Japan's Abenomics: Reload, Reset or Relaunch?

I would like to talk about Abenomics and the challenges Japan is facing. A number of developments have taken place since the International Monetary Fund (IMF) board discussed our report at the end of July and published papers in August. A new stimulus package has been announced by the Japanese government and the Bank of Japan's (BOJ) monetary policy framework has changed. I will update on how we view Abenomics: how far it has come, the remaining obstacles to achieving its goals, and available policy options. Finally, I would like to focus on recent policy developments—what the authorities are doing, which of our recommendations are being adopted and which are not, and our thoughts. Some of the recommendations we make are unconventional or novel, and it is not always easy to put them in the right context.

Abenomics was somewhat successful initially. There was a reversal of the yen appreciation that took place before 2013 and an enormous boost in corporate profits. Actual and expected inflation increased; they remain low but were worse before. For the first time in decades, Japan has experienced three years of sustained wage growth, admittedly at low levels. For all practical purposes, I think the Japanese economy has achieved full employment. Everyone who wants a job has one, whether or not it is ideal. The rest of the world is very envious of Japan's low unemployment rate and cohesive labor market. Finally, we have also seen a steady increase in labor force participation with improved corporate governance, another area where Abenomics made a real difference.

There is consensus that good progress has been made, but we also know that the targets have not been reached on the growth rate, the primary surplus, or the inflation rate. This raises the question of what can be done.

We have to recognize that if we continue the current policies, growth in Japan is likely to remain weak despite the recently adopted economic stimulus package, which will definitely improve the outlook in the near term. We see long-term growth in the Japanese economy and inflation well below the targets. Even over the medium term it will be very difficult to reach the target of 2% inflation if policies are not adjusted.

Fiscal consolidation is very much a work in progress. The consequence is that fiscal debt remains unsustainable. Without significant policy changes, we will continue to have an unsustainable and rising debt-to-gross domestic product (GDP) ratio.

Why has Abenomics not achieved greater success? I believe there are essentially three chapters to talk about. The first is the economic headwinds: exogenous developments beyond the control of the Japanese authorities which have negatively impacted the chances of achieving the targets. The second is domestic structural factors that may hamper the achievement of the targets and that may not have been sufficiently tackled so far. Finally, there are obvious questions about whether the policies have been effective. Efforts may have been too limited or ineffective in some areas.

The headwinds are quite well understood. Around the time Abenomics started to take off, global growth started to weaken significantly. The Japanese economy didn't receive much benefit from the initial depreciation of the foreign exchange rate because there was very weak export demand. The export response to this depreciation has been very mild. More recently, the depreciation has reversed, so we cannot expect much benefit from that side. At the same time, the same global slowdown led to a drop in commodity prices. This came at a bad time for Japan, because attempting to create reflation and inflation domestically during a decline in tradable goods sector prices is very difficult.

Looking at the very near term situation, financial conditions have tightened slightly over the last few months in Japan. The exchange rate has appreciated since the beginning of the year, and there has been some turbulence in equity markets and some issues related to bank stocks. This is reversing a bit now, but these developments have left financial conditions tighter. These issues are also somewhat outside the control of the authorities.

Domestic structural factors may also be impeding success. Everyone is aware of the demographic factors: a declining population and labor force. The contribution of the labor force to potential growth has become negative and will become increasingly more so over the next couple of decades. This means that growth has to rely on total factor productivity (TFP), but TFP may also decline in an aging society. The outlook is therefore relatively subdued.

The labor market is at least an equally important structural impediment. Japan established a labor relations system and a model for the labor market that served its development very well after World War II. It was a coherent model which offered people long-term contracts in exchange for flexibility. Multinationals arose amid growth in the tradable goods sector. It included consensual and clear labor relations. However, the global economy has changed greatly over the last two decades. It is unclear whether Japan's lifetime employment model could actually withstand significant shocks, such as large changes in competitiveness or the emergence of a global labor supply from the expansion of China, India, and other countries. It is quite clear that shortly after the Plaza Agreement, when the yen appreciated quite significantly, employers called for changes to ensure competitiveness which led to the introduction of a set of different labor contracts, including non-regular contracts. This worked well and has continued to work very well despite the global financial crisis and competition from Chinese labor.

There is, however, very little movement from non-regular contracts to regular employment. The consequence of this is a very dual labor market, which has a negative impact on productivity because it doesn't allow much reallocation or mobility of workers among different companies. Also, the fact that now almost 40% of the labor force is employed in non-regular, short-term jobs limits investment in human capital, because enterprises have no incentive to offer training to a short-term, unstable labor force.

Finally, one important issue that underlies much of our policy advice is that Japan has created a labor market with a complete absence of wage pressure. There are more job vacancies than applicants. That would typically lead to a very sharp increase in wages to attract talent, but this is not happening. Why? The lifetimers are more concerned about job security, so they don't ask for higher wages, and the non-regular workers are much more concerned with securing their next job and do not have much control over wages. To us, this is one of the crucial reasons why Abenomics has floundered.

Corporations have amassed massive profits under Abenomics, due largely to the initial depreciation of the yen, which they now hold as cash in mindboggling quantities. These corporate cash reserves now amount to almost 50% of GDP. Essentially, I think this is the major problem with Abenomics: higher profits and depreciation were not shifted to wages and so there is no pressure in the system.

Aging also has a dampening effect on growth. The baseline for the future is one of low potential and a low real growth. Econometric work looking at the impact of changes in old-age dependency on labor productivity and TFP show that this is negative. We do not have a specific explanation for why this is the case, but one hypothesis is that mid-career workers in the 45-55 age group (maybe up to 60 in Japan) are the most productive workers. As the density of that part of the population distribution diminishes, TFP growth falls.

The last chapter of the story of the obstacles to Abenomics is policy. Monetary policy has been used very well, but aside from an initial acceleration of credit growth, there isn't much happening anymore. The recent decisions that were taken by the BOJ and their effectiveness over the past few policy meetings don't seem to have impressed markets.

On fiscal policy, there is a similar story. There is concern about its stop-and-go nature and how that contributes to economic uncertainty. We built a new index of economic policy uncertainty to investigate these effects. The preliminary results show that if there is a shock to policy uncertainty, there will be a very negative effect on investment in Japan. Observing the recent increase in the uncertainty index, we can explain why enterprises are holding back on investment, which is not good for growth in the short or long term.

We looked at the risks and returns associated with three sets of policy options. We call the first a comprehensive policy "Reload" where we want to overcome these headwinds, tackle the structural rigidities, and make policies more effective, and do this as quickly as possible. The question is, "What policies can deliver this outcome?" Second, if the necessary policies to achieve a Reload aren't feasible, what other options are available? We call this the "Reset" option: more realistic targets and timeframes are adopted to achieve those targets. Finally, with the "Relaunch" option, since there has been so much talk about unorthodox policies around the world, we tested the Krugman-Turner-Svensson ideas including helicopter money, etc. I will present them in order from most to least recommended

We at the IMF really like the "Reload" package, which is comprehensive reform. Japan sincerely needs to boost nominal incomes and wages and accompany that with labor contract reform to adapt the labor market to the 21st century and make it work better. Calling for higher wages is an important but controversial element. The IMF usually calls for wage cuts rather than increases.

To be successful, these policies need to be supported by demand policies. An essential requirement of this package is that fiscal and monetary policies need to support demand, especially in the near term. The BOJ went a long way in that direction last week. At the same time, we have to be mindful of the long run. Particularly on the fiscal side, demonstrating an ability to solve the fiscal sustainability problem is necessary. In the long run, potential growth is most important. Structural reforms will be the main driver of this. Wage-bargaining power should be increased, and conditions improved for non-regular workers to improve wage pressure. Very strong, accelerated structural reforms are needed to boost productivity and potential growth.

The duality of the labor market has affected incomes. In Japan, wages have lagged behind productivity growth quite significantly. This is difficult to fix. No clear, immediate policy tool is available. A few different policies can be used in concert to promote wage growth in the economy. We could raise minimum wage growth. The authorities have already done this, raising it to 3% (the inflation target plus the expected productivity change), which makes sense. Tax incentives have been put in place. Some 70,000-80,000 enterprises have used them. Perhaps those incentives can be increased or simplified to encourage their wider use. A "comply or explain" mechanism similar to that used for corporate governance reform could be employed: the government could set the tone by raising the salaries of public workers by 2%.

With inflation expectations backward-looking, the only way to raise them is by increasing actual inflation. Cost inflation (traded goods and wages) will be necessary to generate inflation. Hence, the purpose of income policy is to use wages to push up prices together with contract reform so that workers have greater wage-bargaining power. However, higher real wages cannot be the only goal, as they could depress investment and prices, but this doesn't have to be the case. What we really want is for these increased wages to translate into price increases, creating a virtuous wage-price spiral. In addition, given the gap between real wage and labor productivity growth, a case can be made that labor deserves more, so a small shift from profits to wages is completely justified.

Both economic and fiscal policy need to remain geared at safeguarding long-term sustainability. Consolidation should be preannounced. For example, a smooth, gradual consumption tax increase could be preannounced. Also, a very clear cap can be put on social security spending as well as establishing a mechanism to ensure that spending remains under it. On the monetary framework, last week, the BOJ moved in the direction of greater sustainability. It recommitted to its inflation target by committing to sustainably overshooting the 2% target over the medium term. It has also switched from a quantity to a price-based monetary framework, allowing more sustainable easing which doesn't rely on the availability of certain types of assets in the market but rather sets the price. The BOJ elected not to abandon the quantity target altogether because it would have been difficult to communicate. Further clarification should also be implemented.

All of these policies are mutually reinforcing, so there is no option to implement only some and not others. All of the elements need to be tackled simultaneously, which is a very difficult challenge for policymakers. If this proves impossible, we recommend resetting targets and policies.

Resetting will not allow inflation and real growth to be lifted as quickly as desired. Trying to do so would entail volatility and risk. In that context, monetary policy has to remain easier for a longer period of time. It could be set and allowed to work gradually over time. Similarly, fiscal policy to generate high inflation and wage pressure cannot be used without creating fiscal risks if the other policies are not implemented. Here, too, then, the recommendation would be to go very surely, steadily, and gradually over a very long period of time.

Finally, some unorthodox policies have been suggested. Some small countries are successfully using such policies, but the United States would not allow Japan, for example, to peg its exchange rate. Krugman and Turner recommend large, more or less monetized, fiscal expansions. This works in standard macro models with stylized assumptions. Real world problems could arise, however. The Japanese public might decide to save all of the extra money. Inflation scares could lead to dislocations, etc. The packages are logically coherent; if everything goes well, they might help. The problem is that if one of the risks becomes unmanageable, it could basically create really catastrophic damage not only to Japan but also to other parts of the world. The Japanese government bond (JGB) market and the yen are international financial instruments. Disrupting them could create negative spillovers.

Current Japanese policy lies somewhere between the various packages. On income policy, we have minimum wages and tax incentives, but we don't have private wage increases, public sector wage increases, contract reform, and measures to push wages. With regard to fiscal policy, we have near-term stimulus to support other policies, but we don't have a credible medium-term framework and realistic macro assumptions. On monetary policy, I think we have the accommodative stance and a sustainable framework, and we can still do some work on communication and clarification. On structural reform, we have corporate governance reform, child and nursing care reform, and some other reforms, but we do not have measures to boost the labor supply, and a lot more can be done on productivity, especially in the services sector but even in the financial sector.

Q1. The BOJ has tried to control the yield curve. Do you have any ideas on this unprecedented move? In our internal discussions of these policies, we have identified two main problems: 1) the relationship between the shape of the yield curve and economic activity is unstable and 2) it may be difficult to control the yield curve despite the BOJ's many tools. Achieving the yield curve policy would not be very effective from our perspective.

Luc EVERAERT
You bring up very valid concerns. There is a precedent from the United States which was a partial success. Interestingly, this is what led to the Fed becoming independent. This type of policy strengthened central bank independence. We also think that the policy adopted by the BOJ has pros and cons. The yield, instead of a quantity, can be targeted for much longer than having to rely on the size of a particular market. There is even a sense that it would allow the BOJ to reduce government bond purchases because, after all, central banks don't have to take action to commit to a price target. They can simply threaten the price target. It would be interesting to see how that would play out. We would be able to see a larger residual JGB market in private hands, which might benefit trading, liquidity in the market, etc.

However, you are correct to point out the potential for distortions. The BOJ cannot be sure that the yield curve it has targeted exactly matches the macroeconomic situation of the country. Possible drawbacks exist. It is also important to note that the yield target hasn't been set in stone. The target could be adjusted if positive or negative shocks hit the economy, moving it away from the baseline scenario. For example, a positive shock would raise the interest rate, but if the BOJ were to adhere to the target, the transmission of monetary policy would be strengthened. The BOJ would make its easy stance more effective by keeping the interest rate low. In the opposite scenario—a negative shock to the economy to which the BOJ doesn't adjust—monetary conditions would tighten. In that case, the BOJ could decide to lower the yield target. It also has the option to work on the short end as opposed to the long end, so it can manipulate the slope by moving the short-term rate up or down.

The extent to which these conditions are correct from an economic perspective will greatly depend on the evolution of the BOJ's reaction function.

Q2. On small and mid-sized enterprises (SME) policy, you mentioned a package of policies concerning income policy, contract reform, and so on. This might be good for medium-sized or large companies, but it might be difficult to apply these kinds of policies to SMEs. Do you have any ideas as to how these kinds of policies could be applied to SMEs?

Luc EVERAERT
This is exactly the kind of feedback I like to get. This makes us think very carefully. I don't have a definite answer, but we did consider it to some extent. Even though the Japanese economy consists of an enormous number of small enterprises, a lot of them are actually servicing larger enterprises. I suspect that if the large enterprises set the tone in terms of doing this, it would be difficult for the SMEs not to follow them. Tax incentives for wage increases are being used by some of the small enterprises. Perhaps those tax incentives for SMEs could be strengthened. We will think about this more.

Q3. In the United States, the labor share has been shrinking, and this is also the case in Japan. An ILL report stated the financialization of the economy was behind this. In Japan, there has always been a discussion about the various stakeholders, but do you think with corporate governance reforms and the emphasis on profits, would that make it more difficult to raise wages? Do you think the emphasis on profitability and the push towards greater financialization would have an impact on Japanese wage increases?

Luc EVERAERT
I must admit I haven't studied this in great detail. I think that the corporate governance reform in Japan is probably going to initially strengthen what you call financialization by focusing on share buybacks, mergers and acquisitions, using capital to acquire businesses, and the like. Initially not much pressure to raise wages will exist. Will increased financialization make it more difficult to raise wages? I don't think so. I think that once it is understood that this mechanism is meant to create wage price pressure and not shift profits down, shareholders will accept it.

In the historical context, when the yen has moved, profits have gone through the roof. It is normal for these profits to move to wages and investment. I think enterprises are sitting on a cushion of profitability that can be deployed to raise wages, etc.

There may be a constituency for the implementation of labor market reform. From an enterprise perspective, increasing the share of the labor force that is working under flexible contracts would be win-win for corporations and for labor. It would allow corporations to invest more in human capital but still have the security of being able to lay off these workers.