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.
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