Let me say it again – The Kuroda recovery will be about domestic demand and not about exports

This morning we got strong GDP numbers from Japan for Q1. The numbers show that it is primarily domestic demand – private consumption and investment – rather than exports, which drive growth.

This is from Bloomberg:

Japan’s economy grew at the fastest pace since 2011 in the first quarter as companies stepped up investment and consumers splurged before the first sales-tax rise in 17 years last month.

Gross domestic product grew an annualized 5.9 percent from the previous quarter, the Cabinet Office said today in Tokyo, more than a 4.2 percent median forecast in a Bloomberg News survey of 32 economists. Consumer spending rose at the fastest pace since the quarter before the 1997 tax increase, while capital spending jumped the most since 2011.

…Consumer spending rose 2.1 percent from the previous quarter, the highest since a 2.2 percent increase in the first three months of 1997.

So it is domestic demand, while net exports are actually a drag on the economy (also from Bloomberg):

Exports rose 6 percent from the previous quarter and imports climbed 6.3 percent.

The yen’s slide since Abe came to power in December 2012 has inflated the value of imported energy as the nation’s nuclear reactors remain shuttered after the Fukushima disaster in March 2011.

The numbers fits very well with the story I told about the excepted “Kuroda recovery” (it is not Abenomics but monetary policy…) a year ago.

This is what I wrote in my blog post “The Kuroda recovery will be about domestic demand and not about exports” nearly exactly a year ago (May 10 2013):

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

…I think that the way we should think about the weaker yen is as an indicator for monetary easing. Hence, when we seeing the yen weaken, Japanese stock markets rallying and inflation expectations rise at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

the focus on the“competitiveness channel” is completely misplaced and the ongoing pick-up in Japanese growth is likely to be mostly about domestic demand rather than about exports.

While I am happy to acknowledge that today’s numbers likely are influenced by a number of special factors – such as increased private consumption ahead of planned sales tax hikes and likely also some distortions of the investment numbers I think it is clear that I overall have been right that what we have seen in the Japanese economy over the past year is indeed a moderate recovery led by domestic demand .

The biggest worry: Inflation targeting and a negative supply shock

That said, I am also worried about the momentum of the recovery and I am particularly concerned about the unfortunate combination of the Bank of Japan’s focus on inflation targeting – rather than nominal GDP targeting – than a negative supply shock.

This is particularly the situation where we are both going to see a sales tax hike – which will increase headline inflation – and we are seeing a significant negative supply shock due to higher energy prices. Furthermore note that the Abe administration’s misguided push to increase wage growth – to a pace faster than productivity growth – effectively also is a negative supply shock to the extent the policy is “working”.

While the BoJ has said it will ignore such effects on headline inflation it is likely to nonetheless at least confuse the picture of the Japanese economy and might make some investors speculate that the BoJ might cut short monetary easing.

This might explain three factors that have been worrying me. First, of all while broad money supply in Japan clearly has accelerated we have not see a pick-up in money-velocity. Second, the Japanese stock market has generally been underperforming this year. Third, we are not really seeing the hoped pick-up in medium-term inflation expectations.

All this indicate that the BoJ are facing some credibility problems – consumers and investors seem to fear that the BoJ might end monetary easing prematurely.

To me there is only one way to fundamentally solve these credibility problems – the BoJ should introduce a NGDP level target of lets say 3-4%. That would significantly reduce the fear among investors and consumers that the BoJ might scale back monetary easing in response to tax hikes and negative supply shocks, while at the same time maintain price stability over the longer run (around 2% inflation over the medium-term assuming that potential real GDP growth is 1-2%).

PS Q1 2014 nominal GDP grew 3.1% y/y against the prior reading of 2.2% y/y.

PPS See also my previous post where I among other things discuss the problems of inflation targeting and supply shocks.

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The Kuroda boom remains all about domestic demand

Remember when then Bank of Japan last year initiated its unprecedented program of monetary easing most commentators saw that as an attempt to wage currency war to boost Japanese exports? I instead stressed that the “export channel” was not likely to be what would drag Japan out of the deflationary trap. Rather I stressed the importance of domestic demand.

This is what I said in May last year:

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment are likely to significantly boost Japanese nominal GDP growth – and likely also real GDP growth in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

I think that the way we should think about the weaker yen is as an indicator for monetary easing. Hence, when we are seeing the yen weaken, Japanese stock markets rallying and inflation expectations rising at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first thing we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

Two things are happening at the moment in the Japan. One, the money base is increasing dramatically. Second and maybe more important money-velocity is picking up significantly.

Velocity is of course picking up because money demand in Japan is dropping as a consequence of households, companies and institutional investors expecting the value of the cash they are holding to decline as inflation is likely to pick up. The drop in the yen is a very good indicator of that.

And what do you do when you reduce the demand for money? Well, you spend it, you invest it. This is likely to be what will have happen in Japan in the coming months and quarters – private consumption growth will pick-up, business investments will go up, construction activity will accelerate.

…Hence, the Bank of Japan (and the rest of us) should celebrate the sharp drop in the yen as it is an indicator of a sharp increase in money-velocity and not because it is helping Japanese “competitiveness”.

Since then the Japanese economy has continued to recover  (much more strongly than any other of the major developed economies in the world) and it has to a very large extent been about domestic demand rather than exports.

And this morning we got the latest confirmation of a recovery driven by domestic demand. Just take a look at this story from the Dow Jones News Wire:

Japan’s domestic sales of new cars, trucks and buses climbed 18.7% from a year earlier in December for the fourth straight month, rising from a low basis of comparison a year earlier when demand was hurt after the end of the government incentives to buy fuel-efficient cars.

Sales totaled 254,464 vehicles in December, up from 214,429 in the same month last year, the Japan Automobile Dealers Association said Monday.

Toyota sales rose 11.8% to 102,566, with its Lexus luxury brand registering a 15.1% increase to 3,414. Nissan sold 31,420 vehicles, up a modest 1.0%. Honda’s sales doubled to 38,767 from 18,886 after the introduction of the redesigned Fit compact in September.

With the latest monthly figures counted, the nation’s domestic auto sales for the calendar year 2013 fell 3.8% to 3.26 million vehicles from 3.39 million in 2012, the association said.

Auto sales, as measured by vehicle registrations with the government, are monitored by economists since they are the first consumer spending numbers released each month.

So let me say it again – it’s domestic demand, stupid!

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.

There is no ’fiscal cliff’ in Japan – a simple AS-AD analysis

It is now very clear that what Milton Friedman advocated the Bank of Japan should do back in the mid-1990s – to expand the money base to get Japan out of deflation – is in fact working. Nominal spending growth is accelerating and with it deflation has come to an end and real GDP growth is fairly robust.

However, some have been arguing the success of Abenomics will be short-lived and that the planned increases in the Japanese sales tax might send Japan back into recession. In other words Japan is facing a fiscal cliff.

In this post I will argue that like in the case of the 2013-US fiscal cliff the fears of the negative impact of fiscal consolidation is overblown and that the risk of recession in Japan is very small if the Bank of Japan keeps doing its job and try to get inflation expectations back to 2%. It is yet another illustration of the Sumner Critique.

All we need is the AS-AD framework

I think it is pretty easy to illustrate the impact of a sales tax increase in a world with a central bank with a credible inflation target within a simple AS-AD framework.

We start out with a Cowen-Tabarrok style AS-AD framework. We use growth rates rather levels and aggregate demand curve is given by the equation of exchange (mv=py).

The graph below is our starting point.

AS AD

We have assumed that inflation in the starting point already is at 2%. This obviously is not correct, but it does not fundamentally change the analysis of the “fiscal shock”.

Japan’s sales tax will be raised to 8 percent from 5 percent in April and to 10 percent in October 2015, but here we just assume it is one fiscal shock. Again that is not important for the conclusions.

A negative fiscal shock in a Cowen-Tabarrok style AS-AD framework is basically a negative shock to money velocity (v), which will push the AD curve to the left as nominal spending drops.

However, as it is clear from the graph this will initially push inflation below the Bank of Japan’s 2% inflation target. We are here ignoring headline inflation will increase, but we are here focusing on core inflation as is the BoJ. Core inflation will drop as illustrated in the graph below.

inflation target BoJ ASAD

If the Bank of Japan is serious about its inflation target it will respond to any demand-driven drop in inflation by counteracting that with an one-to-one increase in the money base to bring back inflation to 2%.

The consequence of BoJ’s 2% inflation is hence that there will be full monetary offset of the negative fiscal shock and as a consequence inflation should broadly speaking remain unchanged at 2% and real GDP growth will be unaffected. Hence, under a credible inflation target the fiscal multiplier is zero. As in the case of the US there will be no fiscal cliff. There will be fiscal consolidation but not a negative impact on growth.

This of course does not mean that the fiscal shock will not have any impact on the Japanese economy or markets. It very likely will. It is for example clear that if the markets expect the BoJ to step up asset purchases (increase money base growth) in response to fiscal tightening then that would likely weaken the yen further. Something Japanese exporters likely will be happy about. As a consequence the sales tax hikes will likely change the composition of growth in Japan.

Finally, it should be noted that everybody in Japan is fully aware of the miserable state of public finances and as a result it is hardly a surprise to Japanese households that the government sooner or later would have to do something to improve public finances. In fact the sales tax hike was announced long ago. Therefore, we should expect some Ricardian equivalence effects to come into play here – an increase net government saving is likely to reduce net private savings. So even with no monetary offset there is likely to be some Ricardian offset. That in my view, however, is significantly less important than the monetary policy offset.

How aggressive will the BoJ have to be to offset the fiscal shock?

A crucial question of course will be how much additional monetary easing is needed to offset the fiscal shock. Here the credibility of the BoJ’s inflation comes into play.

If the BoJ’s inflation target was 100% credible we could actually argue that the BoJ would not have to increase the money base at all. The Chuck Norris effect would take care of everything.

Hence, if everybody knows that the BoJ always will ensure that inflation (and inflation expectations) is at 2% then when a fiscal shock is announced the markets will realize that that means that the BoJ will ease monetary policy. Easier monetary policy will push up stock prices and weaken the yen. That will in itself stimulate aggregate demand. In fact stock prices will continue to rise and the yen will continue to weaken until the markets are “satisfied” that inflation expectations remain at 2%.

In fact this might exactly be what is happening. The yen has generally continued to weaken and the Japanese stock markets have been holding up quite well even through the latest round of turmoil – Fed tapering fears, Syria, Emerging Markets worries etc.

But obviously, the BoJ’s inflation target is not entirely credible and inflation expectations are still well-below 2% so my guess would be that the BoJ might have to step up quantitative easing, but it is certainly not given. In fact the Japanese recovery is showing no signs of slowing down and inflation – both headline and core – continues to inch up.

A golden opportunity for the BoJ to increase credibility

Hence, I am not really worried about the planned sales tax hikes. I don’t like taxes, but I don’t think a sales tax hike will kill the Japanese recovery. In fact I believe that the sales tax hikes are a golden opportunity for the Bank of Japan to once and for all to demonstrate that it is serious about its 2% inflation.

The easiest way to do that is basically to copy a quite interesting note from the Reserve Bank of New Zealand on “Fiscal and Monetary Coordination”. This is from the note:

“…the Reserve Bank, therefore, is required to respond to developments in the economy – including changes in fiscal policy – that have material implications for the achievement of the price stability target;”

And further it says:

“These… features mean that monetary and fiscal policy co-ordination occurs through the Reserve Bank taking fiscal policy into account as an element of the environment in which monetary policy operates. This approach is to be contrasted with approaches to co-ordination that involve joint determination of monetary policy by the monetary and fiscal policy agencies.”

And finally:

“While demand – and thus inflation – pressures may originate from a range of different sources, the task of monetary policy is to respond so as to maintain an overall level of demand consistent with keeping inflation in one to two years’ time within the target range. For example, if the government increases its net spending, all other things being equal, monetary policy needs to be tighter for a time, so as to slow growth of private demand and “make room” for the additional government spending.”

If the BoJ copied this note/statement then it basically would be an open-ended commitment to offset any fiscal shock to aggregate demand – and hence to inflation – whether positive or negative.

By telling the market this the Bank of Japan would do a lot to reduce the worries among some market participants that the BoJ might not be serious about ensuring that its 2% inflation target will be fulfilled even if fiscal policy is tightened.

So far BoJ governor Kuroda has done a good job in managing expectations and so far all indications are that his policies are working – deflation seems to have been defeated and growth is picking up.

If Kuroda keeps his commitment to the 2% inflation target and stick to his rule-based monetary policy and strengthens his communication policies further by stressing the relationship between monetary policy and fiscal policy – RBNZ style – then there is a good chance that the planed sales tax hikes will not be a fiscal cliff.

‘Bullish Mikio’ makes me optimistic on BoJ (and the world)

As my loyal readers would know I have been somewhat critical about the Bank of Japan’s handling of the recent rise in bond yields in Japan. See for example here and here.

However, there is no reason to give up on the Bank of Japan. At least that is what the always clever Mikio Kumada is telling us. This Mikio’s excellent comment on my latest comment on the BoJ.

“Just wanted to say that in substance, I share your concerns. And I think it’s important that you raise these questions/criticisms.

I am, however, perhaps, less ideological, and try to look at things in the context of the real world.
Policy makers act in a political/institutional framework, with constraints. And in that context, the BoJ under Kuroda is dong a good job – as good as it gets, so to speak, from a market monetarist perspective.

By the way, yesterday, Kuroda met Abe and both made statements afterwards. Neither of them mentioned the need to keep interest rates low. They said all the other things – Kuroda reaffirmed he will beat deflation and Abe said he will do his part via reforms, but they didn’t make statements about interest rates.

That is another indication that Kuroda believes that higher nominal rates are desirable, and logical. And he may have convinced Abe not to talk about “lowering interest rates” (if Abe needed any convincing). But at the same time, Kuroda can’t yet openly that say he wants rising nominal rates.

My sense is that Kuroda, and also Prof. Koichi Hamada, a trusted advisor to Abe, are open to market monetarist ideas. But they would probably face a hailstorm if they openly say things that are too “revolutionary”. They first have to convince enough people that rising nominal yields are good, as long as real yields (and real wages) remain low, or keep falling during the “reflation” phase. But I would not recommend Abe to talk too much about “falling real wages” publicly ahead of an election, of course. He should just stick to demanding rising (nominal) wages.

I also sense that yesterday’s decline in stocks may have been due to (an erroneous) “disappointment” of investors that Abe/Kuroda didn’t say they want low/lower long term rates.

So, overall, I remain quite optimistic that, over time, the market will come around to accept the view that higher nominal rates are a good thing.”

I find it hard to disagree with Mikio’s comments. So I am starting the weekend being quite optimistic that the BoJ eventually will get it right and if Mikio indeed is right then the market turmoil we have seen over the last couple of weeks will soon come to an end. Fingers crossed.

PS Joseph Gagnon has an excellent comment on the BoJ and the need for not stepping back on monetary easing.

Join the Global Monetary Policy Network on Linkedin here (Mikio is a member).

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.

Japan: It’s domestic demand, stupid

I have been reading the reports on the Japanese trade data for April, which have been published this morning. The reporting is extremely telling about how most journalists (and economists!) fail to understand what is going on in Japan (the markets understand perfectly well – Nikkei is nicely up this morning).

In nearly all the reports on the data there is a 90% focus on the fact that exports grew slower than expected (3.8% y/y) and that the Japanese trade deficit remains in place. The slightly “disappointing” numbers is then in most news stories used to speculate that Bank of Japan’s monetary easing is not working – or rather the weaker yen has failed to boost exports as much as expected. On the other hand there is nearly no focus on the import data, which grew by nearly 10% y/y.

It is really the strong import growth, which is the interesting story here. As I earlier have argued the monetary easing in Japan is likely to boost domestic demand rather than net exports. This is from my latest post on BoJ:

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works….

…When the Bank of Japan is easing monetary policy it is likely to have a much bigger positive impact on domestic demand than on Japanese exports. In fact I would not be surprised if the Japanese trade balance will worsen as a consequence of Kuroda’s heroic efforts to get Japan out of the deflationary trap.

And this of course is exactly what we are now seeing in the data. Export growth continues to accelerate, but import growth accelerates even faster and the trade data is worsening. That is very good news – monetary policy is boosting domestic demand. Mr. Kuroda please keep up the good work.

The Kuroda recovery will be about domestic demand and not about exports

There has been a lot of focus on the fact that USD/JPY has now broken above 100 and that the slide in the yen is going to have a positive impact on Japanese exports. In fact it seems like most commentators and economists think that the easing of monetary policy we have seen in Japan is about the exchange rate and the impact on Japanese “competitiveness”. I think this focus is completely wrong.

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

The weaker yen is an indicator of monetary easing – but not the main driver of growth

I think that the way we should think about the weaker yen is as a indicator for monetary easing. Hence, when we seeing the yen weakeN, Japanese stock markets rallying and inflation expectations rise at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

Two things are happening at the moment in the Japan. One, the money base is increasing dramatically. Second and maybe more important money-velocity is picking up significantly.

Velocity is of course picking up because money demand in Japan is dropping as a consequence of households, companies and institutional investors expect the value of the cash they are holding to decline as inflation is likely to pick up. The drop in the yen is a very good indicator of that.

And what do you do when you reduce the demand for money? Well, you spend it, you invest it. This is likely to be what will have happen in Japan in the coming months and quarters – private consumption growth will pick-up, business investments will go up, construction activity will accelerate. So it is no wonder that equity analysts feel more optimistic about Japanese companies’ earnings.

Hence, the Bank of Japan (and the rest of us) should celebrate the sharp drop in the yen as it is an indicator of a sharp increase in money-velocity and not because it is helping Japanese “competitiveness”.

The focus on competitiveness is completely misplaced

I have in numerous earlier posts argued that when a country is going through a “devaluation” as a consequence of monetary easing the important thing is not competitiveness, but the impact on domestic demand.

I have for example earlier demonstrated that Swedish growth outpaced Danish growth in 2009-10 not because the Swedish krona depreciated strongly against the Danish krone (which is pegged to the euro), but because the Swedish Riksbank was able to ease monetary policy, while the Danish central bank effectively tightened monetary conditions due to the Danish fixed exchange rate policy. As a consequence domestic demand did much better in Sweden in 2009-10 than in Denmark, while – surprise, surprise – Swedish and Danish exports more or less grew at the same pace in 2009-10 (See graphs below).

Similarly I have earlier shown that when Argentina gave up its currency board regime in 2002 the major boost to growth did not primarly come from exports, but rather from domestic demand. Let me repeat a quote from Mark Weisbrot’s and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

…the fastest growing sectors of the economy were construction, which increased by 162.7 percent during the recovery; transport, storage and communications (73.4 percent); manufacturing (64.4 percent); and wholesale and retail trade and repair services (62.7 percent).

The impact of this rapid and sustained growth can be seen in the labor market and in household poverty rates… Unemployment fell from 21.5 percent in the first half of 2002 to 9.6 percent for the first half of 2007. The employment-to-population ratio rose from 32.8 percent to 43.4 percent during the same period. And the household poverty rate fell from 41.4 percent in the first half of 2002 to 16.3 percent in the first half of 2007. These are very large changes in unemployment, employment, and poverty rates.”

And if we want to go further back in history we can look at what happened in the US after FDR gave up the gold standard in 1933. Here the story was the same – it was domestic demand and not net exports which was the driver of the sharp recovery in growth during 1933.

These examples in my view clearly shows that the focus on the “competitiveness channel” is completely misplaced and the ongoing pick-up in Japanese growth is likely to be mostly about domestic demand rather than about exports.

Finally if anybody still worry about “currency war” they might want to rethink how they see the impact of monetary easing. When the Bank of Japan is easing monetary policy it is likely to have a much bigger positive impact on domestic demand than on Japanese exports. In fact I would not be surprised if the Japanese trade balance will worsen as a consequence of Kuroda’s heroic efforts to get Japan out of the deflationary trap.

HT Jonathan Cast

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PS Scott Sumner also comments on Japan.

PPS An important non-competitiveness impact of the weaker yen is that it is telling consumers and investors that inflation is likely to increase. Again the important thing is the signal about monetary policy, which is rather more important than the impact on competitiveness.

Monetary policy works just fine – Exhibit 14743: The case of Japanese earnings

The graph below shows the ratio of upward to downward revisions of equity analysts’ earnings forecasts in different countries. I stole the graph from Walter Kurtz at Sober Look. Walter himself got the data from Merrill Lynch.

Just take a look in the spike in upward earnings revisions (relative to downward revision) for Japanese companies after Haruhiko Kuroda was nominated for new Bank of Japan governor back in February and he later announced his aggressive plan for hitting the newly introduced 2% inflation target.

This is yet another very strong prove that monetary policy can be extremely powerful. The graph also shows the importance of the Chuck Norris effect – monetary policy is to a large extent about expectations or as Scott Sumner would say: Monetary Policy works with long and variable leads – or rather I believe that the leads are not very long and not very variable if the central bank gets the communication right and I believe that the BoJ is getting the communication just right so you are seeing a fairly strong and nearly imitate impact of the announced monetary easing.

PS As there tend to be a quite strong positive correlation between earning growth and nominal GDP growth I think we can safely say that the sharp increase in earnings expectations in Japan to a large extent reflects a marked upward shift in NGDP growth expectations.

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.”

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