done on that part, with all the effort put on the shorter-term growth.

Last year was a success for Abenomics.

The Nikkei index closed the year with gains above 50%. At the same time inflation picked up and GDP growth was gaining momentum. But then came the problem of fiscal consolidation. Abe put into action the first stage of the consumer tax increases plan. Consumption taxes rose from 5% to 8% in April this year. The consequences could only be negative for GDP growth, which declined 7.3% in the 2Q (on a YoY basis). That was the first skid for Abenomics.

A few weeks ago and after many months of inaction, the BoJ decided to increase the pace of its asset purchases from 60-70 trillion yen to 80 trillion yen. That was the second skid for Abenomics, as such a move is recognition that the bold monetary action is not enough to drive 2% annualised growth.

Monday’s GDP numbers have shown that an increase in taxes is not the same as a writedown in a company’s income statement. The consumption tax hike not only affects current decisions by consumers but also future decisions by producers. If consumption is lower today, businesses will decrease capital spending for tomorrow. That’s exactly what happened and the main reason why the Q3 GDP numbers kept the contractionary route and threw the Japanese economy into a technical recession. That was the third skid.

But there’s no reason to be afraid!

The Nikkei index declined 3% overnight on the GDP numbers but managed to recover 2.2% over the following session. Optimism is still on the table and has just got enhanced by a delay in the consumer tax hike. At the time of writing, Abe is addressing the nation, pushing for early elections (hoping to regain a 4 year mandate, extending its time as Prime Minister from 4 to 6 years) and he just confirmed the postponement of the second stage of consumer tax increases (from 8% to 10%) from October 2015 to April 2017, as the economy is lacking the momentum he needs (not that he added this last part). That’s the fourth skid.

The three arrows plan is full of incongruities and will go through many setbacks.

The recent past tells us that any attempt to consolidate public finances has severe consequences in growth and that not even ultra loose monetary action can prevent them from occurring. Unlike what was first planned, Abe needs to choose between growth and sound public finances, a decision he had already taken and which goes in the direction of growth. This will help the equity market regain momentum for the next few months, as investors would believe growth is lying at the end of the tunnel just to be picked up.

The yen will likely continue to depreciate for some time more, as Janet Yellen is not in a hurry to act because the US economy is gaining momentum. In Europe Mario Draghi has no ammunition, as the sovereign debt purchases he talks about are just a mirage in his mind (at least for now). For these reasons I expect Japanese equities to be on a friendly footing. But in contrast with Krugman, I believe that Abe is just contributing to the deterioration of the living standards of the generations to come, who will herald a huge debt problem to solve.

Persistent low interest rates and ultra loose economic policy should only be used as temporary tools, to smooth the business cycle, and never as an attempt to change the longer-term route of an economy. Sometimes an economy faces structural problems that just can’t be dealt with outright asset purchases. That’s the case when there’s capital accumulation in the wrong sectors for too long.

During the 80s, industrial firms in Japan could borrow as much as they want from banks. Credit was unlimited, house prices skyrocketed, equity prices boomed and some pernicious things happened. At some point the value of the land under the Imperial Palace in Tokyo was greater than the value of the entire land where California is located. Kindleberger very well describes the mood of the time:

“A racetrack entrepreneur from Osaka paid $90 million for Van Gogh’s Portrait of Dr Guichet, at that time the highest price ever paid for a painting. The Mitsui Real Estate Company paid $625 million for the Exxon Building in New York even though the initial asking price had been $310 million; Mitsui wanted to get in the Guinness Book of World Records for paying the highest price ever for an office building. (Kindleberger: Manias, Panics and Crashes, 2005, pg.9).”

Optimism was huge and a massive credit bubble emerged. The distortions occurred for so long that it would take more than one generation for the situation to correct. The prick of the bubble occurred during the nineties but government policy is perpetuating the problem by preventing the necessary economic adjustments from occurring. The Japanese economy needs to get rid of all bad debts accumulated over the years.

As an extra note, I just wonder what will happen to Malaysia, Singapore, Thailand, Philippines, Taiwan, Australia, and others who significantly depend on Japan for their external trade. With the yen going south, these countries can’t keep interest rates unchanged, at the risk of importing the crisis from Japan.