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Key elements of the Japanese economic revitalization program initiated by Prime Minister Shinzo Abe are highly contradictory. Devaluation of the yen may not bolster exports and economic growth as intended. Pushing the inflation rate higher to 2% may not boost consumption and economic activity.
Historically, a 10% decline in the U.S. Dollar/Yen exchange rate generally results in an increase in Japanese GDP growth of around 0.3%. But changes in the structure of Japan’s economy mean that a lower currency may not have the same effect on exports and growth.
Inflation frustration
Increasing inflation to the targeted 2% level is designed to break the hold of disinflation or deflation on the economy. It is seen as essential to strong nominal growth, increased consumption and ultimately reducing debt.
Unfortunately, the simple adoption of a target does not guarantee rising prices. Loose monetary policy also may not create the required inflation, as Japan’s own experience shows.
Before the recent initiatives, inflation, including energy but excluding cost of fresh food, fell 0.5% per annum in the year to March 2013, the highest rate of deflation in two years.
There are few signs of higher prices in the wider economy, at least as yet. One example: McDonald’s Japan recently announced its largest calorie item in the history of the chain — the “Mega Potato.” The 350-gram serving supplies around half an adult’s daily calorie needs but costs only 490 yen ($5), about half the price of its equivalent — two containers of large fries.
The new initiatives may also create the wrong kind of inflation. Japan needs demand-driven inflation, reflecting the effect of increasing wages, higher consumption and increased purchasing power. Demand-driven inflation also needs supply constraints and pricing power for producers.
Lack of income increases, low economic growth and also an aging population means a structural lack of demand. This is exacerbated by oversupply and excess capacity in many industries, attenuated by the lack of industrial consolidation and renewal.
The regulatory environment and benign shareholders prevent industrial consolidation. Low interest rates encourage banks to maintain loans to zombie companies, which can cover the interest cost but have no viable business, preventing rationalization of capacity. A stagnant market and oversupply means permanent pressure on companies to maintain market share and minimal price increases.
Current policies are more likely to create cost push inflation. Devaluation of the yen has increased the cost of imported goods, such as i-Pods and other luxury goods as suppliers try to preserve profits. The major impact is on imported energy costs, which have driven an 11% increase in the cost of electricity.
Higher costs may, in fact, reduce consumption unless incomes rise commensurately. But wages reached their lowest level since 1992 in January 2013, albeit before the current initiatives.
Higher incomes would also increase Japan’s cost structure. Many financially vulnerable firms operating in competitive industries are not in a position to increase wages significantly, without losing market share. In combination with higher energy and other imported input costs, it would reduce not improve Japan’s international competitiveness without significant labor market reforms.
Stagnant incomes are not offset by the wealth effect of higher stock prices. The bulk of Japanese savings are held as low-yielding bank deposits. More than 80% of Japanese households have never invested in any security; 88% have never invested in a mutual fund. Shares represent around 7% of Japanese household financial assets, compared to around 25% in the U.S.
Rising stock prices affect a very small portion of the population, boosting consumption of luxury items rather than driving broad-based increases in consumption.
The conventional analysis that the current initiatives will increase consumption may prove incorrect. Rising costs may reduce purchasing power, unless matched by rising wages and real incomes. This would reduce spending and confidence, reducing the effectiveness of “Abenomics.”
The internal inconsistencies and contradictions of the economic program mean that it may not succeed. Abenomics may become “awa-nomics” (from the Japanese “awa,” meaning “bubble”) — the term used to describe the prime minister’s program in Tokyo’s red light district.
