For the fourth time since 2008, Japan is back in a technical recession. Its economy unexpectedly shrank for the second quarter in a row, this time falling 1.6 percent as its big sales tax hike continued to slam growth.
That, at least, is what Prime Minister Shinzo Abe seems to be thinking. He reportedly wants to hold snap elections over postponing next year's planned tax increase to try to get the recovery back on track. And that makes sense. Abe, after all, came into office last year with a popular mandate to end Japan's two-decades long malaise. Indeed, despite its super-low unemployment and obvious wealth — I mean, just look at Tokyo — Japan isn't as rich as it should be. As Brad DeLong points out, it lost ground to the U.S. after its bubble burst in the 1990s, and hasn't even made up any of it since, in large part due to its aging population.
So "Abenomics" was born: fiscal and monetary stimulus, together with "structural reforms," like getting more women in the workforce, to make up for at least some of Japan's lost growth the last 20 years. If it worked, prices would stop falling like they have for 15 years now, and there would be a virtuous cycle of inflation leading to more consumer spending leading to more business investment, and finally more inflation at their 2 percent target.
The problem, though, is that the government has started working at cross purposes with the central bank. See, at first, the government was spending money to jumpstart growth, and the Bank of Japan (BOJ) was buying bonds with newly-printed money to do the same. It was enough to send unemployment down to 3.6 percent now, and inflation finally up into positive territory. But then, six months ago, the government became more worried about its debt of 230 percent of GDP than it was about the recovery. It raised the sales tax from 5 to 8 percent, and the economy promptly tanked. The BOJ has responded by buying even more bonds with even more newly-printed money, but not before domestic prices, as measured by the GDP deflator, began falling again, this time at a -0.3 percent pace.
Abenomics, in other words, has gone from being fiscal and monetary stimulus to fiscal austerity and even more monetary stimulus—and that, at least for now, has brought back deflation.
But what's Japan really afraid of? The more you think about it, the less obvious it becomes. Japan's government, you see, has borrowed almost all its money from Japan's people, and—this is critical—in Japan's currency. So there's no reason the government should ever want to or have to default. That's because it would be defaulting on its own voters, which wouldn't exactly endear it at the polls, and it could always use the printing press to pay its debts as a last resort.
Do you see the contradiction? Japan's government, as Paul Krugman points out, desperately wants to end deflation, but still thinks it needs to raise taxes before investors fear it will inflate aways its debts by printing money. Instead, it should be using that fear to convince people of what's otherwise hard to: that inflation is going up. That's what the debt-ridden U.K. did in the 1930s, as economist Nicholas Crafts argues, after its Treasury basically took over monetary policy from its central bank. People assumed that the government had an incentive to increase inflation, and that was part of the reason it did—which made Britain's economy take off. It's also what France inadvertently did in the 1920s, when it inflation get so out of control that people bet it would be the next Weimar. But, as Krugman reminds us, France's economy actually did well—especially compared to Britain, which did all the "right" things—and a few years of inflation left it with much less war debt.
The only thing Japan has to fear is the fear of more inflation. It would mean a better recovery and less debt. But instead, Japan is back in recession because it forgot lesson number one: Nobody ever ended a depression by being responsible.