Lessons from Japan: How to (Not) Revive an Economy

English: Japanese Prime Minister Shinzo Abe at...
The whole world is looking at Japan wondering whether it will make it out of its 20-year deflation. It may look like what is happening in Japan is occurring on another planet and that it has no bearing on the American situation, but that sense of comfort is deceptive. Japan is actually a laboratory experiment of what might happen in future in the developed world, the United States included. Why? Because the Japanese economy has been one of the fastest growing economy ever that has reached a fully developed status, sustained by amazing technological innovations, and it is the first advanced country in the world that has a growing - and soon overwhelming - aging population.

And it's not just America that could learn some lessons,  Europe too, particularly on how to get out of its self-induced Euro-crisis that threatens deflation, exactly the way it happened to Japan.

To address the issue of deflation and economic stagnation, the Japanese Prime Minister Shinzo Abe has resorted to a Keynesian strategy dubbed 'Abenomics' focused on government spending and investing in infrastructure, i.e. aggressive monetary easing coupled with public spending on public works plus somewhat vaguely defined "economic overhauls".

Will it work? 

At first it looked like it would. The international community allowed the Yen to drop without retaliating, providing a boost to Japanese exports. Early first quarter figures showed Japan growing at a robust 3.5% annualized rate, now revised to an even better 4.1% rate.  Still, international investors have qualms,  things are no longer looking so good, hedge funds are betting on a bust. In short, financial markets have taken a dim view, fearing that all this government spending might result in nothing but a throttling debt at the expense of Japanese future generations.

To counter this view, on June 5, Prime Minister Abe outlined his blueprint for recovery, optimistically setting a target of 3% growth in income per head over the next 10 years. A tall order, as noted by Reuters' Andy Mukherjee, in the light of the country's shrinking and greying work force. And as Abe spoke the markets plunged, the Nikkei lost 3.8 percent that day. 

Why? Because it was deemed that he had left out the reforms Japan needs the most: in its labor market and in industry (see New York Times article). The promised "economic overhauls" did not seem to be coming. Perhaps we shouldn't be too surprised: Abe is facing elections this summer, no politician likes to disappoint his electorate.  

So what does 'Abenomics' really propose and what are the problems Japan is facing and that have caused such a long period of stagnation?

The Challenges.

 Simply put:

1. An economy turned inwards: there is no true competition in the Japanese industry and laggards are allowed to linger on behind tariff, tax and bureaucratic protective barriers. They are maintained by state subsidies that further prevent newcomers to enter industries. As a result, firms financed by foreign investors account for only 4% of GDP, compared to 20% in the US and 50% in the UK. 

2. A cumbersome regulatory system that discourages start-ups and closes off markets, for example in the medical sector a ban on Internet sales of non-prescription drugs. 

3. A stultified labor market in desperate need of flexibility, for example workers from ailing companies cannot be easily transferred to promising new ones. 

4. An energy market in the hands of regional monopolies, a situation made critical by the recent idling of nuclear reactors, as a result of Fukushima.

5. A greying population causing a looming  medical insurance and pension problem, with Japan's public pension funds that control more than $2 trillion of savings mostly invested in domestic bonds, meaning that they help finance government spending.

All of this combined means that the Japanese economy is skewed towards favoring large established companies and places Tokyo in a leading, protective role.

Abenomics Solutions

An analysis of Abe's blueprint for recovery shows that it fails to tackle all five challenges and in each case only addresses part of it or in a way that will require time before it is solved.

1.  Announcement of "tax breaks" to encourage foreign direct investment and participation of Japan in the Trans-Pacific Partnership free trade agreement. Both would certainly help open up Japanese domestic companies to more competition - but obviously such measures take time. 

2. A pledge to remove "cumbersome regulations" but specific measures are not mentioned, except for lifting the ban on Internet sales of non-prescription drugs, surely a minor point, and the setting up of special zones to promote entrepreneurial innovation by "experimenting" with regulations. There is no indication of what sort of experiment is intended and much more needs to be done on the industry regulatory front.

3. Opening up the energy market seems to mean "breaking up regional monopolies" without indication of how this will be done, and pushing for an early resumption of Japan's nuclear reactors - which conveniently overlooks nuclear risks.

4. Overhauls of the medical insurance system are announced without giving any specifics and a call is made for extension of maternity leave to allow mothers to focus on child-rearing. The latter is really a minor populist measure that does not address fully the work-family life balance in Japanese society and it was immediately criticized for possibly discouraging female participation in the labor force

5. Calling on Japan public pension funds to shift their holdings towards investing more in higher-return-equities and overseas assets. This would ensure a more efficient use of savings but the risk is high that it will drive up the cost of government borrowing.

All this completely leaves out the needed reforms in the labor market and only barely addresses the major challenges facing the Japanese economy, in particular the high barriers to entry for newcomers - which means that innovation, the main engine of growth, is still muzzled.

It's not game over yet, but Shinzo Abe will need to press down on the accelerator if his proposed 'Abenomics' is to produce results. Will he dare to do so in the face of upcoming elections?

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