China Research

In the third quarter, Japan’s economy tumbled again into a recession. “Abenomics” – i.e. the economic program of prime minister Shinzo Abe (LDP) – proved to be a failure. Expressed very briefly, “Abenomics” means that the Bank of Japan (Nippon Ginko) two years ago was committed to massively print money in completely uncharted waters in order to combat the long-lasting deflationary problem.

Furthermore, Abe wanted to do something about the excessive government debt (more than 240 % of GDP), for example by raising the VAT from 5 to 8 last April – a measure that obviously contributed to the current recession and made Japanese consumers even more reluctant. For this reason, another planned VAT hike has been postponed.

Bad advice

One of the intellectual fathers of “Abenomics” was Nobel Prize winner Paul Krugman who during a long time had complained about Japan’s “irresponsible monetary policy” (and who also had accused the Swedish Riksbank for a similar failure – and who, unfortunately, has quite a number of supporters among Swedish academics and financial analysts). The idea of the whole experiment was to print money in borderless amounts for government expenditure – government expenditure that should give positive multiplier effects on consumers and private corporate investors. Furthermore, some inflation should be created this way.

Today, it seems to be obvious that the Krugman-/Abe-experiment has failed. Extreme monetary expansion cannot work in the long run and never replace a structurally well-founded growth/supply side policy. If it was that easy…Something to remember in Sweden and in Frankfurt (ECB) as well.

It would be good idea if the world listened less to Krugman and consortes. With quite some luck, the previous monetarization in the U.S. by the Fed may be managed without major distortions. Janet Yellen understands economics. But Japan and Europe (ECB; Sweden included) function quite differently and have probably very different reactions functions for increased liquidity.

M x V = P x Q

Old fundamentals may help. Let’s for example, look at Irving Fisher’s so-called “equation of exchange” (1911): M x V = P x Q (M = money in circulation, money supply, V = velocity of money circulation, P = price level, Q = expenditures in real terms).

In our context, V, P and Q are the interesting variables. V stands for the average frequency that one unit of the currency/money is spent. An important point in this context is the fact that the “equation of exchange” is an identity equation which means that it is always valid whatever number you put in it. Consequently, the new number for V is not known in advance when M is changed. The same can be said about P (inflation) and Q. These simple facts make the effects of strongly extended money supply uncertain and, consequently, the whole basket of different kinds of quantitative easing (QE) – an instrument which central banks so actively apply these days or intend to use as an instrument for better growth and higher inflation (the Riksbank, unfortunately, included).

Now, in order to make the whole process of monetarization work, it is necessary that the velocity of money circulation increases visibly. Consumers and investors should be willing to spend more money more rapidly. And here we come finally to the point: consumers and investors must believe in the future. This is about behavioral economics.

Behavioral economics needs more attention

In the Japanese case, this necessary condition for a successful expansion of the money supply is not there. The Japanese are not showing enough confidence in the future. This is why any continuation of Abenomics will fail again under current structural conditions. A new policy failure – and the economic outlook for the currently third largest economy in the world will worsen much more.

In this case: at some point – within the forthcoming decade – negative contagion from Japan on other Asian countries and the whole global economy could happen. Consequently, the next Japanese government has to think more about giving real confidence in the economic future. So far, 25 years have gone without positive results. Institutional economics and the lack of behavioral studies explain a lot of this ineffective economic policy.

Economic history tells us that printing money and other liquidity-creating measures never really could cure long-term problems in the real economy.

This is indeed an important experience that academic researchers, decision-makers in central banks/governments and on financial markets should remember more actively.

 

Hubert Fromlet
Senior Professor of International Economics, Linnaeus University
Editorial board

 

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