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Too Early to Declare That Japan Is Back

03/14/2013 05:11 pm ET | Updated May 14, 2013

Poor Japan, a rich country that is mired in a deflationary trap. For 20 years economic growth seldom exceeded one percent. As living standards stagnated, people turned inward, increasingly fearful that Japan had lost out to China, its newly dynamic neighbor with ten times its population.

Japan's challenges are legion -- a shrinking population, natural disasters, soaring debt, a high cost structure that inhibits competitiveness, and most of all deflation.

Newly inaugurated Prime Minister Shinzo Abe visited President Obama in late February presenting a counterpoint to the prevailing gloom. Addressing a Washington audience following a working lunch at the White House, Abe declared, "Japan is back and so am I." He briefly served as prime minister in 2007 and is Japan's fifth leader since President Obama took office.

Speaking in English at the Center for Strategic and International Studies, Abe laid out his three-arrow revitalization program: aggressive monetary easing, short-term fiscal stimulus, and a growth strategy to boost investment, trade and deregulation.

Abe's determination to combat deflation is laudable but his predecessors made the same promise and failed. As Federal Reserve Chairman Ben Bernanke has said, "once deflation takes hold it is very difficult to emerge from it." Japan is caught in a classic liquidity trap where monetary policy is ineffective because no matter how low the interest rate businesses and consumers don't wish to borrow.

Tokyo University economist Motoshige Ito, a top adviser to Abe, emphasized that point at a Peterson Institute gathering, saying "that for ten years cash-rich Japanese banks found no one who wanted to borrow money." Ito said business and consumers are cash-rich but extremely cautious as to investing and consuming.

Despite decades of failure, Abe's program is off to a strong start. Financial markets like what they see. Since it became apparent that Abe's Liberal Democrats would win December's parliamentary election, the yen has depreciated by 20% and the Nikkei stock market index is up 21% to a near three-year high. A cheaper yen is a key element of Abenomics. The yen's depreciation from what many analysts believe was a an artificially high level has drawn implicit approval from the International Monetary Fund, which dismisses complaints that its decline could trigger a global currency war.

The principal challenge Japan faces is how to compete and coexist with a resurgent China. In 2010 China's gross domestic product overtook Japan's, a signal that without change Japan was being shunted into the slow-lane. Abe, in his Washington talk, rejected any suggestion of Japan being a second tier economy. Ito, his economic adviser, identified fast-growing Asia as Japan's opportunity. With 800 million new middle-income consumers and more arriving each year, he said "Japan must boost its participation in Asian economies."

Abe wants to bring Japan into the U.S. sponsored Trans Pacific Partnership, a trade liberalizing negotiation in which 11 countries are participating. TPP emphasizes foreign direct investment and aims to expand Pacific basin trade in services as well as goods. Economists Peter Petri and Michael Plummer estimate that Japan could be the biggest winner from TPP as its exports could grow 14% above baseline projections. China is not yet part of the TPP negotiations.

While expanding trade is a key component to Abe's growth trifecta, he faces immense challenges from an entrenched farming lobby that has kept Japan's rice tariff at 700%.

Another component of the Abe program, monetary easing, has been tried many times in Japan with little effect. However the shift in Bank of Japan policy, doubling its target for acceptable inflation from one to two percent is significant. That combined with a cheaper yen and the appointment to the BOJ of presumed easy moneyman Haruhiko Kuroda could be decisive. A final element, a boost in government spending in the hope of stimulating economic activity, is similarly not new. It has resulted in high debt and "bridges to nowhere" but no real stimulus to growth.

Japan's demographic challenge is huge. It has the world's oldest population and some projections suggest that Japan's population will shrink from the current 128 million to 90 million by 2050. Clearly, the institutional barriers that keep women out of key professions must change and the age for mandatory retirement must be raised. Economist Ito argues that, "without drastic measures Japan can not survive."

Adam Posen of the Peterson Institute and a Japan expert has this advice for Prime Minister Abe. "Keep quiet about the exchange rate, join TPP, maintain fiscal stimulus, and buy U.S. natural gas." With its nuclear program reeling from the Fukushima meltdown, Japan is on the prowl for natural gas. While the U.S. has a surplus, exporting American shale gas to Japan requires presidential approval.

Mr. Abe, it is far too early to declare, "that Japan is back." There is a huge distance to travel merely to regain what has been lost. The Nikkei is still at only one-third of its 1999 level from which it fell more than 50%. House prices remain 60% below their 1991 peak. And while Japan grows sluggishly, if at all, China and its Asian neighbors race ahead.

Barry D. Wood is North American economics correspondent for RTHK in Hong Kong.

A version of this article appeared on marketwatch.com.