If ever there was a country that illustrates the bizarre economic conditions the world finds itself in, it’s Japan. Usually when a country’s central bank cuts interest rates, its currency weakens, making it easier for businesses to sell goods and services abroad as well as providing incentives for banks to lend. Both are supposed to increase economic growth. Except the old tricks of the global economy aren’t working like they used to, and Japan is the best case in point.
For years now Japan—which has struggled through more than two decades of stagnation—has had interest rates hovering near zero. Recently, policymakers decided to go a step further and cut them into negative territory in order to stimulate the economy. This was intended to generate new tailwinds for “Abenomics,” the much lauded economic-reform plan developed by Prime Minister Shinzo Abe to try to end his country’s two-decade stagnation and bring it back to more robust growth. The problem is that almost immediately after Japanese central bankers cut rates, the currency strengthened, rather than weakened. The Japanese stock market, which is relatively cheap compared with those of other developed countries, fell. So much for conventional economic theory.
What’s going on here? Is this merely the end of Abenomics and bad news for Japan’s Prime Minister? Or does Japan hold uncomfortable lessons for the rest of the world? The answer to both is yes.
Abenomics was never really what it was cracked up to be. Abe’s plan boasted “three arrows” of change: First, a stimulating monetary policy in the form of low rates and “quantitative easing,” or asset buying of the kind that the U.S. Federal Reserve engineered successfully in the wake of the 2008 economic crisis. Second was fiscal reform, including tax reform. Third, and perhaps most vital, was structural and corporate reform. Despite an ample supply of educated and skilled workers, Japan still has a highly regulated and insular corporate sector, which makes it tougher to raise productivity and wages, the catalysts for economic growth.
The problem is that only one arrow in Abe’s quiver ever really hit the target, monetary policy. As in many other parts of the world, the sugar high of easy money actually made governments and companies less likely to do the hard work of fiscal and structural reform—especially in a country as intrinsically conservative as Japan. They were able to rely on cheap money rather than real, underlying innovation and long-term growth to keep the economy afloat.
Now the high is crashing. As a recent BNP Paribas analysis put it, “Interest rates in Japan are so extremely low that further reductions will only have a marginal impact on the spending behavior of corporations.” Easy monetary policy—not only in Japan but also in many other parts of the world—has reached the point of diminishing returns. In fact, negative interest rates are even starting to harm, rather than help, the Japanese economy.
As BlackRock global chief investment strategist Russ Koesterich puts it, “Negative rates imposed by the central bank are being seen as a tax on the banking system.” Banks simply can’t make money on deposits these days. Rather than trying to lend more to compensate, they are simply making credit less available and more expensive. That, of course, makes it harder for businesses to raise new capital, invest and grow.
Why anyone expected anything less amazes me. Most global banks now rely on trading, not lending, as the business model of choice. There’s little reason to think that would change in an economic downturn; quite the opposite, since lending isn’t all that profitable compared with trading.
For Japan, the result of all this is as clear as it is discouraging: more stagnation. The country’s real GDP contracted yet again in the fourth quarter of last year. Put plainly, things will not get better unless major fiscal or structural reform is made.
For the rest of the world, this drama offers important lessons. The U.S., the E.U. and even China continue to rely on monetary policy to buy time for policymakers to make real changes in underlying economic models. But that involves the hard work of reaching broad agreement around issues like tax and financial reform, debt management, corporate governance. Look around: it’s not hard to be skeptical of such reform happening anytime soon.
That leaves Japan—once again—as a distressing cautionary tale about what happens when economies don’t follow through on the real reform they desperately need. It’s a tale Western policymakers should study closely.
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