Japan's bumpy road to a recovery

Meanwhile, criticism over the decline in the yen is coming from abroad. Many, particularly in east Asia, agree with the warning from David Li of Tsinghua University that, far from a rise in Japanese inflation, "the world has merely seen a sharp devaluation of the yen. This devaluation is both unfair on other countries and unsustainable." In a letter to the FT, Takashi Ito from Tokyo responded: "I just find it unbearable that countries that have debased or manipulated their currency can accuse Japan of depreciating the yen". This does begin to look like a currency war.
How do we assess such debates? First, a determination to end deflation and restore growth ought to raise yields on JGBs. A stable economy with annual inflation of 2 per cent will not have long-term interest rates as low as ½ a per cent. Last week's small jump in rates, then, is no mark of policy failure; it is, rather, a tentative indicator of the new policy's success.

Yet it is crucial that interest rates do not rise by more than expected inflation if real interest rates are to fall, as needed. The BoJ must give guidance to the path of long-term rates. It should be willing to buy without limit when interest rates exceed a (presumably, moving) ceiling. It can support the policy by indicating a period over which it will maintain zero short-term rates, subject to some override. Interest rates might stay at zero, for example, until the price level (not the rate of inflation) reached a specified level. In such ways, the BoJ might succeed in bringing a degree of predictability.

Second, the government and the BoJ need to find some good way of managing the mountain of Japanese government debt. The radical step of monetisation has to be a part of any solution. This would probably require a permanent rise in the reserve requirements imposed on banks. That would be a tax on their depositors. But making banks provide ultra-cheap permanent finance to government makes sense in Japan, since prospects for growth are poor, a vigorous revival of private borrowing is unlikely and the stock of public debt is so huge. Low (probably, negative) real returns on bank deposits may also produce a falling yen, rising asset prices and higher private spending. All of these effects would be highly desirable.

Third, the concern about the effect of the weak yen is understandable. Increasing the current account surplus is a way to offset the excess savings of Japan's corporate sector, as discussed in my column of April 9 on "Japan's unfinished policy revolution". But Charles Dumas of Lombard Street Research argues that Prof Li's concern is well-founded: China is the most exposed of the world's large economies to Japan's big devaluation. Yet China has also been a big currency manipulator in the recent past. What is needed is a discussion, under the auspices of the International Monetary Fund, on the principles governing the policies affecting exchange rates. This will not happen. Instead, Mr Abe's economic nationalism may clash with that of China. When elephants fight, the grass suffers.

The risks of domestic and external destabilisation are indeed large. This is painfully clear. But Japan had to break out of its malaise. It could well still do so. But it will only achieve ultimate success with a structural transformation: it must shift income from corporations to shareholders, the government and wage earners. Higher real wages, lower depreciation allowances, higher taxation of retained earnings and much bigger dividends are needed, in the longer run. Ultimately, Mr Abe cannot rely on monetary manipulation and a weaker exchange rate alone. He must tackle Japan's entrenched corporate establishment. That would be a real revolution. Will he try? Alas, I still greatly doubt it.

Copyright The Financial Times Limited 2013

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