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Japanese Economy Update

Beware of a Protectionism Spiral

  Senior Research Fellow


The three biggest surprises of the year 2016

This year, we have seen a number of major events that ended up with a big surprise. I would like to list my three biggest surprises of the year.

First was the Brexit. The referendum in the United Kingdom that took place in June 23 was expected to give a victory, albeit with a narrow margin, to those who supported the UK in staying in the EU. However, the victors were those who argued that UK should leave the EU. It led to a change of the Prime Minister and the Cabinet, and the preparations are now being made to initiate the negotiation between the UK and EU, which takes place after notifying the EU with the will of the UK to leave the union.

Second was the election of Mr. Trump as the next president of the United States. The presidential election that took place in November 8 was expected to name Ms. Clinton as the first woman to be elected president. However, the majority of the electors went to Mr. Trump who may be later know to be a president who restructured the current world order.

Third was the markets’ response to Mr. Trump’s election. When Mr. Trump was elected to become the next president of the United States, because of the increasing uncertainty that Mr. Trumps victory will bring, economists expected a fall in stock prices and an appreciation of the yen (which is seen as a safe haven currency) to take place. However, the actual reaction was just the opposite: the stock prices have been rising to their highest of the year, and yen depreciated from 104 yen/US dollar just before the election to 114 yen/US dollar in December.

Macroeconomic policy mix of the Trump administration

As a result of the Trump rally (as the current stock price rally is called), there is a sense of relieve and a welcome mood towards the macroeconomic policies of the new Trump administration.

Can we really be so optimistic about the outcome of the new policies?

The reason why market reacted positively to Mr. Trump’s election seems to be in his active fiscal policy: He proposes a tax cut for the households (reducing the number to income tax rates to three and cut the maximum rate to 33 percent) and for the companies (cut the corporate tax rate to 15 percent). He also proposes an increase in investment in infrastructure that requires vast maintenance efforts. As a result of these polices, fiscal balance would inevitably see an expansion of its deficit and, in turn, interest rates would face an upward pressure.

It should also be noted that the period in which the expansionary fiscal policy is going to take place is going to coincide with the period in which policy rate hike by the Federal Reserve is expected to proceed. With the labor market showing further improvement, the pace of the policy rate hike would probably pick up next year.

Interest rates, therefore, will be subject to upward pressure from both the fiscal and the monetary policies. It would create a strong basis for the US dollar to appreciate (and other currencies to depreciate).

Historically, similar policy mix led to further protectionism

The expected macroeconomic policy mix in the coming years reminds us of the policy mix in the early 1980s. President Reagan increased government expenditure, especially in defense, and widened the fiscal deficit, while the Federal Reserve, under the chairmanship of Mr. Volker, tightened the monetary policy to fight inflation. Macroeconomic policy mix at that time was also a combination of expansionary fiscal policy and a tight monetary policy.

In the case of early 1980s, it led to high interest rates that agonized the indebted Southern American countries. It also led to the strong US dollar and a widening of the US current account deficit. It is still fresh in our memories that Japan was accused of having been engaged in an unfair trade, and trade disputes arouse in wide variety of areas. Protectionism was at its heights at that time.

This experience tells us that there is a possibility that the macroeconomic policy mix under the Trump administration could lead to further moves in the area of protectionism; on top of what has already been declared (i.e. renegotiation of NAFTA, and withdrawal from TPP).

Trump rally warrants no relief

The current reaction of the market may seem to be favorable to the Japanese economy. However, the macroeconomic policy mix that the market received with a positive note may lead higher interest rates, larger current account deficit, and a reinforced protectionism. We should bear in mind the risks of the policy mix, and the implications that it may have on the Japanese and the global economy.