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Abenomics and the Japanese wealth gapNaomi Fink – CEO, Europacifica ConsultingNovember 2013

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Intro: A framework to examine Abenomics

In the early days of the Abe Administration, public (and market) expectations appear to be riding high

What are the chances the public will be disappointed?

Hint: in order to estimate this, we need to agree about what we expect from Abe, as well as what we expect from the rest of the world

What are the implications for the conduct of policy given these expectations?

What are the implications for welfare (aggregate or relative) if Abe’s policy succeeds or fails?

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What can we expect from public policy?

We assume that elected policy-makers attempt to maximisethe welfare of their electorate (or at least minimise the loss), if only to remain in office.

Most OECD governments, even those with purported “free market” platforms, not only care about aggregate welfare, but also relative welfare (to some degree) and thus some form of redistribution (transfers, national insurance, pensions, tax progressivity, etc). Example: OECD notes that social transfers allayed much of the shock to market income from GFC

Devising a redistribution rule that leaves nobody worse-off is a tough proposition.

The attractiveness of Reaganomics/Thatcherism came alongside the image of the “rising tide” (aggregate growth) that “lifts all boats”.Did it? Possibly not, but it mattered more at the time whether we believed it would.

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Framework for examining public policy

Setup of the policy problem:

To stay in office, governments will make policy promises tominimise welfare losses (and thus stay in office)

Circumstances will often lead to temptation to shift policy togain a more optimal result, abandoning commitment

If the public perceives that temptation is greater than thepolitical cost of breaking promises given (a) particularoutcome(s), they shift their expectations such that theimplemented policy may no longer be optimal (enforcement)

Policy with commitment is more likely when the cost ofenforecement outweighs temptation to deviate

Incomplete markets mean there exists uncertainty…

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A few sources of uncertaintyEconomic cycles

Probabilities associated with welfare gains/lossesassociated with economic fluctuations

ExternalitiesNatural disastersGeopolitical riskEconomic crisesOverseas investment flows/foreign exchange

Asymmetries“Disorderly” inflation risk is greater than welfare lossassociated with deflation

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What does this mean for Abe?We need to estimate all of these factors if we want to answer our initial questions on Abenomics!

We can use Reagan/Thatcher policy examples for qualitative comparison/contrast(since we know outcomes) in doing so.

Source: http://www.kantei.go.jp/

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What can we expect from Abenomics?

Expectations: So far, things look good for Abe: early gauges – market signals (stock market, yen) show positive expectations

Problem: Some probability for implementation to diverge from expectations (no commitment), and if potential divergence is too far, this means loss of credibility. Is the cost to the Abe administration of credibility loss (eventual regime change) greater than the temptation to deviate from reform promises?

Sources of Uncertainty: Asymmetrical credibility risks (especially for the BOJ) Externalities: e.g. US monetary policy, Chinese growth, crises in the rest of the world

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What do these possibilities mean for the wealth gap?

Although cutting capital taxes are a fairly robust way to maximise future aggregate consumption growth and thus aggregate welfare (e.g. Chamley, Atkeson/Chari), cutting capital taxes too radically can widen welfare gaps (Conesa/Kitao/Kruger, Marcet/Mila/Ventura)

If implementation succeeds, it is possible that the wealth gap widens, in the absence of income transfers (either implicit or explicit)

This is one area in which comparing/contrasting Abenomics with the policies of Reagan and Thatcher may be useful

If implementation fails, it is possible that Japan continues to “spread the disutility” – deflation is not only damaging to debtors, it is regressive without fiscal adjustments

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Japan’s wealth gap: “spreading the disutility”

..Yet deflation is regressive –high-capital earning retirees gain more in deflation years

High income earners are getting no richer… but poor are getting poorer

Source: http://www.oecd.org/

2200000

2300000

2400000

2500000

2600000

2700000

2800000

2900000

3000000

1985

1995

2000

2003

2006

2009

Median disposableincome (constantprices)Mean disposableincome 65+ agegroup

1.71.81.9

22.12.22.32.42.52.62.7

1985 1995 2000 2003 2006 2009

P90/P50disposableincome decileratio iP50/P10disposableincome decileratio i

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Post Crisis: Wealth gap shows why OECD fears Japan-like pattern

Japan is still in the disutility-spreading minority

But transgenerational gap is growing across OECD

Source: http://www.oecd.org/

Source: OECD Income Distribution Database (www.oecd.org/social/income-distribution-database.htm)

5. Poorer households tended to lose more or gain lessAnnual percentage changes in disposable income between 2007 and 20101, by income group

Notes: See notes to Figure 1. Information on data for Israel: http://dx.doi.org/10.1787/888932315602.

-15%

-10%

-5%

0%

5%

Icelan

d Mex

ico

Greece

Ire

land

Estonia

Spa

in Hun

gary

New Zea

land

Italy

Turke

y Ja

pan

United

King

dom

United

Stat

es

Portug

al

Netherl

ands

Luxe

mbourg

Norw

ay

Austra

lia

Sloven

ia Fran

ce

Korea

Belgium

Czech

Rep

ublic

Den

mark

Finlan

d Isr

ael

German

y Can

ada

Austria

Swed

en

Chile

Poland

Slovak

Rep

ublic

OECD-33

Total (↗ )

Top 10%

Bottom 10%

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Identifying Policy Parameters

First steps: we can identify Reagan/Thatcher expectations and outcome and find policy

analogues for Abe

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Commitment, under Reagan and Thatcher

Reagan/Thatcher ideologies mostly comprised:Rhetorical/ideological commitment to monetarist policies, pressure for central bank to fight inflation (not to monetise debt) and (in Thatcher’s case) rejection of Keynesian policiesReagan: Emphasis on capital tax cuts and elimination of progressivity of inflation, reallocation of spending to defenceThatcher: Emphasis on deregulation of industry and privatisation – “structural” reform

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Use potential outcomes to identify policy paths….

Actual outcomes for Reagan/Thatcher:Perceived commitment to their respective policy paths, independent of popularity of these policies. Temptation<Enforcement

Reagan: capital tax cuts and reallocation of government spendingThatcher: deregulation of labour and numerous government privatisations

Inflation, high at first in both areas decreased (possibly thanks to the Volcker Fed’s commitment)Economic growth (one measure of welfare), anemic at first, picked up by the end of both administrations (no definitive causality)Fiscal, policy, structural consequences:

US government debt/GDP swelled, UK debt/GDP subsidedThe “great moderation” in inflation continuedGreater wealth gap at the end of Reagan/Thatcher regimes

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Plus lower-probability (now 0%)events, for example…

Stagflation: Volcker Fed fails to maintain credibility, falls prey to asymmetric inflation expectations, fails to subdue inflation, unemployment remains high and real incomes drop within Reagan’s two terms; cost: welfare loss, risk of regime change (for Reagan, possibly for Thatcher)Reagan: Capitalists show scepticism over Reagan’s corporate tax cuts (perceiving temptation>enforcement), fearing budget-balancing hikes in the future (in actuality, Reagan did hike 11 times). Growth fails to pick up; cost: perceived welfare loss, risk of regime change

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Plus lower-probability (now 0%)events, for example…

Thatcher: budget hike fails to quell investor concerns over the UK government budget (clashes with BoE seen as loss of central bank autonomy sabotaging inflation-fighting credentials), UK sees flight of capital and forced austerity is imposed; cost: perceived welfare loss (rise in rates, drop in transfers), risk of regime changeThatcher: deregulation of labour loses traction among voting populace and reform is diluted (optimal, but time inconsistent policy), companies fail to increase hiring activity, unemployment remains high; cost: failure of welfare improvement, regime changeReagan: Failure to negotiate an increase in the debt ceiling (raised 18 times under Reagan), compelling renewed, unpopular tax hikes, forcing reversal of prior cuts (time inconsistency). cost: perception of default, regime change

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Commitment, for AbeMonetary: Rhetorical/ideological commitment to monetarism (Deflation-fighting) without rejection of Keynesian policies.

The above poses a time-consistency question for the BOJ’s monetary policy in its willingness to reflate, then in its ability to subdue eventual inflation

Fiscal: expectations for fiscal easing within the cycle, expectations for eventual fiscal tightening (consumption tax hikes, goal to halve the primary balance surplus). No expectations either for aggressive moves either way

Structural: Expectations for reallocation of government spending to create labour reallocation incentives; slight expectations for prouctivity-enhancing capital reallocation incentives (Japan Post privatisation, TPP, SEZ’s) but potential for temptation>enforcement here

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Use potential outcomes to identify policy paths

Potential outcomes for Abe (examples):“Good” Global markets continue their rally, driving reflation in asset markets, spilling over to Japan. Yet global inflation remains low enough for the Fed to withdraw accommodation amid low inflation expectations. The BOJ leaves stimulus in place until 2% is in sight, and slowly withdraws in an inflating market, while reflation allows Abe’s regime to survive long enough to embark upon structural reform while inflating away existing debt. 17

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Use potential outcomes to identify policy paths

“Bad” The rally in global markets proves ephemeral and the Fed leaves policy accommodation in place for longer than originally expected. Japan remains mired in deflation, as BOJ’s “commitment” to reflate the economy is not seen as strong enough, in a situation of ongoing global stagnation. Without reflation, Abe is unable to deliver on even the mild structural reforms the market expects. “Ugly” Markets lose confidence in the FOMC’s commitment to keeping inflation under control, and inflation expectations spiral uncontrollably. The BOJ, tarred by the same brush as the Fed, fails to enforce its 2% target on the upside, and is left to hike rates after prices have already zoomed. Failure to boost productivity in the services sector results in lagging wage inflation even as wage rigidities contribute to higher unemployment; meanwhile consumer savings are inflated away alongside government debt balances.

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Potential outcomes for the welfare gap (examples)

“Good/Good” The rally in global markets assists capitalists, who redeploy profits and create jobs, while inflation enforces the greater progressivity of income tax brackets even as consumption tax increases are imposed. Tax receipts rise and transfers are directed to reinforcing the social safety net, facilitating implementation of labour reform and further structural reform; aggregate growth improves the situation of all and redistribution (via monetary and fiscal policy, transfers) keeps the wealth gap in check“Good/Bad” Global markets continue their rally and give rise to modest inflation, yet the combination of higher income and corporate tax revenues are insufficient to fund new transfers. To appeal to capitalists (and reverse progressivity), the government inflation-adjusts tax brackets. Interest rates rise, forcing the government to inflate away existing debt balances but reducing their capacity to establish a social safety net. Support fails to crystallise either for labour reform, trade liberalisation or other productivity-boosting measures. The wealth gap widens without structural reform

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Potential outcomes for the welfare gap (examples) II

“Bad”/Good” Reflation persists for a period, but the BOJ reacts too early or aggressively and its 2% target loses credibility. However, due to a healthy global market abroad, the government is able to inflate away a large enough portion of debt to regain credibility in its efforts to regain primary balance. The BOJ’s failure to monetise debt moreover reinforces credibility in the government’s improved fiscal condition; while Japanese growth under-performs, some productivity-enhancing structural reform takes place. Aggressive cuts to capital taxes do not take place, thus allowing mild reflation to introduce a greater degree of tax progressivity.“Bad/Bad” The global market rally falters and Japan falls back into deflation. Structural reforms fail to be implemented, and the government remains constrained in its fiscal maneuver; while the BOJ’s policy is time-consistent with regard to fighting inflation, it cannot be consistent in fighting deflation and it is the government’s debt-monetisation pressures that suffer from lack of credibility. The slow erosion of aggregate and relative welfare (thanks to lack of adjustment of tax brackets) continues.

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Potential outcomes for the welfare gap (examples) III

“Ugly”/Bad Inflation surges far above the BOJ’s 2% target and despite the tax-progressiveness of inflation, languishing productivity fails to keep wage growth in line with inflation on aggregate. The ability for firms in certain sectors to innovate (manufacturing, IT sectors) and thus reduce costs contrasts starkly with those who cannot (services, in which 70% of the labour force is employed) and aggravates the two-speed economy, widening the wealth gap along sector lines. The services sector fails to maintain its function of absorbing capacity spillover from the more productive manufacturing sector. The government inflates away debt but its credibility damaged, is unable to spend a sufficient amount to establish an adequate redistribution rule. “Ugly/Ugly” inflation spirals out of control and depositors dump the yen and capital flight ensues. Those who get out in time retain a far greater part of lifetime wealth.

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Assign probabilities to each scenario, solve backward…

If we can do this in a manner that reflects public opinion, we can estimate the distribution of risks (to the upside and downside) to welfare that will dictate the credibility of the Abe administration in its ability to carry out its stated policy goals. By setting relative wealth as the welfare measure, we also estimate the risks to the welfare gap – to the upside and downside, as a function of how the public is likely to react in each scenario (weighted by likelihood, of course). 22

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Recovering First Best

We want the optimal outcome, and if only to remain in office, so does Abe. How do we get

it?

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Back to the “Three Arrows”Fiscal policy

The policy: Promising reflationary growth alongside maintaining fiscal discipline is by nature a tough proposition. With little room to ease, they are reliant on the BOJ to offer monetary stimulus (which can be time-inconsistent). Mentions of potential corporate tax cuts gain a lukewarm reception. Consumption tax hikes may reinforce fiscal credibility but are seen by many (e.g. IMF) as insufficient. Is it optimal? The risk of jeapordising the BOJ’s credibility is not optimal. There remains “temptation” either for the BOJ to give up its 2% target or for the government to abandon goals to halve the primary balance deficit by 2015

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Back to the “Three Arrows”Monetary policy

The policy: Stock and foreign exchange markets tell us they rate the Kuroda BOJ’s 2% inflation target and stepped up asset purchases, but to some extent, this rally is driven by cyclical recovery in Japan and abroad, supported by the Fed’s monetary policy.Is it optimal? There is asymmetric risk of inflation surging out of control. So long as everybody believes the probability of this event is extremely low this policy could be optimal.

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Back to the “Three Arrows”Structural reform

The policy: Carrying through a partial privatisaton of Japan Post. Pursuing experimental labour and capital reform through special economic zones, with emphasis on specific sectors. Trade liberalisation(TPP) seen as one avenue to bolster productivity.Is it optimal? Most likely too early to tell and path-dependent. As the Koizumi administration learned, reflation makes structural reform more palatable to voters. For now, substantial risks remain in the timing, as well as the temptation to deviate from promises of more aggressive reforms.

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Comparison to Reagan/Thatcher

Platforms: Monetary: Reagan reinforced inflation-fighting activities from Volcker’s Fed while Thatcher used fiscal policy to subvert BoE power to fight inflation.Fiscal: Reagan voiced commitment to tax cuts; Thatcher to spending cuts (alongside some income tax cuts) - overall fiscal tightening.Structural reform: Reagan’s fiscal reform credentials overshadowed regulatory; Thatcher’s platform focused around privatisations and labourderegulation

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Comparison to Reagan/Thatcher

Commitment: perception of time-consistent policy kept both in office

Was it optimal? Monetary: The Fed’s ability to keep inflation in check has been lauded, but there remains no proof that this policy was by nature optimal (Primiceri paper)Fiscal: Laffer curve dynamics (espoused by Reagan especially in justifying supply-side policies) do not actually differ so greatly in Japan and the US.. Corporate tax rates are comparable, bases are narrowStructural: Thatcher’s reforms were credible – some argue optimal on aggregate; many argue sub-optimal when examined with respect to relative wealth.

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Reagan Thatcher & inflation cost: Too great to deviate?

Good luck: One massive difference is that the US/UK were in an enviable position when in regard to monetary policy – they were in a position to tame the huge inflation created in the 1970’s by the Oil shock.

High inflation risk also meant high cost of deviation: the cost of losing credibility on inflation-fighting was likely perceived as much greater than the temptation to re-optimise policy to give rise to interim growth

Would Fed policy have worked under different conditions?

Primiceri results give rise to scepticism

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Even Volcker’s activism is questioned in retrospect“Too loose” policy in 70’s &

80’s vs activist in 90’sBut Primeceri questions Fed

activism effect

Source: Cogley & Sargent (2003)

Source: Primeceri (2005)

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For Abe, structural reform is contingent upon…

Successful monetary policy – money is neutral long-term, but reflation is a pre-requisite to structural reform

Credible fiscal policy – nobody expects the world from Abe, given limited range of maneuver, so refraining from aggressive fiscal tightening may be as much as we can hope for. Still, Japanese debt holders perceive risk of Japanese default, so “temptation” to deviate from primary balance targets is substantial.

Good luck – “Goldilocks” growth in the US and “just right” accommodation from the Fed, attenuation of Europe crisis risks, etc

Structural reform will remain, in retrospect the true measure of Abenomics’ success

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Structural Reform and Productivity

Can Abe attain Japan’s post-bubble holy grail of policy?

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Potential for Structural Reform in JapanVia structural reform, we strive to maximise the contributions of factors of production

Capital: Japan’s capital/output ratio rose in the 1990’s (as did depreciation costs)

Labour: Labour hours dropped significantly over the 90’s and have kept decreasing– labour’s share of income also decreased

Labour “productivity” (output per worker) rose as labour hours fell faster than output

Total Factor Productivity growth (highly correlated with per capita output) has been on a downtrend since the 1990’s.

Technlological advancementEfficiency gains in allocation of labourEfficiency gains in allocation of capital

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Drivers of Japanese GrowthStudy by Hayashi & Prescott: TFP contributed 0.43% of the 3.95% decline in value-added between pre and post lost decade (the periods of 1983-1991 and 1992-1998).

Similar results from my own model (next slide).

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Drivers of Japanese growth

Source: Naomi Fink, 2013

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What is unusual about Japan TFP?

Source: BIS, 2013

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Why it is necessary to take a closer look at deflationPrice declines are not only due to lack of demand – some of them are thanks to technology!

Source: Naomi Fink, 2013

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Deflation and “investment specific technology”An even better fit in simulation using IST!

Base case:

Source: Naomi Fink, 2013

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1989 1991 1993 1995 1997 1999 2001 2003 2005

Ind

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Detrended real GDP per working age person in Japan

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base case model

With investment-specific technology:

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TFP: No surprise; gap in sector growth accounting

Source: JIP, Naomi Fink, 2013

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TFP: Results hold upon more detailed sector examination

Source: JIP, Naomi Fink, 2013

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Empirical Studies: Panel Regression 1, Regulation & Subsidies

Endogenous variables:

A = our own measure of productivity growth (Solow residual), by industryTFPDA: TFP growth rates (baseline case, adjusted for quality of labour only)TFPDB: TFP growth rates (ex- quality of labour)TFPDC: TFP growth rates adjusted for capacity utilization, intermediate inputs)TFPDD: TFP growth rates adjusted for capacity utilization, production indices).

Exogenous variables (from the JIP database):

REG1 : Regulation index with some relevant categories subject to regulationREG2: Regulation index with all relevant categories subject to regulationRDY: ratio of knowledge stock to value addedRDL: ratio of knowledge stock to vaue added, lag of 3 years ITY: ratio of IT capital stock to value addedLK: capital/labour ratio (input measure)SI: log value of real value addedSUB (included in 2nd round of regressions): Subsidies, at 5y intervalsTT = Time trend

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Empirical Studies: Panel Regression 2, Capital Allocation

Endogenous variables:

A = our own measure of productivity growth(Solow residual), by industryTFPD = JIP labour and capital quality adjusted measure of TFP growth

Exogenous variables (from the JIP database):

QL: Quality of labour indexQK: Quality of capital indexINTAY: Stock of intangibles (ratio to output)ECOC: Investment stock of ‘economic competencies’ (ratio to output)INNY: Stock of innovative property (ratio to output)LK: capital/labour ratio (input measure)SI: log value of real value addedTT = Time trend

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Key results, for policy guidance

Deregulation correlated positively with most measures of productivity in highly-regulated industries (Non-IT, Non-manufacturing) but negatively in deregulated industries (IT, Manufacturing). Could this mean an optimum lies in between?

Subsidies may be necessary for other reasons than boosting productivity but their ability to boost ordamage productivity looks weak

Allocation of capital matters broadly to productivity (even in the services sector); the tiny stock of innovative capital, scaled by output, correlated positively to total factor productivity

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Recommendations:Excessive focus on improving productivity in the manufacturing sector – focus on fixing the laggards

Look at how non-IT businesses, above and beyond non-manufacturing alone, can improve productivity

Innovation capital is important in services, non-IT as well as in IT/manufacturing. Create incentives for reallocation of capital toward innovative capital within these lagging sectorsSubsidies might be necessary – while they do not show evidence of damaging TFP too much, they do not improve it either. Use subsidies as an interim measure in non-IT sectors.

There may be an optimal level of regulation between the highly-regulated non-manufacturing/non-IT sectors and their dereglated counterparts. Focus deregulations on these sectors, particularly partial regulations that might damage competitiveness among substitutible goods/services.

Could there be a message for postal privatisation here?

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R&D expenditures rise alongside trade, financial openness

R&D expenditures have risen with trade/financial openness across the OECD

…higher relative wages for skilled workers in traded industries

Rise in quality of labouracross IT/Non IT but stagnation of Non-IT quality of capital

Source: JIP, Naomi Fink, 2013

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ReferencesAmador & Coimbra, 2008. Total Factor Productivity in G7 Countries, IFC Bulletin No 28 (BIS)

Atkeson, A., Chari, V.V. and P.J. Kehoe, 1999. Taxing Capital Income: A Bad Idea. Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 23, 3-17.

Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.

Roberto M. Billi & Klaus Adam, 2004. "Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates," Computing in Economics and Finance 2004 67, Society for Computational Economics

T. Cogley and T.J. Sargent, (2002). ”Evolving Post-World War II U.S. Inflation Dynamics,” NBER Macroeconomics Annual 2001, Volume 16, pages 331-388

Juan Carlos Conesa & Sagiri Kitao & Dirk Krueger, 2009. "Taxing Capital? Not a Bad Idea after All!," American Economic Review, American Economic Association, vol. 99(1), pages 25-48, March

Teresa Garcia-Milà & Albert Marcet & Eva Ventura, 1995. "Supply side interventions and redistribution," Economics Working Papers 115, Department of Economics and Business, Universitat Pompeu Fabra

Fumio Hayashi & Edward C. Prescott, 2002. "The 1990s in Japan: A Lost Decade," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 5(1), pages 206-235, January.

Inui, Tomohiko, 2006. “Regulation and Productivity” http://www.eco.nihon-u.ac.jp/center/economic/publication/journal/pdf/36/36inui.pdf

Growing Income Inequality in OECD Countries: What Drives it and How Can Policy Tackle it ? Forum, Paris, 2 May 2011

G. Primiceri ”Time Varying Structural Vector Autoregressions and Monetary Policy”, The Review of Economic Studies, 72, July 2005, pp. 821-852

RIETI/ESRI/HISTAT JIP data bases: http://www.rieti.go.jp/en/database; http://www.esri.go.jp/en/archive/bun/abstract/bun170index-e.html

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