Japan's '3 Arrows' May Run Into German Wall

Shubiya district, Tokyo, Japan
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Shubiya district, Tokyo, Japan

Japan's bold monetary experiment is producing entirely predictable results: liquidity driven soaring equity prices and the sinking yen.

It will take more time to see the impact of all that on the real economy. The policy change is much too recent. The new leadership took over at the Bank of Japan on March 20, 2013, and the 10.3 trillion yen ($100 billion) stimulus package, announced on January 11, 2013, is unlikely to have led to instant, "shovel-ready," infrastructure projects.

It follows, then, that the economy's 3.5 percent gain in the first quarter is a result of monetary and fiscal policies conducted in the course of last year. That obvious fact is a politically awkward credit to the government of the Democratic Party of Japan (DPJ), which was soundly defeated last December, and to the retired Governor Masaaki Shirakawa's tenure at the Bank of Japan. But, as the saying goes, that's the way the ball bounces.

Indeed, politics is often a discrete social process, whereas economic developments usually have much greater continuity. In this particular case, it is clear that Japan's new government inherited favorable growth dynamics and some promising avenues to support the economy.

Housing Demand and Family Formation

One of these avenues is the housing demand. This post's previous discussions of the Japanese economy have emphasized the importance of residential investments in stirring up the country's sluggish economy. The reason is simple: if housing is made more affordable, Japanese families will migrate from their small quarters (often accommodating several generations) to more comfortable houses and apartments.

(Read More: Hold On, Japan Still Missing Key Pillar of Growth )

And when they buy a new home they will also buy furniture, housing appliances and automobiles – "big ticket" items or consumer durable goods. What happens then is that the stimulus fires up 62 percent of the Japanese economy through residential investments and household consumption.

Working through such a big channel, it is much easier to set in train, and support, a sustained upturn of aggregate demand than by pushing money – as has been the case in earlier stimulus packages - into largely unnecessary infrastructure investments ("highways and bridges to nowhere"), which represent only about 4 percent of the economy.

The most recent evidence shows that residential investment in Japan rebounded strongly since the first half of last year, growing at an average annual rate of more than 5 percent. Predictably, household consumption also rose, over the same period, by nearly 2 percent, a huge improvement from a 0.4 percent growth observed in the course of 2011.

(Read More: Woah, Is It Time to Slow That Yen Fall?)

I hope that these two segments of domestic demand will be the focus of the economic program Japan's Prime Minister Shinzo Abe will present at the G-8 summit in Northern Ireland on June 17-18, 2013.

The effectiveness of that program would be greatly enhanced by meaningful measures to support family formation and to raise Japan's birth rates from the current 1.37 per woman of childbearing age to 2.1 needed to stabilize the population growth and to reverse what is now the world's fastest aging society.

Public Finances and Structural Reforms

The Japanese prime minister will have a tough job in trying to convince his G-8 colleagues that his "three arrows" stimulus program will be able to address deeply ingrained structural problems of an economy that has been stagnating for more than two decades.

Most of Japan's trading partners believe that they need to see more – much more – than an avalanche of liquidity that has taken the yen down 12 percent in trade-weighted terms since the beginning of the year. Some of them even sound like they might need convincing that this whole thing is not a subterfuge to boost exports.

Germans, in particular, will be much more demanding than some other G-8 members inclined to give Japan a free pass. During the G-7 meeting of central bankers and finance ministers on May 11, 2013, the German delegation warned Japan not to rely on excessive monetary expansion, with pointed remarks that "Japanese problems, in the end, are mainly of a structural kind," and that "it is, therefore, especially important to present a reliable path to return to sustainable public finances and … to tackle structural challenges."

That is a tough test. Tokyo's "three arrows" may just run into the German wall, partly because German exports are threatened by the yen's 16 percent decline against the euro since the beginning of the year. And Germans are not alone in suspecting that - to compensate for politically damaged trade relations with China – the Japanese want to use the cheap yen to compete aggressively in other world export markets.

The numbers are there to support these concerns. After a 12 percent decline in 2012, Japanese exports to China fell nearly 3 percent year on year in March (according to latest data available at the time of writing), but they soared 7 percent to the U.S. and 12 percent to Latin America.

(Read More: Dan Loeb Sees a 'Huge Game Change' in Japan )

The Japanese monetary tsunami is also raising fears of growing asset bubbles and destabilizing hot money flows to relatively small Asian neighbors who won't be able to protect themselves from inevitable turning tides of large-scale financial speculations.

Nobody will plead that Asian case at the next G-8 meeting, but Japan should take great care not to cause this particular collateral damage at the time when it seeks to strengthen its regional alliances in response to growing tensions with China.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.