Japan’s Recession Takes Economists By Surprise
Most international economists predicted that the Japanese economy would rebound from a 7.3% Q2 contraction with third-quarter growth of around 2.1-2.2%. However, the economy shrank by 1.6% instead, officially sending Japan into recession.
An increase in the sales tax from 5% to 8%, which sharply curtailed consumer spending in the quarter, is receiving the lion’s share of blame. Prime Minister Shinzo Abe — whose Liberal Democratic Party (LDP) took power in 2012 on a platform of economic reform — raised the tax in an attempt to tame the massive Japanese debt – currently over 240% of GDP.
With his approval numbers dropping, Abe surprised many Japan-watchers by dissolving the lower house of Parliament and calling for a snap election on December 14. Voters will be asked whether a further boost in the sales tax to 10% should be delayed from October 2015 until April 2017. The election will also serve as a referendum on the overall economic policy of the LDP (dubbed “Abenomics”).
If polling conducted this weekend by leading Japanese newspapers is on target, Abe’s move to call the snap election is a shrewd one. Despite an approval rating for his government of just 39%, probable voters said they were three times more likely to vote for Mr. Abe’s party than for the main opposition group, the Democratic Party of Japan.
Basics of Abenomics
Abenomics consists of three “arrows”: loose monetary policy to pump millions of yen into the economy, increases in government spending as stimulus, and structural reform. So far, we are seeing the effect of the first two arrows.
Japan’s government expanded their bond and asset-buying program to the point that it is larger than the U.S. stimulus at the peak (relative to the national economy). The yen has correspondingly dropped to its lowest value against the dollar in seven years, and Japanese stocks have flourished – the Topix Index has almost doubled since Abe assumed power in December of 2012.
At the same time, real wages in Japan have been on a decline for 15 months. Thus, the Japanese people are seeing less of a benefit than the Nikkei would indicate, and as a result, the sales tax had a disproportionate braking effect on growth.
A Challenging Third Arrow
Consider the broad scope of Abe’s program. In many ways, it mirrors the U.S. effort, with significant stimulus through bond purchases and cutting of interest rates. The effect on the national stock market is also similar.
However, Japan faces severe structural concerns that make Abe’s job even harder. Japan’s population is simultaneously shrinking and aging, thus a decreasing number of taxpayers support an increasing number of retirees. This problem is exacerbated by restrictive immigration policies and a cultural bias against women in the workforce — a bias Abe is gamely trying to counter with high profile appointments of women to his cabinet. Changing this bias, however, could take decades in tradition-bound Japan.
Government policies in other areas are further hampering economic growth, particularly in areas with strong national interests like deregulation and trade. Abe has found reforming these areas much more difficult than manipulating fiscal policy, and the corresponding economic recovery is fragile as a result.
What Will Japan Do Now?
Does Abe just ignore the debt for now and continue forward? Should his government survive the election, which seems likely at this time, that appears to be exactly what he will do.
Abe is likely to forge ahead with stimulus and continue to emphasize the need for structural reform as well as push exports, tempting other countries to take temporary advantage of the low yen. Given the resistance he is facing, slow growth (similar to the U.S. but at a lower rate) is probably the best he can hope for over the next few years. He is unlikely to make the same mistake on taxes again, waiting until higher wages can support internal driving of the Japanese economy or worldwide economic improvement can drive it externally.
Economists generally expect the recession to be a temporary setback for Japan, and that Abenomics will eventually prevail. Some tax increases will be necessary long-term, but the Japanese economy was not ready for such a large change at the time.
The Japanese debt, massive though it is, is going to take a back seat to growth policies. As The Economist recently noted, “It is very hard to reduce the debt to GDP ratio in an economy in which the denominator refuses to grow.”
Even if the Japanese recession continues, the effect on the U.S. probably will be minimal. IHS Global Insight Chief Economist Nariman Behravesh predicts that a persistent Japanese recession would only reduce economic growth in the U.S. next year by 0.1%.
The U.S. economy may be growing slowly, but right now, it is one of the fastest turtles in the race. With the Euro zone stuck in a rut and China slowing, U.S. investments are still hard to beat worldwide. Based on recent minutes, the Fed is also likely to use the relative weakness of the worldwide economy as a reason to keep interest rates low, thus keeping stocks on their upward trajectory.
Meanwhile, the Nikkei seems likely to continue its upward trend as long as Abe’s government wins the snap election and Abenomics continues forward with less (if any) short-term concern about long-term debt.
Whether Abe (or any successor) is successful in the long-term depends on whether the “third arrow” of structural reform hits the target. We probably will not know that answer for several years