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Abenomics gets economic diagnosis all wrong

Japan often talks about "15 years of deflation." Prime Minister Shinzo Abe often cites this as the main challenge his government is fighting with its economic policies, known as Abenomics. This belief in deflation has made a strong impression on the population.

     Abe was swept to power in late 2012. When he talks of the 15 deflationary years, he appears to be discussing the period from late 1997 to 2012. However, data in the consumer price index and real gross domestic product statistics do not fit well with the idea of 15 years of deflation.

      It is often said that deflation, even of only few percent annually, can cause a major decline in prices over a number of years. But deflation of such magnitude cannot be found in Japan's CPI during the period in question. The index bottomed out in 2003 and was on a general upward trajectory, partly because of rising raw-material import prices, until 2008, when the index again headed down. Figures at the end of 2012 were only slightly lower than those of late 1997.

     The phrase "15 years of deflation" could imply that real gross domestic product growth was stagnant from 1997 to 2012. But that is not the case. From 2002 to 2008, Japan's longest postwar period of economic expansion, an effective depreciation of the yen helped boost exports, and pushed up real GDP by about 10%.

     If, however, real gross domestic income is used instead of real GDP, and the GDP deflator replaces the CPI as the price indicator, the phrase "15 years of deflation" seems appropriate.

Trade woes

Japan's 21st century economy has faced an increasingly tough international environment. Prices of imported raw materials, such as crude oil, rose steeply. And export-centered industries, such as electric and electronic machinery manufacturing, declined in competitiveness, forcing prices down. As a result, Japan's trade terms -- the yen-denominated value of exports relative to the yen-denominated value of imports -- have significantly worsened.

     Income heads overseas when trade terms are bad because of factors such as high raw-material costs and low prices for goods exported. Even during Japan's longest postwar period of growth, the amount of money going overseas swelled significantly. Trade terms were bad even though exports expanded.

     For the period between the fiscal years through March 2003 and March 2008, real GDI, which includes the amount of money heading overseas, grew 5.5%. Real GDP, by contrast, grew 9.5% during the same period.

     In and after fiscal 2010, when trade terms continued deteriorating as the yen appreciated, the rate of growth measured in real GDI terms ran below that of real GDP. Growth in real GDI was not high enough to push Japan out of its deflationary mindset.

     On the other hand, the GDP deflator declined, reflecting worsening trade terms. Since the late 1990s, Japan's trade terms have been worsening. The GDP deflator fell about 20% between late 1997 and the end of 2012. The decline shows Japan is correct to believe it suffered 15 years of deflation.

     Trends in real GDI and the GDP deflator show deflation is not the result of macroeconomic policy failures. It is a reflection of the unfavorable international environment. Put simply, growth has not left people with more money because income has flowed overseas.

Policy push

Abe and his administration, however, continue to use real GDP and the CPI to check the health of the Japanese economy. The government has all possible macroeconomic policy options on the table in a bid to keep the economy at fever pitch.

     Since returning to office, Abe has poured trillions of yen into the economy on top of the budget, for stimulus and to help rebuild the area devastated by the earthquake and tsunami of March 2011. The Bank of Japan followed suit, launching in April 2013 a quantitative easing on a scale never seen before to bring inflation to 2% in year-on-year terms in the CPI. The central bank has amassed reserve deposits from private banks by paying an above-market rate of interest -- 0.1% per annum -- and used the funds to buy long-term Japanese government bonds. The BOJ's annual target for increasing government bond holdings is extraordinary, initially set at 50 trillion yen ($421 billion) and raised to 80 trillion yen this October. These policies have not expanded real GDP or pushed up CPI rates. 

     The yen, meanwhile, continues to weaken, driven by BOJ easing and changes overseas such as the policy shift at the U.S. Federal Reserve. Imported inflation caused by the weaker currency has been the primary force driving price rises.

     Real GDP posted a certain degree of growth in fiscal 2013, thanks to large-scale public investment and a last-minute shopping frenzy before a sales tax hike in April 2014. That growth has lost much of its energy this fiscal year. The first reason momentum has slowed is that public investment has not had its intended multiplier effect. It has therefore failed to offset the negative effects of sales tax hike going from 5% to 8%.

     Yen weakness has also failed to enliven exports or boost corporate investment and production capacity. And at a time when trade terms have worsened, even if real GDP is boosted by increased exports, it will not lead to a big rise in real GDI, because income is continuing to flow out of the country.

     Abe's second sales tax hike, to 10%, scheduled for October next year, has been postponed for 18 months in acknowledgment of the failure of macroeconomic policies to achieve their desired effect. The Ministry of Finance and the BOJ, which have pushed forward macroeconomic measures on an enormous scale, have lost face. Drastic action, which was supposed to restore public finances to health, is not working.

Time to change

If the 15 deflationary years were correctly diagnosed as symptomatic of an increasingly tough international environment, the government would never have gone ahead with such extraordinary macroeconomic policies. Those ineffective measure have passed along huge amounts of state debt and BOJ liabilities, in the form of reserve deposits, to future generations.

     Japan's economy must adapt to the ongoing shift in growth dynamism and the severe international environment. Capital investment expanded as exports grew during Japan's longest postwar period of economic expansion. But net investment -- the amount spent on capital assets, less depreciation -- did not keep up.

     Net capital expenditures at present are intended in part to prepare for a future expansion of consumption. The current downward trend in capital investment on a net basis suggests that companies anticipate consumption will stabilize at the present level. This reflects the economy's long-term shift toward maturity, and cannot be easily changed by tweaking policy tools such as corporate tax rates.

     It may be time for the government to drop economic growth and inflation as policy objectives. In light of long term trends in the Japanese economy, the nation should switch the principal aim of its reform efforts away from real GDP growth. Instead, measures such as labor market reform and the joining of the Trans-Pacific Partnership trade agreement talks should aim to create an environment in which the high levels of production seen today in Japan can be sustained.

     Some may ask whether this means Japan should reconcile itself to low growth rates. But it takes strenuous effort to sustain high levels of production over the long term. To that end, Japan also needs to maintain the sustainability of its public finances.

     Policymakers should realize soon that CPI inflation, when considered outside of the context of Japan's economy as a whole, is meaningless. Recent declines in crude-oil prices and favorable supply factors could be expected to push inflation considerably down. But like Chinese herbal remedies, they will moderately but steadily improve trade terms and Japan's economic health. Japan does not need drastic measures that throw the economy into delirium; it needs carefully thought out policies that can keep it ticking along.

Makoto Saito is a professor of economics at Hitotsubashi University in Tokyo.

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