Japan is under new leadership, and making fresh attempts to tackle deflation and stimulate demand. So can 'Abenomics' rescue the economy, and restore confidence in the country's fiscal management and social security system?

With the Japanese government now under the stewardship of prime minister Shinzo Abe, Japan is set to pursue an economic policy that calls for bold monetary easing in order to end deflation.

This policy is predicated on the perception that once Japan successfully exits from deflation – by setting an explicit inflation target and taking bold monetary easing measures – the economy will grow and jobs will be created.

This assumption, however, does not necessarily hold. We must acknowledge the basic fact that economic theory has been unable to explain the cause or mechanism of continuous price falls in Japan - that is, long-term deflation – for more than a decade. Why?

Despite trying hard, the government and the Bank of Japan have yet to put an end to deflation. The money supply has been raised to a level significantly higher than that prior to the economic bubble of the late 1980s, but prices are not going up. This indicates that there has been a chronic decline in the velocity of money.

But why is this happening? Anxiety about retirement – or about the future in general – can be cited as a hypothetical cause, but we have yet to find any definitive answer grounded in economic theory. If anxiety about retirement is the cause of deflation, fiscal consolidation and social security system reform would be more important measures, and the government should be pursuing them instead of monetary easing.

Indeed, we must remind ourselves, so as not to have excessive expectations, of the common-sense fact that monetary easing is nothing more than a stopgap measure.

The hypothesis that the economy will begin to grow once deflation is over also requires rigorous scrutiny. Economic growth over the medium to long-term horizon is determined by changes in population and productivity, whereas inflation and deflation have only a nominal impact, if any at all.

An extreme easing of monetary policy by the Bank of Japan would surely drive down the value of the yen, push up stock prices, and give a boost to the economy over a short period of time. This, however, would neither raise long-term economic growth nor increase tax revenues to the point that is sufficient to solve the nation’s fiscal problems. Meanwhile, Japan is facing a series of serious challenges.

Many argue that Japan is in a serious fiscal crisis. However, we rarely see comprehensive cost figures – such as the percentage by which the consumption tax rate will eventually need to be raised.

Up until only a few years ago, Japan was considered to be better off than Italy in terms of government net debt – which is defined as total financial liabilities minus total financial assets of the government. However, Japan’s fiscal condition has been deteriorating at an accelerated pace, and what was considered common sense a few years ago is no longer applicable today.

In the past couple of years, some researchers have performed simulation analyses to examine the fiscal sustainability of Japan. According to their findings, Japan would have to find additional revenue equivalent to an approximately 30% hike in the consumption tax rate in order to restore fiscal sustainability. This fiscal gap must be filled by increasing taxes, reducing social security and other expenditure, and/or creating inflation.

Given the current reality of Japanese politics, this problem seems unsolvable. For instance, one fiscal consolidation plan calls for eventually stabilising the consumption tax rate at 17% - but would take 150 years to be completed.

Furthermore, before reaching that final goal, the consumption tax rate would have to be raised to about 32% and maintained for several decades, and social security expenditures would have to be cut significantly – and all of these measures would only be effective on the premise that Japan achieves 2% inflation.

The seriousness of the crisis Japan faces can be seen in the fact that such unrealistic policy prescriptions are arrived at when you analyse the data in a straightforward manner. Creating a bit of inflation will not solve the problem – 2% inflation, even if realised, would have the impact of curbing the necessary consumption tax rate hike by only about five percentage points.

A drastic cut in social security expenditure – pension benefits and medical expenditures – should be discussed in the sphere of political decision-making, and political leaders should realise that Japan cannot afford to postpone its planned tax hike. The government should raise taxes first and, if the resulting impact on the economy is expected to be too severe, implement stimulus measures. Considering the current state of Japan, raising taxes after the economy gets better is putting the cart before the horse.

As for a long-term growth strategy, the theory of directed technical changes – or induced technological innovation – provides hints for the coming years.

This idea was advocated in the 1970s and formulated into a theory in the late 1990s. The concept implies that changes in the market environment and/or in the distribution of resources determine what technical changes will be profitable in the future. The direction of past technical changes can be explained by this theory to a considerable extent.

Looking to the future of Japan, the biggest change in the market or resource environment is population ageing. Technologies that are in alignment with this trend of demographic ageing – i.e. gerontechnology – will no doubt be in great demand in the coming years.

Since population ageing is taking place across the world, there will be enormous demand overseas. It will not be at all surprising if the production of systems and equipment utilising gerontechnology grows into a leading export industry by the mid-21st century (we should recall that automobiles, which used to be expensive toys for rich people in the late 19th century, became the leading export item of Japan in the latter half of the 20th century).

Meanwhile, both the sovereign problems in Europe and the fiscal problems in Japan can be defined as a phenomenon in which markets are being shaken up amid growing doubts over governments’ ability to make commitments to maintaining social-security systems over a very long period.

In considering economic policy for the future, we must base our discussion on the premises that: the government is no better than the private sector, whether in abilities or morals; the government is just as incapable as the private sector of making long-term commitments, and cannot promise what the policy decisions made today will bring in the remote future.

Going forward, a change of party politics with every change of government will likely become a recurring event in Japan. In order to restore people’s confidence in fiscal management and the social security system in the light of that prospect, institutional systems should be designed in a way to allows flexibility, based on the fact that the government cannot make commitments into the far future.

Political leaders – whether they belong to the ruling or opposition parties – need to come up with new ideas toward achieving that end.

Keiichiro Kobayashi is professor at the Institute of Economic Research, Hitotsubashi University, Japan. A fuller version of this post first appeared on the Vox website