Japan

Explaining Slow Growth: Turning Away from the Stale “Lessons from Japan”

For the past 3 years, macroeconomists and central bankers have grappled fiercely over the topic of developed market economic stagnation, pending a true recovery from the financial implosions of 2008. Many influential “macro guys” and financial analysts now see stark similarities with the Japanese post 1990 experience and the current forecasts given for much of the developed world. Paul Krugman in a recent Op—Ed piece in his New York Times Blog for example stated emphatically that “Nowadays, we are all Japan”, whilst Richard Koo’s (highly informative) “The Holy Grail of Macroeconomics: Lessons from Japan” attempted to empirically relate the current financial position of the US to that of Japan during the lost decade. Nevertheless, I see a number of structural differences between the Japanese economy leading up to 1990 and the other indebted developed markets of today.

Essentially, if China’s economic model is a mirror of Japan’s, and thus awaits an equally daunting “Long Landing” as is expected (See Pettis, China Financial Markets), then surely the U.S and Europe who run a functionally obverse economic model shouldn’t intuitively be in the midst of a Japanese styled slump. To my mind, much of the debate amongst the macroeconomists misses this point and is therefore muddled and wonky. To my mind, a viable opponent to the Japanese analysis, is one based upon the international Balance of Payments (BoP).

I have long found it curious and odd, that even at the height of sub-prime lending in the U.S combined with excessively low interest rates after 2001, that the U.S economy remained on its long term average growth path. Surely the asset bubble and leveraging cycle should have propelled growth. Similarly, the 3 rounds of QE in the post-crisis era should have also stimulated growth and investment. (I share the opinion of Richard Koo in the idea that the US financial sector, contrary to popular sentiment is indeed healthy) One explanation for lacklustre growth is that the US economy has lost much of its comparative advantage, and that without constant monetary pump priming growth would be even slower. Another idea is that of Richard Koo and those of the Japan school, who now believe that the U.S economy is caught in a fierce deleveraging cycle that may take decades to resolve. And yet both of these theories, as intuitive as they may be, are muddled by inconsistent empirical evidence and strange contradictions.

What if however, the U.S and European economies were plagued by a very different type of problem? One which monetary pump-priming and asset bubbles could not solve. What if, the U.S and peripheral European demand over the past 20 years had simply been bled out by distortions in the external account? In this case, the US crisis was driven by external trade policies, and not, by a statist investment orgy as in Japan.

This situation at first glance seems to be supported by simple facts and intuition. The persistent current account deficits of developed markets, specifically the US, to my mind have caused both the inflated asset prices leading up to 2008, and also the below trend equilibrium (rather than actual) growth rates experienced since roughly 1997.

The late nineties were indeed a tumultuous period, and can be seen hence, as crucial to the development of instability within the US financial system. In 1997-8 a few things happened:

  1. East-Asian financial markets, stunned by a sequence of currency devaluations, began to run targeted trade surpluses.
  2. The US capital inflows soared (functionally the equivalent of a rising trade deficit that balanced the East-Asian surpluses)
  3. Lending and credit within the US expanded, funnelled largely into real estate.
  4. Housing prices and volumes began their ominous ascent.

The East-Asian surpluses then, can be seen to have (either directly or indirectly) penetrated the American trade account. Consequently, East-Asian markets served to change the composition of the American economy. The U.S tradable sector, due to financial repression and increasing savings in East-Asia, was beaten to a pulp and workers quickly made redundant. With a contracting tradable sector, the only possible way to redeploy labour is through a surge in foreign-financed debt which expands domestic consumption and investment. In addition, when the economy is balancing away from the tradeable sector most investment becomes speculative and in this case was inevitably funnelled towards the increasingly liquid real estate sector.

Therefore, the capital inflows (functionally current account deficits) can be seen to have both slowed equilibrium growth, as productive workers were redeployed and fired, and simultaneously fuelling a speculative binge. (The impending crisis’ magnitude was of course also amplified by the irresponsible lending techniques rampant within US financial markets which increased the probability of insolvency).

Even to this day, East-Asian capital exports have continued to increase, with China probably consuming a mere 35% of production (GDP) in comparison to the US’ 72% and Europe’s 65% (Rough estimates). The effect of such Underconsumption on the national savings rate is immense and if the US is to bear the brunt of the resultant capital inflows and Chinese production overload (As the PBoC reserve account holdings of USD implies it does) then it means the U .S is being bled white through the gaping hole in the external account.

With the financial crisis having largely capped the private sector’s willingness to further leverage-up and accumulate debt, there thus remains only one natural way for the U.S economy to absorb foreign excess capacity- unemployment and slower growth. Of course also there are a few politically unlikely ways too though. The US could become competitive through devaluation, higher VAT tax or equivalent, labour market reforms, tariffs etc. But the point is that China and East-Asia have purposely pushed their surplus savings onto the US. The US must absorb this excess by either more consumption, more investment (both imply less savings) or by intervening in trade and stopping the central bank purchases of so many treasuries (remember for every net $1 of Treasuries that are bought by foreigners, that is by economic law $1 added to the trade deficit). Since debt financed consumption and investment is not really an option without significant fiscal stimulus from the public sector (the private sector seems unwilling to leverage up further) and intervening in trade is politically unlikely the only other way to reduce savings is to reduce production by an amount more than the reduction in consumption. ie unemployment. This is basically an accounting necessity

Spain is an exaggerated version and perhaps a better example to see why. Spain can’t devalue due to it’s Eurozone membership. It also has a very limited capacity to load up on leverage (Look at sovereign bond risk premiums and the imploding banking sector) and so if Germany’s surplus continues to be pushed onto it, what can the Spanish administration do? All it can do is lower domestic savings by jacking up unemployment or try to become competitive and push it’s own savings out onto the rest of the world. (Like a Vampire state, sucking away at foreign demand to keep employment high). Coincidentally, the quickest way to regain competitiveness without intervening in trade is to grind down wages via unemployment. This is referred to the “internal devaluation” mode of recovery.

It is in this context that the anomalous predicament of the U.S and other developed markets is neither surprising nor complex. Unemployment will remain high until the trade interventions in surplus nations are eliminated, and the deficit ones are allowed to compete on an equal basis. In a situation where demand is being haemorrhaged to foreigners, fiscal stimulus will also need to be focused on innovative investments and cannot be allowed to stimulate consumption as is optimal Japan. In this world we must draw very different conclusions from those of the 90s.

The Redundancy of Supply-Side Economics in Abe’s Japan

Great expectations surrounded the announcement of Shinzo Abe’s economic revolution in Japan to pull the economy out of its 20 year slump. The revolution involved a huge overhaul of public policy, with a three-pronged attack on the macroeconomic conditions beleaguering the nation.

The first prong, a tsunami of monetary stimulus and cheap credit released by the Bank of Japan’s new governor Haruhiko Kuroda was designed to end the deflationary spiral. The second was a similarly immense fiscal stimulus package worth $116 billion designed to offset lacklustre investment from the private sector. But it was the third arrow, a series of supply-side reforms, that was perceived to be key to improving the competitiveness of Japanese firms and bolster long-term growth.

At best, these supply-side measures will prove to be only mildly stimulative to the Japanese economy if it begins to recover from its 20 year slump. By contrast, if the economy falls into another recession and the continued deregulation of Japanese labour markets is pursued aggressively, the result could be damaging.

 So let’s star our analysis by looking at the channels through which labour market reforms increase productivity. The first channel allows low-productivity sectors and unprofitable enterprises to shed labour more easily. The second channel is then designed to allow firms to hire workers more easily, and consequently pick up the previously fired workers. Therefore, in a healthy economy, structural reform redistributes labour from unproductive employment towards productive employment.

In conditions of economic malaise however, the second channel operates rather weakly. It is easy to see why. When aggregate demand is depressed even productive firms may be saturating the market with unsellable produce and as a result, they are hardly likely to increase employment until aggregate demand recovers. Thus, only the first channel operates at full capacity, and labour is fired at increasing rates. Synthesising these two channels in dampened economic conditions therefore results in heightened levels of unemployment, whilst aggregate demand is depressed even further.

If Abe’s supply-side plan is to recognise any success in this case it will have to hope that the effects of monetary and fiscal stimulus hit the economy before the labour market deregulations do. But even in this event (which admittedly is the more likely one), the third arrow of growth will inevitably fail to boost growth substantially.

The fact of the matter is that Japan’s crisis is one of a huge debt-deflation overhang, and one of depressed demand. That is; it is cyclical in nature, not structural. The huge time-frame and multitude of bogus recoveries would seem to imply that the recession is not a normal one, and the implication is correct; the problems are odd. But the peculiarity of the problems does not make them structural.

In an economy suffering from supply-side malaise, firms are unable to compete internationally and produce anything of meaningful values. In this situation, the current account deficit will rise due to domestic inefficiencies (since domestic production will be unable to compete with imports, and exports will falter).When the current account deficit rises, the currency devalues by the natural mechanisms. When the currency devalues imported inflation will rise. And when inflation rises the central bank will attempt to remedy the problem via contractionary monetary policy. Thus an economy suffering from supply-side inefficiencies should be characterised by having:

  • A deficit on the current account.
  • A weak currency
  • High levels of inflation
  • Contractionary monetary policy

These symptoms validate the experience of the USA in the 1970s, when it suffered from stagflation. Indeed, the problems in that situation were supply-side, and the required response was microeconomic in nature. But 1970s America is very different to 2000s Japan.

The Japanese economy for the past 20 years has shared none of the symptoms of stagflation. It has enjoyed persistent current account surpluses, a strong currency (the government has had to step in on numerous occasions to weaken the Yen in the past 20 years), persistent deflation and the most expansive monetary policy seen in history.

This should all point to the fact that Japanese firms are highly competitive on an international-scale. Whilst many academic economists may not realise this reality, one merely has to look in their own home to validate the reality. Japan’s firms are at the forefront of global innovation, and export their products vigorously to western households and businesses.

If Japan’s economy thus does not suffer from supply-side ails, and an economy stifled by over regulation then Shinzo Abe’s measures will be largely fruitless. If the demand-side stimulus measures hit the economy fast, the microeconomic reforms will be redundant. If however, implementation of the fiscal and monetary attacks wavers, the microeconomic reforms could cripple the situation and prolong the pain even further.

The reality stabs policymakers in the face every day. Japan’s problems are demand-side, failing to recognise this jeopardises the livelihood of millions of people.