Japanese asset prices have jumped onto investors’ radar screens of late; the return of the Liberal Democratic Party (LDP) to power late last year has sparked hopes that the new leadership might match their pre-election rhetoric with actions that help to bring years of economic stagnation to an end.
The Diet was dissolved last November, and the LDP, under Shinzo Abe, secured a landslide election victory four weeks later, as voters expressed their disillusionment with the Democratic Party of Japan and backed the LDP’s promises to wage a determined battle against deflation through aggressive monetary easing, alongside flexible fiscal management.
Mr Abe harangued the Bank of Japan (BOJ) during the election campaign, arguing that the monetary authority has been far too timid in its efforts to combat long-term deflation. Further, he threatened to amend the 1998 Bank of Japan Act if the central bank does not soon accede to a two per cent inflation target, and after he assumed the post of Prime Minister, he taunted the monetary policymaker with the words, “There is no future for a country that abandons hope for growth.”
The need for bold action on both fiscal and monetary fronts is not difficult to understand in the context of an economy that has been in relative decline for more than two decades, and recently slipped into its fourth recession since 2000. Real GDP growth averaged more than four per cent a year from 1974 to 1990, but has averaged barely half a per cent a year ever since, as the economy continues to languish in the aftermath of the bursting of a joint asset and credit bubble more than twenty years ago.
The damage inflicted upon private-sector balance sheets by the implosion of the bubble led to a pronounced and protracted deleveraging that saw private-sector savings surge relative to investment. The resulting deflationary impulse has seen the GDP deflator drop almost 18 per cent from its 1994 peak, while nominal GDP is almost ten per cent below the peak registered during the fourth quarter of 1997.
The BOJ cut policy rates to near-zero by 1995, and shifted to a zero-interest-rate-policy (ZIRP) in the spring of 1999, which was followed by the adoption of a quantitative easing policy that persisted from 2001 to 2006. However, the unconventional policy failed to prevent deflation from taking hold and the resulting strong demand for precautionary money balances ensured that the private-sector’s financial surplus persisted at high levels.
High private-sector savings relative to investment contributed to large fiscal deficits that have seen the public-sector debt ratio jump to close to 240 per cent of GDP, a level that is in a class of its own – even compared to the euro-zone’s troubled periphery. Fortunately, the preference for low-risk assets in a deflationary environment ensured that the growing government debt could be financed by private-sector savings at a low interest cost.
Looking forward however, projections of future fiscal deficits and household savings rates as the population ages, suggests that it is only a matter of time before the Japanese is forced to tap foreign capital markets, which are far less likely to provide funding at today’s historically low rates.
An upturn in borrowing costs would have a large adverse impact on the financial sector’s health. Indeed, the central bank estimates that a one percentage point increase in yields would wipe out roughly two years of banking sector profits. Thus, the need to revitalise the Japanese economy is a matter of some urgency.
There is no doubt that the world’s third-largest economy is beset by many structural issues that need to be addressed if nominal economic growth is to be lifted to a level that will put the fiscal position on a more sustainable path. Constructive government policies are required to raise real growth, but ending deflation is the purview of the central bank, and the time for credible action is now.
Sceptics will argue that increasing the inflation target to two per cent will have little durable impact, since the BOJ has already failed to meet its current target of one per cent. However, the central bank has all too often been the architect of its own failings, and has snatched defeat from the jaws of victory on more than one occasion.
Indeed, Ben Bernanke, then a professor at Princeton, remarked as far back as 1999 that “Japanese monetary policy seems paralysed, with a paralysis that is largely self-induced.” He noted “the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work.”
Little has changed in the intervening years, as the BOJ consistently argues that deflation is not the result of timid monetary policy, but stems from structural issues that have lowered the economy’s potential growth rate. The central bank’s rhetoric has signalled to economic agents that it cannot defeat deflation alone, which has almost certainly reduced the potency of its unconventional policies.
Central bank credibility may well be restored under a change of leadership orchestrated by Mr Abe, but deflationary expectations are deeply engrained and the battle will not be easily won. Nevertheless, monetary developments in Japan merit close attention in 2013.