Abenomics is working for Japan. The Japanese yen has fallen below the level of 100 against the US dollar and stocks are up 50% since the beginning of this year. For those of you who do better things than tracking financial markets and complex policy moves, Abenomics refers to economic ideas promoted by Prime Minister Shinzo Abe in Japan to end almost two decades of deflation. Abe campaigned and won 2012 election on the promise, among other things, to use the power of the central bank to end deflation. But why is deflation so bad? Since prices are continuously falling in the state of deflation, there is no incentive to invest in plant and machinery as the realization from investment will keep falling and the debt burden, if any, will keep rising in the real terms. Japan is in a similar situation since 1990s.
Therefore, with a clear mandate from the political establishment, the Bank of Japan (BoJ) on 4 April announced that it will target 2% consumer price inflation at the earliest possible with a time horizon of about two year. In order to accomplish this mammoth task, the Japanese central bank is pursuing a massive quantitative easing programme. BoJ will increase the monetary base by 60-70 trillion yen ($600-700 billion) per year and will buy host of assets from the marketplace.
There are two clear objectives that the policy intends to achieve. First, the commitment to a level of inflation will bring in confidence among Japanese people to spend and invest. Second, the supply of yen in the marketplace by BoJ will pull down the value of yen against its trading partners which will help revive exports. The strategy, as of now, seems to be working. Stocks are up, consumers are spending, housing start is up, and the currency is depreciating. However, the moot question is will this experiment, possibly the boldest by any central bank, solve the problems of heavily indebted and ageing Japan. Even though Abenomics is showing signs of initial success, there is something deeply unconvincing about it. If things were so simple, why quantitative easing did not work in the past? If the quantum of commitment is expected to do the trick, why was it not tried in the last two decades?
To be sure, the newly found policy zeal of Abe and now BoJ are not exactly an “out of the box” approach. This was prescribed to Japan number of times in the past by heavyweight economists including Paul Krugman and Ben Bernanke. Bernanke, in fact, called for a “Rooseveltian resolve” in a 1999 paper. “Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for some Rooseveltian resolve in Japan,” Bernanke then noted in conclusion. Further, in an address in Tokyo in the year 2003, Bernanke again called for aggressive action and said: “In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say ‘no’ to the government. With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for.”
Interestingly, even though the Japanese central bank and the policy administration at that time did not accept such experimental ideas, Bernanke had to put them into practice in his own country as the chairman of the Federal Reserve in order to minimize the damage inflicted by the worst financial and economic crisis since the Great Depression. But the unconventional and open-ended route of monetary easing is reaching a critical stage. In a recent address in Chicago, Bernanke underlined, “In light of the current low interest rate environment, we are watching particularly closely for instances of ‘reaching for yield’ and other forms of excessive risk taking, which may affect asset prices and their relationships with fundamentals.”
Concerns have also been expressed by several members of the board of the Federal Reserve. In the 19-20 March meeting, members agreed that there are potential costs and risks to the asset purchase programme. Therefore, sooner or later, the Federal Reserve will have to device an exist plan despite no potential inflationary threat.
Remember this is a completely uncharted territory and we do not know how the markets will react and what will happen to the inflationary expectations in the US. In fact, we may be looking at a scenario where assets prices fall despite improvement in the economic activity as the Federal Reserve begins to exit, either under pressure from rising asset prices or because of getting closer to its target of unemployment level of 6.5%.
Coming back to Japan, with its rapidly aging population, things are far more complex than in the US. Too much should not be read into the initial success in the capital market. The hint of quantitative easing was sufficient to attract global fund managers sitting on truckloads of cash in the developed world, but making money cannot be as easy as shorting yen and buying shares for a long time. Remember reversals in financial markets are equally sharp.
End note: It is not difficult to argue that a timely monetary policy intervention helps in containing the damage after a mishap, as successfully demonstrated by the Federal Reserve in the aftermath of the crisis in 2008, but it still remains to be seen if the power printing press can solve hard economic problems in the long run. Meanwhile, there will be some indented consequences of Abenomics as well.
For starters, it is hard to believe that South Korea and China in the region would be willing to pay the price for a Japanese revival for long.