The release of Japan’s third quarter real GDP data last week took observers by surprise. Rather than growing, the Japanese economy shrank by annualized rate of 1.6%. This comes on the back of a 7.3% decline in the second quarter, meaning that the Japanese economy is technically in recession again. Does this mean that the economic policies of Prime Minister Shinzo Abe—the so-called Abenomics—are failing to bring the economy out of two decades of deflation and weak growth? Our view is that is not the case. Japanese policies are on the right track to get the Japanese economy out of deflation, but weak global demand and lower commodity prices are making it more difficult to achieve this objective.
Almost two years ago in December 2012, Shinzo Abe assumed the prime minister office with the aim of reviving the Japanese economy after its long stagnation. Before Abe came to power, Japan’s so-called “lost decade” (more accurately “lost two decades”) had three main problems. First, Japan’s growth had been weak since its financial crisis in the early 1990s. Japan grew by an annual rate of less than 1.0% between 1991 and 2013, compared with more than 4.0% in the 1980s. This was partly due to the bursting of the housing and stock market bubbles, but it was also accentuated by the declining population, which reduced the supply capacity of the economy.
Second, as households and corporates cut their spending in order to reduce their high levels of debt, aggregate demand collapsed and negative inflation (that is deflation) set in. Deflation depressed aggregate demand further as consumption was postponed in anticipation of lower prices in the future and investment was reduced as real interest rates increased. Third, when the government stepped in with stimulus measures to boost aggregate demand, government debt ballooned from 69.4% of GDP in 1990 to around 243% of GDP in 2013, raising questions about the sustainability of public finances.
Abenomics has attempted to attack these problems over the last two years with three arrows: monetary easing, fiscal stimulus and structural reforms. Almost immediately after Abe took office, the Bank of Japan (BoJ) introduced an inflation target of 2% in an attempt to escape deflation. This was followed by a complete overhaul of the BoJ’s leadership, with a new governor and two deputies. The new BoJ leadership did not waste time and introduced a massive program of asset purchases, quantitative easing (QE), on its first meeting in April 2013. This was followed by another round of QE in November 2014.
On the fiscal side, Abenomics combined permanent tax increases (in order to keep public finances sustainable over the long run) with temporary stimulus (to sustain aggregate demand in the short run). Finally, Abe’s third arrow involves structural reforms to boost the supply capacity of the economy with attempts to increase participation of women in the labour force to counteract the impact of the declining population. In addition, these reforms seek to boost competition and productivity in the labour market as well as the agriculture and health sectors. However, these reforms take time to yield a growth dividend.
The initial impact of Abenomics was quite positive, especially QE. Real GDP grew by 1.5% in 2013 and consumer price inflation reached 1.6% in March 2014. Inflation expectations responded positively to the new measures, suggesting that the economy could finally escape deflation. As a result, policymakers felt confident enough to proceed with the planned increase in the consumption tax from 5% to 8% in April 2014.
Following the tax increase, GDP declined by 7.3% in Q2 2014. This was initially attributed to consumers shifting their purchases to the first quarter of the year (where growth reached 6.7%) ahead of the tax hike, so the decline was expected to be temporary. But the much lower-than-expected real GDP data for Q3 suggest that the impact of the tax hike might be longer-lasting. Moreover, weak demand for Japanese exports due to the faltering global economy further depressed the Q3 GDP numbers, despite the competitiveness boost from a weaker Japanese Yen. Progress on inflation also has stalled, partly due to falling commodity prices as Japan is one of the largest commodity importers in the world.
This leaves Abenomics at a juncture: either proceed with the original plan for another hike of consumption tax (from 8% to 10% effective from October 2015) and risk deepening the recession further; or postpone the tax hike until the economy has gathered enough velocity to escape deflation, risking a fiscal crisis given the high levels of public debt. Abe has favoured the latter option. Abe has decided to postpone the tax rise until April 2017 and call for early elections later this year.
This presents a reality check on the early optimism surrounding Abenomics. The lesson from the Japanese experience is that escaping a deflation trap is not easy. It is made even more difficult when the global economy is faltering and global commodity prices are falling. It is therefore better to do whatever it takes to avoid falling into a deflationary trap in the first place. The Eurozone should take note.