At a time when economic optimism is growing and stock markets are hitting new highs almost daily, it is worth asking what could go wrong for the global economy in the year or two ahead. The standard response, now that a war with Iran or a euro breakup is off the agenda, is that some kind of new financial bubble could be about to burst in the U.S. But a very different, and rather more plausible, threat is looming on the other side of the world.
Japan is the world's third-biggest economy, with national output roughly equal to France, Italy, Spain, Portugal and Greece combined. This year, Japan has become, very unusually, a leader in terms of financial prosperity and economic growth. According to the latest IMF forecasts, Japan's 2% growth rate in 2013 will be the fastest among the G7 countries, easily outpacing the next strongest economies, Canada and the U.S., each with 1.6% growth. Japan's stock market has gained 70% since last December, far exceeding the 25% bull market on Wall Street, and Japan's corporate profits are projected to increase by 17%, according to Consensus Economics, compared with the paltry gains of 3 to 4% in Germany and the U.S.
As someone very much caught up in the economic optimism inspired by the election of Shinzo Abe, I fear it is now time for a reality check. And observing the complacent inertia that seems suddenly to have paralysed Japan after July's Upper House election, it seems worth recalling the famous maxim (usually attributed to Keynes) about unexpected events: "When the facts change, I change my mind."
The reasons for pessimism follow directly from the main driving forces of Japan's new economic program, the so-called "three arrows" of Abenomics: fiscal stimulus, monetary expansion and structural reform. The second of these arrows - monetary expansion - is flying as fast as ever. But the first, fiscal, arrow is about to turn into a boomerang that could kill Japan's economic recovery stone dead. In April an increase in consumption tax from 5 to 8%, along with some cutbacks in public spending, will produce a narrowing of the structural budget deficit worth 2.5% of GDP, according to the IMF.
This massive fiscal tightening, which happens to be exactly equivalent to the U.S. fiscal tightening in 2013, to Italy's in 2012 and to Britain's in 2011, is a very big risk to take with the Japanese economy's still-tentative recovery. While the Abe government has made vague promises to cut other taxes or boost public works spending to offset some of the deflationary impact of the consumption tax increase, it has notably failed to provide any details. Given that the tax hike will hit the economy in April, time is running out for any effective offset to be proposed. It seems, in fact, that the Finance Ministry opposes any significant easing of next year's fiscal burden. Far from being ready "to do whatever it takes" to promote economic recovery, as I had expected, Japan's bureaucracy seems to prefer to wait and see how April's tax hike affects the economy before proposing any compensating relief. The trouble is that by the time a collapse in consumption becomes apparent, it may well will be too late to prevent another recession.
Financial markets are at present unperturbed by the danger of next year's fiscal tightening because they expect the Bank of Japan to ease monetary policy even further to compensate. The BOJ may well start to expand its balance sheet even faster than the near-doubling already announced this year, but how much will this help? The recent experiences of the U.S., Britain and Europe all suggest that monetary expansion tends to be less powerful than fiscal tightening when interest rates are near zero and therefore cannot be reduced any further. In these conditions, monetary policy can only work indirectly by boosting asset prices and creating wealth effects. And the scope for quantitative easing to boost bond prices is even more limited in Japan than it has been in the U.S. and Britain.
Finally, the third arrow of Abenomics, structural reform, has turned out to be more like a straw. Most of the reform programs that were eagerly anticipated after July's Upper House election have been quietly forgotten. Labor market and wage liberalisation, tax restructuring, nuclear power restoration, changes in corporate governance, service industry deregulation and pension fund asset re-allocation have either been abandoned or repeatedly postponed. Admittedly, some trade reforms are under active consideration because of the Trans-Pacific Partnership talks with the U.S. But these changes will mainly involve agriculture and are unlikely to stimulate economic activity significantly, especially in the next year or two.
The main hope for an offset to next year's consumption tax hike would be large wage increases next year, and there has been talk that some leading companies such as Toyota intend to raise wages. However, there are few signs of such generosity spreading beyond the largest and most profitable companies. A survey published this week by the Nihon Keizai Shimbun showed that only 7 percent expected to use cash reserves, "to raise salaries." Most companies "remain cautious about upping wages," according to the paper, despite piling up record cash reserves of $690 billion. Most estimates of next year's wage round suggest average wages increases of around 1% - barely enough to keep pace with inflation and not sufficient to offset the impact of the consumption tax.
It is possible, of course, that all these risks to Japan's economy will be overwhelmed by monetary stimulus. That is what financial markets currently suggest, and the message of the markets should never be ignored. But if you want to believe in the prescience of financial markets, it seems safer to heed the growing optimism on Wall Street and in London, Hong Kong and Frankfurt, than to get too bullish about Japan.© (c) Copyright Thomson Reuters 2013.