Bold New Stimulus Plan for Japan: Will It Work?
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By Knowledge Wharton,
Knowledge@Wharton
February 14, 2013

Newly elected Prime Minister Shinzo Abe wants to take Japan's economy in a daring new direction to pull it out of two decades of stagnation and deflation. It turns out that his policies closely resemble past efforts – but he wants to put far more firepower behind them this time.

He aims to relax already very loose monetary policies and sharply raise government spending to boost demand. Some analysts say it's just the medicine Japan needs and, on the spending side at least, the opposite of what Europe and the U.S. are doing. But Wharton finance professor Franklin Allen, in an interview with Knowledge@Wharton, says the plan carries serious risks and could even lead to a big meltdown. And while the new policies may help in the short run, they won't combat the serious structural problems that have sapped Japan's competitiveness.

An edited transcript of the conversation follows.

Knowledge@Wharton (K@W): With the recent election of Prime Minister Shinzo Abe, there has been a fairly dramatic change in economic policies, which he telegraphed ahead of time. It looks like it's a reaction to a long-term trend in Japan that is pretty well known – 20 years of economic stagnation, deflation, and lately, a loss of competitiveness. Fiscal stimulus and loose monetary policies have been tried many times in Japan over the years, but a lot of critics say these were half-measures in the case of monetary policy, and that the stimulus was withdrawn too soon before it was actually able to jump-start the economy. This time, it looks like a real shake up. I'm wondering if you see this as a huge change in direction and what you think will happen as a result.

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Franklin Allen (FA): It raises an interesting question: If something doesn't work very well, what should you do? Should you try something else, or should you try harder? Up until now, the conclusion has been that we should try something else. And now, Prime Minister Abe has brought back the issue of, Well, let's try harder at what we did and try again.

Part of that is driven by what the Japanese see going on in the U.S. and in Europe, where we have central banks essentially going out and, in the case of the U.S., with [quantitative easing], buying large amounts of bonds on a regular basis and printing money to do it. And in Europe, in the ECB (European Central Bank), we see with the outright monetary transaction program the potential for the ECB to also buy out very large amounts of government bonds.

The interesting thing is that in the U.K., there's now begun a discussion – since they've also had quantitative easing in fairly large proportions, and the Bank of England holds a great deal of government debt on its balance sheet – about the next step. Fairly serious people there, such as Lord Adair Turner, the head of the Financial Services Authority, have suggested that they go one step further. If you go out and print money to buy bonds, why not take it another step and go out and print money and give it to people and monetize the debt?

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In Japan, they haven't gotten that far yet. But Prime Minister Abe wants to start giving the Bank of Japan a much higher inflation target – 2 percent rather than the current 1 percent. He also wants to have fiscal stimulus and to have more bond buying, more purchase of assets by the Bank of Japan. What will be the effects of these actions? If you do it in small amounts, it seems as though it doesn't have that much of an effect. [Fed] Chairman [Ben] Bernanke has argued that it's had very positive effects – on things like employment and the output of the economy. 

Knowledge@Wharton

One of the other views, which Governor Shirakawa put forward at the IMF meetings back at the end of last year, was that this quantitative easing has an effect, but it has a big effect on emerging economies. If we look at what's happened in Brazil, there has been a huge run up in asset prices. The currency has strengthened a great deal, and that put their manufacturing sector under tremendous strain. And growth in Brazil is now stopped. So, there are these effects within the economy, and there are also effects globally.

Exactly what kind of an effect will happen with Japan remains to be seen. I think we've already seen a very large change in the exchange rate, much larger than we've seen for some time in Japan [the yen has dropped some 9 percent over the last six weeks]. I presume that is not in response to the moves the Bank of Japan has already made, because those have been relatively small. They've promised to try to get inflation up to 2 percent as soon as possible, whatever that means. The bond buying program that they announced is going to be starting in 2014, so it's some time away. And by and large the measures that actually were announced were not that big. But I think what the markets are probably expecting is a new claim coming in that will do radically different things in terms of all these measures.

The real problem is that although in the press people talk about these things as though it's turning a dial, it's not really like that. And we're in a lot of uncharted waters. We don't know what happens if you have these long-run bond buying programs. It seems as though they haven't been too successful in Japan in the past. Maybe they didn't try [hard] enough. But there is, as you mentioned, a long loss of competitiveness among many Japanese companies.

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If you look at companies like Sharp and Panasonic, it's not at all clear that these companies, which 10 to 20 years ago dominated their industries, are going to be able to survive. A part of this is these monetary measures have pernicious long-term effects. If we try them even harder, we may have inflationary effects. We don't really know what will happen. As I say, in the U.K., they're talking about printing money and handing it out to people. In Japan, it will be interesting to see how soon, if ever, they get to that point. But they're really out ahead of [the U.S.]. Everybody has been saying, 'We don't want to be Japan.' But it looks as though most countries are following [its] slow growth and economic stagnation. We're now five years into the crisis at least and we're still not doing very well... But that's with huge monetary stimulus and significant fiscal [stimulus]. In the eurozone, they have significant monetary stimulus, not fiscal stimulus, but they are, of course, shrinking.

K@W : You said the U.S. and Europe seem to be following Japan's old policies. What are those policies that have created conditions in Europe and the U.S. similar to what Japan's been seeing over the last 20 years?