Abenomics 2.0 - Just What Are They Trying To Achieve?

The recent move by the Bank of Japan to take further measures to accelerate the rate at which it ramps up its balance sheet took almost everyone - market watchers included - completely by surprise. The consequence was reasonably predictable - the yen has once more fallen strongly against almost all major currencies - and most notably against the USD - and Japan's main stock indexes are sharply up.

On the other side of the balance sheet the cost of imported goods - and especially energy - is expected to rise, real wages are likely to continue to fall, and ex-tax inflation looks set to remain moderate, possibly around 1% - short of the 2% objective but comfortably away from deflation.

Meantime this week's GDP figure show's that the country fell back into recession again in the third quarter with a 1.6% annualized drop following one of 7.3% in the April-June period. The headline number makes it likely Abe will go ahead with snap elections in December, and indeed postpone the second stage of the consumer tax hike which was due to be implemented next autumn.Obviously, if what you are trying to do is stimulate inflation then sending the economy regularly into recession by weakening consumption isn't going to help.

But what all these conflicting signals underline is the lack of clarity about just what the principal objective of Abenomics actually is. Simply creating inflation cannot be the goal. If it is achievable on a sustained basis this inflation has to be a means to something else. For Paul Krugman that something else would be a lowering of the real interest rate via rising medium term inflation expectations. This lower real rate would - so the theory goes - stimulate investment in capital goods and hence provoke an ongoing (and self sustaining) recovery in the Japanese economy after years of sub-par growth.

But what if Alvin Hansen was right, and in economies suffering from structurally weak consumer demand linked to ongoing demographic dynamics (and not simply a balance sheet recession) the principal determinant of investment decisions is not the cost of capital but the anticipated size of the future market? In this case even success on the inflation expectations front would probably not deliver the expected recovery.

And there are downside costs. While financial markets boom, the living standards of the majority of Japanese families continues to fall as real wages drop month after month. It's hard to see consumption booming in this case. Then there is the debt: gross government debt current stands at around 245% of GDP.

It is often argued that in a country running a current account surplus and using its own currency such debt doesn't represent any special problem. I for one remain unconvinced that this is the case. This debt level, among other issues arising, effectively rules out any eventual "normalization" in interest rates since the servicing burden on the government would just be too high. But then - as some argue - this may now be old hat, since the Wicksellian natural rate of interest in Japan may have turned permanently negative. If, however, this is the case, why try formulate policy on neo-classical lines working towards a "classic" recovery? A recovery which may never come. If the natural rate is permanently negative we are hardly standing on the ground over which the traditional liquidity trap theory was built.

But it isn't only me who has doubts. Multilateral institutions like the IMF and the OECD also do. That is why they have been conducting debt sustainability analyses, and arguing for the consumer tax hike. Naturally proponents of the timidity trap suggest that such moves to bring Japanese government debt under control is a mistaken sequencing of priorities. First get sustainable inflation going, then get a self-perpetuating recovery, then address the debt the argument goes. But doesn't this beg the question of whether the objective is, in fact, attainable.

The late Karl Popper started to think about what distinguishes science from other social practices by confronting the apparent "irrefutability" of ideological systems like marxism or psychoanalysis. The problem with such world views is that they never seem to be testable, there is never any clearly identifiable fact "in the world" which can refute them. The "timidity trap" argument gives me a horrible deja vu feeling in this sense. Each time things don't work out as planned what Mr Abe and Mr Kuroda have to do is more of the same, no matter if you blow Japan clean out of the water, since the only reason the recommended recipe hasn't worked to date is that the balance sheet expansion and the associated stimulus haven't been big enough. I think it is time Paul came of age intellectually speaking and started to identify for us some concrete indicators which could prove his hypothesis wrong if they moved in the expected direction without producing the expected result, and stop telling us repeatedly that he has normally been right.

What if the Japanese economy simply can't sustain the desired inflation anymore, what if the historical epoch during which that expectation was feasible is now over? Obviously it isn't difficult to generate a certain amount of consumer price inflation if you raise consumer taxes, and again you can also get it if you devalue your currency, and keep doing so. But as we are now seeing, you do need to keep repeating the moves. There doesn't seem an underlying mechanism there waiting to be kick-satrted.

Without more tax hikes last April's increase will simply drop out of the inflation data by the time we reach next spring, and absent the implementation of the Abenomics 2.0 yen devaluation the currency-depreciation-induced inflation was already dropping out. The first round of Abenomics took the yen from 75 to 100 to the USD, the current bout has now taken it to around 115, but to keep injecting inflation in this way Kuroda would have to keep increasing the rate of balance sheet expansion on an annual basis and the yen would have to keep falling to lower and lower levels.

In a globalized economy currency depreciation is a zero sum game. One man's inflation is another's deflation. The so-called "foolproof path" is only really effective in the case on a single economy (or currency area) but not in the face of a generalised problem. Under current circumstances those whose currencies are forced upwards simply import the deflation/disinflation that is being exported by the the devaluers and on and on we go.

Paul Krugman has been pretty vocal in decrying those who have seen inflation where it wasn't, but what if he himself is falling foul of his own trial-by-fire in seeing inflation where it isn't in Japan inflation expectations? What if the drop in Japanese trend growth is long term and continuing, then why should we really expect the Abenomics experiment to work?

As Gavyn Davies pointed out in a recent FT blog post,  over the years growth expectations for developed economies have persistently turned out to be too high. Three of Davies' colleagues at the research firm Fulcrum have examined the behaviour of long run GDP growth in advanced economies, and using customized versions of dynamic factor models they have produced a set of real time estimates of long run GDP growth rates.

On analyzing their results they found an extremely persistent slowdown in long run growth rates for the G7 as a whole. More surprisingly perhaps, it looks like this slowdown has been ongoing since the 1970s, and is not just a sudden decline after 2008.  Averaged across the G7, they traced the slowdown to trend declines in both population growth and labour productivity growth, with the combined impact being a halving in long run GDP growth trends from over 4 per cent in 1970 to just 2 per cent now.

As they also state, the aggregate G7 result is a composite of widely differing trends at the individual country level. As can be seen from the chart below, the Japanese case is a particularly clear one (the blue lines mark one and two standard error bands).

As it happens, Gavyn Davies' post produced a particularly poignant and cutting response from Paul Krugman  - What secular stagnation isn't - in which he argues that secular stagnation "is not the same thing as the argument..... that the growth of economic potential is slowing". He suggests that this  "is a really important distinction, because secular stagnation and a supply-side growth slowdown have completely different policy implications."

But this attempt at making a supply-side/demand-side distinction is a strange one, not only because - as Marginal Revolution's Tyler Cowan coherently argues - in the medium to long run supply-side and demand-side are deeply interconnected.   It is also confusing because Paul himself has spoken of the Japan problem being one of the country suffering from a "shortage of Japanese", a supply side problem if ever there was one. I would say it should be obvious on simply a common sense level that having a smaller working age population restricts both potential growth AND aggregate demand. Krugman however doesn't see things this way, and argues that:

"If labor force growth and productivity growth are falling, the indicated response is (a) see if there are ways to increase efficiency and (b) if there aren’t, live within your reduced means. A growth slowdown from the supply side is, roughly speaking, a reason to look favorably on structural reform and austerity."

That seems clear enough, doesn't it? If Japan's potential workforce is declining and productivity deteriorating due to an increasingly aged workforce then, roughly speaking, we should favour structural reforms and austerity (Mrs Merkel, are you listening?)

But then comes the catch.

"But if" - on the other hand - "we have a persistent shortfall in demand, what we need is measures to boost spending — higher inflation, maybe sustained spending on public works (and less concern about debt because interest rates will be low for a long time)."

Perhaps the key word here is "shortfall". Shortfall relative to what? To what it was in the past, or to potential demand now. If it is the latter, then there must be something at work now, something beyond simple demographic and productivity dynamics (and the mountain of government debt), that is holding growth back. If that is the case, it would be interesting to know what that "something" was. Since otherwise Japan seems to be heading deeper and deeper into a very risky experiment based on a misunderstanding about what the problem facing the country actually is.

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The above analysis is based on arguments fleshed out in much more detail in my  "mini book" the A B E of Economics.

The book is available with Amazon as an e-book. It can be found here. You don't need to buy a Kindle to read this book. You can download a free app from Amazon.

Is Japan Back In Recession?

“People should seriously consider that Japan’s economy may have fallen into recession despite the weaker yen and a stock rally from the BOJ’s easing and the flexible fiscal policy by Abe’s administration,” said Maiko Noguchi, senior economist at Daiwa Securities. “Initial expectations that the economy could withstand the negative effects of a sales tax hike through a virtuous circle seem to be collapsing.”

"the risks are rising that the economy will later be determined to be in recession,” said Yuji Shimanaka,  chief economist at Mitsubishi UFJ Morgan Stanley Securities Co.

Worsening Picture

As noted in my post - Does Abenomics Work? -  (published 19 September) the tide of media opinion finally seems to be turning against Shinzo Abe and his economic reform plan for Japan known as "Abenomics". The degree of skepticism only seems to have grown on the back of a slew of recent data confirming the impression that the recovery of economic activity from the post sales-tax slump isn't going to be as easy as either the Japanese government or the Bank of Japan initially thought it would be. As the authors of the Bloomberg report from which the above quotes are taken - Oops Japan Did It Again? Sales-Tax Spurs Recession Debate - put it: "Weak industrial production data from Japan today raises concern that the world’s third-largest economy may be back in recession, challenging Prime Minister Shinzo Abe’s growth strategy." In fact, output which was down 1.5% between July and August (and down 2.9% over August 2013) has fallen in three of the past five months.

Other indicators point in a similar direction. Household spending was down 4.7% year on year in August, and the coincident composite index, which consists of 11 key indicators, including retail sales and industrial production, fell 1.4 points to 108.5, according to the Cabinet Office this week. The August drop was the the first fall since June.

Even corporates  are becoming more gloomy. The latest Bank of Japan Tankan confidence survey fell back three points from June, the second successive fall since it peaked just before the tax hike.

As the FT's Ben McLannahan points out the Tankan numbers also suggested that "the recent drop in the yen – which fell more than 5 per cent against the US dollar in September – remains a double-edged sword for Japan Inc, pushing up profits for big exporters with extensive overseas operations while squeezing the margins of smaller manufacturers, which struggle to pass on the higher cost of imports." Unsurprisingly it is the small manufacturers who are most disgruntled about the impact of Abenomics.

The economy fell between April and June by an annualized 7.1% and even though the rate of decline will have been much slower from July to September all the indications seem to point towards the possibility that growth was negative, which would mean that at least technically Japan is back in recession.  Abe is having more success with inflation, which is running at the highest level in nearly two decades.  Yet even the inflation – which is running at a 1.3% annual rate once you strip out the tax hike – has largely been driven by the rising cost of imports, and there are serious doubts whether this will be sustained if there are not further yen devaluations.

The Tokyo University frequently purchased items index (obtained from supermarket scanner data) shows underlying inflation continuing to ease.

But even the inflation proves to be problematic in a country where wages constantly fail to rise significantly. The fact that non inflation adjusted monthly wages rose at the highest rate in 17 years in July makes a nice headline, but the fact that real take home pay was actually down 1.4% due to the impact of inflation gives a more realistic description of the difficulties involved in trying to refloat consumption..

The theory being applied here assumes that Japan is in some sort of "temporary" liquidity trap due to the presence of a balance sheet recession, but what if the trap is permanent rather than temporary - see my Paul Krugman's bicycling problem - and is the result of the country's demographic evolution, in that case what - apart from participating in a mass Labour of Sysiphus - do we really hope to achieve?

 A policy which is exclusively aimed at attaining a positive natural rate of interest when the natural rate may be permanently negative seems of dubious value at the least, and when this policy seems unable to drag the economy stably out of recession and only benefits the 10% of the Japanese population who have financial assets and senior management in large global companies  then in its application it seems almost noxious. A state of affairs which doesn't escape the notice of the average Japanese in the street.

Falling Popularity

The popularity of Prime Minister Shinzo Abe's cabinet was falling sharply going into the summer, forcing him to stage a reshuffle in September. The current approval rating is now back up at 64% but if the country's economic fortunes don't improve it will surely start to head back down again.  On the critical question of whether to go ahead with next October's second tax hike, some 68% of those interviewed say they are opposed while only 28% supported implementation.

Most market participants assume that the Bank of Japan will react to further bad news by increasing the rate of Japan Government Bond purchases, but it is far from clear that this will happen. Indeed only this week Bloomberg reports that members of the governing Liberal Democratic Party's governing council are starting to call for the formulation of an exit strategy from the yen weakening process as the debate over the policy's pros and cons steadily grows more intense.

Meanwhile the Japanese government recently announced that the number of people over 65 reached 25.9% of the population in September – up 1.1 million from a year earlier.

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The above analysis is based on arguments fleshed out in much more detail in my  "mini book" the A B E of Economics.

The book is available with Amazon as an e-book. It can be found here. You don't need to buy a Kindle to read this book. You can download a free app from Amazon.

Does Abenomics Work? - The Doubts Grow

Is something in the air? Do I detect a change in consensus on the way things are going in Japan? Certainly a slew of articles have been published in the financial press over the last month questioning where the Abenomics experiment is headed for. The general conclusion seems to be that wherever it is it is certainly not the originally designated endpoint. Thus the Economist.

"It is crisis mode in the Kantei, the office of Shinzo Abe, Japan’s prime minister. A succession of awful data has pummelled his economic programme, which consists of three “arrows”: a radical monetary easing, a big fiscal stimulus and a series of structural reforms. On September 8th revised figures showed that GDP shrank by 1.8% in the second quarter, or by 7.1% on an annualised basis, even worse than the initial estimate of 1.7%."

Or David Pilling in the Financial Times:

Something odd is going on with Japan’s labour market. Unemployment is at 3.7 per cent. Recently, it has been as low as 3.5 per cent, considered by some economists to be pretty much full employment....... You would have thought that wage inflation would be going crazy as a result. Unfortunately for Japan, you would be wrong. The government has badgered companies, which are making record profits, to share the love. Some have responded with modest wage increases, but not enough to keep pace with prices, which are rising thanks to monetary stimulus and a 3 percentage-point increase in sales tax......

Japanese wages do not seem to be responding to normal market pressures. Why not? The conundrum has its roots in the altered structure of the labour market. Contrary to common perception, Japan has an exceptionally flexible workforce. Outside the ranks of the protected “job-for-lifers” – a much rarer breed these days – nearly 40 per cent of workers are about as flexible as you get. They work in poorly paid jobs for hourly rates. Benefits are all but non-existent. For most of these workers, sometimes referred to as the “precariat”, unemployment is a mere “sayonara” away.......

For its reflationary experiment to work, wages must begin to rise in line with inflation. But the casualisation of the labour force is short-circuiting that process. Moreover, people in the precariat are less likely to marry and have children. If Japan is to solve its demographic problem, it will have to tackle the labour issue.

The WSJ's Takashi Nakamichi - in an article entitled Japan's Tax Increase Puts Abenomics at Risk- continues in a similar vein:

Mr. Abe took office in December 2012 and quickly engineered an upturn in growth that was dubbed Abenomics. Mr. Abe's policies were backed by the monetary "bazooka" of Bank of Japan Gov. Haruhiko Kuroda, who started flooding the economy with more cash in April 2013. Though economists warned that the recovery was still fragile, Mr. Abe decided to increase taxes, hoping to reduce Japan's massive debt load. On Friday, top government officials stuck by their view that Abenomics remains on track. Officials described the downturn in consumer spending as temporary, suggesting it had been exacerbated by rainy summer weather in parts of western Japan.

Or Stanley White at Reuters (Export recovery proves elusive for hollowed-out Japan) who focuses on the fact that, despite the sharp yen devaluation, exports have hardly improved.

Mazda Motor Corp  has returned to profit as the falling yen has rewarded the carmaker's export-heavy strategy. Mazda's response? Move some production to Mexico. Investing in plant abroad is hardly an endorsement for Prime Minister Shinzo Abe's strategy to revive the fortunes of the world's third largest economy, and one driven by exports. "Companies are not that interested in expanding capacity in Japan," said Kaori Yamato, senior economist at Mizuho Research Institute. "This is a problem for exports." With companies making less goods at home, it has become structurally difficult for exports to rise, even with the yen at multi-year lows as a result of Abe's policies, economists say.

In fact White's conclusions seem especially pessimistic. "Economists say the lost production may never come back," he tells us, and he could be right.

List As Long As Your Arm

The list of arguments about why Abenomics is not working is growing, but the core issues touched on above seem to be:

i) Unemployment is down, but an excessively flexible labour market means that wages keep falling.
ii) Inflation is rising (partial success) but living standards are falling.
iii) Beyond inflation Abenomics doesn't have clearly defined priorities and fiscal policy continually falls between the two stools of stimulating  the economy and reducing the debt: you can't eat your cake and have it.
iv) Times have changed in Japan, the workforce is ageing and to some extent the decline of the export industries may be becoming unstoppable.

Curiously despite the meager harvest the "put on a brave face" brigade are still out there, and even managed to not feel ridiculous putting up headlines like "Japan Wages Make Biggest Jump in 17 Years" which is true, but leaves out the inconvenient little detail that inflation is rising at a rate which takes us back even further in time. (See my Japan inflation at a 32 year high).

Indeed you have to work your way through to the end of the WSJ article todiscover that "the increase in earnings, however, was negative after accounting for inflation".

One of the problems external observers have in following Japan is that there are a variety of ways in which wages and salaries are measured and the headline number can vary according to which measure you take. One of the most popular ones  is worker household income (published monthly by the statistics office). According to this indicator household income even fell in nominal terms in July (-2.4% see below), and was of course way down in real terms (-6.2%).

The WSJ journalist chose to cite the preliminary monthly report from the Ministry of Health, Labor and Welfare, which showed average  total cash earnings (including bonuses and special payments) rose by 2.6%.in July over a year earlier. Average contractual cash earnings, on the other hand, were up just 0.9%. In both cases you have to subtract the 3.3% annual inflation to find the full impact on wages and earnings.

In fact the Health, Labor and Welfare ministry also publish a real wages index which is included as part of the same report. This initially showed basic real wages fell by 3% year on year in July. At the end of the day whichever indicator you choose the result has one common thread - it is always negative. (And indeed these preliminary numbers were revised down on Sept 18. Contractual cash earnings  went from a 0.9% to a 0.5% non inflation adjusted rise, and real basic wages went from -3% to -3.4%, so there you go).

Inflation May Not Be Sustainable

Then there is the question of whether Japanese inflation is not simply the result of the strong yen devaluation plus the tax increase (I have gone into this at some length here and here). Certainly real doubts exist about the sustainability of the current inflation given the lack of final demand to drive it. Economists Tsutomu Watanabe and Kota Watanabe at Tokyo University maintain a daily price index based on point of sale scanned price data. The index only covers 17 percent of the official Japan CPI in terms of consumption weight, but gives an indication of the trend in frequently purchased items - you can find a list of items covered by the index here. Certainly - if you look at the chart below its hard to see any clear inflationary push over the last six months, au contraire. (Click on image for better viewing).

Exports Going Nowhere

Perhaps the most evident flaw in the Abenomics story is to be found in the export department. The sharp yen devaluation was supposed to lead to a sharp boost in exports which would then drive the economy. And for a time it did.

But then, as Reuters Stanley White points out, the export drive simply ground into the dust, and Japanese exports have been moving sideways since the spring (see chart above). This should be pretty worrying for Abenomics theorists, since the stagnation in exports can't be put down to the tax hike.

Where we go from here is anyone's guess. The economy is surely going to have a brush with recession this quarter, and in any event it is hard to speak about a recovery in anything except inflation and the stock market.

Consensus economists are now expecting Bank of Japan governor Kuroda to go for another round of quantitative easing - to force the yen down yet one more time. But why should what didn't work once do any better the second time round? And anyway, Hurhiko Kuroda himself seems to be trying to talk down expectations in this regard. "Japan's economy has been on a path suggesting that the price stability target of 2 percent will be achieved as expected," he told business executives in Osaka last week, adding that "exchange-rate stability is extremely important". This suggests he is not contemplating any further sharp devaluation. Any yen weakening we will see is likely  be contained and not pronounced.

On the other hand the administration still has to decide whether to go ahead with next year's additional tax hike. The government is caught in a double bind, since if it doesn't raise the consumption tax as planned and cuts spending to compensate then the economy will still contract. And if it doesn't do either of these things  then the debt level will continue its march upwards. At the moment the government is mulling the idea of raising the tax and doing a 5 trillion yen ($47 billion) additional stimulus to compensate. Which sort of leaves me wondering why they want to raise the tax in the first place.

What makes people like me nervous is the thought that if the central bank can't deliver on its promise to deliver inflation and revive the economy, or if the Japanese voters decide they have had enough of the experiment, then a loss of confidence might ensue, and all those dubious risky asset positions might unwind suddenly, just like an earlier set did in 2008.

And there are plenty of people in Japan who have been pointing this out all along. Seki Obata, a Keio University business school professor for example, who in 2013 published a book "Reflation is Dangerous," argues exactly this, that "Abenomics" is exposing Japan to considerable risk without any clear sense of what it can accomplish. Obata also makes the extremely valid point that there is simply no way incomes can rise across the entire economy because the baby boomers are now retiring to be replaced by fewer young workers with post labour reform entry-level wages. Japan's overall consumer spending power will therefore fall, rather than rise as Abe hopes. "Individual companies may offer wage increases, but because of demographics it is simply impossible to increase the total amount that is paid out in wages," says Obata. "On the contrary, that amount will shrink." Simple logic you would have thought, but logic in the face of irrational exuberance scarcely stops people in their tracks.

As far as I can see, all of this  points to one simple and evident conclusion: that Japan needs deep seated cultural changes, especially ones directed to greater female empowerment and more open-ness towards immigration. Hardly matters for central bank initiatives, and indeed ones for which Shinzo Abe, who naturally has given his name to this new economic trend, is singularly ill equipped to carry through. Japan needs a series of structural reforms – like those under discussion around the third arrow – but these would be to soften the blow of workforce and population decline, not an attempt to run away from it. Monetary policy has its limits. As Martin Wolf so aptly put it, "you can't print babies".

The above analysis is based on arguments fleshed out in much more detail in my  "mini book" the A B E of Economics.

The book is available with Amazon as an e-book. It can be found here. You don't need to buy a Kindle to read this book. You can download a free app from Amazon.

Abenomics - What Could Possibly Go Wrong?

If this week's economics news is positive then that is good.  But if it's bad then that's even better, since there is more potential for it to improve next week, and if it doesn't, well that's doubly better since there will be  even more reason for central banks to step in and push up asset prices. Maybe all this sounds peculiar, even perverse, but it would seem to be how many people working in financial markets are reasoning these days.

In an article entitled "Why Japan's GDP Plunge Isn't As Bad As It Seems", Bloomberg writer Bruce Einhorn put it like this:

The last time Japan raised the consumption tax, in 1997, the economy went into a tailspin. The impact doesn’t seem to be as bad this time, though. The economy contracted at an annualized 6.8 percent in the second quarter of the year. Bad, to be sure, but not dismal. For all its severity, the plunge was actually smaller than many economists had expected, with a survey of 37 economists by Bloomberg showing a median estimate of a 7 percent decline. That’s why investors looked at today’s numbers and shrugged. 

 Takeshi Minami, chief economist at the Norinchukin Research Institute in Tokyo also felt the number wasn't a disaster, since he told Bloomberg despite the sharp fall, “the probability is high that the July-September quarter will see a rebound.” Well, naturally, after a 19.2% annualised drop in household consumption, or a 35.3% drop in residential investment doing better won't be hard, but that's a kinda low bar to be working from.

Another line of argument you can find repeatedly in the financial press is that the number was a bad one, but the silver lining is that this means the Bank of Japan is more likely to do additional QE. “The contraction was sharp. There is no argument about that,” Toshihiro Nagahama, chief economist at Dai-Ichi Life Research Institute told the Wall Street Journal, however he had “no doubt” the government and the Bank of Japan would come under pressure to act as a result. Pressure from whom? As we will see later, maybe not from Japanese the citizens these institutions are supposed to represent.

At the end of the day what matters isn't whether Japan's economy grows slightly (or not) in the coming quarter, but whether the country is on a stable recovery path or whether growth will continue to remain lackluster and weak even as the government debt level rises.

Apart from the obvious shockers, details worth noting are the 1% of GDP's worth of quarterly inventory accumulation (see chart above), which will have to be sweated down in the next quarter, and the 20.5% annualized fall in imports. This was good for the net trade component, which was positive for the first time in yonks, but the fall is simply the reverse side of the consumption drop. In fact Japanese export growth has been weakening steadily in recent months, and this obviously has nothing to do with the sales tax.

Exports were down 2% in June over a year earlier, and in volume terms they were down 2.5% from September 2012, just before the Abenomics driven yen devaluation started. So if one of the objectives of Abenomics was boosting exports it is obviously failing. As Naohiko Baba, chief Japan economist at Goldman Sachs Group and former central bank employee told Bloomberg: “The BOJ predicted that a weak yen would boost export volumes and spur spill-over effects by increasing domestic production and expanding the overall economy -- but that path isn’t working. It raises the question of what the weak yen has done in terms of living standards of the general public.”

It seems that manufacturers have been moving production to lower-cost countries during the years of yen strength, thus reducing the effect of exchange rates on exports. Honda, for example, has more car production capacity in North America than its home market and last year exported more vehicles from its U.S. factories than it imported into the country from Japan.

Inflation Surge Weakening?

The Bank has had more success with inflation since core inflation was up 3.3% over a year earlier in June. But that number soon shrinks in proportion when you strip out the estimated impact of the recent tax hike. According to the Bank of Japan the ex-tax number for June was 1.3%, down from 1.4% a month earlier. And even this inflation isn't demand driven: it is largely a carry over from the earlier yen devaluation. As such it is quite likely to disappear with time.

Representatives of the Bank of Japan continue to insist that the country is on course to exit deflation, but many external observers aren't convinced, as this recent chart from analysts at Credit Suisse suggests. 

 

As the Wall Street Journal put it:

 "The latest data, which exclude the effects of April's consumption-tax hike, suggest that Japan is slipping away from the 2% inflation target set by Mr. Abe's central banker, Haruhiko Kuroda. Price increases for imports, triggered by a yen-devaluation campaign, have now filtered through the economy. Since Abenomics hasn't included concrete economic reforms, Japan is sliding back into its status quo before Mr. Abe was elected in late 2012."

Winners and Losers

Another problem which faces Abe is that the results of his policy have been very unevenly distributed.Those who gained from the yen devaluation (shorting the yen) or from the rise in Japanese equities, or those corporates who  made windfall profits on their sales have been the lucky ones, because the rest of the Japanese have been facing falling living standards. As the Economist pointed out: even as jobs grow scarce, real wages continue to fall.

Nominal wages have been rising again in Japan. Average total wages, consisting of base pay, overtime and bonuses covering both regular and part-time workers, grew 0.4% on year in June, following increases of 0.6% for May and 0.7% for April and March. Four straight months of year-on-year risse is the longest stretch since total wages grew for six straight months between June and November 2010. But real wages - which take into account inflation and matter much more to consumers than nominal wages, declined 3.8% on year in June, the fourteenth consecutive month of decline, and the biggest drop since December 2009.

Shadow Over Abenomics?

Not unnaturally many Japanese are starting to get fed up with Premier Abe and his economics revolution. What good to them is a policy which only helps the upper 10% of the population and the overseas investment community. Tokyo University's Shin-ichi Fukuda has carried out some pretty interesting research in this regard. As can be seen in the two charts reproduced below, most of the movement in both  the Nikkei has taken place while the Japanese themselves were offline and asleep.

And pretty much the same picture emerges if we look at movements in the yen.

It shouldn't surprise us then to find that Shinzo Abe's popularity is plummeting in Japan. Opinion surveys conducted in July by Japan’s major newspapers show Abe’s support ratings have fallen below 50 per cent for the first time since he became Premier, while the number of people who say they disapprove of his government is approaching the number who say they approve.

And at the heart of the dissatisfaction lies the governments economic policy. A recent survey published by the Sankei newspaper showed 47 per cent of respondents said they disapproved of his government’s handling of the economy, 7 percentage points more than the number who approved.The Sansei, described by the FT's Jonathan Soble as a "right-leaning" daily that has mostly "cheer-led" for Abe, had a headline stating "There is a shadow over Abenomics". As Soble says one of the reasons for such dissatisfaction among many Japanese "is simply that Abenomics has made them poorer, thanks to its uneven effect on prices and wages."

So while many in the markets and in the academic community think the obvious response to what is happening in Japan will be more BoJ easing, the Japanese themselves may not see it this way.

Part of the reason they might not see it in the same light as the central bank dependent investment community is that there is a solid body of opinion in Japan that recognizes that a large part of the country's issue is demographic and that simply "jump starting" a bit of inflation won't make the problem go away..

The question I would ask is this: given all the doubt which exists about the real roots of Japan's problem, and the fact that it may well be a permanent structural problem and not a temporary liquidity trap one, is it really justified to run such a high risk, all-or-nothing experiment? Even Paul Krugman seems to have changed his assessment various times since the  problem started and while he still fully supports the general approach being taken he now thinks the natural rate of interest may remain permanently negative and that fiscal stimulus might be necessary on a permanent basis (liquidity trap without end, amen).  What makes people like me nervous is the thought that if the central bank can't deliver on its promise to deliver inflation, or if the Japanese voters decide they have had enough of the experiment, then a loss of confidence might ensue, and all those dubious risky asset positions might unwind suddenly, just like an earlier set did in 2008.

And there are plenty of people in Japan who have been pointing this out all along. Seki Obata, a Keio University business school professor for example, who in 2013 published a book "Reflation is Dangerous," argues exactly this, that "Abenomics" is exposing Japan to considerable risk without any clear sense of what it can accomplish. Obata also makes the extremely valid point that there is simply no way incomes can rise across the entire economy because the baby boomers are now retiring to be replaced by fewer young workers with post labour reform entry-level wages. Japan's overall consumer spending power will therefore fall, rather than rise as Abe hopes. "Individual companies may offer wage increases, but because of demographics it is simply impossible to increase the total amount that is paid out in wages," says Obata. "On the contrary, that amount will shrink." Simple logic you would have thought, but logic in the face of irrational exuberance scarcely stops people in their tracks.

As far as I can see, all of this  points to one simple and evident conclusion: that Japan needs deep seated cultural changes, especially ones directed to greater female empowerment and more open-ness towards immigration. Hardly matters for central bank initiatives, and indeed ones for which Shinzo Abe, who naturally has given his name to this new economic trend, is singularly ill equipped to carry through. Japan needs a series of structural reforms – like those under discussion around the third arrow – but these would be to soften the blow of workforce and population decline, not an attempt to run away from it. Monetary policy has its limits. As Martin Wolf so aptly put it, "you can't print babies".

The above is based on arguments fleshed out in much more detail in my  "mini book" the A B E of Economics.

The book is available with Amazon as an e-book. It can be found here. You don't need to buy a Kindle to read this book. You can download a free app from Amazon.

Japan Inflation At A 32 Year High?

Just in case anyone was in any doubt last weeks newspaper  headlines blared it out for us loud and clear - Japanese inflation is back, and has even hit levels last seen in 1982. (Click on image below for better viewing).

In fact consumer prices in Japan rose at an annual rate of 3.4% in May according to the Bank of Japan's preferred measure, driven higher from one month to another by the growing impact of the April sales tax hike. The May surge in inflation follows a previous jump to 3.2%  in April, up from 1.3% in March. Apart from the tax hike, the delayed impact of last years yen devaluation is still being felt: electricity charges rose 11.4% year on year in May, gasoline was up 9.6%, while fresh seafood prices climbed 14.3%.

However, stripping out the effect of the higher tax, Japan's core consumer-price index rose 1.4% in May according to statistics office estimates (see BoJ chart below), below the 1.5% increase the previous month. This underlying inflation fell, even while the headline core index rose, which is why I say the "growing impact" of the tax hike, since it is clear that businesses passed on more of the tax rise in May than they did in April. The slowdown in price growth was the first since September 2013, and BoJ governor Haruhiko Kuroda also recognized last week that ex-tax core inflation is "expected to slow to around 1%" in the summer, as the effects of higher imported energy prices diminish.

But beyond the waning impact of rising energy prices, a second factor is likely to put downward pressure on Japan prices: the continuing shortfall in domestic demand. Household spending was down 8% year on year in May, following a 4.6% drop in April.

And it's not hard to fathom why consumption is so weak: wages excluding overtime payments and bonuses fell for a 23rd month in April. In fact real wages fell 3.8% year on year. With the purchasing power of salaries falling, and weak demand for credit it is hard to see how consumption wouldn't be falling - maybe not as sharply as in May, but falling all the same.

On the positive side,  Japan's unemployment rate hit a 16-year low of 3.5%  in May. At the same time, the availability of jobs rose to its highest level since 1992, with the jobs-to-applicants ratio for May hitting 1.09, meaning there were 109 jobs available for every 100 job seekers. The data showed the job market tightening across the economy, from construction to auto manufacturing to education.

In fact it isn't just unemployment that is falling - employment is also rising, and was up by just over half a million workers over the last twelve months taking the number of jobs in the economy to a post crisis high.

But if the number of people employed is rising, why isn't what Prime Minister Abe calls the "virtuous cycle" starting to work, with jobs growth producing income growth to spur consumption, so lifting corporate profits and investment spending? Part of the answer lies in the kind of jobs being created. The growth in the number of workers on short-term or part-time contracts means that total earnings (as opposed to basic wages) across the economy are not rising. Employment was up 0.9% while disposable income among worker households FELL 3.4% in real terms. The numbers just don't add up.

As the Economist (who prepared the above chart) puts it, "workers used to be protected by an expensive system of lifetime employment. But firms place new entrants on short-term, ill-paid contracts. Nearly two-fifths of the workforce now falls into this “irregular” category."

The Price Of Permanent Stimulus

Nothing, as we know, comes free, and Abenomics is no exception. Apart from the problem of inducing consumption on the back of falling real wages, the country's external balances are also suffering.  Japan logged its 23rd successive month of trade deficits in May, as exports and imports both declined. The May deficit  was 909 billion yen ($8.8 billion), as exports to the U.S. fell by nearly 3 percent from a year earlier. Exports fell 2.7 percent to 5.6 trillion yen ($54.9 billion) while imports dropped 3.6 percent to 6.5 trillion yen ($63.7 billion).

The current account surplus is also deteriorating and plunged 76.1% in April when compared with the previous year. The current account balance was the lowest seen in April since1982 according to the Japanese Finance Ministry.

All this notwithstanding, with the Bank of Japan buying almost all new issue Japan Government Bonds, yields remain incredibly low. As the FT's James Mackintosh points out the yield on the 7-year bond fell to just 0.28% last week, only 6bp above its all-time low.

As James notes, rising inflation and falling bond yields don't mix well in the longer term, and don't offer much prospect of a serious market beyond BoJ purchases, unless of course the inflation is not sustainable.  The black line in the following chart shows an index of inflation-linked JGB real yields, while the other two show the 7- and 10-year yields minus inflation.

Really there isn't that much mystery about what is going on in Japan. Falling working age population is steadily reducing the country's potential growth rate (as the chart below from the Bank of Japan illustrates), and while structural reforms may help raise productivity and offset the decline on the supply side to some extent, they won't address the underlying structural demand shortage problem. So it could be that at the end of the day the only lasting legacy of the Abenomics experiment will be a seriously distorted economy and a pile of sovereign debt which will be hard to ever pay down and will make raising interest rates in the longer term really problematic.

More detailed arguments to justify the idea that Abenomics is unlikely to achieve its objectives can be found in my recent short book - The ABE of Economics (for more information visit my webpage). The book is available with Amazon as an e-book. It can be found here. You don't need to buy a Kindle to read this book. You can download a free app from Amazon.

Will Japan Re-enter Deflation in April 2015?

Reading the most recent statements from Bank of Japan Governor Haruhiko Kuroda or Finance Minister Taro Aso you would get the impression that the days of deflation are now well and truly numbered in Japan. Martin Schulz, economist at Fujitsu Research Institute in Tokyo, goes even further. “Deflation is over in Japan,” he told Bloomberg Television First Up’s Angie Lau . Even Japan’s industrial leaders now believe inflation is here to stay: the country’s inflation rate will be 1.5 percent in the spring of 2015, and 1.7 percent in 2017, according to average forecasts in a Bank of Japan survey conducted in March this year.

But is such optimist justified? According to the Bank of Japan's favored index, which includes energy but not the cost of fresh food, inflation stood at an annual 3.2% in April. Sounds good if what you want to do is generate inflation.

But before getting too excited, it is worth bearing in mind that inflation one month earlier has stood at only 1.3% on the same measure. The difference between months is, naturally, the result of the impact of the 3% sales tax hike which came into force on 1 April. Without that, inflation would have been much lower since the base effect of the 20% yen devaluation is now starting to work its way out of the calculation. Indeed stripping out energy costs (which are the principal knock on cost effect of the devalued yen), inflation in April was but 2.3%, notably below the size of the tax hike. So the question which should be being asked is what will the level of annual inflation be in April 2015, assuming that is there are no further yen devaluations or tax hikes to help push the number back up again? Analysts at Credit Suisse seem pretty clear (see chart below), we’ll be back in deflation again.

Leaving aside the sustainability issue, the type of inflation Japan has been experiencing since the advent of Abenomics – driven by rising energy costs and tax hikes – also constitutes a problem. It has been described by Bloomberg journalists Tsuyoshi Inajima and Brian Swint as the "wrong kind", a way of putting things which highlights the amount of confusion there is out there about just what it is that the BoJ is doing and what it is supposed to be achieving.

To back their point they cite Klaus Baader, chief Asia Pacific economist for Societe Generale in Hong Kong to the effect that “this isn’t the kind of inflation we want in Japan to break the deflation mindset. We’d like inflation that is a reflection of higher wages, whereas this is pure cost inflation that decreases purchasing power.” So now we learn that Japan doesn’t need just any old inflation, it needs a very specific kind, which could be described as “demand pull”, but this brings us straight back to the original problem: domestic demand in Japan just isn’t strong enough to generate this kind of inflation, and nudging up inflation expectations for a couple of years won’t change anything substantial in this regard. Possibly the type of cost push inflation Japan is experiencing is the "wrong kind" for adherents of the Abenomics approach, but it is more than likely the only kind they are going to get. If the structural lack of demand argument I have been advancing is valid, then this means there is permanent downward pressure on costs in an environment of constant oversupply making inflationary wage increases difficult to envision. Indeed, as reported by another group of Bloomberg journalists (Masaki Kondo, Mariko Ishikawa and Yumi Ikeda) , reality itself belies such expectations, since Japan's wage index hit a post 1992 low at the start of 2013. And the downward drift has continued. In April 2014 the average basic salary fell for the 23rd straight month, declining 0.2 percent to 243,989 yen, while average real, or inflation-adjusted, wages decreased 3.1 percent from a year earlier, marking the largest year-on-year fall in more than four years.

Rising inflation and falling wages don’t seem like the sort of combination to make for a sustainable recovery. Indeed it seems so off-mark as to make you wonder whether official sector economists really thought through what they were doing before embarking on this experiment.

The thing is this, given all the doubt which exists about the real roots of Japan's problem, and the fact that it may well be a permanent structural problem and not a temporary liquidity trap one, is it really justified to run such a high risk, all-or-nothing experiment? Even Paul Krugman seems to have changed his assessment various times since the  problem started and while he still fully supports the general approach being taken he now thinks the natural rate of interest may remain permanently negative and that fiscal stimulus might be necessary on a permanent basis (liquidity trap without end, amen).  What makes people nervous is the thought that if the central bank can't deliver on its promise to deliver inflation then a loss of confidence might ensue, and all those dubious risky asset positions might unwind suddenly, just like an earlier set did in 2008.

And there are plenty of people in Japan who have been pointing this out all along. Seki Obata, a Keio University business school professor for example, who in 2013 published a book "Reflation is Dangerous," argues exactly this, that "Abenomics" is exposing Japan to considerable risk without any clear sense of what it can accomplish. Obata also makes the extremely valid point that there is simply no way incomes can rise across the entire economy because the baby boomers are now retiring to be replaced by fewer young workers with post labour reform entry-level wages. Japan's overall consumer spending power will therefore fall, rather than rise as Abe hopes. "Individual companies may offer wage increases, but because of demographics it is simply impossible to increase the total amount that is paid out in wages," says Obata. "On the contrary, that amount will shrink." Simple logic you would have thought, but logic in the face of irrational exuberance scarcely stops people in their tracks.

As far as I can see, all of this  points to one simple and evident conclusion: that Japan needs deep seated cultural changes, especially ones directed to greater female empowerment and more open-ness towards immigration. Hardly matters for central bank initiatives, and indeed ones for which Shinzo Abe, who naturally has given his name to this new economic trend, is singularly ill equipped to carry through. Japan needs a series of structural reforms – like those under discussion around the third arrow – but these would be to soften the blow of workforce and population decline, not an attempt to run away from it. Monetary policy has its limits. As Martin Wolf so aptly put it, "you can't print babies".

The above is an extract from my new "mini book" the A B E of Economics.

The book is available with Amazon as an e-book. It can be found here. You don't need to buy a Kindle to read this book. You can download a free app from Amazon.

The Growing Mess Which Will Be Left Behind By The Abenomics Experiment

According to wikipedia, "overdetermination is a phenomenon whereby a single observed effect is determined by multiple causes at once, any one of which alone might be enough to account for ("determine") the effect.That is, there are more causes present than are necessary to generate the effect".  In this strictly technical sense Japan's deflation problem is overdetermined - there are multiple causes at work, any one of which could account for the observed phenomenon. Those who have been following the debate can simply choose their favourite - balance sheet recession, liquidity trap, fertility trap - each one, taken alone, could be sufficient as a cause. The problem this situation presents is simply epistemological - in a scientific environment the conundrum could be resolved by devising the requisite, consensually grounded, tests.

But I would here like to use the term "overdetermination" in another, less technical, sense, since it seems to me Japan's problem set is overdetermined in that we always seem to be facing at least one more problem than we have remedies at hand.

The case of the country's ongoing energy dependency which is producing a growing trade and current account deficit would be a good example. Notionally the problem forms part of the legacy of the tragic tsunami which hit the country in March 2011 and lead to the decision to phase out  nuclear energy capacity.  But now  that decision has been reversed, and starting this summer nuclear generating capacity is once more to be "phased up". The issue is, from a strictly economic point of view would that be good news? Well, it would certainly help with the deteriorating trade balance:

But what about deflation? Would having cheaper domestically produced energy help here? Wasn't generating inflation supposed to be the whole point of the Abenomics exercise? Don't rising energy costs constitute the lions share of the country's recent, much heralded, inflation? Damned if I do, and damned if I don't would seem to be the only conclusion to draw. A win-win policy which both closes the trade deficit and foments inflation (if that's what you think Japan needs) doesn't seem to be on the table. The trade deficit could also be corrected by reducing the fiscal deficit, but that would lower domestic demand, possibly send the economy back towards recession and almost certainly ignite deflation yet one more time.

The remainder of this post can now be found in my Kindle e-book published with Amazon.

You don't need to buy a Kindle to read this book. You can download a free app from Amazon.