Japan Economy

Krugman provided his proposal on the problem of Japan economy back in 1998, which centered on the liquidity trap and inflation expectation. It recommended using monetary policy aggressively to boost inflation expectation to get it out of the liquidity trap (where the IS curve has shifted to the left). That idea was sounding so great – as it does not require any pains of surgery in the economic system – that Abenomics was designed and structured based on that brilliant idea.

Here’re the tweaks that Krugman made last year ( http://krugman.blogs.nytimes.com/2015/10/20/rethinking-japan/ )

Abenomics – reviving inflation expectation through unconventional monetary expansion – did not work as it supposed to do in his original suggestion. He picked up a few items why it did not – mostly he sees more secular economic problems than thought and depressed demand problem (well demand problem remains the same in my opinion). He brought the trend of demographics, working population, GDP per capita, and fiscal balance to point out how irregular Japan’s economic situation is. His new suggestion is to get more aggressive and set even a higher target of inflation. Then combine it with fiscal policy to make the inflation high enough to maintain full utilization of capacity and contribute to fiscal consolidation through devaluing nominal debt through inflation.

That must have sounded like a big disappointment for economic policymakers in Japan (Keynesians perhaps) who seemed to have designed the prescription based on Krugman’s painless solution.

Let’s see what liquidity trap is first. At first, it looks as if it means there is excess cash as savings in the system that was not spent. The prospect of inflation should then work as a catalyst for the owners of liquidity to proceed to spend more to protect their real value of liquidity. Moreover, that spending would shift the IS curve to the right. That looks logical, and it was the early version of Krugman’s prescription.

What was not well-inspected was the reason why in the first place, there occurred excess liquidity (i.e., liquidity trap) in Japan, which remained historically and for some time in the past. In other words, deflation behaviors such as low inflation rate, low consumption, and capital expenditure are the leading indicators or just the parameters between cause-and-effect? Is trying to move those figures directly through monetary policy alone a real key to realizing the crucial causality in the system?

Another factor that should not be missed is that in the open economy system, the one side of seemingly “liquidity trap” phenomena is offset by another side of “capital investing.” Isn’t the US economy with little saving but high ROI that benefited from capital flow from excess liquidity? Then the causality of liquidity has a shape just like Mobius Strip? The integrated capital economy, isn’t the view on local and closed perspective missing the causality as an economic system?

Once before, there was a theory of lifetime earnings consumption. According to it, the expectation of lifetime earnings determines the pattern of spending. Thus, financial leverage (student loans and mortgage) in the early stage of life is regarded as a rational behavior from the perspectives of through-life earnings.

On the CapEx, isn’t it the case that the companies decided it based on their projection of future cash flows?

Are the Japanese companies’ projected cash flows in completely sync solely with the domestic inflation expectation?

Are they net exporters to non-Japnese economies whose cash flows are affected more by global & cyclical capex cycle?

Also, how much have the Japanese companies spent to change themselves to tackle the aging business model?

Haven’t they restructured to bring the fixed cost down and accelerate hollowing-out of the economy and employ more temporary workers, all of which led and worked as a real cause of lowered lifetime earnings expectations?

Are the companies the actual beneficiaries of the low-cost and skilled labor force for the long time which have been unable to feel confident to change successfully, leading to the structural deflation that has been lasting for more than decades?

There could be a group of people who may advocate that corporate governance is starting to change in Japan, which should lead to a bright future. I would recommend those to look at Japanese financial service companies’ track record of governing the companies in which they have significant stakes. Unless those legacy and real stakeholders learn & change themselves, get credentials as insightful & respected teachers to educate and direct the companies. Just the voices of a group of minority shareholders would not move the deep-rooted needle. Financial service companies’ governance and management have to be a gold standard to lead the industries and show the directions and the necessary discipline to raise profitability so that the industries can self-restructure and provide opportunities to raise wages and add more new values. Unfortunately, that has never happened and will not take place through the monetary policy alone.

What will be needed is to grow the industries that can provide both higher wages and added values? In 1998 when Krugman wrote the first piece of his message to Japan, he saw the temporal stagnation of consumption was the key. For the 25 years to 1998, what drove the labor income was the massive growth of Japan’s service sector. The manufacturing sector’s contribution to GDP was down from 37.6% in 70 to 25% in 98, while the service sector’s weight grew from 10% to 17%. Currently, the manufacturing industry accounts for 19% of GDP, and the service sector is tied at 19%.

The structural shift toward high enough ROI that can accommodate inflation lifetime earning expectation should come ahead of inflation figure that is a lagging indicator. So influencing inflation expectation directly should accompany the structural shift not just as a catalyst to force people to spend early. However, it is a painful process as it has to restructure (i.e., remove) the industries and companies operating below the required level. As mentioned, the key stakeholders are not equipped with determined and independent intelligence, which has been and is very rare.

Krugman’s view is so smooth and painless that it was nicely received and tried as a real experience in Japan. Now it comes to the sub-zero rate world, and GDP is still running at a negative level. His prescription tells that Japan needs to do more and aggressively. Yet, even minus 1 % long rate would not fix the problem (could be harmful) to inflate the economy, and the wealth distribution is heading in the wrong direction.

Fiscal spending would grow the unprecedented level of government debt even more. The JGB rating may be downgraded to BB from the current A, leading to much higher risk asset weight by banks (at present, it is set zero by a particular rule of FSA Japan). That could change the whole perception that JGB has no risk, as it is fully financed domestically and by BOJ. The population is aging, and the tax burden will be passed on to the next generation. Assuming deposit per capita grows around the nominal inflation rate, the rapidly declining population of Japan will decrease domestic deposits significantly. As observed in systematic and huge currency devaluations in history, the adjustment devaluation occurs in a very short period of time and at once.  

There are great businesses on a company level in Japan, but the macroeconomy is approaching the edge of a cliff.