Prospects and Risks of the Three-Pronged Policy Package

GOTO Yasuo
Senior Fellow, RIETI

Change in policy as a last resort

The macroeconomic policy recently launched by the new Japanese government, dubbed "Abenomics," is off to a good start. Both the foreign exchange market and the stock market are responding favorably, and the depreciation of the yen and higher share prices are continuing. These developments alone are enough to anticipate an improvement in corporate earnings for export companies and an expansionary effect due to the influence on household assets and other sectors. The three-pronged policy?involving bold monetary policy, flexible fiscal stimulus, and growth strategies?has been producing better results than expected.

The implications of this highly anticipated policy package are significant, given the long-term trends in economic policies since the collapse of the bubble economy. Japan, which suffered a lost decade in the 1990s, had looked for a major change in government policy and began implementing changes, such as Koizumi's Structural Reform (2001-2006) during the Junichiro Koizumi administration, and the transfer of government power to the Democratic Party of Japan (2009-2012). However, the results, at least as measures to boost the economy and break away from deflation, did not appear to be as effective as most of the public had expected. The high hopes for Abenomics would seem to be in reaction to these circumstances.

Although multifarious economic measures have been taken by multiple governments since the 1990s and the collapse of the bubble economy, the idea this time is that the third time's the charm, so to speak, as a big policy turnaround. Given that the fiscal situation has been consistently worsening over the years and has now reached the point of being "stuck" in a conventional sense, Abenomics could be a policy of "last resort."

Importance of appealing to expectations

Escaping from deflation, or a macroeconomic policy centered around an inflation target, which is one of the pillars of Abenomics, is easy to understand as far as its principles are concerned, and is fully in line with standard economic theory. Appealing to expectations is its most important factor, and there are few economists who would disagree with the importance of expectations in the economy. If the economy is believed to be moving toward inflation, then prices set by companies will gradually become inflation-oriented, and as a result, the economy is likely to self-inflate as a self-fulfilling prophesy.

Although this is just hindsight, it is clear that the Bank of Japan itself, as a price watchdog, has reinforced deflationary expectations. It has repeatedly claimed that "there are limits to what monetary policy can do," and, particularly since the collapse of Lehman Brothers in 2008, has given the impression that it is ineffective in implementing monetary policy, and has fallen behind its European and American counterparts in this regard. Of course, it is understandable that the Bank of Japan would have something to say regarding this view. If it allows expectations for monetary easing to take root unnecessarily, it is likely to fall into simply financing the fiscal deficit (covering the profligate binge in public spending) as the government's fiscal reform efforts are precarious. Although it is hard to say which is responsible for the entrenched deflationary expectations?the government or the Bank of Japan?in any case, a massive shakeup will be necessary to change these deeply rooted deflationary expectations.

Huge gamble

The prologue, appealing to expectations, is starting off on a good note. However, to put the outcome into perspective, the current policy package faces huge challenges of a different kind from the economic measures taken by successive administrations. These challenges include a short-term challenge (in five years or so) and a long-term challenge (in 10 years). The short-term challenge is how to handle monetary policy when prices, the economic temperature, actually start to rise in earnest if Abenomics works as well as expected. Experts are particularly concerned in no small measure about the risk of causing fiscal unrest via accumulated fiscal deficit (or concerns for such) in the event there is a mistake in the policy management at a stage when long-term interest rates begin to rise. The combination of monetary easing and fiscal expansion, which now seems to work well, can turn into a negative factor that will immediately bring about a sharp rise in long-term interest rates.

There is also the challenge from a long-term perspective, which is how to formulate subsequent policies if this current bold policy does not produce the desired effect or bring about the undesirable outcome described above. Japan, which failed to break away from economic stagnation even after going through structural reforms that have left no sanctuary and postwar political reform, has put the management of its economy to a policy package that could be considered to be a deadly poison. It's hard to imagine the future if this package doesn't work out. In the sense of being at the end of its rope, as just described, the current policy package very much has an element of a huge gamble.

It is not being suggested that the government should stop implementing this policy just because these problems exist. Rather, the government should think hard about how to get this policy on a comprehensive, sound path just as it is about to go well. To that end, it is important to reduce the gamble element as much as possible, and efforts to avoid provoking anxiety regarding the fiscal situation from a short-term perspective and the growth strategy, the third prong, from a long-term perspective are key. Particularly, regarding the latter, the argument that the population decline and shrinking innovation will reduce the growth potential of the economy, which creates a hot bed for various problems including the financial crisis in developed countries across the board, has been deeply rooted from the beginning. The Great Stagnation by Tyler Cowen, which was published in 2011, is a typical work supporting this argument. If this gamble is an inconvenient truth, then the policy that is currently being carried out will only be a temporary fix, and we will need to overhaul fundamentally the overall economic structure, including public finance and social welfare, at some stage.

This is also an important expectation route that will determine how successful the policy is, in the sense that the government will be able to carry it out easily, as long as it has a contingency plan in place in case the pitfalls of the policy become apparent.

March 19, 2013

March 19, 2013

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