Japan woke up to bad news Monday morning: The economy contracted 1.6 percent in the third quarter, technically falling into a recession. Economists don’t expect the recession to last very long but it’s a reminder about the potential for misguided policies to strangle economic recoveries—not just to Japanese policymakers, but to their American counterparts as well.
To understand why the Japanese economy is a warning for the U.S., you have to understand the history behind Japan’s economic malaise. For more than two decades now, Japan has had weak growth and deflation (when prices fall instead of rise). Deflation may sound like a good thing but it can have disastrous effects on an economy. For instance, it makes it much harder for debtors to pay back their debts. When consumers expect prices to fall, they also become hesitant to spend money. This creates a self-fulfilling prophecy where the expectation of falling prices causes consumption to fall, which leads to lower prices. Japan has been stuck in this cycle since the mid-1990s.
In 2012, Shinzo Abe was elected prime minister of Japan and committed to using all available tools to get the economy out of this deflationary trap, including fiscal and monetary stimulus. The Bank of Japan has printed huge amounts of money to boost inflation and lower the value of the Yen. Abenomics, as it became known, would hopefully restore consumer confidence and boost exports to get the economy going again.
It’s hard to judge how successful Abenomics has been. The Nikkei, the Japanese stock market, has surged since the program began. But the Bank of Japan still has a credibility problem: The public and investors are not convinced that the central bank can actually get inflation to 2 percent. For that reason, businesses have been hesitant to invest and use the devalued Yen to grow their exports. Although unemployment is low and wage growth has picked up (although it is still negative in real terms), workers haven’t been convinced to spend money either. “You’ve gotten some wage growth and the hope was that would jumpstart some consumption and get the economic engine revved up,” said Mark Zandi, the chief economist at Moody’s. “So far, that really hasn’t happened. I don’t think people really believe yet that it’s here to say. They’re still very cautious.”
But before the Bank of Japan had a chance to prove its credibility, Japanese policymakers made a critical policy mistake: They increased the consumption tax—a value-added tax (VAT) as it is officially called—from 5 percent to 8 percent, the first increase since 1997. If your goal is to get consumers spending money again, it’s easy to see why raising taxes on them is such bad policy. It gives them less money to spend. The effects of the tax were felt immediately after it took effect on April 1. In the second quarter of the year—from April 1 to June 30—the economy contracted at an annualized rate of 7.3 percent. “The hope was that all the other stimulus they were providing would offset and wash out the impact of the VAT,” Zandi said. “That hope is not coming to fruition. They made a big mistake with that. They did a similar thing back in the late 1990s. It worked out just as badly, if not worse.”
In October 2015, the VAT is scheduled to rise once again. Economists now believe that Abe will delay that increase or postpone it indefinitely, having learned from this tax hike. That should boost consumer confidence. Lower oil prices will also help the economy, which is heavily reliant on imported oil. But the soft underbelly of the economy remains. “The Bank of Japan is doing the right thing now,” Zandi added. “Now it’s up to fiscal policy, the Abe administration and other leadership to really hunker down and try to make some fundamental changes. … The problem with that is that usually those times of reforms hurt in the immediate near future. It only reaps benefits over a longer time. It’s going to be a while until they really get things back on track.”
Since weak growth in Japan has been a consistent feature of the global economy for so many years, the recession, assuming it is short-lived as economists expect, will not have a significant effect on the U.S. economy. But it does offer a very clear message to U.S. policymakers: Don’t pull out support for the economy too soon or the recovery will collapse. The U.S. economy has improved in recent months with job growth picking up. Last week, the Commerce Department reported that workers are quitting their jobs at the fastest rate in six years—a positive sign that workers are confident the economy will keep growing. But it’s very easy for policymakers to cut off the growth if they implement dumb policies, as Japan did with the VAT increase.
In particular, this means that the Federal Reserve should not raise interest rates from zero until workers actually see significant wage growth. So far, Fed Chair Janet Yellen has demonstrated a commitment to ignoring inflation hawks inside and outside the central bank. She must continue to do so.
It also means that Congress cannot raise taxes on broad swaths of Americans or make significant cuts to government spending. In the past few years, U.S. policymakers have made this mistake multiple times, in particular by letting the payroll tax cut expire at the end of 2012 and allowing sequestration to take effect last year. The latter, which Republicans leveraged from President Barack Obama in the 2011 debt ceiling fight, cost the economy 1.2 million jobs in 2013 alone, by one estimate.
Some congressional Republicans reportedly want to extract further policy concessions from the president when the debt ceiling must be raised next summer. This strategy is especially dangerous because Obama will no longer allow Republicans to use the debt ceiling as a hostage-taking device. If the GOP, spurred on by its victory in the midterms, chooses that strategy, it would set up a nasty fight that could spook investors and significantly damage the economy. Republicans should heed the warnings from Japan’s economy and adopt a “do no harm” economic agenda. Only then can economy fully recover.