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Economic Insights

The Japanese seem willing to give Abe room to reform when he decides to act.

Prime Minister Shinzo Abe's Liberal Democratic Party (LDP) recently won an impressive majority in the upper house of Japan's Diet, its parliament. This victory gives the party complete control of Japan's government for at least three years. The prime minister said he will use that control to take the unpopular steps of reform that will put Japan's economy back on track. To channel Abraham Lincoln: "Fondly do we hope, fervently do we pray..." If Shinzo Abe implements needed fundamental reform, the country and its markets could offer huge economic and investment opportunities. But so far, Abe has done little in this regard—or even proposed anything. Until he does, the economy's prospects remain dubious. 1

So far, the prime minister's policies have had more of a cyclical rather than a fundamental orientation. His program, popularly called "Abenomics," has two basic parts: massive spending on infrastructure, amounting to about 2% of the Japanese economy, and extreme monetary ease by the Bank of Japan, aimed in no small part at boosting export sales by depressing the yen's foreign exchange value.2

The immediate response to his agenda has been remarkably positive. In the months after Abe first took the prime minister's office late last year, the yen has tumbled some 25% in value against the dollar. Japanese stocks, according to the Nikkei Index,3 have soared. They first rose 55% from late 2012 to late May,4 sold off again later in the spring, along with most stock markets around the world, but have come back since, almost recovering their old highs. Meanwhile, as if to confirm the wisdom of those market moves and Abe's policies, Japan's exports have surged, consumer prices ticked up late in spring, hinting at a pause from the deflation that has plagued Japan on and off more than 20 years now, and last quarter’s real gross domestic product (GDP) jumped at an annual rate of 4%, an impressive pace of expansion, not just for Japan but also for developed markets generally these days.5

But for all this immediate success, questions remain. The government's fanfare for its own policies cannot hide that Abenomics is little different from the policies long followed by the LDP. Since the end of the Second World War, in fact, the party has relied heavily on infrastructure spending for economic stimulus, not the least because it also allows the LDP to reward its supporters. This constant recourse to infrastructure spending, especially during the last two decades of stagnation, is why public debt in Japan already exceeds 250% of the country's GDP. Japan under the LDP has also long strived to keep the yen cheap in order to promote exports as an engine of growth. The scope of Abe's policy has clearly had an impact, but the difference from the past is more one of degree than kind. If the nature of these policies is so fundamentally similar to the past, including the last two lost decades, it is only reasonable to question whether they will have a lasting effect this time.

Japan also has deep structural problems that these policies fail to address. One is demographic. Japan has the oldest population on earth, and it is getting older. Already in Japan almost one person in four is of retirement age, leaving barely three of working age available to support each retiree. This demographic reality has already strained government budgets and limited the country's ability to grow in a number of ways. And it only promises to get worse in coming years. Though Abe has alluded to the need to address this matter, he has offered little in the way of specific policies. There is no talk of pension reform. He has no agenda that might relieve strains on the current work force by, for instance, encouraging older people to work longer or bring a greater proportion of women into the workplace. On both these counts, Japan trails the United States and Europe. Nor has he advanced educational or training initiatives that might make the existing work force more productive.

A second structural problem is Japan's industrial organization. The country has long taken an extremely top-down approach to economic management, setting its direction through a combination of politicians, bureaucrats, and big business, referred to popularly as the "iron triangle." For a long time, when Japan trailed the West and directions for its economy were obvious, this approach worked well by marshaling the country's economic and financial resources to a clear agenda. Now that Japan has caught up with the West, it needs the economic experimentation of entrepreneurial effort to keep its economy dynamic. But because startups and entrepreneurial effort by nature upset the staid arrangements through which the triangle exerts its influence, it naturally resists. Abe so far has offered little more to rectify things than support for the new Trans-Pacific [Trade] Partnership (TPP). And though more open trade would ease demographic pressures and encourage more economic innovation, it is far from the complete answer this economy needs.6

Even if he were to advance fundamental policy change on the scale required, it is not apparent how far he would get. On TPP alone, many in his own party retain an allegiance to the old closed system, in agriculture especially, but elsewhere as well. After all, the LDP established the current system, including the so-called iron triangle, more than 50 years ago. Many in the party, even under Abe's leadership, will stick with those old ways and fight the pact, much less support still more aggressive fundamental reform. Indicative of the pressure on Abe is the unmistakable fact that many of his policies actually conflict with these fundamental structural reform needs. His emphasis on exports, for one, though of a piece with the LDP's decades-long approach, runs entirely counter to the country's demographic reality. It is preposterous for a country to strive to remain the workshop of the world when such a large portion of its population has ceased active production. Actually the country should turn to a consumer-based growth model. But in another one of his policies, Abe continues to contemplate a doubling of the consumer tax from 5% to 10%.

To be sure, the prime minister and the Diet could still turn to the economy’s fundamental needs. Abe and his party certainly have the political base to do so. But until they do, Japan, no matter how impressive its recent cyclical response, courts a relapse into the deflationary stagnation with which it has suffered for more than 20 years now. Investors should though keep in mind that the economy has seen flashes of growth and activity during this difficult time—only to relapse quickly into its debilitated state. Fundamental reform now under Abe can likely prevent that pattern from recurring, but while the prime minster and the Diet wait, Japan long term remains a dubious bet.


1 Yuka Hayashi, Tko Sekiguchi, and George Nishiyama, "Voters Endorse Abe's Vision for a New Postwar Japan," The Wall Street Journal, July 22, 2013.
2 Toko Sekiguchi, "Japan's Abe Cautions Party Backtracking on Economy," The Wall Street Journal, July 23, 2013.
3 The Nikkei 225 Index is a price-weighted index comprised of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange.
4 Bloomberg data.
5 Mitsuru Obe, "Japanese Prices Rise, Signaling Rebound," The Wall Street Journal, July 26, 2013.
6 Thomas Catan, "Japan Revival Bid to Have Global Consequences," The Wall Street Journal, July 29, 2013.

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