Is Abenomics Flagging?

Analysts have praised Japan’s third-quarter annualized domestic product growth at 1.9 percent, slightly ahead of expectations of 1.7 percent, with the consensus commending the Japanese Prime Minister Shinzo Abe’s decisive moves to reflate his long-stalled economy.

But in fact it appears that most of the new third-quarter growth came from increased public expenditure instead of a burst of private sector spending, which the country badly needs. That may sound ominously familiar.

It raises the danger of taking Japan back to two decades of priming the economic pump by pouring money into public sector projects that resulted in bridges to nowhere and airports where no planes fly, and with the resuscitation of the Construction State, a government-political-construction complex that has saddled Japan with the biggest debt load on the planet.

Abe took power in December 2012, succeeding the luckless Yushihiko Noda and vowing to forge a muscular economic policy to end the so-called Lost Decades. That economic policy included what he called his famous three arrows. The first, Abe having dispatched Masaaki Shirakawa, the previous, cautious governor of the Bank of Japan, and replacing him with Hiruhiko Kuroda, the former Asian Development Bank head, was quantitative easing by having the Bank of Japan buy government bonds and asset-backed securities to double the amount of money in circulation in an attempt to reach a 2 percent inflation target, pushing down the value of the yen.

The second arrow was investment in public works and renewing the flagging infrastructure built beginning 60 years ago after the devastation of the country in the wake of World War II, which ended in 1945.

Arrow one has been fired, bringing down the value of the yen against the US dollar by 15 percent, from ¥86/US$1 last January to ¥99.9. Arrow two featured ¥10.3 trillion (US$116 billion) in new government spending. Of that, ¥3.8 trillion was to be directed at disaster spending and reconstruction from the devastating Fukushima Earthquake, ¥3.1 trillion to stimulate private investment and other measures. The extra spending was aimed at creating some 600,000 jobs. Government spending has risen by 27.8 percent on an annualized basis for public investment in the third quarter.

The third arrow – deregulation and creation of sustainable growth - remains somewhere in Abe’s quiver, leading the International Monetary Fund, in its August consultation on the economy, to warn that “the new policies are buoying the near-term outlook. Unprecedented monetary easing, supported by fiscal stimulus is leading to a pickup in domestic demand with GDP growth projected at 2 percent this year and inflation rising gradually. However, all three arrows need to be launched for the policies to succeed. Uncertainty about the ambition of fiscal and structural reforms is adding to underlying risks.”

So far, worryingly, there is no indication that the private sector is responding, as this chart from the Hong Kong-based Asianomics financial research and advisory firm indicates. Stripping out the public sector would yield annualized growth of just 0.5 percent in in the third quarter..

If the Abe government can’t get private spending moving, it dares considerable political risk from the massive boost in public spending, a return to what has been called the Construction State, in which the growth of the construction industry as much as anything paralleled the growth of the military industrial complex in the United States. The political power of the large general construction companies was unparalleled in Japan during the lost decades until the Democratic Party of Japan slashed public works budgets by a third.

“Influence-peddling by LDP politicians seeking money for favours from construction companies will increase, leading to money politics and financial scandals,” wrote Aurelia George Mulgan a Professor at the University of New South Wales, Australian Defense Force Academy, Canberra, in the East Asia Forum in February. “There will be a return to large-scale bid-rigging (dango) by construction companies with the collusion of politicians and government officials.

“The political power of large, general construction companies (zenekon) famous for building economically wasteful projects will be restored. Local construction companies will mobilize in elections as vote-gatherers and money donors for LDP candidates, and petitions for public works projects filed by municipal and industry organization leaders will put direct pressure on LDP politicians to deliver pork to specific groups and regions,” Mulgan continued.

At the same time, the devalued yen as much as anything is aimed at benefiting Japan’s traditional mercantile economy – selling cars and electronics overseas. Toyota at least has recovered, forecasting record net profit although its rivals, Nissan and Honda, are struggling with heavy expansion costs.

But this is hardly restructuring. It is a return to the decades before the country got in trouble economically. Its electronics industries have staggered as other countries have caught up with its engineering and design prowess. As the IMF warns, the question is whether the Abe government can sustain the momentum without plucking the bowstring for the third arrow. While the debate is centered on tax incentives to spur domestic capital expenditure, deeper reforms are needed. Japan can’t continue doing the things that got it into trouble in the first place. Mercantilism and placating the construction industry at the expense of more damage to the public purse prevents the reforms the IMF is asking for.