Japanese Prime Minister Shinzo Abe must rethink his Abenomics program in its entirety.
So far, only Abenomics' third and final arrow, reform, has come in for widespread criticism. But arrows one and two – monetary and fiscal stimulus – are also flagging in their efforts to pull Japan out of its economic funk.
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Annualized GDP growth fell to 1 percent in the second half of 2013 from more than 4 percent in the first half. If Abe does not refocus his reform program, the country risks a dangerous reliance on the Bank of Japan and its ultra-loose monetary policy. The country should resist this 'Hail-Mary' approach.
Barring substantial reforms elsewhere in the Japanese economy, using the 'first arrow' to repeatedly weaken the yen is an unsustainable source for growth in the long-run. Under Abenomics, growth in Japanese exports has failed to keep pace with the rising cost of imports.
Japan saw a record trade deficit in January, while exports by volume fell compared with January of the previous year. While an ever-weakening currency might stimulate short-term growth, it risks promoting a self-fulfilling cycle of yen weakness, greater trade deficits, and further depreciation.
In a country with an aging and shrinking population, real long-term growth can only be realized through improved productivity. QE reduces companies' cost of debt and supports their share prices without requiring CEOs to make productive investments. We have seen a similar dynamic at work the U.S. – the stock market has reached a record high, but capex and hiring has lagged woefully behind.
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To stimulate productive investment, Japan must revamp the second arrow of Abenomics and focus on tax incentives rather than government spending. The new tax breaks tied to capital investment are surely too small to encourage significant new domestic investment, and only apply if companies can meet a 15 percent return on investment hurdle, a level which may be unrealistic in such a stagnant economy.
Japan has also offered limited tax relief for money allocated to research and development, but needs to go much further if it is to reverse its decline in global research and development rankings since the 1980s and 1990s. In 2010, Japan was overtaken by China as the world's second top spender.
These kinds of measures should prove more effective, and safer, than fiscal stimulus. Japan's government debts are already more than twice its GDP, and continually tapping the bond market and spending the proceeds unproductively will ultimately prove problematic. Without more sustainable growth-generating measures, Japan risks an "Abegeddon" scenario – entrenched stagflation that prompts outflows of capital and a run on the government bond market.
The third arrow of Abenomics, reform, also requires redirection. First, Japan needs to ensure its businesses use its people properly. To do this it will need to address a rigidity that has led to the development of a 'dual' labor market. Around 40 percent of workers are now deemed 'temporary,' in jobs which provide low pay, a lack of social insurance, and little opportunity to develop skills.
Once in these non-regular jobs, securing regular employment is even more difficult – a mass waste of the potential of the Japanese labor force. Second, Japan should encourage its largest conglomerates to split. Japan has too many vast holding companies operating unprofitable non-core business lines. With inefficient businesses hidden in conglomerate accounts, it is not surprising that Japan's returns on capital investment are the lowest of any major developed economy.
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If Japan executes on these kinds of reforms, it may still need to lean on the Bank of Japan to boost growth. But it would be doing so from a much stronger position. Countries operating in competitive markets need to make their products as well, and as efficiently, as possible before slashing prices.
For investors, however, betting on this outcome is problematic. Politics tends to follow the path of least resistance, which in this case appears to be further monetary stimulus and an ever weaker yen. But it will not make for a strong Japan.
Alexander S. Friedman is the Global Chief Investment Officer of UBS Wealth Management and UBS Wealth Management Americas and is the Chair of the UBS Global Investment Committee. Kiran Ganesh is a cross-asset strategist at UBS Wealth Management.