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Newly elected Prime Minister Shinzo Abe wants to take Japan’s economy in a daring new direction to pull it out of two decades of stagnation and deflation. It turns out that his policies closely resemble past efforts — but he wants to put far more firepower behind them this time. He aims to relax already very loose monetary policies and sharply raise government spending to boost demand. Some analysts say it’s just the medicine Japan needs and, on the spending side at least, the opposite of what Europe and the U.S. are doing. But Wharton finance professor Franklin Allen, in an interview with Knowledge@Wharton, says the plan carries serious risks and could even lead to a big meltdown. And while the new policies may help in the short run, they will not combat the serious structural problems that have sapped Japan’s competitiveness.
An edited transcript of the conversation follows.
Knowledge@Wharton: With the recent election of Prime Minister Shinzo Abe, there has been a fairly dramatic change in economic policies, which he telegraphed ahead of time. It looks like it’s a reaction to a long-term trend in Japan that is pretty well known — 20 years of economic stagnation, deflation, and lately, a loss of competitiveness. Fiscal stimulus and loose monetary policies have been tried many times in Japan over the years, but a lot of critics say these were half-measures in the case of monetary policy, and that the stimulus was withdrawn too soon before it was actually able to jump-start the economy. This time, it looks like a real shake up, and I’m wondering if you see this as a huge change in direction, and what you think will happen as a result.
Allen: It raises a very interesting question: If something doesn’t work very well, what should you do? Should you try something else, or should you try harder? Up until now, the conclusion has been that we should try something else. And now, Prime Minister Abe has brought back the issue of, well, let’s try harder at what we did and try again. Part of that is driven by what the Japanese see going on in the U.S. and in Europe, where we have central banks essentially going out and, in the case of the U.S., with [quantitative easing], buying large amounts of bonds on a regular basis and printing money to do it. And in Europe, in the ECB (European Central Bank), we see with the outright monetary transaction program the potential for the ECB to also buy out very large amounts of government bonds.
The interesting thing is that in the U.K., there’s now begun a discussion — since they’ve also had quantitative easing in fairly large proportions, and the Bank of England now holds a great deal of government debt on its balance sheet — about what is the next step. Fairly serious people there, such as Lord Adair Turner, who is the head of the Financial Services Authority, have suggested that they go one step further. If you go out and print money to buy bonds, why not take it another step and go out and print money and give it to people and monetize the debt?
In Japan, they haven’t gotten that far yet. But Prime Minister Abe wants to go out and start giving the Bank of Japan a much higher inflation target — 2% rather than the current 1%. He also wants to have fiscal stimulus and to have more bond buying, more purchase of assets by the Bank of Japan. The interesting thing is what will be the effects of these actions? If you do it in small amounts, it seems as though it doesn’t have that much of an effect. [Fed] Chairman [Ben] Bernanke has argued that it’s had very positive effects — not huge positive effects but positive effects on things like employment and the output of the economy and so on.
One of the other views, which Governor Shirakawa put forward at the IMF meetings back at the end of last year, was that this quantitative easing has an effect, but it has a big effect on emerging economies. If we look at what’s happened in Brazil, there has been a huge run up in asset prices. The currency has strengthened a great deal, and that put their manufacturing sector under tremendous strain. And growth in Brazil is now stopped. So, there are these effects within the economy, and there are also effects globally.
Exactly what kind of an effect will happen with Japan remains to be seen. I think we’ve already seen a very large change in the exchange rate, much larger than we’ve seen for some time in Japan [the yen has dropped some 9% over the last six weeks]. I presume that is not in response to the moves the Bank of Japan has already made, because those have been relatively small. They’ve promised to try to get inflation up to 2% as soon as possible, whatever that means. The bond buying program that they announced is going to be starting in 2014, so it’s some time away. And by and large the measures that actually were announced were not that big. But I think what the markets are probably expecting is a new claim coming in that will do radically different things in terms of all these measures.
The real problem is that although in the press and so on people talk about these things as though it’s turning a dial, it’s not really like that. And we’re in a lot of uncharted waters, I would say. We don’t know what happens if you go out and have these long-run bond buying programs. It seems as though they haven’t been too successful in Japan in the past. Maybe they didn’t try [hard] enough. But there is, as you mentioned in your introduction initially, a long loss of competitiveness among many Japanese companies. If you look at companies like Sharp and Panasonic, it’s not at all clear that these companies, which 10 to 20 years ago dominated their industries, are going to be able to survive. And I think a part of this is these monetary measures have pernicious long-term effects.
If we try them even harder, we may have inflationary effects. And I think we don’t really know what will happen. And we’ll see what happens. As I say, in the U.K., they’re talking about printing money and handing it out to people. In Japan, it will be interesting to see how soon, if ever, they get to that point. But they’re really out ahead of [the U.S.]. Everybody has been saying, ‘We don’t want to be Japan.’ But it looks as though most countries are following very much in the footsteps of Japan, with slow growth and economic stagnation. We’re now five years into the crisis at least, and we’re still not doing very well. In the U.S. we’re sputtering along, but that’s with huge monetary stimulus and significant fiscal [stimulus]. In the eurozone they have significant monetary stimulus, not fiscal stimulus, but they are, of course, shrinking.
Knowledge@Wharton: You said that the U.S. and Europe seem to be following Japan’s old policies. What are those policies that have created conditions in Europe and the U.S. similar to what Japan has been seeing over the last 20 years?
Allen: They had tremendous fiscal stimuli for much of the time. They had public works. And they’ve had very low interest rates for many years now. None of these have solved the problem. They’re still growing at very slow rates. They were very hard hit by what happened after the default of Lehman. Their GDP fell around 10% within a year, basically. And this was a tremendous blow. But it didn’t really have too much to do with their financial system, because their banks weren’t in trouble. And, by and large, it wasn’t a financial crisis there. They were very badly hit by the drop in world trade.
Knowledge@Wharton: Japan is now doing monetary stimulus and trying to hit a 2% inflation target because they’ve had deflation for so long. Of course, inflation is a two-edged sword. A little bit might be a good thing, but then how do you keep it at a little bit and not go beyond that?
But then they’re also doing fiscal stimulus, which seems different than what certainly Europe is doing. They’re imposing austerity in most cases. And now they’re doing some quantitative easing. The U.S. did some fiscal stimulus, but that’s been over for a long time and now we’re in austerity mode, with state and federal government spending down quite a bit over the last few years. Japan, in a way, is doing something different than either the U.S. or Europe, and different than what it’s done in the past to some degree — in volume at least.
Allen: At the moment, it’s not doing anything that radically different than what it’s done before. When the new Bank of Japan team gets in, that may change drastically. That’s why the exchange rate has changed. The interesting question is, what are the risks? Why did they do it before?
There are a lot of risks involved, as you suggested. You can’t guarantee that inflation is only going to be 2%. And it could well be that we suddenly get a wave of inflation because, for example, if households start to worry about what’s going to happen to interest rates, they may suddenly move money out. The exchange rate may weaken even more. Interest rates on government bonds in Japan are incredibly low — much, much lower than in the U.S. or Europe, except for Switzerland. There is huge scope for a big rise in interest rates, which — given the level of their debt — would also be very risky.
There are [many] upside risks in what they’re doing. That’s why the Bank of Japan has, in my view, quite prudently avoided these risks previously. Maybe now, with the problems with China and the drop in GDP at the end of last year, Japan has to try other things. But there are risks involved. The rest of the world will look hard if they have a big meltdown of some kind, which could happen.
Knowledge@Wharton: When we spoke in November, you made a couple of predictions that have turned out to be correct. You more or less predicted that Abe would be the new Prime Minister. You predicted that, I believe, because he’s much more of a nationalist and because there are problems between Japan and China over [a dispute about which country controls a group of uninhabited islands]. And you also said that there is a possibility that the yen might begin to deteriorate quite a bit and quite quickly, which has actually happened. Since October, it’s depreciated about 10% or 12%. You’ve got a great track record there. As difficult as it is to look ahead, what do you think is most likely to happen in Japan over the next six months to a year?
Allen: That’s a very difficult one to predict. The first difficulty is over the islands dispute. A few days ago, they stepped back. Then the tensions keep coming back, so we’ll see how that plays out. That’s clearly a big factor in what will happen in the Japanese economy, because their exports to China and their businesses in China have not been doing well. It seems that the islands dispute is part of that.
The usual view is that Japanese companies will do much better with a weaker yen, and there are various calculations as to how much the profits of Toyota and Honda and the other Japanese companies will improve for each change of yen against the dollar. Certainly, there are those short-run effects. Company profits are likely to go up, and the stock markets reacted. But in the long run, it doesn’t seem that this solves their problems, because if you look back over the last few years, the exchange rate has varied a great deal and it has never really gotten them back on track. This is the thing that they need to worry about. They may do better over the next few months. Exchange rates do help in the short run. But they have a real long-term competitiveness problem, and that’s what they need to start thinking about how to address.
In particular, they have problems now competing with Korean firms. If you think about Samsung and LG, these companies are doing much, much better than Sharp and Panasonic or even Sony. It’s not just electronics now; it’s also in the auto industry. Hyundai has been doing very well. Japanese car companies are still strong, but they’re not in the dominant position that they were maybe a decade ago.
I think this is Japan’s long-term problem. These policies have not worked, and the real difficulty is that they are not the strong, competitive economy that they used to be. I think they will try these policies. I don’t think that they will be successful in the medium to long run, although they may have positive effects in the long run. There are these big upside risks we talked about a few minutes ago, but there’s also this long run competitive problem. They need to start thinking about how to solve that.
Knowledge@Wharton: If they use these policies as a short-term fix that buys them time to make structural changes, which I think is what you’re talking about, what are those structural changes? What are the changes that would help them in the long run and the medium run?
Allen: I think they need more competition. That’s what they lack. What the Japanese were so very good at 20 to 30 years ago was just competing globally. The domestic firms never quite got that. The problem is that the general lack of competitiveness has spread to more sectors in the Japanese economy, and they need to reverse that by having more competition. It will be interesting to see what the Japanese government’s reaction is to a major bankruptcy in the electronics industry — whether they will allow that, or whether they will force some of the more healthy firms to take over the weaker firms and preserve employment that way. I think they need to think hard about how to introduce competition and make Japanese companies more competitive.
Knowledge@Wharton: Is that a matter of regulatory change internally — becoming more competitive? What does that look like?
Allen: Many people believe that allowing hostile takeovers would be one way of doing that. I would be very surprised if they did that. Making foreign entry easier — making foreigners able to more easily compete — is one way to do that. But it’s a very difficult problem that every country is currently dealing with — which is how do you get growth going?
The problems in the financial system have made it very difficult for most countries to grow. There are exceptions — as I said, Korea over the last few years has done pretty well. There aren’t many countries currently introducing policies which seem to be leading to competitiveness and companies growing. Now, the currency issue is one of the big issues there because the whole issue of currency wars is one which countries may try to adopt.