August 9th, 2016 | By Nick Sargen
Shortly after his re-election as Prime Minister, Shinzō Abe embarked on an ambitious program in February of 2013 to get Japan’s economy moving again. The key component of his strategy – dubbed “Abenomics” – included prodding the BOJ to set an inflation target of 2%, while the government embarked on a fiscal stimulus program equivalent to 2.6% of GDP along with several structural reforms to the economy. Investors greeted the news enthusiastically by boosting Japan’s stock market by about 25% from its lows in the autumn, while the yen depreciated markedly against the dollar and the euro.
At that time, there was a debate among economists about whether Abenomics would finally put an end to two decades of lassitude. In a commentary (See “Japan at a Cross-Roads,” February 13, 2013), I contrasted the views of Martin Wolf of the Financial Times, who was a skeptic, with those of John Makin of the American Enterprise Institute, who was more hopeful. I concluded the piece with the following observation:
“I believe addressing deflation is necessary, but not sufficient, to alter Japan’s long-term growth trajectory. For three decades now, Japan has struggled to find a strategy in which economic growth is led by domestic forces and not by its once powerful export engine. This is a key component that Japan’s new government needs to address to convince investors that it has finally turned the corner.”
Since then, assessments of Abenomics have fluctuated. During the first three years of the program, the yen depreciated by 35% against the dollar, which contributed to a rebound in Japanese corporate profits and generated positive price increases. Since the beginning of this year, however, the yen has appreciated by about 20% versus the dollar, even though the BoJ implemented negative interest rates. This development, in turn, has caused the economy to soften while consumer prices have fallen for four consecutive months. Accordingly, many observers now believe that Abenomics has failed to attain its goals, and that Japanese officials will have to formulate a new strategy.
One option that investors are pondering is the possibility the BoJ could undertake a permanent increase in the monetary base in order to finance government spending – i.e, creation of so-called “helicopter money.” (Note: The term was first coined by Milton Friedman in a 1969 paper titled “The Optimum Quantity of Money.”) This approach has the advantage of directly injecting money into the hands of the public via government purchases of goods and services, whereas quantitative easing works indirectly by creating excess reserves in the banking system, some or all of which may never be utilized. The main reluctance to pursue full-scale helicopter money is that, to be credible, the central bank would permanently write off government debt while at the same time abandoning its inflation target. The worry with this so-called “nuclear option” is that once the forces of inflation are unleashed, they may not be contained.
Market participants were disappointed when the BoJ refrained from making a dramatic announcement at its last policy meeting, and the yen subsequently strengthened while the Japanese stock market sold off. The BoJ, nonetheless, announced that it would conduct a review of quantitative easing and negative interest rates at its next meeting in mid-September. There is a possibility that some milder forms of helicopter money will be considered including a commitment by the central bank to purchase newly issued Japanese government bonds (JGBs) that are part of a fiscal stimulus package and a commitment to reinvest the proceeds indefinitely.
Some observers, in fact, contend Japan is already engaged in “helicopter-like” operations. In the first half of this year, for example, BOJ holdings of JGBs rose by Y85 trillion, which exceeds JGB issuance by more than two times. As Brendan Brown, chief economic advisor of Mitsubishi UFJ Securities International notes:
“As regards helicopter money, the reality is that the new program has been in operation for at least two years already. The BoJ’s massive JGB purchases – effectively occurring in the just issued JGB market and exceeding the government deficit, in the context of absolutely no intension ever to reverse the massive balance sheet expansion – amounts to blatant money printing by any definition.”
In the meantime, Prime Minister Abe has unveiled a new fiscal stimulus package that on the surface is one of the largest since the 2008 global financial crisis. The package totals Y28 trillion ($275 billion), of which Y7.5 trillion, or 1.5% of GDP, consists of direct government spending that will be spread over 2017-18. The gap between the two figures is the inclusion of large, multi-year programs, including amounts of lending that may or may not occur and earthquake relief that may take years to disseminate.
In the past, such programs failed to deliver much of what was promised, and there is a risk this could be true again. One difference is that the priority of the latest package is to include programs that will boost productivity and encourage labor market reforms that are designed to foster long-term growth, whereas previous programs were targeted at short-term growth objectives. Nonetheless, it remains to be seen whether the latest initiatives will bear fruit.
Compared to Japan, the circumstances in the U.S. are far less dire, as the U.S. economy has expanded at a moderate 2% pace since the expansion began seven years ago, jobs growth has been solid and inflation is approaching the Fed’s target of 2%. Consequently, the Federal Reserve has the luxury to contemplate normalizing interest rates at some point. In basing its policy decisions, however, the Fed must also be cognizant of conditions abroad, with both Japan and Europe stagnating and fending off threats of deflation with negative interest rates.
One of the main lessons of Japan’s experience is that once a psychology of deflation becomes pervasive, policymakers increasingly find themselves with limited options to alter expectations. With the limits of monetary easing being reached, the most likely outcome is that governments increasingly will turn to fiscal stimulus, with Japan and the new British government leading the way and the U.S. set to follow after the presidential election, irrespective of which candidate wins.