Japan: Abe’s Exchange Rate Strategy Failed

While the yen has massively lost in value against the key currencies of the world, Japan’s exports have not grown significantly. How come? The reason lies in the industrial structure of Japan’s exports.

Like Germany, most of the goods Japan exports are highly specialized and sophisticated. They are sold based on quality and performance – not on price. Thus, they are price-inelastic.

All that has happened is that Japanese companies have used the weaker yen to boost their yen-denominated profits. That has helped boost the Nikkei stock index – but has not led to any gains in their international market share for Japanese companies.

The expected export of deflation to the rest of the world has not – yet – happened. It won’t be long though. The weaker yen puts increasing pressure on other exporting countries like Korea and China to lower the price of their currencies as well.

Germany benefits in this context from being part of the Eurozone. Given the new efforts of the ECB to become a little bit “Japanese,” the euro has tended to weaken since this past summer.

Imports to the rescue?

On the other hand, import prices in Japan have surged significantly. The country is a big importer of commodities and has had to pay more for them in yen terms, given the weakening of the exchange rate.

On the surface, this has led to the intended increase in inflation. In fact, the Bank of Japan might well reach its target of 2% inflation in 2015.

However, the side effect of these rising import prices is highly negative in macroeconomic terms. It leads to lower real incomes for the private households – a far cry from boosting domestic demand that the Keynesians in Japan and elsewhere are aiming for.

Of course, the solution would be higher corporate spending. Corporations could spend more on higher wages. That would support domestic demand and could be justified by the upcoming scarcity of labor.

Alternatively, corporations could spend more on investments to support productivity growth in order to stem a continued decline in Japan’s working-age population.

Taxation over investment

But why should companies invest? Japanese companies, like their counterparts in Europe, have no incentive to invest at home, given the outlook of a shrinking population and low economic growth.

Investment and innovation are risky and it is therefore rational for firms to focus on, first, optimizing the existing capital stock and second, investing in those regions of the world which will show higher growth rates in the decades to come.

Of course, there is always taxation. It is clearly not acceptable that the corporate sector is a massive net saver, while the government — and soon private households — run significant deficits.

If Japan’s government now (and Europe’s later) wants to change this behavior, it could start taxing corporations more aggressively. In a nutshell, any profits which are not used to make investments would be taxed at a higher rate.

Given the continuing international opportunities for companies to shift their profits from one tax locale to another, this is improbable – an experience shared by Europe and the United States as well.

This is why the Japanese government has opted to increase the taxes that it can control. Hence the inclination to raise the sales tax. But in doing so – even if Abe now plans to postpone the next hike – he amplifies the problem of suppressed domestic demand. Abenomics will not break through the wall this way.

What next?

Japan’s government and the central bank have doubled down on their efforts in the last weeks, announcing even bigger quantitative easing. A debt restructuring seems not to be a political option and growing out of the debt problem does not work. So Japan seems to be trying a new approach of fixing an unsustainable debt overhang.

The Bank of Japan will buy an ever increasing share of government bonds, i.e., monetize the debt.
Then the debt could be seen as being owed to oneself – and therefore not being relevant anymore.

However, that is a spectacular exercise of circular logic, given that both the government and the bank “belong” to the people of Japan.

The bank could wire back the interest it receives in the millisecond it is paid and prolong the debt forever. Result: the debt problem of the government is resolved. No one loses any money, as the savers don’t hold any more government debt but other assets like stocks and corporate bonds. Problem solved.

Weimar-style economics

These ideas are not new. Already a few years back, a discussion started in the UK to cancel the government debt held by the Bank of England, as the bank is part of the government anyhow.

Critics see this as a step towards “Weimar”-style economics. They refer to the German hyperinflation in the 1920s, when the central bank funded ongoing government deficits for several years.

Others say that the risk is low if it is a one-off move. As they see it, the central bank just has to make clear that it will not repeat this in the future.

That is an assumption which can easily be challenged, given the temptation that the pursuit of such a policy would have for politicians. If the public were indeed to lose trust in money, that would without a doubt generate significant inflation.

In Germany’s Weimar period, everyone knew that the central bank was funding the government. For a while, this happened without any significant inflation and instead featured solid economic growth and full employment. But once the trust in money started to erode, unstoppable inflation took place.

A risk for Japan as well?

Little wonder then that Japanese pension funds have already decided to reduce their exposure to Japanese government bonds and to invest in other assets, notably stocks in Japan and globally. This decision is very smart, as it assures that true value will be preserved in case of a monetary collapse in Japan.

Japan has not been a role model for how to deal with an economic situation of over indebtedness and deteriorating demographics.

Now it will show us the endgame of debt-based politics. Its options come down to this: bankruptcy, hyperinflation or a miraculous accounting trick that works. The world should hope for the last, but – like the Japanese themselves – better prepare for the others.