Japan’s Sharp Drop in 2nd Quarter GDP Proves Abenomics Has Failed

by the Curmudgeon with Victor Sperandeo



We report and analyze the sharp drop in Japan's second quarter GDP followed with scenarios for what the Japanese government might do if economic growth remains weak.  Next are excerpts from David Stockman's blog post on the huge failure of Japan's expansionary monetary and fiscal policies.  Victor wraps up with his unique perspective on Japan's misguided economic policies and a suggestion they follow the Hong Kong model of ultra-low taxes.


Steep Decline in Japan's Economy Blamed on Sales Tax Increase:


Without much U.S. press coverage, Japan's Cabinet Office on Wednesday reported that GDP declined at a 6.8% annual rate in the second quarter.  On a quarter-to-quarter basis, Japan’s economy shrank 1.7% from April till June.  That sharp drop was mostly attributed to an increase in the national sales tax from 5% to 8%, which triggered a sharp fall in consumer spending.  Contrast that dismal report with the 6.1% growth in the January-March quarter, when Japanese consumers shopped heavily before the higher tax took effect (see chart below).


Although Japan's economic contraction was a bit milder than the consensus forecast, it was still far more severe than most experts had predicted when the sales tax rise took effect on April 1st.  It's Japan's worst economic contraction since the earthquake and tsunami more than three years ago.  Consumer and business confidence remains fragile, despite the bold stimulus program of the Shinzo Abe government (AKA Abenomics). 


The Abe administration has increased public spending and backed a super aggressive monetary expansion by the Bank of Japan (BoJ).  Approximately 75% of all Japanese government bonds issued have been purchased by the BoJ.  That's essentially a version of debt monetization/quantitative easing (QE)/money printing on steroids. 


Yet Japanese government fiscal and monetary stimulus programs didn't offset the April 1st sales tax increase, which took a heavy toll on household spending.  Private consumption in the April-June quarter decreased 5% compared with the previous quarter (which was before the 3% sales tax increase took effect).  Economists said the sales-tax increase might be squeezing households because they are paying more for every day goods, but they haven't seen much increase in their incomes.




"Note the sudden impact of the stimulus after the earthquake in 2011, followed by its big fade that lasted four quarters. That’s how stimulus works. Then, in the first half of 2013, the beginning of the Abenomics era, the economy got high on promise, hype, and hope and on money-printing. In the second half, reality set in, and the economy languished. And so far in 2014, the net effect of frontloading and hangover is that GDP has actually declined."


Several economists are worried that exports are not expanding in response to a weakening of the Yen (through the government policy of money printing).  Exports fell 0.4% on quarter in real terms, through external demand contributed 1.1% to growth in the April-June period as imports also fell.  Another concern is that consumer prices are increasing much faster than wages.  When coupled with the consumption tax increase, that could depress household spending for quite some time.


The 1% increase in inventories last quarter is also troubling to economists.   "This doesn't bode well for the July-September quarter," said Yasuo Yamamoto, senior economist at the Mizuho Research Institute. "Inventory adjustments will be necessary, meaning production may not grow."


Yasunari Ueno, Chief Economist at Mizuho Securities thinks the domestic economy might stay sluggish for longer than expected.  "The next focal point is how much the economy will rebound in the July-September period. If the upward pressure is weak, it will likely increase the chance that Prime Minister Abe decides in December to delay the next sales-tax hike," he said.


How will the Japanese Government Respond to Sustained Economic Weakness?


Japan's economics minister, Akira Amari, signaled the government’s readiness to prepare a supplemental budget this year if growth in the third-quarter stayed weak.  However, any fiscal stimulus would probably not be enough to have a major effect on the economy, given Japan’s troubled government finances (huge budget deficits and humongous debt).


Mr. Abe will have to address the sales tax issue again soon. The April increase was the first of two that were approved by parliament before he took office.  The next phase – an additional 2% rise, to 10%– is scheduled to take effect in October 2015. Mr. Abe needs to decide by this December whether to let the tax increase go into effect or cancel it out of concerns that the economy is too fragile.


“Confirmation of a return to a clear recovery tone in the third quarter would make a consumption tax increase likely,” said Tomo Kinoshita, Head of Japan Economists at Nomura Securities.  He added that a “decline in GDP in the second quarter of 2014 would make strong growth in the third quarter easier.”


Curmudgeon's Conclusions:


Our conclusion is that it's extremely doubtful the IMF's 2014 forecast of 1.4% for Japan's GDP growth will be achieved this year, primarily as a result of the increased sales tax and lackluster export growth.  The government’s expansionary fiscal and monetary policies have been offset by tax increases that have resulted in a decline in GDP this year.


For a comprehensive analysis and expose of Abenomics, we suggest you read Voodoo Abenomics-Japan's Failed Comeback Plan by Richard Katz, in the current edition of Foreign Affairs magazine.  Please also read the section below and Victor's comments.


Japan’s Keynesian Demise: A Cautionary Tale For Our Times:


In a very revealing August 15th blog post, David Stockman (Budget Director during Reagan's first term as President) chronicles the history of Japan's great debt build up and the folly of Abenomics.   He refers to the BoJ’s latest round of QE as "a madcap rate of balance sheet expansion that would be equivalent to $250 billion per month at the scale of the U.S. economy."


Stockman writes that "the BoJ is absorbing almost all of the available government bond supply and on some days has actually left the private market bid less.  Indeed, it is monetizing assets at such a frenzied rate that it has now become a major buyer of ETFs and other equities. In effect, the central bank in Japan no longer merely runs the casino; it has become the casino."


According to Stockman, the only thing Abenomics has accomplished was to attract hot institutional money that drove Japan's Nikkei stock index from 8,000 to 16,000 in a matter of months.  "But that excitement is now over," he says.  


"The fact is, after the most recent quarter’s GDP wipeout, Japan’s real GDP is only 0.8% larger than it was five quarters ago when Abenomics was installed at the BoJ. And therein lies the frightful future.  Were the BoJ to actually achieve and sustain its 2% inflation target the Japanese government bond market would either collapse, or need to drastically reprice. The former case amounts to disaster now; the latter would entail fiscal collapse very soon as Japan’s revenues would be soon devoured by a surging carry cost on its towering debt."


Summing up, Stockman writes: "There is no possibility that Abenomics will result in “escape velocity” Japan style and that Japan can grow its way out of it enormous fiscal trap. Instead, nominal and real growth will remain pinned to the flat line owing to peak debt, soaring retirements, a shrinking tax base and a tax burden which will rise as far as the eye can see."


Victor's Comments:


As I've stated several times in previous Curmudgeon posts: the biggest problem world economies face today are caused by an ideological shift towards Socialism.  In Mussolini's version it was called Fascism -or "control" of the means of production - rather than outright "ownership" of productive property.


"Abenomics" (instituted by Japan PM Shinzo Abe) got a shock last week with the deep decline in second quarter GDP.  Abe's policy of "three arrows1" hit a bump in the road as Japan's GDP declined last quarter (-6.8% annualized rate). This was largely caused by a 60% increase in sales taxes from 5% to 8% this April.  But that is only phase 1. of sales tax hikes.  As noted by the Curmudgeon above, a phase 2 sales tax increase (to 10%) is scheduled for October 2015.  If it goes through, that would be a 100% increase (from 5% to 10%) in the national sales tax! 


Note 1. Three Arrows: Monetary and fiscal stimulus, i.e. public works spending, was arrows one and two.  The third arrow was structural reform, which really meant changing “union like" job protections that don't allow companies to fire workers.   In a blog post titled, "Abenomics Hits the Skids,         ” Wolf Richter referred to the three arrows as "promise, hype, and hope."


Somehow tax increases were not mentioned in the three arrows quiver.  Why not? This is exactly what is killing most major nations.... Tax increases needed as an excuse for debt payments!


Consider the effects of taxation, on spending by Japanese consumers:

·         The medium adjusted gross disposal income  (net income adjusted for income  taxes)  is $25,066 per year (SOURCE: OECD Better Life Index),

·         Sales tax increase of 3% (from 5% to 8%) from April 2014, 

·         Moderate inflation (a hidden tax) projected to be 2% in 2014,

·         Personal savings at 10% of disposal income (the Japanese are big savers. They saved 20% of disposable income in the 80's). 

Based on a "back of the envelope" calculation, the total effect of all of the above is approximately 12% less net, real disposable income for the average Japanese consumer.  That will be reduced further if the 2nd sales tax increase to 10% goes into effect in October 2015.  The key takeaway here is that Japanese consumers will spend significantly less due to inflation and the sales tax increases.


One may conclude that Japan is not a place to build a business.  Japanese consumers are not likely to step up spending with rising inflation, higher priced imports (due to government policy to weaken the Yen), and increased consumption taxes.  That translates into lower domestic demand for goods and services. 

There are other taxes that reduce aggregate demand and investment.  Those include:  40%- 44%  maximum tax on income;  20% capital gains tax this year;  6% local taxes; other taxes for the usual prospects of property, liquor, tobacco, gasoline, vehicles;  another separate tax for business owners (the enterprise tax), plus other miscellaneous taxes.


Japan government policies are a clear example of the politics of control over freedom.  It leads us to another quote from Vladimir Lenin: "the surest way to destroy a nation is to debauch its currency."  If Japan wants to survive economically their "three arrow" policies are in urgent need of "Seppuku" (Hara-Kiri).


Japan's debt to GDP stated ratio is headed to 227%, second to Zimbabwe, while Hong Kong (with much lower taxes) has a debt to GDP ratio of only 33.84%.  

In my opinion, Japan should adopt Hong Kong's mentality for its economy.  Hong Kong has a 15%-17% flat tax on income, no sales tax or VAT, zero gift and capital gains taxes, and a relatively simple (only 400 page) tax code.  This compares to the U.S. tax code of 77,000 pages!   Hong Kong's low 16.5% corporate profits tax rate is the same for foreign and local companies.


With a score of 90.1, Hong Kong was rated #1 in 2013 by the Heritage Foundation's Index for in Economic Freedom.  Hong Kong has held the #1 position for 19 consecutive years now!  In sharp contrast, Japan is ranked #24 and sinking.  [The US is #10 and also dropping.]

As a result of Hong Kong's zero capital gains tax rate, Lord William Rees-Mogg said:  "There are many middle class people in Hong Kong with five or ten million dollars to invest."   SOURCE: The "Capitalist Manifesto," Chapter Two. -- A Silly Foreigner, by James D. Davidson.  


An even more powerful quote from Rees-Mogg -- one that relates to QE/debt monetization in Japan [and the U.S.]:   "The value of paper money is precisely the value of a politician's promise, as high or low as you put that; the value of gold is protected by the inability of politicians to manufacture it."


Till next time........................


The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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