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This newsletter is really a public policy thought-letter. While excellent newsletters on specific themes within public policy already exist, this thought-letter is about frameworks, mental models, and key ideas that will hopefully help you think about any public policy problem in imaginative ways. It seeks to answer just one question: how do I think about a particular public policy problem/solution?
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Shinzō Abe, the longest-serving Japanese PM ever, stepped down from office last week. His second term that began in late 2012 was marked by his prescription for reviving Japanese economy. The world called it Abenomics.
Through a mix of unconventional monetary policy, robust fiscal stimulus, and structural reforms to boost growth, Abenomics was seen as a marked departure from the timid response that characterised the previous regimes. Abe was determined to jolt Japan out of the economic morass it had dug itself in for over a quarter-century since 1990. We will discuss Abenomics and what lessons it holds for us in more detail later. But let’s go back to the lost decades of Japan that gave us the pejorative term ‘Japanification’ and understand what happened during that time.
Bubble, Bust And No Recovery
Japan was the miracle economy following WW2, benefitting from U.S. largesse in infrastructure spending, government investments in technology and research, rise in entrepreneurship and increase in factor productivity for over three decades. Low-interest rates and all-round prosperity in the 80s led to an asset bubble. The stock market and real estate valuations went through the roof on the back of speculations and easy credit policy. There’s an urban legend (or truth?) of three sq.mts. of land near the royal palace being sold at US$ 60,000. That meant the appraisal value of the palace was more than the state of California then. In little over 25 years from 1960, the land value went up by 5000 per cent in Tokyo and other major cities. By the end of 1989, the Nikkei index was at its historic high of 39,000. This was a bubble and like all bubbles, it popped in 1990.
Japan hasn’t recovered since. The obvious reasons were discerned immediately. The policy response to the bubble was to increase interest rates and quell speculation. But as the equity market and real estate prices crashed, borrowers who had overleveraged themselves were trapped. A debt crisis soon followed with widespread loan defaults. The contagion now engulfed Japanese banks who were staring at a huge pile of NPAs. The credit dried up, investments fell, and the growth slowed dramatically. The sentiment turned negative and the consumers cut down on spending. This began a deflationary cycle.
The Bank of Japan (BoJ) was slow to respond and the deflation spiral set in. Why would you spend today when you know the prices would be lower in future? BoJ began cutting interest rates and brought it below 1 per cent by mid-90s to spur investment. But these actions weren’t coordinated with a fiscal response. The hike in consumption tax in 1996 meant the further dampening of consumption sentiments. The loan default crisis led to the collapse of three banks in mid-90s. By 1997, as BoJ and the government were getting their act together, the Asian financial crisis dealt a crippling blow to the economy. This set it back for another three years.
What Went Wrong?
Krugman in 1998 argued the lost decade of the 90s was because of monetary policy failure. His view was the BoJ should have publicly taken a high inflation target that would have avoided a deflation and prevented interest rates from going down to zero. Of course, this is supported by theory. A higher inflation target anchors inflation expectation at a higher number and this increased expectation in turn leads to higher inflation because of the forward-looking aspect of the aggregate supply equation. Further, the increase in inflation expectation would reduce the real interest rate because it takes time for nominal interest rate to reach its long-term level. In the short-term, this reduced real interest rate stimulates growth which in turn increases inflation. A kind of a virtuous cycle sets in.
Anyway, this wasn’t done by BoJ. The other option was to reduce the interest rate to zero quickly and provide substantial monetary stimulus quickly to check loss in output. A combination of a high inflation target (as suggested by Krugman) and monetary easing policy could have possibly worked.
Between 2001-06, the BoJ went on a quantitative easing overdrive purchasing long-term Japanese government bonds. After the global financial crisis of 2008-09, the BoJ extended this programme to purchase private sector financial assets including corporate bonds, ETFs (therefore equity in private companies), CPs and invest in real estate investment trusts (REITs). This had an impact on financial markets with stock markets rising, fall in bond yields and increase in corporate bond issuances. But this expansionary policy came at a cost. The debt to GDP ratio which was around 60 per cent in the 90s went up to 240 per cent by 2012. However, all of these measures didn’t move the needle on inflation. It is possible a higher purchase of private risky assets like corporate bonds and commercial paper instead of government bond would have spurred growth and raised inflation expectations. But that was not to be.
Separately, the lack of coordination between monetary and fiscal policies hurt the economy. There were multiple increases in taxes to balance the budget while the monetary policy was working to increase consumption sentiments. Lastly, there was a lack of clear communication to manage expectations among the public about long-term inflation, interest rates or growth. A forward-looking guidance by the central bank on these parameters provides assurance to market participants more so when the financial system is weakened by high NPAs and general risk aversion. A recent example of this was seen when the US Fed indicated it will purchase corporate bonds as part of its stimulus during the pandemic. The planned purchase announcement itself did the trick in raising bond prices before Fed actually bought a single one of them.
Abenomics In Play
Shinzo Abe and BoJ Chairman Haruhiko Kuroda assimilated the learnings from the lost quarter-century to formulate the ‘three arrows’ of the Abenomics in 2013. The three arrows were:
* A monetary policy based on qualitative and quantitative easing (QQE) framework with a 2 per cent inflation target, significant purchase of long-duration government securities and private risky assets, expansion of BoJ balance sheet and upfront guidance on these numbers. BoJ promised to double its monetary base to 54 per cent of the GDP by 2014.
* A robust fiscal policy that increases absolute government spending on areas like public infrastructure, welfare for its ageing population and servicing the debt. This was to be done in close coordination with the monetary policy actions.
* Structural reforms to spur growth and private investment. This includes lower corporate tax, increase in participation of women in the labour force, more immigration and acceptance of high-skilled foreign workers, more inbound tourism to Japan and championing free trade (TTP), lower FDI barriers and global liberal order to counter China.
You couldn’t fault their prescription based on what they learnt from their past. Abenomics wasn’t a radically new construct but in bringing the three arrows together, setting targets for them and then communicating it clearly indicated Abe meant business. Japan needed to be jolted into a path of recovery and this was the way to do it. The salience of Abenomics grew as more economies, including US and EU, followed the path of QE to stimulate growth and manage financial stability.
Did It work?
Well, it is a mixed bag. The inflation in Japan remained persistently below 1 per cent. The primary objective of the 3 arrows was to ‘warm up’ the economy to an extent that spurs demand and gets the investment cycle going. On that count, it failed. It has seen limited success in increasing women labour force participation, more immigration and in keeping debt to GDP at a near-constant level of 240 per cent (pre-Covid) despite the increase in monetary base. It’s not an unqualified success. The counterfactual, of course, can be asked. Could Japan be worse off today if not for Abenomics?
I think it would.
Lessons From Abenomics
So, what are the lessons learnt from 7 years of Abenomics in Japan? Robin Harding writing for the Financial Times has six lessons from Abenomics for the world struggling with ‘Japanification’. I am paraphrasing below:
* Monetary policy through massive purchase of government securities and private assets work. The ‘bazooka’ of 2013 had a positive impact on the Japanese economy – stock markets boomed, credit uptake went up and unemployment fell.
* Despite the promise of coordinated monetary and fiscal actions, Abe couldn’t keep fiscal hawks down. The rise in consumption tax from 5 to 8 per cent in 2014 worked counter to the efforts in increasing consumption. The economy went into a recession. Another increase last year to 10 per cent had the same impact.
* Communication and future guidance on targets didn’t materialise. The promised inflation target of 2 per cent was never met and the consumption tax hikes meant the premise of raising expectations and letting it do the heavy lifting in raising inflation didn’t work.
* Expectations management works if you meet the expectations. Beyond a point, you need to intervene directly to meet your targets. The key commitments of Abenomics were never kept and soon the market stopped responding to the BoJ plans of further easing.
* Stimulus doesn’t cause an increase in public debt to GDP ratio going up. We have discussed this already. It remained range-bound at 240 per cent.
* Structural reforms didn’t cut to the key issues confronting Japanese society – an ageing population leading to a fall in total factor productivity, a disappointed younger generation carrying the burden through levies and taxes on income, strong hierarchical working style stymieing innovation and a reluctance to embrace large scale immigration to get out of this rut (an advantage so far for the US).
Our Lessons
These are important lessons for India as we consider the options to revive growth after the pandemic. The fears of an increase in fiscal deficit and a rise in debt, lack of coordination between fiscal and monetary actions and poor communication or guidance to the public about the road ahead should look familiar to all of us. We can avoid these pitfalls and yet bank on the demographic dividend that’s still available to us to have a version of Abenomics work for us.
The Abe playbook didn’t work for him, but it could work for his friend, PM Modi.
HomeWork
Reading and listening recommendations on public policy matters
* [Paper] Paul Krugman’s famous paper in six parts on Japan’s liquidity trap written in 1998 that explains the reasons for the lost decade.
* [Paper] Yoshino and Taghizadeh-Hesary in their ADB paper blame structural reasons of Japan for the lost decades. The paper counters the arguments of Paul Krugman that the Japanese economy is in a liquidity trap. For them Japan’s economic stagnation stems from a vertical IS curve rather than a liquidity trap.
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