Japan is back in recession. This was the shocking news circulating the world after the government announced that, contrary to the expected mild recovery during the third quarter of 2014 (forecasted at 2.2 percent annualized GDP growth), the economy actually shrank by 1.6 percent. This shattered any expectation that Japan could engineer a quick V-recovery after the economy took a dive (shrinking 7.6 percent in annualized GDP) in the aftermath of the first increase of the consumption tax in 17 years last April from 5 percent to 8 percent.
The figures on Japan’s economic performance over the past six months matter greatly. They were instrumental in Prime Minister Abe’s decision to delay the second increase in the consumption tax by 18 months (the increase to 10 percent now has a pushed-back target date of April 2017); and to call for a snap election to renew his public mandate after this important change in the course of economic policy. But the figures also matter because they have forced us to ask some of the most poignant questions regarding the future of Abenomics. They have forced policymakers to recognize that in order to restore the Japanese economy to health, it will be necessary to prioritize amongst the goals of economic stimulus and fiscal consolidation. This implies that difficult choices must be made on which policy measures to put on the front and back burners.
Undoubtedly, in the long-term, economic growth, fiscal rehabilitation, and structural reform are essential to Japan’s sustained economic recovery. But in the short to medium term, progress on one front may undermine achievements in other areas. So when fiscal policy swung from all-out stimulus last year to fiscal tightening with an increase in the consumption tax this spring, consumer spending took a big hit. Hence, the effort to boost demand in Japan fell flat. The image of the three arrows of Abenomics flying in unison now appears less convincing.
Japanese policymakers—and heavy-weight economists on both sides of the Pacific—have engaged in an intense debate on which form of credibility matters most for Japan at this juncture: staying the course on increasing taxes (fiscal credibility) or steadfastness in the anti-deflationary campaign (monetary regime change credibility). Advocates of the former worry about financial turbulence in the stock and bond markets if Japan, the industrialized country with the highest public debt (at 240 percent of GDP), sends the message that it is politically impossible to raise taxes. Moreover, longer term challenges loom as it will not be possible to fund the pensions and healthcare expenses necessary for a rapidly ageing population. However, supporters of delaying the tax increase argue that overcoming the deflationary trap is the first order of business, and that it will not be possible to convince firms to invest and raise wages and consumers to spend more money in a recessionary climate: no virtuous cycle of economic growth will ensue.
Achieving the 2 percent inflation target rate has proven an elusive goal—as attested by the major expansion in the quantitative easing program recently engineered by Bank of Japan President Kuroda (despite a divided board vote) to a whopping 80 trillion yen per year (an increase of 10-20 trillion yen per year). Because additional fiscal tightening risks further economic contraction, it puts the anti-deflationary campaign at risk. Hence, supporters of delaying the consumption tax increase make the compelling case that—when forced to choose—growth has to come first, because with a shrinking economic pie it will be an uphill battle to service the debt and to overcome zero-sum dynamics in the structural reform agenda.
This was Prime Minister Abe’s choice in postponing the tax increase. In many ways, his calculation was made easier by the dismal GDP figures. If the nascent recovery that most economists expected for the third quarter had materialized, the decision on the consumption tax would have been a much more contested one. But who can fault him for not moving ahead with raising taxes when the economy is in recession?
And yet, there are still fundamental questions in the eventful decision to postpone the tax increase that require answers:
Why call for a snap election to renew a mandate that already exists?
The Japanese public is overwhelmingly in support of the tax increase postponement. The main opposition party, the Democratic Party of Japan, who negotiated the original tax-social security reform grand bargain with the ruling Liberal Democratic Party (LDP), concurs on the need for the delay, and the tax legislation itself grants the Prime Minister the discretion to decide on the timing of the second installment of the tax increase depending on the state of the economy. This is an unnecessary election for the purpose of delaying the tax increase, but it is an effective electoral strategy. By choosing the timing of the election, the ruling party seeks maximum electoral advantage. But the election should also be used to recommit to the cause of economic reform. By winning now, the LDP will not have to convene another Lower House election for another four years, creating political space to deliver on bolder reforms on deregulation, market opening, and labor market flexibility. Economic revitalization is the undisputed mandate from the public and the only long-term winning political strategy for any party in Japan.
What can be done differently in the next 18 months to restart the engines of growth and restore fiscal credibility?
The fall in real wages and the reluctance of firms to invest their sizable cash reserves and raise regular wages (and not just seasonal bonuses) have foiled efforts to boost demand-led growth in Japan. The government has secured an 18 month reprieve on the tax front, but absent progress in these core areas we can expect déjà vu in April 2017: a fragile economic recovery thwarting efforts to raise taxes and achieve fiscal sustainability. The government must deliver on the productivity-enhancing structural reform measures, but the onus on wages and investment is largely on corporate Japan. It should be all hands on deck at this critical juncture in Abenomics.