Can the Euro Area Learn Lessons from Japan?

The GED Project is launching a new series: GED Economic Outlook. In this series, we will look at what the future might bring for countries or economic variables we are interested in. In this first installment of the series, we look at Japan. Japan was hit by an economic crisis in the 1990s and has since struggled to return to high economic growth rates. While some predict a similar fate for the Euro Area, Japan might be ending its period of stagnation and deflation. Are there lessons to be learned?

What is Abenomics?

Shinzo Abe came to power in 2012 with an economic programme to end Japan’s long period of stagnation and deflation. The strategy of “Abenomics” had three main components:

1. An aggressive quantitative easing programme to further ease monetary policy – this arm of Abenomics was pursued aggressively and as a result the Bank of Japan holds the largest balance sheet of many G7 central banks. Inflation rates have picked up somewhat but remain below the target of two percent.
2. Increased government spending to stimulate the economy – this feature of Abenomics was not much used. Given the very high debt ratio of Japan (well over 200 percent in gross terms), the Japanese government actually pursued a consolidation path, rather than increase government spending
3. Structural reforms, unlocking some untapped growth potential of the economy – while some observers called for a more ambitious reform strategy, Abe’s government has in fact tackled some tricky structural reforms, most importantly in the energy markets and the agriculture. However, important challenges such as the sharp duality between permanent and temporary jobs in the labour market yet remain to be addressed.

Policy measures similar to Abenomics have also been suggested to revive growth in the Euro Area, avoiding to slip into the low growth trap that Japan has encountered. Hence, it seems interesting to have a closer look at what Abenomics has achieved for Japan and what scenarios are recommended for the Japanese economy in the foreseeable future – some of this might be relevant for the Euro Area as well.

As can be seen in the chart above, inflation is expected to pick up in the next years. The driver behind this is not only monetary policy but also the rapid demographic change (cf. chart below). With an ageing population, less people enter the workforce than retire. The result is an increasing shortage of workers which will lead to upward pressures on wages. Those in turn are an important contribution to bringing inflation close to target, implying that the long period of deflation might be over. GDP growth is also forecast to develop positively, but both the OECD and the IMF made several important policy recommendations in their country reports on how the Japanese government could further underpin and accelerate growth.

Proposed Economic Policies

The IMF and the OECD mostly agree on their analysis of the Japanese economy. In their latest country reports, both call for more structural reforms in order to enhance productivity, increase confidence in Japan’s growth strategy and to counter demographic headwinds. All challenges that the Euro Area faces as well. More precisely, the key recommendations are:

• Labour Market: Break down the stark job market dualism between regular and non-regular workers. Increase the labour market participation rate by fostering the share of women in employment.
• Fiscal Policy: The IMF calls for a credible consolidation plan to reduce Japan’s burden of debt in order to improve confidence in the Japanese government.
• Structural Reform: Relax product market regulation in order to improve productivity, especially in the service sector. Improve the contestability of markets and facilitate the creation as well as the exit of non-viable firms. This includes an improvement of the mergers and acquisitions market and the availability of venture capital. The government should also provide incentives for the private sector to engage in larger investment, particular in research and development.

Scenarios

Using the Oxford Global Economic Model, this paper develops economic scenarios based on the implementation of some of these policy implications.[1] The simulation is based on the following changes to the baseline projection:

• Scenario 1: Structural Reforms:
  • Increase of the labour force participation rate: We assume reforms which cause an immediately beginning and subsequently linear rise in labour supply from now 67m workers to 69m in Q4 2022
  • Higher service sector productivity: Immediate exogenous shock increases productivity by 5 percent
  • Higher private R&D expenditures: R&D expenditures are assumed to increase constantly by .005 of GDP.
• Scenario 2: Structural Reform + Consolidation
  • Cautious consolidation plan
• Scenario 3: Structural Reform + Investment
  • Increase in public investment

The Structural Reform Scenario (Scenario 1) leads to interesting results: GDP and consumer spending pick up quickly and the economy proves more resilient against the upcoming VAT tax rise shock that the government has already announced. Also investment takes a more positive path. Unemployment rises as the labour market would be unlikely to absorb the entire newly generated workforce. The increased labour supply takes the pressure from wages, thus leading to lower headline inflation which would in fact turn into negative territory again. The central bank would be required to step in by further lowering interest rates or expand its QE programme. As a result, also bond yields would move into negative territory while equity prices develop favourably. Competitiveness improves (a smaller index value implies a more competitive economy). The government balance improves as well.

In a subsequent step, we further develop the above described scenario by modelling different fiscal policy scenarios on top. First, we look at a careful consolidation plan. This is implemented by adopting a lower path for real government consumption. Instead of rising to almost Yen 28,000 bn by Q4 2022, we assume a rise only to slightly above Yen 27,000 bn (2011 prices). As one would expect, the most important effects are a lower growth and inflation rate but also a faster improvement of the government balance.

Scenario 3 studies the opposite case. We now assume a strong increase in real government investment. Since the baseline scenario already assumes a sharp increase in nominal government investment until Q3 2018 (by Yen 1 bn over the current level), we assume a continuation of this course increasing it until Q4 2022 by Yen 2.5 bn over the current level (all 2011 prices). In the baseline scenario, investment would fall back to almost current level after its peak in late 2018. As a result, GDP growth is substantially higher and overall fixed investment in the economy smoother. The unemployment rate would remain below 4 percent and inflation would mostly remain near zero, not drop into negative territory. Such an investment path would be consistent with a continued closing of the government balance, albeit at a slower pace.

Conclusion

What can be learned from Abenomics? It is clearly evident, that an aggressive monetary policy is effective in avoiding a deflationary trap. This is a lesson that the Euro Area has already respected well with the ambitious QE programme of the ECB. Also the Euro Area requires structural reforms that help to free labour and product markets in many countries. Expanding the labour market participation rate is key to counter demographic headwinds – this however should be implemented with a view to the capacity of the labour market to absorb any newly activated workforce. In a comparison with the Euro Area, the demographic decline that Japan faces is much more severe than the demographic change Europe will encounter. Finally, fiscal policy is to be used with the right balance: Too rigid fiscal policy may counter the stimulating effects of monetary policy and structural reforms. Overly loose fiscal policy risks raising debts to unsustainable levels. For Japan, a cautiously accommodative fiscal policy might help to accentuate the positive effects of Abenomics. As European economies could not sustain overall debt levels similar to Japan, there is less room for fiscal manoeuver. In countries, where growth is still sluggish, fiscal space should be used if possible and in line with European and national fiscal rules. Countries with solid growth can use this boom to improve the health of their public finances.

[1] These scenarios are based on assumptions motivated by illustrating the effects of a certain policy path. While efforts have been made to make these assumptions realistic, the aim is to show direction of the effects rather than develop precise policy recommendations or projections.