Abe should repeat Roosevelt’s successes, but not his mistakes

There is more good news from Japan today as new data shows that core inflation rose to 0.8% y/y in August and I think it is now pretty clear that the Bank of Japan is succeeding in defeating 15 years’ of deflation. Good job Mr. Kuroda!

BoJ chief Kuroda has done exactly done what Ben Bernanke called for back in 1999:

Franklin D. Roosevelt was elected President of the United States in 1932 with the mandate to get the country out of the Depression. In the end, the most effective actions he took were the same that Japan needs to take—- namely, rehabilitation of the banking system and devaluation of the currency to promote monetary easing. But Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and to experiment—-in short, to do whatever was necessary to get the country moving again. Many of his policies did not work as intended, but in the end FDR deserves great credit for having the courage to abandon failed paradigms and to do what needed to be done. Japan is not in a Great Depression by any means, but its economy has operated below potential for nearly a decade. Nor is it by any means clear that recovery is imminent. Policy options exist that could greatly reduce these losses. Why isn’t more happening?

To this outsider, at least, Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced. Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for some Rooseveltian resolve in Japan.

So far so good and there is no doubt that governor Kuroda has exactly shown Rooseveltian resolve. However, while Roosevelt undoubtedly was right pushing for monetary easing to end deflation in 1932 he also made the crucial mistake of trying to increase wages.

One can say that Roosevelt succeed on the demand side of the economy, but failed miserably on the supply side of the economy. First, Roosevelt push through the catastrophic National Industrial Recovery Act (NIRA) with effectively was an attempt to create a cartel-like labour market structure in the US. After having done a lot of damage NIRA was ruled unconstitutional by the US supreme court in 1935. That helped the US recovery to get underway again, but the Roosevelt administration continued to push for increasing labour unions’ powers – for example with the Wagner Act from 1935.

While it is commonly accepted that US monetary policy was prematurely tightened in 1937 and that sent the US economy into the recession in the depression in 1937 it less well-recognized that the Roosevelt administration’s militant efforts to increase the unions’ powers led to a sharp increase in labour market conflicts in 1936-37. That in my view was nearly as important for the downturn i the US economy in 1937 as the premature monetary tightening.

Prime Minister Abe is repeating Roosevelt’s mistakes   

The “logic” behind Roosevelt’s push for higher was that if inflation was increased then that would reduce real wages, which would cut consumption growth. This is obviously the most naive form of krypto-keynesianism, but it was unfortunately a widespread view within the Roosevelt administration, which led Roosevelt to push for policies, which seriously prolonged the Great Depression in the US.

It unfortunately looks like Prime Minister Abe in Japan is now pushing for exactly the same failed wage policies as Roosevelt did during the Great Depression. That could seriously undermine the success of Abenomics.

This is from Bloomberg today:

“Abe last week began meetings with business and trade union leaders to press his case for wage increases, key to the success of his effort to spur growth under his economic policies dubbed Abenomics.”

This is exactly what Roosevelt tried to do – and unfortunately succeed doing. His policies was a massive negative supply shock to the US economy, which pushed wages up relatively what would have happened with out policies such as NIRA. The result was to prolong the depression and I am fearful that if Prime Minister Abe will be as successful in pushing for higher wage growth in Japan it will undermine the positive effective of Mr. Kuroda’s monetary easing – inflation will rise, but economic growth will stagnate.

What Prime Minister Abe is trying to do can be illustrated in a simple AS-AD framework.

Abe wage shock

Mr. Kuroda’s monetary easing is clearly increasing aggregate demand in the Japanese economy pushing the AD curve to the right (from A to B). The result is higher inflation and higher real GDP growth. This is what we are now clearly seeing.

However, Prime Minister Abe’s attempt of increasing wages can only be seen as negative supply shock, which if successful will push the AS curve to the left (from B to C). There is no doubt that the join efforts of Mr. Kuroda and Mr. Abe are pushing up inflation. However, the net result on real GDP growth and employment is uncertain.

I am hopeful that Mr. Abe is not really serious about pushing up wages – other than what is the natural and desirable consequence of higher demand growth – and I hope that he will instead push much harder to implement his “third arrow”, which of course is structural reforms.

Said, in another way Mr. Abe should try to push the AS curve to the right instead of to the left – then Abenomics will not repeat the failures of the New Deal.

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Japan badly needs structural reforms, but not more than the rest of the G7 countries

A key critique of monetary easing in Japan is that Japan’s real problem is not monetary, but rather a supply side problem. I strongly agree that the Japanese economy is facing serious structural challenges – particularly an old-age population and a declining labour force. However, I also think that there often is a tendency for commentators to overstate these problems compared to supply side problems in other developed economies.

In this post I will therefore try to compare Japan’s structural problems with the structural problems of the other G7 economies – the US, UK, Canada, Germany, France and Italy.

The conservative US think tank Heritage Foundation every year produces an Economic Freedom Index. Even though one certainly can discuss the methods used to calculate this index I overall believe that the Index gives a pretty good description of the level of economic liberalization in difference countries. And yes, I do equate the level of economic liberalization with less structural problems.

The graph below shows the ranking of the G7 countries in the 2013 Index of Economic Freedom.

Economic Freedom Index G7

The picture is pretty clear. The Anglo-Saxon countries Canada (6), USA (10) and the UK (14) are significantly more economically free than particularly the interventionist South European countries France (62) and Italy (83).

Japan (24) shares the “median” position with the other large exporter in the group – Germany (19).

So while there certainly is scope for reforms in Japan it is hard to argue that Japan in general is a lot more interventionist than the other large economies of the world.

In fact it is also hard to argue that Japan has performed worse than the other G7 countries over the past decade. As the graph below shows Japanese GDP/capita has grown more or less in line with the other G7 countries since 2001-3. The real underperformer is Italy rather than Japan, which should not be surprising given Italy’s interventionist policies and excessive regulation.

A closer look at Japan’s structural weaknesses

But lets have a closer look at the data and see what Japan’s structural problems really are.

The graph below shows Japan’s relative ranking among the G7 economies in each of the subcategories of Index of Economic Freedom. I have indexed the average G7 ranking for each category at 100. The higher a score the more “free”.

Economic Freedom Japan 2Again the story is the same – Japan falls smack in the middle among the G7 countries when it comes to economic freedom – with an average for all the categories score of 101.

The breakdown of the numbers reveals both Japan’s relative strengths and weaknesses.

For example the Japanese public sector is relative small compared to the average of the other G7 countries and the Japan’s labour market is relatively free.

However, it is also clear that there are some clear regulatory weaknesses. This is particularly the case in the areas of trade, business, investment and financial freedom.

The three first of them all really is about an overly protectionist Japanese economy – both when it comes to foreign and domestic investors and I think it is pretty obvious that this is where the reform effort in Japan should be focused.

Mr. Abe please open up the Japanese economy

I really think it is straight forward. If Prime Minister Abe seriously wants to reform his country’s economy he needs to open it up to competition – both domestic and foreign.

In the domestic economy I would like other commentators highlight the lack of competition in the retail sector where for example the  “Large Scale Retail Location Law” tend to give artificial protection to small retail outlets (mom-and-pop shops) rather than bigger and more efficient retail shops such as hypermarkets.

Similarly zoning laws are hindering competition in the retail sector while at the same time is deepening the decade long Japanese property market crisis.

Finally I would note that interventionism in the agricultural sector in Japan is at least as bad as in the EU with price controls and very high levels of subsidies. Just see these scary facts from a recent WSJ article:

“In 2010, farmers added 4.6 trillion yen ($45 billion) in value and consumed 4.6 trillion yen in subsidies, meaning the industry netted out to zero. The average Japanese farmer is 66 years old and tills 1.9 hectares of land.”

This is hardly an efficient use of economic resources. The need for retail, housing and agricultural reforms therefor for seem to be very clear and this is where the focus should be for Mr. Abe when he fires off what he has called his “Third arrow” - structural reform.

Trade and investment liberalization will could enhance global support for Abenomics

Bank of Japan’s efforts to ease monetary policy has been criticized for being a beggar-they-neighbour policy. I think is a completely misplaced critique, however, it is indisputable that the outside world increasingly think of Japan as protectionist. I believe that a good way to calm these fears would be for the Japanese government to unilaterally remove all trade barriers and trade tariffs as well as opening up the Japanese economy to foreign investments. That would be in the best interest of the Japanese economy and would significantly boost Japanese productivity, while at the same making it very hard to the outside world to argue that Japan is protectionist.

The focus on monetary reform as been right and will support structural reforms

Even though there is an urgent need for economic reforms in Japan I fundamentally don’t think that the need for economic reforms is bigger than in France or Italy or even in Germany and I therefore think that the focus on monetary reform has been correct.

Furthermore, as the new monetary policy regime is likely to pull Japan out of deflation and boost economic growth (in the next 2-3 years) the Abe government is likely to get more support for implementing less popular reforms. Furthermore, as the new monetary policy regime is very likely to increase nominal GDP growth both public finance and banking problems are likely to be reduced, which in itself is likely to support real GDP growth over the longer run.

Concluding, the Abe government has gotten it more or less right on monetary regime (even though I would have preferred NGDP targeting to inflation targeting) and it is now time for Prime Minister Abe to prepare for his Third Arrow.

Answering Tyler’s question on Japan with old blog post

Here is Tyler Cowen on Twitter:

Still not seeing much discussion of 4.1% unemployment rate in Japan, would love to see “jump start” defined.

What Tyler is basically saying is that there really is not an argument for “jump starting” the Japanese economy with fiscal and monetary stimulus when unemployment is this low. I many ways I share Tyler’s skepticism about “stimulus” in the case of Japan.

I have long argued that Japanese story is a lot more complicated than it is normally said to be (my first post on the topic was: “Japan’s deflation story is not really a horror story” from October 2011). It is correct that Japan’s lost decade was not a story of two lost decades and in my view quantitative easing ended the “lost decade” in 2001. This is what I said in my post “Japan shows that QE works”

In early 2001 the Bank of Japan finally decided to listen to the advise of Milton Friedman and as the graph clearly shows this is when Japan started to emerge from the lost decade and when real GDP/capita started to grow in line with the other G7 (well, Italy was falling behind…).

The actions of the Bank of Japan after 2001 are certainly not perfect and one can clearly question how the BoJ implemented QE, but I think it is pretty clearly that even BoJ’s half-hearted monetary easing did the job and pull Japan out of the depression. In that regard it should be noted that headline inflation remained negative after 2001, but as I have shown in my previous post Bank of Japan managed to end demand deflation (while supply deflation persisted).

And yes, yes the Bank of Japan of course should have introduces much clearer nominal target (preferably a NGDP level target) and yes Japan has once again gone back to demand deflation after the Bank of Japan ended QE in 2007. But that does not change that the little the BoJ actually did was enough to get Japan growing again.

This graph of GDP/capita in the G7 countries illustrates my point:

g7rgdpcap

As I said in my earlier post: “A clear picture emerges. Japan was a star performer in 1980s. The 1990s clearly was a lost decade, while Japan in the past decade has performed more or less in line with the other G7 countries. In fact there is only one G7 country with a “lost decade” over the paste 10 years and that is Italy.”

Hence, Japan came out of the crisis from 2001. However, it should also be noted that Japan has once again fallen into crisis and more importantly Japan’s monetary policy certainly is not based on a rule based framework so the risk that Japan will continue to fall back into crisis remains high. This in my view is a discussion about securing Japan a “Monetary constitution” rather than about stimulus. Unfortunately Prime Minister Abe’s new government do seem to be more focused on short-term stimulus rather than on real institutional reform.

There is no such thing as fiscal policy

– and that goes for Japan as well

The Abe government is not only pursuing expansionary monetary policies, but has also announced that it wants to ease fiscal policy dramatically. This obviously will scare any Market Monetarist – or anybody who are simply able to realise that there is a budget constrain that any government will have to fulfill in the long-run.

This is what I earlier have said on the fiscal issue in the case of Japan:

Furthermore, it is clear that Japan’s extremely weak fiscal position to a large extent can be explained by the fact that BoJ de facto has been targeting 0% NGDP growth rather than for example 3% or 5% NGDP growth. I basically don’t think that there is a problem with a 0% NGDP growth path target if you start out with a totally unleveraged economy – one can hardly say Japan did that. The problem is that BoJ changed its de facto NGDP target during the 1990s. As a result public debt ratios exploded. This is similar to what we see in Europe today.

So yes, it is obvious that Japan can’t not afford “fiscal stimulus” – as it today is the case for the euro zone countries. But that discussion in my view is totally irrelevant! As I recently argued, there is no such thing as fiscal policy in the sense Keynesians claim. Only monetary policy can impact nominal spending and I strongly believe that fiscal policy has very little impact on the Japanese growth pattern over the last two decades.

Above I have basically added nothing new to the discussion about Japan’s lost decade (not decades!) and fiscal and monetary policy in Japan, but since Scott brought up the issue I thought it was an opportunity to remind my readers (including Scott) that I think that the Japanese story is pretty simple, but also that it is wrong that we keep on talking about Japan’s lost decades. The Japanese story tells us basically nothing new about fiscal policy (but reminds us that debt ratios explode when NGDP drops), but the experience shows that monetary policy is terribly important.

My advise: Target an 3% NGDP growth level path and balance the budget 

My advise to the Abe government would therefore be for the Bank of Japan to introduce proper monetary policy rules and I think that an NGDP level targeting rule targeting a growth path of 3% would be suiting for Japan given the negative demographic outlook for Japan. Furthermore, if the BoJ where to provide a proper framework for nominal stability then the Japanese government should begin a gradual process of fiscal consolidation by as soon as possible to bring the Japanese budget deficit back to balance. With an NGDP growth path of 3% Japanese public debt as a share of GDP would gradually decline in an orderly fashion on such fiscal-monetary framework.

So what Japan needs is not “stimulus” – neither fiscal nor monetary – but rather strict rules both for monetary policy and fiscal policy. The Abe government has the power to ensure that, but I am not optimistic that that will happen.

Earlier posts on Japan:

There is no such thing as fiscal policy – and that goes for Japan as well
The scary difference between the GDP deflator and CPI – the case of Japan
Friedman’s Japanese lessons for the ECB
There is no such thing as fiscal policy – and that goes for Japan as well
Japan shows that QE works
Did Japan have a “productivity norm”?
Japan’s deflation story is not really a horror story

PS even though I am skeptical about the way Shinzo Abe are going about things and I would have much preferred a rule based framework for Japan’s monetary and fiscal policy I nonetheless believe that the Abe government’s push for particularly monetary “stimulus” is likely to spur Japanese growth and is very likely to be good news for a global economy badly in need of higher growth.

Update: Scott Sumner also comments on Japan and it seems like we have more or less the same advise. Here is Scott:

“Just to be clear, my views are somewhere between those of Feldstein and the more extreme Keynesians.  I agree with Feldstein that Japan has big debt problems and big structural problems, and needs to address both.  And that fiscal stimulus is foolish (as even Adam Posen recently argued.)  Unlike Feldstein I also think they have an AD problem that calls for modestly higher inflation and NGDP growth.  At a minimum they should be shooting for 2% to 3% NGDP growth, instead of the negative NGDP growth of the past 20 years.”

Ambrose on Abe

Here is our friend Ambrose Evans-Pritchard in the Daily Telegraph:

Japan’s incoming leader Shinzo Abe has vowed to ram through full-blown reflation policies to pull his country out of slump and drive down the yen, warning Japan’s central bank not to defy the will of the people.

…The profound shift in economic strategy by the world’s top creditor nation could prove a powerful tonic for the global economy, with stimulus leaking into bourses and bond markets – a variant of the “carry trade” earlier this decade but potentially on a larger scale.

…”It is tremendously important for global growth, and markets are starting to take note,” said Lars Christensen from Danske Bank.

Mr Abe’s Liberal Democratic Party (LDP) won a landslide victory on Sunday, securing a two-thirds “super-majority” in the Diet with allies that can override senate vetoes.

Armed with a crushing mandate, Mr Abe said he would “set a policy accord” with the Bank of Japan for a mandatory inflation target of 2pc, backed by “unlimited” monetary stimulus.

“Its very rare for monetary policy to be the focus of an election. We campaigned on the need to beat deflation, and our argument has won strong support. I hope the Bank of Japan accepts the results and takes an appropriate decision,” he said.

Mr Abe plans to empower an economic council to “spearhead” a shift in fiscal and monetary strategy, eviscerating the central bank’s independence.

The council is to set a 3pc growth target for nominal GDP, embracing a theory pushed by a small band of “market monetarists” around the world. “This is a big deal. There has been no nominal GDP growth in Japan for 15 years,” said Mr Christensen.

Did I just say that NGDP hasn’t grown for 15 years in Japan? Yes, I did…it is actually worse – Japanese nominal GDP is 10% lower today than in 1997.

NGDP Japan

The ECB is the only one of the major central banks in the world that is not at the moment taking decisive steps in the direction of getting out of the deflationary scenario. I hope we don’t have to wait 15 years for the ECB to do the right thing. The Japanese experience should be a major warning to European policy makers.

If you don’t think you can compare Europe today and Japan in 1997 then maybe you should should take a look at this post.

PS a friend of mine who once spent time at the BoJ is telling me not to get overly optimistic…

PPS Matt Yglesias also comments on Abe.

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Previous posts on Japan:

Japan shows that QE works
Did Japan have a “productivity norm”?
There is no such thing as fiscal policy – and that goes for Japan as well
Friedman’s Japanese lessons for the ECB
The scary difference between the GDP deflator and CPI – the case of Japan

BoJ might become the first central bank in the world to introduce NGDP targeting

I stole this from Britmouse (who got it from Bloomberg):

Abe advocates increased monetary easing to reverse more than a decade of falling prices and said he would consider revising a law guaranteeing the independence of the Bank of Japan. (8301) In an economic policy plan issued yesterday, the LDP said it would pursue policies to attain 3 percent nominal growth.

Talk about good news! Shinzo Abe of course is the leader of Japan’s main opposition party the Liberal Democratic Party (LDP). LDP is favourite to win the upcoming Japanese parliament elections – so soon Japan might have a Prime Minister who favours NGDP targeting.

So how could this be implemented? Well, Lars E. O. Svensson has a solution and I am pretty sure he would gladly accept the job if Abe offered him to become new Bank of Japan governor. After all he does not seem to happy with his colleagues at the Swedish Riksbank at the moment.

PS I would love to get in contact with any Japanese economist interested in NGDP targeting – please drop me a mail (lacsen@gmail.com)

PPS I can recommend vacation in Langkawi Malaysia – this is lunch time blogging in the shadow of the palms

Update: Oops – Scott also comments on this story.

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