When Prime Minister Shinzo Abe took office in December 2012, he announced a strategy - comprising three "arrows" - to overcome the economy's combination of slow growth and low inflation: very easy monetary policy, a short-term fiscal stimulus, and structural reforms to labour and product markets. But Abenomics has not fixed Japan's problems.
After Mr Abe appointed Haruhiko Kuroda as the new head of the Bank of Japan (BOJ) and charged him with getting the inflation rate to two per cent, Mr Kuroda loosened monetary policy immediately and dramatically, by slashing interest rates and launching large-scale purchases of long-term government bonds. This caused a sharp fall in the value of the yen and sent the interest rate on ten-year bonds toward zero. The more competitive exchange rate raised the profits of Japanese exporters, but not their output, while the weaker yen also raised import prices, reducing the real incomes of most Japanese households.
In January, the BOJ went further and introduced negative deposit rates on commercial banks' mandatory reserves, which markets interpreted as a confusing act of desperation. That had the adverse effect of weakening household and business demand. And, despite the BOJ's easing, global financial conditions soon caused a rise in the value of the yen, which rose nearly 10 per cent relative to the dollar.
This week, the BOJ surprised markets by making no policy change at its meeting, contrary to the widespread expectation of a significant further easing of monetary conditions. Markets reacted sharply, with the yen strengthening by two per cent against the dollar and the Japanese stock market falling three per cent.
Mr Abe began his fiscal policy with a substantial spending program, focused primarily on repairing and replacing infrastructure affected by the 2011 earthquake. But he also raised the value-added tax (VAT) from 5 per cent to 8 per cent to address the enormous deficit and growing national debt. The result was an economic downturn, with two quarters of declining GDP. The level of real GDP now is no higher than it was in 2008.
The third arrow of Abenomics - structural policies aimed at boosting potential growth - has barely been launched. Meanwhile, Japan's declining population and shrinking labour force is a major long-term challenge - reflected in Mr Abe's call for more women to work outside the home.
Reluctance to expand the number of foreign workers and to change work customs to encourage more married women to join the labour force may reflect the relative affluence that Japan currently enjoys. The Japanese public may prefer to maintain its current lifestyle and cultural homogeneity, even though doing so is preventing more rapid economic growth.
Japan's biggest immediate problem, however, is the budget deficit and government debt. If the BOJ succeeds in achieving a two per cent inflation rate, the deficit will rise rapidly, as the interest rate on government debt would increase from the current zero level. Failure to implement the spending cuts and revenue increases needed to reduce the budget deficit would undermine confidence.
Mr Abe thus faces a dilemma in deciding whether to raise the VAT further. Doing so is undoubtedly hard at a time when GDP has declined and CPI inflation has turned negative. And yet failure to do so or to cut spending means continued large deficits and soaring government debt.
Mr Abe has said he would offset the immediate contractionary effect of the VAT hike with a short-term fiscal stimulus in the form of higher government spending. That might allow the necessary permanent reduction of the deficit without causing a repeat of the economic downturn that accompanied the last VAT increase.
Another strategy that might help sustain aggregate demand would be to phase in the VAT increase at an annual rate of one per cent for three or four years. This would give consumers an incentive to increase spending, especially on large-ticket items, before each increment raises prices.
If Abe can get public finances under control, Japan will be in a much stronger position to face its other economic challenges.
©Project Syndicate, 201.
The writer, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan's Council of Economic Advisers from 1982 to 1984