Nov 19, 2014

    Japan's woes suggest economic policy can do only so much

    WHEN I was a wee thing, just a slip of a girl launching herself into the mad and exciting world of economic-policy reporting, you used to hear a lot of talk about Japan's Lost Decade.  

    From World War II to about 1990, Japan posted the most miraculous economic transformation of the 20th century. Then the Nikkei crashed and the mighty engine stalled.

    Japan alternated between stagnation and recession for the better part of a decade.  Then longer. Eventually, the "Lost Decade" stretched past 20 years.

    Many times during this Longest Decade, Japan has made some policy changes. Abenomics was the latest and arguably the best of these reforms.

    Japanese Prime Minister Shinzo Abe's "Three Arrows" of fiscal stimulus, monetary easing and structural reform were designed to attack three of the biggest problems that economists have identified with Japan's economy: insufficient consumer demand, deflation, and a highly protected and inefficient domestic sector that bears little resemblance to its world-class exporting powerhouses.  

    Economists reacted enthusiastically. Markets reacted enthusiastically. Gross domestic product began to look positively perky.  

    And now the big oops: Japan just posted its second straight quarter of negative growth, which is a good working definition of a recession.

    Commentators are focusing on Japan's decision to raise its consumption tax, which seems to have put a damper on consumer ardour.  Despite a really good package of reforms, Japan's economy is so fragile that a 3 per cent hike in the sales tax  - even one accompanied by a US$51 billion (S$66 billion) stimulus programme - is enough to push it back into recession.  

    The sales tax was a modest attempt to curb Japan's substantial budget deficits, which are in turn an attempt to prod the economy back to generating some growth. Those deficits have been running at an annual rate of 8 to 9 per cent since 2008. If the economy really can't survive on a more modest fiscal programme, then Abenomics is merely delaying the inevitable.

    What this suggests to me is that there may simply be limits to what good economic policy can achieve.

    Japan's economic problems, particularly its long demographic shift, may simply not be very amenable to better policy. Japan's exports have a lot more competition than they used to, and the country is heading for the demographics of an assisted living facility. Better monetary policy won't change either of those facts.

    This problem is not uniquely Japanese.  The whole world is in the middle of that same demographic transition, in more or less dramatic forms. Productivity in the richest countries is growing more slowly than during the decades after World War II.

    Again, fiscal stimulus is not going to fix that.  Fiscal and monetary policy can smooth temporary fluctuations in output. I'm less than convinced that they can, by themselves, improve our economic capacity.  

    But ultimately, fiscal and monetary stimulus are better tools for managing temporary crises than long-term growth problems.

    We should still advocate better policy. First, because the margins matter, and second, because a lot of marginal changes may, over a lot of time, add up to real differences in the underlying economy.  

    But we should be modest about what our advocacy can achieve. People are not automatons, the economy is an organic outgrowth of their activity, not a malfunctioning machine. There is no button we can push to make it do what we want; at best, we can prod the vast beast in a slightly different direction.