Desperate times call for desperate measures. The International Monetary Fund seems to have lost hope that monetary and fiscal policy can shift the Japanese economy out of its deflationary torpor. The IMF, usually the embodiment of conservative mainstream economics, has published this working paper and these consultation documents that suggest Japan should embark on a comprehensive incomes policy so that wages will rise strongly.
Incomes policies are normally imposed in order to restrain wages, not to boost them. What’s going on?
Prime Minister Abe’s 2012 ‘three arrows’ program projected a speedy return to growth, 2% inflation and a balanced budget by 2020. The initial reaction to ‘Abenomics’ was favourable: the stock-market rose 60% and the exchange rate fell by more than 20%. This eased financial conditions, boosted corporate profits, and lifted actual and expected inflation into positive territory.
But this improvement was not sustained. The exchange rate has appreciated. The IMF expects the Japanese economy to grow by 0.5% this year, 0.3% next year and slower still thereafter. Core inflation is expected to decline and headline inflation, running at 0.2% this year, will rise to 0.6% next year – well short of the 2% target.
The economic conjuncture in Japan is special, perhaps unique. In the past 25 years (1990-2015) real GDP has grown at an annual average of 1%, which might sound slow, but demographics mean that Japan’s working population has been declining. Japan’s GDP growth per worker over these 25 years (the so-called ‘lost decades’) is about the same as America’s. And current unemployment is quite low: 3%. So maybe Japan is doing just about as well as should be expected for a super-mature economy with declining population. [fold]
There are two abnormalities. The first is the chronic low inflation (the GDP deflator has fallen by 0.3% annually over the past 25 years). The result is that, even when the policy interest rate is set at zero (or a small negative, as at present), it does not provide a strong incentive to borrow. The second is that persistent budget deficits have built up a staggering level of government debt: the ratio of gross debt to GDP is 250%, well over twice that of other G7 countries. Japan is still adding to the debt by running a sizeable budget deficit (5% of GDP) so there isn’t room for much fiscal stimulus. In fact, Japan needs to get the deficit down just as quickly as possible.
Thus the two standard macro-instruments – monetary and fiscal policy – are both constrained. In response, the IMF proposes what might seem an outlandish approach: pressure businesses to give larger wage increases so that they will have to raise their prices, thus boosting inflation. The IMF says that ‘slow wage-price dynamics amount to a missing link in the transmission of rising corporate earnings to inflation (actual and expected)’.
If Japan did succeed in getting inflation up to Bank of Japan’s target of 2%, this would mean that the policy interest rate, already slightly negative in nominal terms, would be substantially negative in real terms, which might encourage more borrowing for investment. Then again, it might not: if demand in the economy is stagnant, even the most attractive borrowing opportunities won’t induce investment. Many argue that the near-zero rates prevailing in recent decades just discouraged necessary restructuring, keeping ‘zombie’ firms going rather than encouraging new investment.
The IMF suggests income policy might help in other ways. A lift real wages might boost consumption spending. If it does succeed in raising inflation, this would make the debt burden seem smaller: higher nominal GDP lowers the debt/GDP ratio.
But all this is surrounded by pitfalls. Higher inflation might force up the interest rate on government debt, which would greatly increase the deficit. Other suggestions (examined in detail by the IMF) seem equally fraught. Paul Krugman has long argued that the Japanese authorities should undertake ‘irresponsible fiscal and monetary policy’, threatening to embark on such expansionary policies that inflation will rise. Lars Svennson (influential academic and former Swedish central bank board member) offers the Japanese a ‘foolproof’ method of getting inflation up: depreciate the yen enough to get inflation up via higher import prices. Adair Turner (former head of the UK Financial Services Authority) wants the Japanese to embark on substantial fiscal expansion, financed by central bank money creation.
All this is borderline-nuttiness. Rather than provoking inflation, the Krugman proposal is more likely to set off bond-yield rise, which would blow out the budget deficit. Svennson’s devaluation idea would require a huge forced devaluation, which would be hard to achieve operationally and would be totally unacceptable to Japan’s trading partners, who would suffer a counterpart appreciation. Adair Turner’s ‘helicopter money’ proposal doesn’t offer any advantages (in terms of debt/GDP ratio or interest cost of funding) over issuing more bonds to fund the fiscal expenditure.
Meanwhile, the Japanese authorities seem ready to maintain current policies: strong quantitative easing; a mildly negative policy interest rate in the (so far unfulfilled) hope that this will cause a depreciation of the yen; postponing a fix of the budget deficit, as even modest attempts to raise the value-added tax cause consumers to go into a spending funk; and raise the minimum wage by a regular 3% annually. One tiny structural shift: more women are entering the workforce. The truly radical policy would be to ease immigration restrictions, but change here is likely to remain glacial.
The Japanese are travelling a narrow road with big risks on both sides and no safe haven in sight. The one clear lesson is that it’s much harder to run an economy with aging population and shrinking workforce.
Photo: Flickr/Soumei Baba