Abe's 3 ways to fix Japan's economy

With its economy contracting, Japan's much-heralded, three-pronged Abenomics revival plan is beginning to look like a two-legged stool.

The latest evidence came Monday with a surprise drop in Japan's gross domestic product, which fell at an annual rate of 1.6 percent in the third quarter after plunging 7.3 percent in the second quarter. That followed a rise in the national sales tax, which clobbered consumer spending.

That wasn't the plan when Japanese Prime Minister Shinzo Abe was elected in 2012 on a pledge to revive Japan's long-moribund economy, the world's third-largest. He promptly announced that he had three arrows in his quiver to meet that target.

The first involved aggressive monetary stimulus in the form of a stepped up bond-buying program by the Bank of Japan known as quantitative easing. Originally deployed by the Japanese central bank in 2001, U.S. central bankers adopted the strategy in 2008 to offset the credit crunch created by a global financial panic.

To further spur growth, Abe's second arrow called for massive government borrowing and spending; more than $100 billion was announced two years ago. The plan also called for borrowing roughly half that amount, further swelling a debt pile that is now more than twice the size of Japan's gross domestic product.

But the world has been waiting for Abe to unleash the "third arrow," a package of structural reforms critical to any revival.

Now, news of Japan's economic contraction comes amid signs that outside the U.S. the global economy is slowing. Once-rapid expansion in China and the developing world has cooled. Europe remains mired in an economic slog burdened by piles of bad debts weighing on its banking system.

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Treasury Secretary Jack Lew warned last week ahead of a meeting of G-20 leaders that the world can't rely on the U.S. to drive global growth. Lew's assessment included comments aimed squarely at Abe.

"The first two arrows — monetary and fiscal stimulus — contributed to stronger growth in 2013, but growth has weakened this year as Japan stepped back from its efforts on the fiscal side," Lew told reporters. "The third arrow — structural reforms — has not been fully released."

And it remains to be seen just how far that arrow will fly.

The "third arrow" proposals aim to spur capital spending, boost private and foreign investment and offset the headwinds from Japan's shrinking labor force brought by a long-term shift in demographics that has left Japan with the heavy burden of caring for a rapidly aging population.

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To offset that ongoing drag on Japan's economy, Abe is seeking reforms in these key areas:

Private investment. At the top of the list is a cut in Japan's corporate tax rate, which is among the highest in the world. The reforms also include cutting regulations and promoting policies that help business start-ups, including public investment. That would also mean a shift away from government bailouts in failing companies. The government has created "special economic zones," to spark entrepreneurship, but the program has been slow to take hold.

The plan also calls for increased investment in stocks by Japan's massive public pension fund. The government also wants to double foreign direct investment in Japan by 2020.

Labor reforms: As Japan's workforce ages into retirement, Abe's government wants to ease labor shortages by putting more women to work. That means by providing better access to child care; the plan aims to eliminate day care center waiting lists by 2017 and urge employers to offer child care leave of up to three years. The plan aims to boost the employment rate of Japanese women aged 25 to 44 from the current 68 percent to 73 percent by 2020.

The government also wants to make it easier for foreign workers to come to Japan and find jobs. That means shortening requirements for permanent residency from five years to three.

Protective regulations: Japan has long insulated politically powerful domestic industries with a thicket of trade restrictions, subsidies and other regulations that make it hard for foreign firms to compete in Japan. Cutting those barriers would spur growth and boost opportunities for expanded trade.

Abe's "third arrow" calls for doubling exports from Japan's farms and fisheries by 2020. But those trade deals would mean dropping protections for Japanese farmers, a big reason Abe has been holding up completion of the U.S.-sponsored Trans-Pacific Partnership.

Though the third phase of badly needed reform proposals have been praised by Japan's trade partners and foreign investors, they've been much harder for the Abe government to implement than the first two rounds of massive government spending and monetary easing.

Cutting the corporate tax rate, for example, without replacing those revenues with other taxes would further swell Japan's budget deficits, potentially spooking bond investors. The government is widely expected to postpone a second sales tax hike, set for next year, to avoid further harm to consumer spending.

But the longer term problem, relying solely on deficit spending and money printing to spur growth, remains.

"While (the latest) poor GDP data may provide a good excuse to delay the sales tax hike planned for next year, any such decision could still damage the government's credibility," said Capital Economics economist Julian Jessop.

And there are limits to the Bank of Japan's "easy money" policy, no matter how many more trillion yen's worth of bonds it decides to buy.

"You're not getting enough of the big reforms happening," said David Mann, head of Asia research at Standard Chartered. "Part of it is demographics. You need to do big things to be able to counter what is a massive drag on growth that will go on for years."

—By CNBC's John Schoen.