Japan: are there lessons for other developed economies?

A while ago I wrote that the radical economic policies of Japan’s new government under Shinzo Abe would be an interesting experiment for the world. They were much lauded by austerity sceptics, such as Paul Krugman, who drew attention to aggressive monetary policies and fiscal stimulus, which they were advocating for other developed economies. I was sceptical. But early results have exceeded expectations. There is a good analysis here from the Economist, which also discusses the new government’s nationalist tendencies. Is this evidence that the austerity policies being pursued by much of the rest of the developed world are mistaken?

My scepticism when I last posted was based on two things. First that the policies¬†hinged on companies raising wages, when their profits were under pressure. Second was that, based on Mr Abe’s previous form, I did not think that structural reforms to Japan’s economy would be pursued with vigour. On both counts it looks as if I was too pessimistic. This means that Japan’s economy might well get a sustained period of growth, and that it will reduce the burden of government debt. But applying its policies to other developed economies is problematic. There are three reasons for this.

The first is that for longer term success it is still the element of structural reform that is critical. Mr Abe refers to his programme as “three arrows”, in reference to a Japanese folklore story that you can snap the shaft of a single arrow easily, but not three held together. These three are monetary easing, fiscal stimulus and structural reform. Austerity policies in Europe and America are firmly based on structural reform: especially in reducing the size of the state. Opponents of austerity tend to want to halt or slow down structural reform. Some say that it should wait until growth is resumed; others would rather avoid the reform process altogether. The three arrows approach would in fact promote reform, alongside the monetary and fiscal palliatives, and, indeed, the more considered critics of austerity do say this. But here there is a problem: Japan does not have an oversized state, so cutting back government expenditure is not a major reform priority, as opposed to opening the economy up to more competition and reforming corporate taxes. In Britain, France, Italy, Spain and so on the size state has run beyond what the economy can sustain, and so it has to be cut back, which in turn drains demand from the economy in the short term. There is good reason to doubt whether fiscal or monetary stimulus, beyond their current levels, are compatible with the need to shrink the state.

There is a second important difference in Japan. Its economy has a trade surplus and (which is linked) a savings surplus, albeit temporarily challenged as it has to import energy while its nuclear programme is in abeyance. That means that a fall in the exchange rate, as has happened to the Yen, will generate an immediate bonus to businesses, easily outweighing the extra costs imposed on the economy. This allows companies to put wages up. The savings surplus also means that the economy is not dependent on borrowing from overseas investors, who might be shaken by such currency depreciation. This is not the case with the austerity economies. Where their exchange rates have fallen, as in Britain, this has simply contributed to the squeeze on consumers without benefiting business to anything like the same degree.

Mentioning the exchange rate brings me to a third observation. It is that a lot of Japan’s success so far has less to do with with the country’s actual economic policies than with the effect of announcements on the zeitgeist. Implementation has hardly started, and yet the exchange rate has already plummeted and stock market risen, which is having the necessary warming effect, and set off a virtuous circle. The same can be said, in reverse, for austerity policies in the West, of course. But where reforms are necessarily painful, this is almost impossible to do. Economists have long been reluctant to admit the role of psychology in macroeconomic policy, and have let it in only gradually (through such ideas a inflation expectations). Governments and central banks have long known it – and Mr Abe’s government is acutely aware. The question for Europeans, in particular, is whether further aggressive monetary easing, linked to higher inflation expectations, combined with some fiscal stimulus would lift the zeitgeist and get the economies moving again. We have reason to be sceptical.

Almost all the developed economies in the world are experiencing difficulties. It is easy to fall in with the idea that this must be for similar reasons and that the solutions for each economy are similar. In fact each major economy is unique. And the differences between Japan and the others is amongst the largest. Abenomics may work for Japan, but that does not mean they will work anywhere else.