Monday, July 20, 2009

What's So Funny About Japan?

by Claus Vistesen and Edward Hugh

The following article appeared in the June 2009 issue of Japan Inc.

Japan’s economy just does not seem to be able to catch a break at the moment. GDP contracted at an annual pace of over 15.2 percent in the first three months of this year, while industrial output fell by over 34.5 percent following a contraction in exports which was nearer to the 40 percent mark. As a result the International Monetary Fund (IMF) now predicts the Japanese economy will contract by about 6 percent over the year as a whole (which compares with their current forecast that the U.S. Activity will decline by a “mere” 2.8 percent), and just to add insult to injury, Japan seems once again to be headed back into that same old dreaded deflation which it has just spent the best part of a decade and a half trying to escape from.

Of course, behind these horrendous numbers lies the ongoing global economic and financial crisis which, after hitting the headlines in the middle of 2007 with the “turmoil” surrounding the subprime mortgages problem in the United States, has steadily spread its grasp across one economy after another around the globe. But while this crisis is certainly a global one, its impact is most definitely local, and not all countries have been on the receiving end in similar measure. The striking thing about what is happening now in Japan is how suddenly, after what appeared to be such a marked and sustained recovery, the economy has folded in on itself. What was once again being seen as a star performer has now become one of the worst case scenarios. So the question naturally arises: Why is this happening?

What is so funny about Japan’s economy?

So why is Japan special? Well obviously for a whole bundle of reasons, but the one we would like to pick up here, in this brief review of the current state of play, would be Japan’s demographics, defined as they are by many years of extremely low fertility, and what could at best be described as extremely tepid efforts to stimulate inward migration. As far as we can see, it is Japan’s demography which, in many ways, condemns it to the kind of painful vulnerability to external shocks to which we are all currently bearing witness.

Demography is a problem for Japan, since the aging population is clearly leading to lacklustre domestic demand, and this is what lies behind the country’s evident increasing dependence of exports. Back in 2006, Morgan Stanley’s chief Japan economist Robert Alan Feldman got to the heart of the problem when he asked one very simple question: What is so funny about consumption in Japan? The conundrum, according to Feldman, is one of why we have seen such high capital expenditure (capex) and such low consumption during the recent very pronounced expansion. Now even the most basic economic intuitions suggest that such a relationship is far from stable. If government spending holds constant, firms should adjust their investment decisions to the level of demand for their products, and this, in a modern economy, is normally driven by the rate of growth in demand coming from end consumers. The problem is that in Japan’s case, the key end consumers are largely “elsewhere,” that is, they are outside Japan. Feldman’s answer to the conundrum this represents is really quite neat. Starting with the obvious fact that Japan is aging, Feldman points out as the total population is set to shrink much more slowly than the labor force, each worker will need to be supported by more capital to keep productivity, and thus living standards, stable.

This intuition, derived as it is from the fundamental tenets of standard economic growth theory, is however only as good for as far as it goes. The key issue to grasp is that since Japan is an open economy, the internal deficit accumulated by having a high capex, low consumption economy can only be made good by exporting “excess” products or capital. This in turn means that domestic investment decisions respond to foreign demand and rates of return.

Feldman’s solution to Japan’s problem is attractive in that, as well as being intuitive economics, it also finds strong circumstantial backing in the data itself. Movements in Japanese private consumption have lagged well behind headline GDP growth, while the country has been running a sizeable external surplus, as expressed in its current account balance hitting an all time high of 4.8 percent of GDP in 2007, boosted by both a trade surplus and a surplus on income flowing back from Japanese savings invested abroad. What export dependence means in the context of an economy with a rapidly aging population is that investment becomes tightly linked with exports, thus breaking one of the key economic transmission mechanisms, since when this link breaks down, there is no second leg to offer support and growth goes rapidly into reverse gear. This situation is abundantly clear in the current economic crisis since a collapse in demand elsewhere has caused both industrial production and exports to plunge leaving Japan with no line of defense in terms of independent economic momentum.

Fiscal stimulus and quantitative easing, will it be enough?

While it is certainly true that the Japanese economy is currently struggling, it is not entirely true that there is no line of defense. Japan still has both monetary policy and fiscal policy tools at its disposal. The problem is that having spent a decade and a half attempting to fight the twin problems of deficient internal demand and ongoing deflation, the force of these tools has been steadily ground down. Interest rate adjustments, after many years when Bank of Japan (BoJ) rates have been held near zero levels, have little additional push to offer, while less conventional tools (like simply printing even more money via quantitative easing) or strong fiscal stimulus face clear limits in a country where gross debt to GDP is forecast by the OECD to hit 193 percent in 2009.

So what can Japan do? Well besides simply grinning and bearing it, the tragedy is that there is not a lot that can be done in the short term. Evidently the Japanese government should give what support it can through highly targeted spending programs. The Bank of Japan, meanwhile, should be moving ahead with an aggressive policy of quantitative easing to provide as much relief as possible to Japan’s struggling households and corporates. But the only real way forward here is to try to slow the rate of population aging, and that means a change in national discourse and priorities, giving more support to those Japanese women who want to have children and radically changing the mindset about the extent to which Japan needs to promote an active immigration policy.


Anonymous said...


I'm not certain what level of personal experience you have with Japan. However, I travelled there extensively for business in the last year. What i can tell you is this: there is no political will to prevent the population aging/decline, or to encourage immigration, because it is quite simply not a national goal. This is because most Japanese feel their island nation is too crowded, and could use a smaller population.

Not noting this sociological aspect will inevitably mean this appears to be a "conundrum" when it is in fact a quite logical result.

Growth-based econometry is all well and good, but what Japan is planning is quite unorthodox from a standard economic viewpoint.

Edward Hugh said...

"what Japan is planning is quite unorthodox from a standard economic viewpoint."

National bankruptcy you mean. Well I agree, this is a very unothodox way to try to protect your old people. I also agree that it is very unlikely they will change course, all we are trying to do is point out the more or less inevitable consequence of this decision.

Aslak said...

I think you can reasonably argue that Japan is overcrowded and a smaller population might be beneficial. The problem is not a declining population in itself but the speed with which it occurs combined with Japan's extreme aging. As Edward points out, it is a recipe for economic disaster.

Anonymous said...

Their debt is Yen so they could just print Yen. Don't see how Japan is going Bankrupt.

Japan has a habit of not changing at all and than change completely in a microsecond.

Edward Hugh said...

"Their debt is Yen so they could just print Yen. Don't see how Japan is going Bankrupt."

Quickly, since this is a complex issue, but this works as long as Japan is able to maintain a current account surplus: ie so long as Japan is a net saver. But as Japan ages this becomes increasingly difficult, and once Japan slips into negative balance (permaently, since she won't get younger again), then gradually she will need to attract the savings of others to finance the debt. That is when it all becomes unsustainable, since you won't be able to do this with near zero interest rates, while the Japan government debt becomes very very expensive if you pay "normal" global rates. That's when the debt dynamics become unsustainable.

Edward Hugh said...

To take an example. The US has its debt in USD, and can print those. But everyone is now worried about what happens if the Chinese stop buying Treasuries. You need the ability to print and a permanent current account surplus to be able to turn your back on the rest of the world and keep pushing your gross government debt to GDP onwards and upwards over 200%.

At the moment this works, till the day it doesn't, but by the time it doesn't it will be far too late to turn back.