Thursday, November 27, 2014

The Japanese Experiment

NEWPORT BEACH – After years of tweaks, Japan has now initiated a major shift in its policy paradigm, with reactions ranging from great optimism that the country may finally be lifted out of a quarter-century of economic stagnation, to concerns that the authorities’ dramatic change of course may in fact end up making things worse. But, while debate naturally focuses on Japan’s economic, financial, and political maneuvers, the tipping point could well lie abroad.

Prime Minister Shinzo Abe’s new government has embraced a revolutionary (rather than evolutionary) economic-policy approach that engages several initiatives, some of which were once deemed implausible, unthinkable, or even undesirable. From the doubling of the money supply to additional fiscal stimulus and wide-ranging structural reforms, the new policy paradigm is nothing less than one of the boldest economic-policy experiments in Japan’s post-war history.

To demonstrate their seriousness, Japanese officials moved quickly to commit to measurable metrics. On the policy input side, they have specified and begun to implement purchases of securities totaling $75 billion per month (three times as much, in relative terms, as the US Federal Reserve currently purchases under its unconventional monetary-policy regime). On the output side, and after many years of persistent deflation (prices fell 0.5% last month), Japan is now targeting a 2% inflation rate within two years, thus underscoring its commitment to avoid a pre-mature withdrawal of monetary support for growth.

Already, financial markets have responded with alacrity. The Japanese equity market is up an impressive 55% since hints of the paradigm shift started hitting investors’ radar screens. At the same time, the Japanese yen has depreciated sharply, including by more than 20% against the struggling euro.

This response is part of the transmission mechanism for the Japanese government’s policies. The surge in the stock market benefits domestic investors, making them likelier to spend more (what economists call the “wealth effect”). This, in turn, should revive corporate “animal spirits,” leading to higher investment in new plants and equipment, together with higher wages and salaries.

These are, of course, the same mechanisms that the Fed has targeted for almost three years in its own efforts to stimulate higher growth in the US. The macroeconomic outcomes have consistently fallen short of expectations, and there is reason to believe that it will be even more difficult in Japan for monetary policy alone to gain sufficient traction.

Japan’s aging population mutes the potential impact of both the wealth effect and animal spirits. Resource flexibility is lower than in the US. Interest rates are already low. The experience of deflation is well entrenched. And, given Japan’s high level of public indebtedness, the risks of collateral damage and unintended consequences are potentially higher.

With gross overall government debt already at 238% of GDP, some worry that Japan would face the threat of economic and financial dislocation were a failed policy experiment to lead its private sector – which traditionally has displayed an enormous home bias – to disinvest from Japan. This does not mean that Japan’s policy revolution will necessarily disappoint. But, critically, it does mean that even if you believe that the BOJ’s actions are necessary for Japan to emerge from its economic malaise, they certainly are not sufficient.

Japan’s experiment requires meeting two additional conditions if it is to avoid going the way of previous failed policy initiatives: meaningful structural reforms that essentially change how segments of the economy respond and operate; and other countries’ continued acquiescence in the currency depreciation needed to boost the impact of slower-moving domestic dynamics through meaningful gains in global market share.

Meeting the first condition is in the hands of Japanese citizens and their elected representatives. The required reforms, though achievable, will test the government’s resolve and implementation capabilities, as well as the population’s willingness to face immediate disruptions in exchange for the promise of longer-term gains.

The second requirement is very different. It can be achieved only if other countries are willing to sacrifice output, either because they have no choice, or because they believe that, over the medium-term, a stronger Japanese economy will benefit them as the longer-term income effects offset the impact of immediate market disruptions.

But will the rest of the world accommodate Japan’s bold policy experiment, or will it take protective steps and thus impede the operation of a crucial policy transmission mechanism? While initial indications are encouraging, the jury is still out.

Many affected countries – including those hit by the trade effects (such as China, South Korea, Taiwan, and eurozone members) and those susceptible to the capital-flow channel (such as Brazil, Indonesia, and Mexico) – have not yet had enough time to react. Japan’s policy change was big and abrupt, and several of the countries on the receiving end have been focused on complex domestic challenges.

A few countries – particularly Brazil, China, and South Korea – have noticed. But their reactions have been generally muted by Japan’s success in getting a US-led initiative at the G-20 to classify its policy response as constituting the use of “domestic tools” to pursue “domestic objectives.”

It is just a matter of time until the rest of the world catches up with the reality of how Japan’s experiment affects them. The hope is that, bolstered by evidence of Japan’s serious pursuit of structural reforms, they will accommodate the experiment in two ways: by not retaliating, and by undertaking their own domestic reforms that compensate for the output lost to Japan. In other words, a growing pie for all better accommodates all.

The fear is that neither Japan’s subsequent actions nor the affected countries’ domestic realities will justify the risk of lost market share, especially at a time when the global economy as a whole – and global policy coordination – is struggling. Here the risk involves currency wars and other beggar-thy-neighbor disruptions.

There is currently insufficient data to predict either outcome confidently. As we await additional evidence, let us appreciate how rarely we witness, in real time, such a momentous policy shift.

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    1. CommentedKazumi Funahashi

      Japan is not experiencing a "paradigm shift." This is just an intesification of what Japan has done in the past "qarter century"; pour more money into the market.

      I agree with the article that Japan needs a "structural reform" that would make Japanese more competitive.

      But waht I would call a "paradigm shift" would be things like dramatically slashing trasfers to local governments, welfare and social security spending, and other extravagant expenditures so that the budget becomes much leaner.

      It is just unconsciounable that the measure the Japanese come up with is to create another bubble after all these years since the bubble burst in the early 90s.

    2. CommentedCraig Hardt

      Great article Mr. El-Erian. It would seem that after the first quarter of Japan's policy resulted in better-than-expected growth (3.5 %) Abenomics may be working. My question, however, is how much of this can be attributed to real growth and how much is based on temporary factors like higher confidence levels and increases in exports that won't be sustainable if and when other nations adjust to the devalued Yen.
      Abenomics seems to hinge on whether it can operate as something of a lone-wolf. If it's successful, it's likely that many other nations will attempt to simulate some or all of its efforts and if that happens, the positive effects for growth will be negated.

    3. CommentedHeriberto Arribas

      Measurable metrics?

      Only have two measures. The money intro $75 billion per month and the inflation rate 2%.

      Why a transmission mechanism? It's better direct. To make a experiment we need few variables. About the quantity theory of money they are a lot of literature, but no data, no measures. Write aboud hyperinflaction is not quantify. Fist step is have real data, maybe give $590 a each japanesse and measur. The theory say, but ... Can we take this risk?

      The mechanism has two setbacks. Increase the number of variables. How much money will go to the stock market? and, how much the bond market? What is the relationship with “wealth effect”?

      On the other hand, increases the the risks of collateral damage. We suppose there is a one-year delay to action. If the effect is rapid, i.e. in four months, after delay, it reaches 2%. You can stop, but continue to grow for a year. We can not turn back. But with direct injection, we can put a tax and withdraw money.

      This opens the way to other experiments, money expires, if not spent in one month away, not given more money. But better, not to mix, step by step.

      This experiment is so well made, and has so many security measures, as another: Chernobyl

    4. CommentedZsolt Hermann

      Today we use previously shocking, impressive expression so frequently that they lose their shocking capacity, their true impression, thus we gradually lose the true meaning of those expressions.
      Today everybody is a hero, everything is a miracle, everybody is making history and so on...
      Here the article talks about paradigm change which I think is just as misplaced.
      These policy changes to do not create a new paradigm, they are not even revolutionary.
      All the changes happen within the same framework, pointing to the same mistaken direction as any other "solution" or policy change all around the world, maximum the Japanese reaction is more desperate.
      The paradigm we would need to change is our obsession with constant quantitative growth, with this exploitative and expansive economic model which has became unstable and unsustainable.
      What the Japanese policy and action is doing is like injecting steroid as doping into a race horse that is already dead.
      There exists no way out of the crisis within the same framework, keeping the excessive, growth model paradigm. We still think we can run away from the crisis, using the same false tools in turbo mode, without acknowledging the true root causes, problems.
      Humanity has to return from the artificial illusion within the natural framework of necessity and resource based economy and lifestyle.
      And instead of the fragmented, polarized, ruthless competition based interrelationships, humanity has to acknowledge the interconnected and interdependent network we evolved into by adapting to it, using these interconnections in an altruistic way, for the benefit of the whole.
      This would truly be a revolution and paradigm change that could save our present and our future.

        CommentedRay Halpin

        You are right, Mr Hermann. But to create the kind of paradigm shift you seem to wish for, we'd have to create a new man - and we're not very good at that. New men do come along, but only after history has dispensed with large numbers of the old. In so doing, it somehow persuades those who remain to 'give up their oul sins'. I hate to be flippant, because the point at issue here is about as grave as they come. But I see no way around flippancy in the face of such touching optimism as your own.

        People rarely change voluntarily. And crises only produce denial*. The skies will darken and the bloodletting will begin. But until then, Zsolt Hermann's paradigm shift will have to wait. Break out the popcorn - it's squeaky bum time.

        CommentedEdward Ponderer

        Its totally mind-boggling that you feel this way Mr. Hermann! -- Which of course, in the worn-out pizzazz new-speak that you expose, really means that it is perfectly natural that you feel this way because your analysis seems quite correct.

        When you get to be my age (-- and no, I ain't tellin' :-) ), you've got to have a smile on your face every time youth discover "sex," and the world is once again introduced to the brand new Vanilla/Cherry/Lemon/Lime Coke/Pepsi. Now, a new generation comes with pretty much the same hormones and taste buds of the previous -- and what sold will sell again, its smart enough.

        However, globalization is a whole new deal, and all the sex symbols, fancy-flavored soft drinks, and isolated nation money shifting tricks in the bag will neither keep Humpty Dumpty from experiencing a fall off the wall, nor much less, put him back together again.

        This is a whole new economic reality of a massive, closed, and deeply, nonlinear coupled system. A local top-down approach is a drunkard's walk right into chaos. The only realistic approach is a properly aimed, atomic bottom-up approach -- working out the behavioral economics of establish the sense of mutual responsibility and trust that will lead to stable short and long-range interactions through the emergent intelligence of the system itself. In other words, nothing less than a direct analogy to a natural biological homeostasis.

        This is what thrives on such a nonlinear coupling complex, which is why natural systems such a the human heart, tend to a fractal structure -- and particularly in the heart's case, a fractal beat. So much so, that in fact, again in the case of the heart, if the beat begins to smooth and simplify toward a simple sinusoidal pattern -- its the surest sign that cardiac arrest -- plain flat line -- is just around the corner.

        A real paradigm shift, and specifically the only one that I can see with a realistic hope for success, is to initiate grass-root programs in integral education world-wide. This, as well as work on using the using the media's amazing power of persuasion in a self-help manner to promote an environment that values mutual responsibility over the best sex and the tastiest colas.

    5. CommentedPaul Jefferson

      Also at issue is Abe's plan to change the Japanese constitution to deprive individuals of their rights and allow military aggression. Let's hope Japanese voters oppose this in the coming elections.

      Yes, Japan should depend less on the USA militarily. But free speech should never be suppressed, as it enables citizens to hold their own government accountable, and oppose unprovoked wars.

      Japan must recognize that its economic weakness has bred political extremism, which could lead to eventual national catastrophe.

    6. CommentedFrank O'Callaghan

      The deep question is about what happens if or when governments represent their people's interests rather than those of banks/bondholders.

    7. CommentedProcyon Mukherjee

      The Japanese problem cannot be replicated with the problem in U.S., where wealth effects on consumption has not been studied as is the case with U.S.

      In the seminal NBER Working paper, WEALTH EFFECTS REVISITED:1975-2012 by Karl E. Case, John M. Quigley & Robert J. Shiller, we have seen a startling conclusion, “The housing wealth elasticity in a falling market is estimated to be about 0.10 and in a rising market about 0.032. the effect of increases in housing market wealth upon consumption is positive and significant; the effect of decreases in housing market wealth upon consumption is negative and is also significantly larger. The statistical models also report a relationship between increases in stock market wealth and increases in consumption, and a larger relationship between decreases in stock market wealth and decreases in consumption. Changes in
      housing values continue to exert a larger and more important impact upon household consumption than do changes in stock market values.”

      This is actually an endorsement of Prospect Theory by Kahnemann and Tversky, where they had shown that home sellers behave differently in reaction to declines in home prices, than in reaction to increases and the same is also true in the case of equities.

      QE3, while it has helped to inflate financial assets, may not be having the same wealth effects on consumption as before as consumers may be cautious, stemming from their earlier experience on ‘asset bubbles’, to still anchor on a lower wealth elasticity in rising market than 0.032, which means for every rise in $1 wealth the consumption would alter by less than 3.2 cents.

      This is precisely the reason that $85 Billion of monetary stimulus per month is translating to less than 200,000 of new job additions per month ($500,000 of marginal cost per job) in U.S.

      This issue is less predominant in Japan, both in terms of unemployment as a problem and also the anchoring effect.

    8. CommentedTim Chambers

      "by not retaliating, and by undertaking their own domestic reforms that compensate for the output lost to Japan. In other words, a growing pie for all better accommodates all."

      Wouldn't it be wonderful if we could see the benefits of such adjustments in the U.S., particularly for the unemployed and the long term underemployed.

    9. CommentedMacro Themes, Trends and Trades

      Mr El-Erian, thanks for this great article, it is always such a pleasure to read you...
      Actually I presented quite a similar view on my blog in mid-january (, and given the Abenomics craze lately, it is highly reassuring to see that you share these doubts about the final outcome.
      I have two questions.
      1/ You are talking about "wide-ranging structural reforms". I have not seen them yet and had the impression that most would be announced after June's elections. Could you be more specific?
      2/ Would you agree that EUR/JPY strength, probably has something to do with Germany's sudden and sharp slowdown? Not because of its REER of course but because Germany and Japan are competing on the same goods markets?
      Thanks and best regards.