Policy dictates that you expand demand during a demand shortage and suppress it during a supply shortage. This seems like common sense, yet Japan’s long-term stagnation is the direct result of failing to make this basic distinction.
1. The Post-Bubble Collapse
After land and stock prices plummeted, businesses and financial institutions were forced into “balance sheet adjustments”—cutting spending to restore damaged equity. While rational for each individual actor, this led to a “fallacy of composition” where the entire economy suffered from an endless contraction of demand.
Initially, the government attempted proactive fiscal policy, but it was insufficient. This led to a fatal misunderstanding: rather than concluding that the stimulus was simply too small to fill the massive demand gap, critics claimed that fiscal policy “doesn’t work and only increases debt.” Mainstream economists joined this chorus. The Hashimoto administration (1996–1998) began cutting public investment and hiked the consumption tax in 1997. This set the stage for the Koizumi era. After the 1997 Asian Financial Crisis, Japan spiraled into chronic deflation.
2. Early Deflation: The Koizumi “Structural Reforms”
Deflation is a symptom of demand shortage. Yet, the Koizumi administration responded with a fundamentally flawed prescription:
- Primary Balance Targets: This was austerity, plain and simple—the polar opposite of what the economy needed.
- Structural Reforms: Deregulation of the labor market and postal privatization. These measures might work when labor is scarce by shifting workers to high-productivity sectors. But what happens when you deregulate in a labor surplus? It leads directly to wage suppression and unemployment. That is exactly what happened.
The same applies to the push for increased labor supply (women, seniors, foreigners). These measures only deepen deflation. One should focus on these structural changes after the economy is back on a growth track, not while it’s drowning in a demand deficit.
3. Late Deflation: Abenomics
Abenomics aimed to fight deflation with “Three Arrows”: (1) bold monetary easing, (2) flexible fiscal policy, and (3) a growth strategy to encourage investment. In my view, the second arrow (fiscal) was only fired at the very beginning. As for the third, you cannot expect investment to surge while consumption is languishing. The biggest obstacle was the government’s own interference—tax hikes and social security “reforms” that strangled consumption.
Consequently, Abenomics relied too heavily on monetary easing. While it had some effect, it wasn’t enough to restore normal growth. The situation demanded fiscal stimulus, but the Abe administration—bound by a three-party agreement with the opposition—did the exact opposite: it hiked the consumption tax twice.
While my evaluation is harsh, Abenomics was a significant improvement over the Koizumi era. Had a “Third Abe Term” materialized, we might have seen true fiscal activism. Tragically, he fell to an assassin’s bullet, and Sanae Takaichi, who sought to carry on his legacy, was defeated in the 2024 LDP leadership race.
4. The Post-Pandemic Era
Aggressive fiscal policy in the U.S. sparked a global demand surge, which, combined with a weak yen due to global rate hikes, brought “cost-push inflation” to Japan. However, Japan’s output gap remains negative, and real wages are consistently falling. Domestic demand is still fundamentally lacking.
Critics now wrongly claim that Abenomics failed because it “only caused a weak yen.” This is incorrect. Japan’s yen weakened because we failed to implement the same aggressive fiscal policy seen in the West. Had we done so, our demand shortage would have vanished. To call for interest rate hikes (a demand-suppression tool) to “fix” the yen is absurd. As I explained in my blog on credit creation, you can only justify raising rates once fiscal policy has generated genuine “demand-pull inflation.”
5. Conclusion
From the bubble collapse to the present, Japan has been suffering from a continuous shortage of demand. Therefore, fiscal and monetary policies must remain focused on expansion. If critics disagree, I challenge them to explain why deflation worsened so much under Koizumi, or why real wages are still shrinking today.
The government’s current approach is a repeat of past failures. Just as “fiscal policy underperformed → let’s try austerity” was a mistake, “monetary easing underperformed → let’s hike rates” is equally flawed. In which textbook does it suggest raising rates during a demand shortage?
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