Abenomics: A Failed Growth Strategy?

My contention has been that the first two arrows of Abenomics gave the Japanese economy a short window to bring the Japanese labour market back to full employment, re-ignite wage gains, and institute structural reforms. In my view, Abe has not used this window effectively and the stock market and economic gains of the beginning of 2013 are going to recede. Last month I predicted Abenomics would ‘fail’ as Japanese GDP growth slips below 0.5%. We are well on that path.

If one looks at the Japanese economy through the sectoral balances lens, it was clear that Abenomics would be a boon to GDP and corporate profits.

Japan sectoral balances

The shift toward greater government deficits was more important than the threats about the inflation target because that’s what increased GDP and moved currency exchange rates.

Using the sectoral balances approach to understand the impact of this policy is important. And despite the protests of investors like Hayman Capital’s Kyle Bass, bond vigilantes cannot unilaterally force a sovereign currency issuer intodefault. Nor can bond vigilantes force a sovereign currency issuer’s domestic interest rates up to onerous levels because the Japanese situation is all about policy rates, expected future policy rates, expected inflation and currency depreciation.

We have to remember that the central bank is the central government’s agent. In exigent circumstances fiscal and monetary policy unification will always occur, creating a consolidated central bank/treasury balance sheet style modus of operation. That’s what we see in Japan – and I believe will eventually see elsewhere.

When a country is trying to institute financial repression by keeping policy interest rates low while letting inflation rise, the currency is the release valve, something that can lead to current account deficits. This is what we have seen in Japan, as the country will record its first current account deficit since 1980.

So, that’s the setup here: Deficit spending increasing private surpluses and corporate profits, financial repression increasing inflation, lowering the exchange rate, and worsening the external balance – all very predictable. The question is what next?

This piece is cross-posted from Credit Writedowns with permission.