Sunday, March 20, 2011

Surely There Is Nothing “Funny” About What Is Going On In Japan?

As Japanese officials continue to toil away in what we all hope will be a successful bid to avert a worst case scenario nuclear meltdown even while thousands of Japanese still remain missing and unaccounted for, financial market participants across the globe have been struggling with themselves to answer one and the same question: just how serious are the economic consequences of all this devastation likely to be?

Basically, the economic issues raised by Japan's continuing agony can be broken down into a number of categories, and especially we need to think both of global and local impacts, as well as the short term, mid term and long term implications of these.

Short-term Pain, Mid-term Gain?

The short term local consequences are evidently likely to be quite severe. Given that large parts of the country have been (and continue to be) without electricity, that factories have been flooded and part of productive capacity permanently destroyed etc, etc, GDP is bound to plummet quite substantially as output drops and takes time to recover.

At the global level the short term consequences are hard to evaluate. That there will be dislocation to extended supply chains is obvious, the Japanese may well buy less luxury goods, while on the other hand becoming more dependent on imported energy, a development which could well affect oil prices. In terms of global demand, it is important to remember that Japan is a significant net exporter, so in theory one country exporting less should simply leave room for others to step in and fill the gap. But things aren't as simple as that, and global trade inter-linkages mean that local shocks can easily be amplified in a way that conventional economic models find hard to capture. The shock that radiated out from the US during the great depression is a classic example from history. Impacts were much greater than a cursory inspection of direct trade effects would have suggested.

But more than anything the issue which is being raised by Japan is one of confidence, and one of how we think about risk (an issue which has been lurking in the background without being resolved since the start of the financial crisis). Problems in evaluating risk and shocks to confidence levels are hardly good for risk sentiment, and it is an increasein this sentiment which is, at the end of the day, giving momentum to the current expansion in global economic activity. And of course risk-negative phenomena are not only to be found in Japan, a fact of which this weekend's opening of military engagements in Libya is just one more painful reminder.

Low Frequency Events Becoming More Frequent?

The whole of the last week has been characterised by a high level of uncertainty, with oil prices remaining extremely volatile and sharp movements in the value of the yen having such a negative influence on currency markets that the G7 felt itself forced to step in. So while the external economic damage seems at the present to have been contained, with one “bad luck” event after another taking place the momentum behind the current recovery is surely coming under a lot of pressure, and all prudent analysts will doubtless be busy revising downwards their growth forecasts for the second half of the year across the board.

There are two reasons which make me think that such a move is completely warranted. In the first place we have a global system which is completely "tensed" at this point. Many problems generated by the financial crisis have been simply kicked down the road a bit, in a bid to buy the time to find the solutions. What this means is that the whole global edifice is extremely sensitive to the impact of unusual events and sudden shocks. Which means that there is a tendency to find that just when you thought things were getting better you start to discover they are actually getting worse.

Japan has provided us with one very good example of this. Towards the end of last year the Japanese economy had been going through what is euphemistically called a "soft patch" - the economy actually contracted in the last three months of the year - but in January and February there did seem to be signs that things were getting better, and one guage of small-business sentiment (the Economy Watchers Index) had even started to surge.
The Economy Watchers' Survey index for current conditions in Japan rose to a seven-month high of 48.4 in February from 44.3 in January, posting the first rise in two months thanks to a recovery in weather and labor conditions, the Cabinet Office said on Tuesday. But the outlook index was unchanged in February, ending a third straight month of an improvement, leading the government to maintain its assessment of public sentiment. The government repeated that the latest survey showed that "the economy has shown signs of picking up."

This much more optimistic reading, suggesting better weather was lifting confidence, was, ironically, written on Tuesday 9 March, just three days before the deadly earthquake struck. It is a stark, if somewhat tragic, illustration of just how uncertain the world we live in actually is, and of just how difficult it is to forsee certain kinds of phenomena. On another front, who at the start of 2011 would have imagined we would at this very moment be facing a UN backed military invasion into Libyan territory.

Longer Run Impacts

Serious as the short term impacts may well be, in the longer run the shadow which will be cast by what is currently happening in Japan could well be very long indeed, in a way which few today can even contemplate (although see this for a good first pass). The justification for this assertion is not only our increased awareness of our collective vulnerability to the impact of natural disasters, there is also Japan’s pioneer status in one very new and very global phenomenon - population ageing - to think about. As we will see below, the optimistic (I would say denial) prognosis is that Japan will soon valiantly overcome this latest bout of adversity in a similar way to which they overcame the post WWII devastation. The Japanese will surely be valiant in their efforts (one only has to think of the spirit of sacrificeof those poor workers who have been asked to handle directly the reactor problem), but their ability to overcome adversity will not be comparable to that registered in an earlier epoch when they had the wind behind them rather than gusting straight into their faces.

It is for this reason that I recently likened the earthquake and tsunami to another mindset-shaping natural disaster: the Great Lisbon Earthquake of 1755. Both events, for their magnitude, and for the seeming arbitrariness with which they strike any given set of individuals, inevitably leave (and left) searing scars in our psyche, the latter being characterised for the way it opened up the path to what many have termed the modern era, while the latter potentially could draw it to a close.

What I have in mind is this, the Lisbon earthquake lead to a questioning of the "natural order of things" in a way which facilitated a more rational approach to the problems in hand. But the application of this rational approach gave rise to a "second degree" natural order of things, in which (thanks to good governance, an economic hidden hand, and technical expertise) the permanence and stability of the social and economic world around us was almost totally taken for granted.

One good example of this would be the idea of the birth of a "Modern Growth Era", whereby it was assumed that economies would simply grow and grow in perpetuity, driven possibly by the dynamising capacity of ongoing technical change. The curious thing about this kind of interpretation is that Robert Solow, founder of the modern neo-classical growth model, intentionally and explicitly left technology out of his model. From a general equilibrium perspective technology does not necessarily generate economy growth.

And now we are faced with a significant number of advanced economies which may well find themselves, far from growing, actually starting to shrink at some point during the next 50 years. The reason for this, of course, is that working-age populations will be declining and ageing at the same time as the elderly dependent population (and their health and pension needs) will be rising and rising. So it seems we are now about to become aware that the Modern Growth Era was simply that, one particular era in our history as a species and as a group of social and political animals. This era is now, in some countries, starting to draw to a close, and a new one will surely open up. My conjecture is that what is happening now in Japan may well mark a tipping point in our awareness of this process in just the same way as the surge in Sovereign Debt in some countries which occured during the financial crisis marked a turning point in how we think about demography and economics, and in how we see the sustainability of health and pension systems.

Of course, as with all issues, there are still those who remain in denial.

But there is another dimesnion to the Japan crisis and how we see it that ties in with the Lisbon earthquake parallel, and that is our need to change mindset. Basically the issue concerns complexity, and how useful old-mindset linear models are in helping us address the kinds of issue which arise in managing highly interconnected and interlocked economic, social and technological systems.

The Spent Fuel Rods Storage Problem

Evidently examples of inter-connectedness, and the issues this gives rise to, are legion. I have already mentioned trade linkages, and from this point of view it will be highly instructive to watch just how the shock-waves radiate-out (or don't) from their Japanese epicentre in the weeks and months ahead. The global financial crisis was also chock-full of similar examples: Lehman Brothers folded and the rate of infant mortality in Northern India shot up, to name just one. But the unfolding events in Japan give us an almost "locus classicus" version of the problem: what to do with the used fuel rods. Now using a simple and straightforward risk management model, it might even seem to be efficient to store the spent rods in the same enclosures as you put the reactor. They are, after all, easier and cheaper to keep and eye on there, and anyway, this procedure helps overcome the sensitivity of members of the general population to being un the proximity of any form of nuclear waste. But looked at from another point of view, grouping risky elements in close proximity in this way only piles risk on risk in a geometric and not a linear fashion, exposing the entire social and economic system to the impact of a positive feedback melt-down process in almost the most literal sense.

I personally cannot help feeling that something similar is going on in relation to positive-feedback-process risk in connection with the individual units which constitute the Spanish financial system. As long as things don't go wrong, well, they don't go wrong, but if and when they do...............

So while the initial impact will surely constitute what most traditional economists like to call a “shock”, both to the real economy and to the equity and currency markets, this shock is unlikely to knock either the global or the local economy completely off their orbits in the short run. We are not talking (barring that worst case scenario that we all have our fingers tightly crossed won’t happen) about another Lehman type event. We are talking about a major natural disaster in a country with proven response ability. Even if Japan is currently now back in recession, rebuilding will almost certainly mean the local economy bounces back quickly again in the second half of the year. The longer run effects, however, will almost certainly be much more important. On one front the impact may well be to cast a much larger and more intense spotlight on the Japanese economy itself, with increasing questions being asked about the sustainability of its current path giving the declining and ageing population issues which confront it. And on another front, the events of the last week may well end up changing our way of thinking about the world we live in, and how we manage risk and insecurity. One week ago few would have imagined it was possible for a developed country to find itself spinning-off out of control, now the previously "unthinkable" is certainly a lot more thinkable.

At The End Of The Day Isn’t There Something "Funny" About Japan?

Japan’s economy is totally export-dependent, riddled with deflation, has central bank interest rates pegged almost permanently close to zero, while government debt seems to be on a virtually unstoppable upward path. Just to give some idea, IMF Japan projections are for GDP growth of around 1.75% a year between now and 2015. During the same period the government debt to GDP level will rise from 225.8% in 2010, to 234% in 2011 and then onwards and upwards to 249.2% in 2015 - that is the debt is rising at over 5% of GDP a year, while GDP is growing at under 2%. Personally I'm surprised that more people don't think there is something funny about these numbers, especially in the context of ongoing deflation and massive liquidity provision from the central bank.

According to one widely held theory, none of the above matters too much since Japan’s government debt is financed from domestic saving. On this view having near permanent deflation seems to be a massive positive, since it enables money to be printed and debt to be accumulated on a never-ending basis. The perpetual motion machine has finally been invented, and is alive and well and living in Japan. Certainly the situation has all the appearance of permanence, since it would now seem to be virtually impossible for the Bank of Japan to move into reverse gear and raise benchmark rates to what was in earlier days a "normal" level of 5% since how would the government continue to finance itself, whether the savings are domestic or external? And of course, if at some point Japan did come to depend on external funding, and interest rates were forced up to 5% or more...........

It continues to surprise me that more people do not find the whole situation odd: gross government debt to GDP only goes up and up, across all horizons, and this is supposed to be normal and sustainable?

On another version of events, the gross debt argument (gross debt is used simply to be able to make a comparison with other countries, such as members of the EU, where it is gross debt that is measured and quoted) is misleading, since Japan's government also has assets (like land which was acquired during the bank restructuring of the 1990s), and it is the net debt level we should be looking at. I have two responses to this objection. In the first place, the argument fails to take into account the implicit liabilities of the Japanese pension and social security systems. Once this is done you have a number which while still being lower than the gross debt figure is consideably above the hypothetical level of net savings. In the second place, while the values of the Japan government's gross liabilities to its creditors are known and quantifiable, it is much harder to put mark-to-market numbers on the assets being held.

But in any event it is the debt dynamic which is worrying. This is not a cyclical phenomenon, but long term structural, and it is hard to see how this dynamic can be broken at this stage. Looking at the two lines in the above chart, they are moving up almost in tandem. Net debt will hit 130% of GDP this year according to the IMF, and could well be around 155% by 2015, and that was before the earthquake. So I don't really get the point people are trying to make with this argument.

Another issue which leaves me a bit cold is the size-of-corporate-savings one, since what people are saying is unsustainable is government debt. It is simpleton-type thinking to suggest that corporate savings could simply be handed over to the government, since this involves the private sector bailing out the public sector in a way which parallels the way the public sector is often bailing out the private sector in Europe. If things were that simple, don't the people who emphasise this detail imagine someone would have thought of it and done it already?These savings are in private hands, and any attempt simply to appropriate private savings would meet with substantial resistance, not to mention the dangers of capital flight, or larger corporates simply moving offshore.

A Population Which Has Been Allowed To Get Too Old Too Fast?

Evidently what we have here is a clear example of something which only goes on until the day it doesn’t. The underlying problem in Japan is not lack of technical ingenuity, nor is it a shortage of credit; Japan’s fundamental problem is a demographic one. The country has a rapidly ageing population, which after many years of ultra-low fertility and rising life expectancy is now the oldest in the planet, with a median age of 45 and rising. This is the backdrop to all these weird and wonderful economic phenomena we are observing, and is the root cause of the weak domestic demand, and of the ultra-sensitivity of the economy to movements in the external trade balance.

So the big question people need to be asking themselves is just what happens when Japan can no longer deliver the external surplus it needs to sustain economic growth? Trend growth has been falling consistently, and overdecades, in a way which is unlikely to change and logically it will at some stage turn negative.

In particular this is long term contractionary pressure is evident since Japan's workforce is shrinking and ageing. The process is, unfortunately, only compounded by the current "irradiation" problem since it will lower the ability of the country to attract immigrants (at least over the next few years), even were Japan's leaders to give this a priority, which is itself unlikely to happen.

As luck would have it Japan did record its first trade deficit in two years in January, and while this is currently only a passing and transient phenomenon, it does constitute some kind of warning shot for what could one day happen. In fact, the Japanese economy returned to negative growth in the last quarter of 2010, and has been struggling to find the level of exports it needs to sustain growth (even despite the strong emerging market demand) as it has been weighed down since the onset of the crisis by the continuing high value of the yen. Since it is now entirely possible that growth this quarter will also be negative, Japan is now almost certainly technically back in recession.

Japan’s Prime Minister Naoto Kan has already stated that Japan is now facing its worst crisis since the end of World War II, and I think it is hard to disagree with this assessment, both in the context of the current “facts on the ground” and given the major challenge the country faces on the demographic front. This is what the consensus view which holds Japan is likely to suffer a temporary economic hit and then enjoy a boost from reconstruction seems to be missing. Japan is very unlikely to have a “New Deal" like economic recovery, for the simple reason that it cannot really afford to have one due to the pressing need to get the debt dynamics better under control.

Indeed already there is talk of raising taxes to help pay for reconstruction work, since clearly a supplementary budget which incorporates more deficit is the last thing JGB market watchers want to hear about at this moment in time. So even if some increase in government debt now looks inevitable this year, the pressure to claw it back in a near term future will be significant.

Not least of the reasons for such caution will be the growing vigilance the country’s debt is attracting from the rating agencies. Standard & Poor’s cut their Japan rating in January, and while Moody’s have been quick to point out that the current crisis will not affect their analysis, they did change their Japan rating outlook to negative from stable at the end of February on concern that the country’s political gridlock will limit efforts to tackle the debt burden. These concerns will only be heightened in the aftermath of recent events.

According to Marcus Noland, deputy director of the Peterson Institute for International Economics in Washington what Japan is facing “is a Keynesian stimulus program that nobody can argue with”. Unfortunately, this is far from being the case, Japan is at the end and not the start of its "modern growth era" and any attempt to finance a massive reconstruction programme by issuing yet more debt is likely to provoke just what Noland discounts: a lot of argument. Funny how so many people still fail to find anything “funny” about what has been happening in Japan.


benj said...

The most astonishing thing of all is really the end of the article when we discover that there are still economists, in 2011, that believe in "Keynesian stimulus" when we know and have been knowing for decades that it does not work and has never work anywhere - including the New Deal that was a disaster.

Anonymous said...

Who cares about demographics, we're all getting rich! If life = work + leisure, the cost of living is going down because the cost of leisure is in utter freefall. Ipads, google, kindle, skype (less need to travel to visit in-laws)etc, etc..

I don't understand why I should worry about Solow-type growth in a world that isn't growing its population.