Global Policy Watch #1: The Road Not Taken
Insights on policy issues making news around the world
— Pranay Kotasthane
East Asian economic success is one of India’s favourite public policy discussion themes. Regardless of the facts, we have strengthened our own beliefs based on that transformation. For instance, many Indians are convinced that South Korea, Taiwan, and Japan became powerhouses through well-executed industrial policies in which governments threw their full weight behind specific domestic sectors and companies. East Asian examples are often used to justify India’s protectionist trade measures, a business environment that places higher compliance requirements on foreign companies, and generous pro-business subsidies.
In this debate, we forget the role of two other crucial factors. One, the role of geopolitics. As Arthur Kroeber’s notes in China’s Economy, Japan, South Korea, and Taiwan were part of the US alliance structure and benefited immensely from programs of technical assistance, educational exchanges, and access to the American market.
Two, what’s more significant is that South Korea’s transformation as an export powerhouse predates industrial policy measures. Like India, South Korea too had a scarce foreign exchange reserves problem. Like India, it too opted initially for trade and monetary policies ostensibly aimed at preserving these reserves. But starting 1964-65, South Korean leaders—nudged by the US—were able to reimagine a future in which their foreign exchange problem was to be ameliorated not by import controls but by increasing exports.
To explain the freakish similarities and differences between the paths India and South Korea chose, read these excerpts from an excellent NBER paper From Hermit Kingdom to Miracle on the Han: Policy Decisions that Transformed South Korea into an Export Powerhouse by Douglas A. Irwin.
The economic problems of the 1950s South Korea were uncannily similar to India:
Korea’s economic policy in the 1950s was built around “the three lows”—low grain prices, low interest rates, and a low price of foreign exchange—and the controls needed to maintain them. Although the controls led to perpetual shortages of grain, capital, and foreign currency, each had a rationale. The government sought low grain prices to keep the cost of living down, relying on grain imports from the United States made available through PL 480 (food assistance) grants. The government maintained interest rate ceilings, ostensibly to help borrowers and promote investment, but negative real interest rates meant there was little incentive to save, diminishing investment and financial development. The government kept the price of foreign exchange artificially low to make imported goods, particularly capital goods, cheaper than they otherwise would have been.
The shortage of foreign exchange led the government to introduce import controls to conserve foreign exchange reserves. Import licensing was introduced in 1946 to impede the purchase of nonessential foreign goods. In 1949, the Ministry of Finance began preparing a quarterly foreign exchange budget to determine how export earnings and aid inflows should be allocated in purchasing imports.
The overvalued currency had a devastating effect on the country’s merchandise exports, which declined from $40 million in 1953 to just $16 million in 1958, a year in which imports were $370 million.
South Korea too had an aborted devaluation attempt in the 1960s.
The government devalued the won in two steps… The February 1961 devaluation was made in conjunction with a major reform of the foreign exchange system. The government rationalized the complicated multiple exchange rate system and began to relax import controls, paving the way for a fully unified exchange rate in June of that year.
The devaluation increased exports significantly, but caused pain in the short term.
In the first two months of 1961, prices rose 15 percent, and industrial production, which depended on cheap imported intermediate goods, fell.21 The devaluation hurt the political fortunes of the deeply divided government, which went through several major cabinet reshuffles during its short period in power and never enjoyed strong public support. The government was widely seen as inept, and public dissatisfaction with the country’s situation led to protests. After renewed political unrest and street demonstrations by students, a military coup overthrew the nine-month-old government on May 16, 1961.
Changing tack, the incoming military rulers opted for atmanirbharta:
The government envisioned state investment to build up heavy and chemical industries to increase national security and end the country’s dependence on US aid and foreign sources of supply. Given Korea’s enormous trade deficit and tiny export base, the government thought it easier to replace imports by expanding domestic production of those goods rather than to try to make up the gap by exporting more. The plan was to make the country self-reliant in its ability to pay for its imports, but the plans were formulated “without due consideration of Korea’s short supply of capital and technology,”
This plan failed as each of these required more foreign exchange, which was the limiting condition. Then came a food crisis.
The US also withheld economic aid from Korea, including PL480 food assistance at a time when food was in desperately short supply. In April 1963, Korea agreed to a new stabilization program to reduce the budget deficit, in the hope of bringing inflation under control. The government also agreed to dismantle trade controls and eventually adopt a floating exchange rate. Aid was released, but by July it was clear the government was not living up to the agreement.
Things begin to change after elections in 1963. Eventually, the government went ahead with another devaluation, and a slew of decisive policy reforms in 1964-65.
In essence, Kim believed that the government would have to get rid of “the three lows”—the low exchange rate, the low-interest rate, and low grain prices—as well as reform the foreign exchange system. The devaluation had already raised the exchange rate; getting rid of low interest rates and low grain prices would be deeply unpopular. Said one leader: "“Eventually, the entire business world will protest the policies. Plus, the National Assemblymen will join them and intelligent media editorialists will criticize the policies . . . it will be very difficult.”
The government began promoting slogans such as “exports alone promise a way to economic self-reliance” and “exports as the yardstick to measure the sum of our national strength”
The economy started reaping the rewards even before the industrial policy kicked in:
“The export success of the 1960s and 1970s was basically due to the removal of impediments to trade, namely, the complicated foreign exchange system and the negative effects on export of the protectionist import policy,” “Once the impediments were removed, the economy began realizing its huge export potential, which had been left unexploited until then."
So next time someone sings paeans about South Korea’s industrial policy success, do tell them aap chronology samajhiye.
The global outpouring of respect and admiration for Shinzō Abe is proof of his outsized impact on Japan and the world. To put his economic contributions in perspective, here’s an edited version of RSJ’s essay on Abenomics from edition #69.
Global Policy Watch #2: Abe Yaar! Lessons From 'Japanification' (From our Archives)
Insights on policy issues making news around the world
—RSJ
Shinzō Abe, the longest-serving Japanese PM ever, stepped down from office last week. His second term which began in late 2012 was marked by his prescription for reviving the Japanese economy. The world called it Abenomics.
Through a mix of unconventional monetary policy, robust fiscal stimulus, and structural reforms to boost growth, Abenomics was seen as a marked departure from the timid response that characterised the previous regimes. Abe was determined to jolt Japan out of the economic morass it had dug itself in for over a quarter-century since 1990. We will discuss Abenomics and what lessons it holds for us in more detail later. But let’s go back to the lost decades of Japan that gave us the pejorative term ‘Japanification’ and understand what happened during that time.
Bubble, Bust And No Recovery
Japan was the miracle economy following WW2, benefitting from U.S. largesse in infrastructure spending, government investments in technology and research, a rise in entrepreneurship and an increase in factor productivity for over three decades. Low-interest rates and all-round prosperity in the 80s led to an asset bubble. The stock market and real estate valuations went through the roof on the back of speculations and easy credit policy. There’s an urban legend (or truth?) of three sq. mts. of land near the royal palace being sold at US$ 60,000. That meant the appraisal value of the palace was more than the state of California then. In little over 25 years from 1960, the land value went up by 5000 per cent in Tokyo and other major cities. By the end of 1989, the Nikkei index was at its historic high of 39,000. This was a bubble and like all bubbles, it popped in 1990.
Japan hasn’t recovered since. The obvious reasons were discerned immediately. The policy response to the bubble was to increase interest rates and quell speculation. But as the equity market and real estate prices crashed, borrowers who had overleveraged themselves were trapped. A debt crisis soon followed with widespread loan defaults. The contagion now engulfed Japanese banks which were staring at a huge pile of NPAs. The credit dried up, investments fell, and the growth slowed dramatically. The sentiment turned negative and the consumers cut down on spending. This began a deflationary cycle.
The Bank of Japan (BoJ) was slow to respond and the deflation spiral set in. Why would you spend today when you know the prices would be lower in future? BoJ began cutting interest rates and brought it below 1 per cent by the mid-90s to spur investment. But these actions weren’t coordinated with a fiscal response. The hike in consumption tax in 1996 meant the further dampening of consumption sentiments. The loan default crisis led to the collapse of three banks in the mid-90s. By 1997, as BoJ and the government were getting their act together, the Asian financial crisis dealt a crippling blow to the economy. This set it back for another three years.
What Went Wrong?
Krugman in 1998 argued the lost decade of the 90s was because of monetary policy failure. His view was the BoJ should have publicly taken a high inflation target that would have avoided deflation and prevented interest rates from going down to zero. Of course, this is supported by theory. A higher inflation target anchors inflation expectation at a higher number and this increased expectation, in turn, leads to higher inflation because of the forward-looking aspect of the aggregate supply equation. Further, the increase in inflation expectation would reduce the real interest rate because it takes time for the nominal interest rate to reach its long-term level. In the short term, this reduced real interest rate stimulates growth which in turn increases inflation. A kind of a virtuous cycle sets in.
Anyway, this wasn’t done by BoJ. The other option was to reduce the interest rate to zero quickly and provide substantial monetary stimulus quickly to check loss in output. A combination of a high inflation target (as suggested by Krugman) and monetary easing policy could have possibly worked.
Between 2001-06, the BoJ went on a quantitative easing overdrive purchasing long-term Japanese government bonds. After the global financial crisis of 2008-09, the BoJ extended this programme to purchase private-sector financial assets including corporate bonds, ETFs (therefore equity in private companies), CPs and invest in real estate investment trusts (REITs). This had an impact on financial markets with stock markets rising, a fall in bond yields and an increase in corporate bond issuances. But this expansionary policy came at a cost. The debt to GDP ratio which was around 60 per cent in the 90s went up to 240 per cent by 2012. However, all of these measures didn’t move the needle on inflation. It is possible a higher purchase of private risky assets like corporate bonds and commercial paper instead of government bond would have spurred growth and raised inflation expectations. But that was not to be.
Separately, the lack of coordination between monetary and fiscal policies hurt the economy. There were multiple increases in taxes to balance the budget while the monetary policy was working to increase consumption sentiments. Lastly, there was a lack of clear communication to manage expectations among the public about long-term inflation, interest rates or growth. Forward-looking guidance by the central bank on these parameters provides assurance to market participants more so when the financial system is weakened by high NPAs and general risk aversion. A recent example of this was seen when the US Fed indicated it will purchase corporate bonds as part of its stimulus during the pandemic. The planned purchase announcement itself did the trick in raising bond prices before the Fed actually bought a single one of them.
Abenomics In Play
Shinzo Abe and BoJ Chairman Haruhiko Kuroda assimilated the learnings from the lost quarter-century to formulate the ‘three arrows’ of Abenomics in 2013. The three arrows were:
A monetary policy based on a qualitative and quantitative easing (QQE) framework with a 2 per cent inflation target, significant purchase of long-duration government securities and private risky assets, expansion of BoJ balance sheet and upfront guidance on these numbers. BoJ promised to double its monetary base to 54 per cent of the GDP by 2014.
A robust fiscal policy that increases absolute government spending on areas like public infrastructure, welfare for its ageing population and servicing the debt. This was to be done in close coordination with the monetary policy actions.
Structural reforms to spur growth and private investment. This includes lower corporate tax, increase in participation of women in the labour force, more immigration and acceptance of high-skilled foreign workers, more inbound tourism to Japan and championing of free trade (TTP), lower FDI barriers and global liberal order to counter China.
You couldn’t fault their prescription based on what they learned from their past. Abenomics wasn’t a radically new construct but bringing the three arrows together, setting targets for them and then communicating it clearly, indicated Abe meant business. Japan needed to be jolted into a path of recovery and this was the way to do it. The salience of Abenomics grew as more economies, including US and EU, followed the path of QE to stimulate growth and manage financial stability.
Did It work?
Well, it is a mixed bag. The primary objective of the 3 arrows was to ‘warm up’ the economy to an extent that spurs demand and get the investment cycle going. On that count, it is a mixed bag. It has seen limited success in increasing women's labour force participation, more immigration and in keeping debt to GDP at a near-constant level of 240 per cent (pre-Covid) despite the increase in the monetary base. It’s not an unqualified success. The counterfactual, of course, can be asked. Could Japan be worse off today if not for Abenomics?
I think it would.
Lessons From Abenomics
So, what are the lessons learnt from 7 years of Abenomics in Japan? Robin Harding writing for the Financial Times has six lessons from Abenomics for the world struggling with ‘Japanification’. I am paraphrasing below:
Monetary policy through the massive purchase of government securities and private assets works. The ‘bazooka’ of 2013 had a positive impact on the Japanese economy – stock markets boomed, credit uptake went up and unemployment fell.
Despite the promise of coordinated monetary and fiscal actions, Abe couldn’t keep fiscal hawks down. The rise in consumption tax from 5 to 8 per cent in 2014 worked counter to the efforts in increasing consumption. The economy went into a recession. Another increase last year to 10 per cent had the same impact.
Communication and future guidance on targets didn’t materialise. The promised inflation target of 2 per cent was never met and the consumption tax hikes meant the premise of raising expectations and letting it do the heavy lifting in raising inflation didn’t work.
Expectations management works if you meet the expectations. Beyond a point, you need to intervene directly to meet your targets. The key commitments of Abenomics were never kept and soon the market stopped responding to the BoJ plans of further easing.
Stimulus doesn’t cause an increase in public debt to GDP ratio going up. We have discussed this already. It remained range-bound at 240 per cent.
Structural reforms didn’t cut to the key issues confronting Japanese society – an ageing population leading to a fall in total factor productivity, a disappointed younger generation carrying the burden through levies and taxes on income, a strong hierarchical working style stymieing innovation and a reluctance to embrace large scale immigration to get out of this rut (an advantage so far for the US).
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Global Policy Watch #3: How Social Media Expands our Reference Networks
Global policy issues relevant to India
— Pranay Kotasthane
In edition #173, I argued there are three meta-mechanisms that make social media a powerful instrument: reference network expansion, Overton Window Expansion, and disproportional rewards for extreme content due to information overload.
This article generated an interesting conversation on social media (where else!). One of the discussion points was: what are the precise ways through which reference networks expand? Here’s an initial answer.
To rewind a bit, our reference network comprises “people whose beliefs and behaviour matter for our behaviour”. Social media expands our reference networks as people worldwide can now instantly and repeatedly influence our perceptions. It’s common to misinterpret reference network expansion as echo chamber-isation. However, there’s something much deeper going on.
A reference network expands when an individual associates herself with a new set of individuals. This association could be of two types: comparative and preferential. In the first type, we compare ourselves with others who we imagine to be similar to us. Social media expands the number of people who we can compare ourselves with.
In the second, the focal point is our preferences. Our behaviour is determined by the likes and dislikes of others we encounter on social media.
In the framework above, I have mapped these associations with likely impacts on our behaviours. It explains to a large extent how even domestic issues have global resonance, and why people are willing to support or hate people they’ve never met outside their social media apps.
From this perspective, echo chambers span two kinds of preferential associations (“others like what I like”, and “others hate what I hate”). There are four other mechanisms through which reference network expansion takes place.
Are there other ways you have seen reference network expansions happening on social media? Do leave a comment.
HomeWork
Reading and listening recommendations on public policy matters
[Report] State of Discrimination Report by Bhuvana Anand and Sarvnipun Kaur analyses all the state-level legal barriers to women's employment in India.
[Book] For those interested in community building, Peter Block’s Community: The Structure of Belonging has excellent insights. The portal abundantcommunity.com too has some handy resources.
#176 Of East Asian Transformations