Japanese Economy Proof Abenomics Is Working

Japanese Economy Proof Abenomics Is Working

Be it a weak jobs report, anemic GDP growth numbers, political gridlock, or a government shutdown, the list of headwinds against economic growth is a mile long. Time and time again, a piece of bad news will rack capital markets with uncertainty and dampen hopes of a recovery. It's a narrative that's become all too familiar in the United States.

Post-recession, the world's largest economy struggled to carry a global recovery plagued with the mistakes of bad governance. In this desert of pessimism, investors should look to Japan as their oasis. The country remains an economic force with the power to revitalize growth in Asia as well as the rest of the world.

Since his return to the prime minister's office, Shinzo Abe's quixotic attempt to revive the Japanese economy has garnered both admiration and admonition. His vision for Japan's comeback, the succinctly titled "Abenomics," hinges on three distinct "arrows":

  1. Looser monetary policy to devalue the yen and increase exports.

  2. A fiscal stimulus, mostly for public works, infrastructure, and similar projects.

  3. Structural reforms that increase competitiveness.

The goal of the plan is to finally extricate Japan from its two-decade affair with stagflation. In doing so, it also aims to unleash the potential of the world's third-largest economy.

Japan in crisis
During the 1970s and 1980s, Japan's economy soared to new heights. It elevated its standard of living and cemented itself as an engine of innovation and creativity. By the early 1990s, however, a culture of speculation pervaded the market and ended with a spectacular collapse of the asset price bubble. What followed was a decade (1991 to 2000) devoid of growth, consumer confidence, and aggregate demand. This period of Japanese history came to be known as The Lost Decade. What happened in Japan is an anomaly of economics: a scenario economists refer to as a "liquidity trap."

A country enters a liquidity trap when the central bank has exhausted its supply of tools to stimulate the economy. When short-term interest rates are near zero, more money has been printed, more bonds have been bought, and the economy still drags along, the country has entered the largely uncharted waters of a liquidity trap. Everyone starts hoarding cash because it's the safest thing to do. No one wants to be the first person to put their cash on the table.

Monetary and fiscal stimulus
As far back as 1998, economist Paul Krugman identified that Japan was in a liquidity trap. He concluded that the only way to treat the economic malaise was to raise inflation expectations. If consumers believed their money would be worth less in the future, it would incite them to spend more in the short term. Higher expected inflation would be factored into the nominal interest rate, forcing businesses to invest while the rates remained low. Of course, the trick is not to scare everyone so much that they doubt the future value of the currency, as hyperinflation can devastate an economy for a generation. Abenomics's dual monetary and fiscal-stimulus programs are designed to tread that line with care.

The face of monetary stimulus in Japan is similar to the Federal Reserve's quantitative-easing program. In April, the Bank of Japan committed to more than 7 trillion yen in bond purchases per month while targeting an inflation rate of 2%. Earlier still, Abe's cabinet devoted 10.3 trillion yen to public-works projects designed to invigorate the construction and manufacturing industries. If the central bank communicates its tolerance for moderate inflation effectively, investors will demand higher interest rates for the increased government spending. Investor sentiment is hard to predict, so just the imminent danger that they would demand higher rates should convince businesses to invest.

Keeping it balanced
In trying to manipulate so many market actors, Abe's government runs the risk of appearing irresponsible. To maintain credibility, the prime minister declared an increase in the consumption tax from 5% to 8%. The proceeds will largely be used to finance corporate tax cuts, however. So it's actually just a clever move to signify a commitment to fiscal consolidation without actually taking money out of the economy. Moreover, a devalued yen would boost exports and strengthen investor confidence in the country's economic prospects. That is in itself a natural counterweight to deliberately spooking the market.

The reforms package
Both the monetary and fiscal programs have widespread support from international investors and economists. Abe's critics, however, point to the third arrow -- structural reforms -- as the weak link. It involves deep changes to the institutional fabric of Japanese society, a feat requiring no small amount of political courage. Key priorities on the docket are trade liberalization, health care reform, overhauling employment laws, and creating specialized zones for economic activity.

Details of the plan have yet to be revealed, but Japan's new commitment to the Trans-Pacific Partnership is an encouraging sign. The free-trade agreement aims (among many, many other things) to remove Japanese import tariffs on agricultural goods such as rice or beef. Incidentally, the powerful agriculture lobby has been among the most vocal opponents of Prime Minister Abe.

Is it working?
This week, Bloomberg reported that Japan's gargantuan pension fund "isn't ready for Abenomics." The fund managers are complaining of overexposure to interest rate risk and trying to diversify away from government bonds. According to the article, some members wanted the fund to "add new assets such as real-estate trusts, infrastructure, and private-equity investments and commodities."

Maybe it's jut me, but I think that's a positive sign. Re-evaluating the fund's investment objectives and parameters may be a nuisance for its managers, but that's hardly the point. Guiding capital into more productive assets is great for the overall Japanese economy.

Ultimately, the long-term success of Abenomics will lie in the depth and breadth of structural reform. America's history has shown that the machinery of capitalism works best when unfettered by trade barriers and excessive regulation. But maybe Japan will show America that proactive government is the grease the machine needs to run smoothly.

Investments around the world
With the American markets reaching new highs, investors and pundits alike are skeptical about future growth. They shouldn't be. Many global regions are still stuck in neutral, and their resurgence could result in windfall profits for select companies. A recent Motley Fool report, "3 Strong Buys for a Global Economic Recovery," outlines three companies that could take off when the global economy gains steam. Click here to read the full report!

The article Japanese Economy Proof Abenomics Is Working originally appeared on Fool.com.

Gaurav Seetharam has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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