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Reform opportunities for Japan, US in 2017

Amid economic challenges, patience needed to implement changes, rely less on soft money

BOJ Gov. Haruhiko Kuroda, left, and Prime Minister Shinzo Abe attend a year-end reception with economists on Dec. 8.

Recent developments in Japan and the U.S. offer a chance in 2017 to evaluate shared opportunities and challenges for reforms for faster growth, reduced reliance on central banks and more economic inclusion. In both nations, bold leadership has defined a reset, and in both, impediments to achieving long-run goals are real.

Growth Trumps

The core economic opportunity and challenge for both Japan and the U.S. is to increase the pace of economic growth. This challenge incorporates both the need to reset expectations for a faster-growth economy and about particular policies that make faster growth possible. Though benefits of growth seem obvious, it bears repeating why "growth" is the answer to "first things first" in policy: An improvement in growth improves domestic living standards, provides the resources for global soft power, and yields support for openness in markets and dynamism.

In Japan, Prime Minister Shinzo Abe has clearly emphasized a resetting of growth expectations and a set of policies to increase growth (the three arrows). Abenomics has articulated a long-term goal of 2% annual real GDP growth. Arrows (targets) include anti-deflationary policy on the part of the Bank of Japan, fiscal stimulus to be followed by long-term fiscal consolidation, and structural reform. These second and third elements are intertwined, as better growth from reform is key to achieving fiscal consolidation.

An objective of 2% real GDP growth for Japan, while aspirational, is likely difficult to achieve. Growth can be decomposed into growth in hours worked and growth in labor productivity. While additional increases in labor force participation rates of older workers and women, goals of Abenomics, will increase growth in hours worked for a period of time, they ultimately represent a one-time change. Soon the labor force will be decreasing by about 0.5% per year.

The bigger effect must come from more rapid productivity growth. From the immediate postwar period to 1990, Japanese productivity growth was rapid. Further room to grow is indicated by the significant gap in the level of productivity between the U.S. and Japan. But, given the decline in the labor force, the required increase in productivity growth to achieve 2% real GDP growth is almost surely implausibly high. Nonetheless, policy elements of better productivity performance -- tax and regulatory reform and support of research and development and innovation -- remain important. And, even if Japanese annual GDP growth were 1%, real GDP per capita would increase by 1.5% each year, much better than the post-1990 average growth.

As in the U.S., Japanese workers are concerned about lackluster wage growth. The Abe government has prioritized improving wages for part-time workers. While important, a market-based wage mechanism to bolster wages for full-time workers, two-thirds of the labor force, will be needed to stimulate aggregate wage growth. I say "market-based" because wages appear to be more responsive for part-time workers than for full-time workers. Hence, structural reforms in the labor market will be important in advancing workers' incomes.

The U.S. faces growth challenges of its own. Sluggish GDP growth in the aftermath of the 2007-2009 global financial crisis was made worse by a policy mix that favored near-term stimulus over addressing long-term impediments to growth. Both academics and policymakers have discussed the potential for "secular stagnation," or very sluggish growth going forward for a very long time. Such a view portends little effect of a change in the direction of economic policy.

I think this view is too pessimistic, and a new policy shift will be a test: The incoming administration of President-elect Donald Trump has acknowledged the need to reset low expectations and to emphasize policies that can lead to faster growth. As Abe has done in Japan, he has offered aspirational targets -- in the U.S. case, 3.5% real GDP growth.

As with Japan, such an aspirational target is difficult to achieve in the long run, given underlying trends in hours worked and productivity. But the incoming administration is proposing fundamental tax reform and regulatory reform that can significantly raise the pace of growth in the near term and in the long run. The U.S. has more room to increase hours worked via lower marginal tax rates, payroll tax reform for older workers, and health care reform to reduce cost growth and raise wages. Proposed business tax changes and regulatory overhaul in financial services, energy and infrastructure have the potential to jump-start productivity growth and increase potential output. If implemented quickly, such policy changes could boost growth substantially in the near term and increase subsequent growth to 3% per annum over a decade.

Central banks cannot solve all challenges

Both Japan and the U.S. have emphasized changes in monetary policy much more in recent years than structural reform. This relative emphasis will need to change in the coming year to lift possibilities for growth.

Understandably, Abenomics prioritized ending Japan's long-running deflation, with a goal of raising the core consumer price index by 2% per year. BOJ Gov. Haruhiko Kuroda's policy shifts have shaken the nation's deflationary mindset, though the inflation target has not been achieved. While an accommodative policy will continue to be required, negative interest rates have not been successful in raising inflation or economic activity. Fiscal expansion aimed at investment, followed by fiscal consolidation, along with a focus on structural reform in regulation and the energy sector will be needed.

U.S. policymakers have more clearly over-relied on monetary policy from the Federal Reserve. While the Fed played a constructive role in the immediate aftermath of the global financial crisis, arguments to continue the hyper-accommodative economy in a period of virtually full employment are not strong. And the continuation of that policy risks credit misallocation and a nod toward financial engineering over real investment. While the U.S. faces structural problems in declining labor force participation and weak productivity growth, those problems are better addressed through structural reforms in taxation and regulation. That proposed policies of the incoming Trump administration center on precisely these forms is encouraging from a growth perspective.

Economic inclusion remains important

Finally, both Japan and the U.S. face challenges in economic inclusion, even if they are able to improve prospects for growth on average. For both countries, investment in and support for low-wage workers will advance inclusion. Such investment also bolsters political support for economic dynamism and growth.

Among OECD countries, Japan ranks seventh in the relative poverty rate (that is, the fraction of individuals with income less than half of median disposable income); the U.S. is second. An increase in the proportion of non-regular workers also portends growth in the ranks of the working poor. As I observed earlier, incorporating support for job training and income support of low-wage workers will be important in raising hours worked and incomes of low-wage workers.

The U.S. also faces challenges for low-wage workers, who have seen their relative incomes decline for some time. Greater support for skills education and job training is critical. But so, too, is income support for work. Congressional leaders have championed an increase in the Earned Income Tax Credit (an income support program for low-wage workers); that increase should be significant and focus on childless workers as well to achieve a goal of supporting work and incomes.

Japan and the U.S. are at economic policy inflection points. In Japan, the ambitious reset proposed by Prime Minister Abe has some successes, but relies on patience as structural reforms are slow to come. In the U.S., optimism has risen that growth and inclusion will improve under a new president. The coming year offers both hope and milestones for Abenomics and Trumponomics.

Glenn Hubbard, dean of Columbia Business School, was chairman of the U.S. Council of Economic Advisers under President George W. Bush.

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