Japan could be a world-beating exporter but went for easy BOJ money instead

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When Japan's new team of central bankers took over in March 2013, domestic consumer prices and industrial production were falling at annual rates of 0.9 percent and 6.7 percent respectively. Average economic growth in the fourth quarter of 2012 and in the first quarter of 2013 was an alarming 0.1 percent.

The newly-elected prime minister wanted quick action, and the money managers he brought in thought that they could deliver with an avalanche of fresh liquidity.

That looked like a good bet. Inflation and deflation being the monetary phenomena, they have to be addressed with appropriate degrees of tight or easy monetary policies.

But here is the rub. To stop and reverse price deflation, the monetary policy must create rising capacity and cost pressures in labor and product markets. Or, if you prefer, the monetary policy has to start pushing prices up by raising demand for labor, products and services to the point where price increases begin to accelerate.

How is that expected to work through an economic system?

Easy. By providing cheap credit, interest-sensitive components of aggregate demand – such as household consumption, residential investments and business capital spending – are supposed to rev up demand for labor, goods and services. So, with some time lag, because all this is not an instantaneous event, the economy and the general price level should begin to push up. At that point, the central bank killjoys are already plotting the course toward monetary restraint.

Impaired monetary multiplier

Sounds good? Yes, but what was the result of that policy in Japan three years on?

Well, here is what we got. Japan's consumer price inflation and industrial production in March were flat compared with their year-earlier levels. The country's GDP was also flat in the first quarter (year-over-year), after an annual growth of only 0.5 percent in 2015. Taking a longer view, the average GDP growth since the second half of 2013 has been 0.6 percent.

Can the Bank of Japan now declare victory and tell the government to do its part? Maybe it should, but the Japanese central bank says it has "plenty of ammunition" to fight on for its inflation policy target of 2 percent announced more than three years ago.

I think, however, that they – and their boss, the prime minister – may wish to reconsider. A good starting point would be a close examination of the reasons why the monetary policy cannot bring the economy up on a steady and sustained growth path – and keep it there. Put more technically, they have to find out what's wrong with Japan's monetary multiplier.

Why is it, for example, that, in spite of free money, the household consumption (61 percent of GDP) fell 0.6 percent in the first quarter from the year before, after a 1.1 percent decline in 2015? Or why the business investments (18 percent of GDP) dropped 0.9 percent in the first quarter and grew only at an average rate of 1.2 percent since the beginning of 2015?

Japan's residential investment, another interest-sensitive segment of domestic demand, accounts for only 3 percent of GDP. But that does not mean that it should be ignored, because changes in the housing demand have a strong influence on purchases of consumer durable goods. A new house, or a new apartment, may require new furniture, appliances, cars, etc. In the case of Japan, the housing sector has shown a large volatility since the new monetary policy was put in place in the early 2013. For example, a modest recovery over the last three quarters comes on the heels of a large, 9.7 percent, decline over the previous five quarters.

This quick review shows that Japan's ultra-easy monetary policies, initiated and maintained since the spring of 2013, are delivering neither price stability nor a steadily growing economy.

Losing Asian export markets

What can Japan do then? There are two more demand components that Tokyo could work on: Government spending and exports.

With Japan's proverbial "roads and bridges to nowhere" apparently finished, it seems difficult to come up with public sector infrastructure programs large enough to rev up the economy. Apart from that, budget deficits and the gross public debt of 6.7 percent of GDP and 250 (?) percent of GDP, respectively, are putting off-limits that particular policy option.

That leaves exports - 18 percent of GDP - as the most promising source of economic stimulus.

Exports are also the key part of Japan's traditional growth model. Here is how that works.

Rising exports (i.e., external demand for goods and services) lead Japanese businesses to invest in the expansion of their production capacities. That, in turn, supports employment growth and increasing labor compensations. Higher jobs and incomes then set in train growing household spending, and the upward business cycle is in full motion.

With its broad range of world-beating industries, Japan should have no trouble at all to sell - and outsell - anybody on world markets. Asia, in particular, should be Japan's most important export playground. That area is the fastest-growing segment of the world economy, it represents one-third of the global output and takes 53.3 percent of Japan's total overseas sales.

Unfortunately, Japanese exports to Asia and the rest of the world are not doing well. They plummeted at an annual rate of 8.4 percent in the first four months of this year. Over the same period, exports to Asia fell a whopping 11.5 percent, marking a continuation of Japan's weakening export trend to its Asian neighbors observed during 2015. It is intriguing that all that is happening to Japanese exports in (Asian) economies where GDPs are advancing at annual rates between 3 percent and 7.3 percent.

Investment thoughts

Instead of continuing to do the same thing and expecting a different result (remember Einstein's mirabile dictu?), Japan's economic strategists would do well to look at reasons preventing the monetary policy to revive the economy and to maintain it on a steady and sustainable growth path.

My guess is that they know these reasons because they are simple and they are not new. Declining demography and a rapidly aging population are holding back household consumption (61 percent of the economy), and business investments (another 18 percent of the economy) are weakened by dwindling domestic and foreign sales.

Since nothing can be done in the short-run about the population issue, and binding fiscal constraints are precluding large-scale public spending, exports are the only demand component that could make a significant contribution to Japan's economic growth and price stability.

I hope the Japanese leaders realize that. If they don't, they should have a word with Keidanren (Japan's Business Federation). Japanese businesses are fighting against formidable odds to hold on to their positions in a number of key export markets.

I also hope that architects of Japan's economic policies will not continue to neglect structural reforms. Opening up the economy and reversing strongly negative demographic trends are existential issues. I don't know who would want to dine in charming restaurants around Ark Hills and Omotesando operated by friendly robots.

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