Can the Japanese Economy End Deflation With These Steps?

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Japan's newly elected Prime Minister Shinzo Abe is taking aggressive measures in an attempt to end the deflationary spiral that has plagued the Japanese economy for more than twenty years.

The return of Abe's Liberal Democratic Party (LDP) to power in a landslide election victory last month is seen as a mandate to do whatever it takes to revive the flagging Japanese economy.

One of the first policies likely to be put into place is the passage of a massive supplementary budget for fiscal 2012 (the year ending March 31, 2013). Depending upon how you count it, the budget ranges from 10 trillion yen ($112 billion) to 20 trillion yen ($224 billion).

Observers have expressed concern over the size of the stimulus and what impact it might have on Japan's sovereign credit rating and on the Japanese government bond (JGB) market, plus what it could do to the U.S. economy.

Let's take a look.

Arm Twisting the Bank of Japan

The supplementary budget is nothing but good, old-fashioned pork barrel spending; the kind of money politics the LDP was known for when they governed Japan for more than 50 years.

What is new and different about Prime Minister Abe's approach to reviving the Japanese economy is his strong arm tactics against the Bank of Japan (BoJ), Japan's central bank.

BoJ independence was enshrined in law only in 1999. Abe has run roughshod over the intent of the law by demanding that retiring BoJ Governor Masaaki Shirakawa sign a written document agreeing to do whatever is necessary-generally considered to be "unlimited easing"-to achieve an inflation target of 2% over the medium-term.

At its last Monetary Policy Committee (the equivalent of the Federal Reserve's Open Market Committee) meeting, which took place just after Abe's landslide election victory, the BoJ agreed to review its policy goals and come back in January with updated policy recommendations. The next Monetary Policy Committee meeting takes place over two days on Jan. 21 and 22.

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