Japan’s fall from grace provides a cautionary tale of economic decline which long predates the global financial crisis.

Japan went from economic powerhouse in the 1970s and 1980s to economic invalid. Over the last 20 years, it has grown by an average of 0.8% a year, a fraction of the growth rate seen in other industrialised economies. House prices have halved from their peaks in the late 1980s and are back to where they were in 1981.

Japan’s travails have haunted Western policymakers for almost a quarter of a century.

But the standard view of Japan as a broken economy, hamstrung by an ageing population and risk-averse institutions, is being challenged by a revolution in economic polices unleashed by Prime Minister Shinzo Abe.

Re-elected last December, Mr Abe has set himself the staggeringly ambitious goal of more than doubling Japan’s average growth rate over the next ten years to 2.0%.

To achieve it, Mr Abe has put in place policies which are at least as aggressive as those pursued by the authorities in the US and Europe to fight the global financial crisis. 

The Bank of Japan’s famously cautious governor has been replaced with a long term critic of the Bank’s policy. In an audacious bid to end deflation, the new governor has set an inflation target of 2.0% and committed the Bank to print as much money as is needed to hit it within two years.
 
The new government has also introduced a sharp, if short-lived, boost to government investment spending in an effort to bolster growth this year.

Mr. Abe's long term strategy is to bring Japan’s spiralling government debt burden under control. As a share of GDP, Japanese government debt eclipses that of all industrialised nations, including the likes of Italy, Greece and Spain. Mr. Abe's gamble is that by 2014 the Japanese economy will be in strong enough shape to withstand sharp rises in consumption taxes needed to hit the government’s target of a budget surplus by 2020.  

The most uncertain elements in Mr. Abe’s plans are proposals to improve competitiveness through freeing up markets and boosting competition. The experience of other industrialised economies shows that such reforms often face fierce opposition while the benefits take years, rather than months, to become apparent. The IMF has its doubts and has urged the Japanese government to develop detailed plans and a timetable for implementing them.

Despite the uncertainties that surround Japan’s policy revolution, it has had a big impact on financial markets and on expectations for growth – and far more than the policies of the US, UK and euro area have had on their economies over the last year.

Japanese stock markets have risen by more than 60% since June 2012, the most powerful rally in 50 years, as markets bet on stronger growth and profits to come. Deflation shows signs of waning, with price pressures rising and economists nudged up their inflation forecasts.

The prospect of higher inflation has led to a sharp fall in the yen, providing a boost to Japanese exporters.

Economists’ forecasts for Japanese growth this year and next have risen markedly since the reforms were unveiled. Japan is the only major industrialised economy where the IMF reckons growth over the next few years will be better than it was in the decade before the global financial crisis.

But with the Japanese government running large deficits, any sustained recovery will need to come from the sectors of the economy which do have money – the consumer and, above all, the corporate sector.

Japanese corporates responded to the end of the boom in the late 1980s just as UK, US and euro area corporates have in the last five years – by slashing costs and building up large cash balances.

Japanese business confidence has risen sharply. But, as in the West, growth in Japan is heavily dependent on whether corporates now run down their cash balances and spend on wages, investment and dividends. If Japanese corporates do regain their appetite for risk, some of that cash is likely to be used to buy assets abroad in order to lock into faster growing parts of the world.

Whether Mr. Abe’s growth plan will go the way of numerous other attempts to kick start Japanese growth is anyone’s guess. But he has got off to a good start. Markets are betting on faster growth and more inflation in the next couple of years.

The Japanese economy has faded in the last quarter of a century and, as it has, Japan has faded somewhat from the news in the West. China and the other BRICs make a far more exciting story. Yet Japan is still the world’s third largest economy. Whether Mr. Abe’s experiment works matters enormously for global growth.

It’s worth keeping an eye on Japan.