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The Japanese Experiment

NEWPORT BEACH – After years of tweaks, Japan has now initiated a major shift in its policy paradigm, with reactions ranging from great optimism that the country may finally be lifted out of a quarter-century of economic stagnation, to concerns that the authorities’ dramatic change of course may in fact end up making things worse. But, while debate naturally focuses on Japan’s economic, financial, and political maneuvers, the tipping point could well lie abroad.

Prime Minister Shinzo Abe’s new government has embraced a revolutionary (rather than evolutionary) economic-policy approach that engages several initiatives, some of which were once deemed implausible, unthinkable, or even undesirable. From the doubling of the money supply to additional fiscal stimulus and wide-ranging structural reforms, the new policy paradigm is nothing less than one of the boldest economic-policy experiments in Japan’s post-war history.

To demonstrate their seriousness, Japanese officials moved quickly to commit to measurable metrics. On the policy input side, they have specified and begun to implement purchases of securities totaling $75 billion per month (three times as much, in relative terms, as the US Federal Reserve currently purchases under its unconventional monetary-policy regime). On the output side, and after many years of persistent deflation (prices fell 0.5% last month), Japan is now targeting a 2% inflation rate within two years, thus underscoring its commitment to avoid a pre-mature withdrawal of monetary support for growth.

Already, financial markets have responded with alacrity. The Japanese equity market is up an impressive 55% since hints of the paradigm shift started hitting investors’ radar screens. At the same time, the Japanese yen has depreciated sharply, including by more than 20% against the struggling euro.

This response is part of the transmission mechanism for the Japanese government’s policies. The surge in the stock market benefits domestic investors, making them likelier to spend more (what economists call the “wealth effect”). This, in turn, should revive corporate “animal spirits,” leading to higher investment in new plants and equipment, together with higher wages and salaries.

These are, of course, the same mechanisms that the Fed has targeted for almost three years in its own efforts to stimulate higher growth in the US. The macroeconomic outcomes have consistently fallen short of expectations, and there is reason to believe that it will be even more difficult in Japan for monetary policy alone to gain sufficient traction.

Japan’s aging population mutes the potential impact of both the wealth effect and animal spirits. Resource flexibility is lower than in the US. Interest rates are already low. The experience of deflation is well entrenched. And, given Japan’s high level of public indebtedness, the risks of collateral damage and unintended consequences are potentially higher.

With gross overall government debt already at 238% of GDP, some worry that Japan would face the threat of economic and financial dislocation were a failed policy experiment to lead its private sector – which traditionally has displayed an enormous home bias – to disinvest from Japan. This does not mean that Japan’s policy revolution will necessarily disappoint. But, critically, it does mean that even if you believe that the BOJ’s actions are necessary for Japan to emerge from its economic malaise, they certainly are not sufficient.

Japan’s experiment requires meeting two additional conditions if it is to avoid going the way of previous failed policy initiatives: meaningful structural reforms that essentially change how segments of the economy respond and operate; and other countries’ continued acquiescence in the currency depreciation needed to boost the impact of slower-moving domestic dynamics through meaningful gains in global market share.

Meeting the first condition is in the hands of Japanese citizens and their elected representatives. The required reforms, though achievable, will test the government’s resolve and implementation capabilities, as well as the population’s willingness to face immediate disruptions in exchange for the promise of longer-term gains.

The second requirement is very different. It can be achieved only if other countries are willing to sacrifice output, either because they have no choice, or because they believe that, over the medium-term, a stronger Japanese economy will benefit them as the longer-term income effects offset the impact of immediate market disruptions.

But will the rest of the world accommodate Japan’s bold policy experiment, or will it take protective steps and thus impede the operation of a crucial policy transmission mechanism? While initial indications are encouraging, the jury is still out.

Many affected countries – including those hit by the trade effects (such as China, South Korea, Taiwan, and eurozone members) and those susceptible to the capital-flow channel (such as Brazil, Indonesia, and Mexico) – have not yet had enough time to react. Japan’s policy change was big and abrupt, and several of the countries on the receiving end have been focused on complex domestic challenges.

A few countries – particularly Brazil, China, and South Korea – have noticed. But their reactions have been generally muted by Japan’s success in getting a US-led initiative at the G-20 to classify its policy response as constituting the use of “domestic tools” to pursue “domestic objectives.”

It is just a matter of time until the rest of the world catches up with the reality of how Japan’s experiment affects them. The hope is that, bolstered by evidence of Japan’s serious pursuit of structural reforms, they will accommodate the experiment in two ways: by not retaliating, and by undertaking their own domestic reforms that compensate for the output lost to Japan. In other words, a growing pie for all better accommodates all.

The fear is that neither Japan’s subsequent actions nor the affected countries’ domestic realities will justify the risk of lost market share, especially at a time when the global economy as a whole – and global policy coordination – is struggling. Here the risk involves currency wars and other beggar-thy-neighbor disruptions.

There is currently insufficient data to predict either outcome confidently. As we await additional evidence, let us appreciate how rarely we witness, in real time, such a momentous policy shift.

Mohamed A. El-Erian is CEO and co-CIO of PIMCO, and the author of When Markets Collide.

Copyright: Project Syndicate, 2013

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