Thursday, November 20, 2014

Japan is Bac… Maybe Not: Still A Long Way to Go

The late Milton Friedman once stated “monetary theory is like a Japanese garden, an apparent simplicity conceals a sophisticated reality.” Interestingly, experience of the last twenty years of Japanese economy shows us that the solving economic problems Japan has been facing requires not one-and-done expansionary monetary policy, but more sophisticated yet unfamiliar policy tools, including unconventional monetary policy, expansionary fiscal policy and structural reforms.

The period of Japanese stagnation was initiated by the falling asset prices in the early 1990s, which in turn led to large deleveraging process by households and firms . The deleveraging process further caused a decline in aggregate demand and a persistent deflationary period from the end of 1990s until recently. In addition to the aggregate demand deficiency, there is a deeper and unavoidable cause for the problem in the Japanese economic performance in the long-term: changing demography. As a big part of Japanese labor force is retiring and the fertility rate in the nation isn't high enough to keep the population growing, the labor force has not been sufficient to continue the economic growth Japan experienced during decades prior to the 1990s.

However, Japan is able to reach its current potential output through a combination of appropriate and perfectly timed fiscal and monetary policies under prime minister Shinzo Abe. The policymakers should note that expansionary monetary policy is appropriate only if there is significant under utilization of labor resources in the economy. Use of both expansionary fiscal and monetary policy even after the economy reaches its potential and shows signs of ability to maintain it without those only creates fear of repeating the mistake the BoJ made in the late 1980s to not tighten the monetary policy leading to soon-to-be burst stock market bubble. Considering the recent sluggish growth in 2014 and both medium-term and long-term economic goals of Japan, I propose that Abe’s government and the Bank of Japan continue quantitative and qualitative monetary easing (QQE) until the unemployment rate drops to and stays at the natural rate of unemployment* for a considerable amount of time and offset contractionary fiscal policies such as increasing tax and cutting government spending by further monetary policy stimulus to keep the nominal GDP growth on trend. The next blog posts will further elaborate on these proposals and more detailed policy recommendations.