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Saturday, October 05, 2002


Japan is going to burst. Left on its present course, like the proverbial nineteenth century steamship with the boiler overheating, one day one too many of the bolts will sheer off, a boiler plate will give and then the devil take the hindmost.

Of course one of the few remaining debateable points is whether or not there is really anything left to be done. Common sense says there is, and sheer humanity says that there ought to be. That's the easy part. The tricky bit is what.

This weeks news of a cabinet reshuffle over in Tokyo could be interpreteted as a positive signal. Something is finally to be done about all those bad loans clogging up the banking system. That has to be good news doesn't it. Well yes, and no.

For one thing, the response in the Tokyo stock markets shows that some people have had a very nasty fright. The declared stance of Takenaka could cause even the not so faint of heart to tremble a little, and the appointment of Kimamura with his hitlist of 30 'zombie companies' to the FSA taskforce, could indicate that this time we should take all this seriously. Other will of course say that in Japan 'we've seen it all before'. That is, that there will be a lot of noise but little action as the warring factions battle it out. This could well be, but Koizumi has summoned a special meeting of the Japanese Diet for the 18th October, the day after the anti-deflation plan is to be announced, and Takenaka's strong talking is building up a lot of expectation. The question could be asked, can Koizumi survive politically if he does not deliver this time?

Be that as it may, the problem still remains as to whether we have really got to grips with the heart of the matter yet. Drastic surgery is, after all sometimes necessary. It's just that first it might be worth checking out whether we have a reasonable diagnosis. You see, collapsing an economy is not too difficult, it's reviving one which is often the hard part.

Morgan Stanley's Robert Alan Feldman groups the possible approaches to Japans deflation problem into four groups:

The Monetarist Approach
The IS-LM Approach
The AS-AD Approach
The Trade Theory Approach
Source: MS Global Economic Forum LINK

Actually this division is a bit schematic since of course there may be considerable overlap in policy proposals between these four lines of analysis. Thus both the monetarist and IS-LM lines can concur that monetary easing should continue, despite the fact that, as Feldman says, "the sharp acceleration of the BoJ balance sheet and of base money has been answered by equally sharp declines of the money multiplier in recent years. On the other hand those following the IS-LM approach will tend, following Krugman's lead, to emphasise fiscal expansion. Again, the best that can seem to be claimed here is that such fiscal policies have avoided an even worse recession. They do not seem to offer hope for a cure.

The trade theory analysis addresses the problem that with declining import prices relative to domestic prices consumer wlfare can actually improve within a golbal macro negative situation. This can help us understand why there are so many internal comments from Japan about what's really so bad about inflation, but offers little policy leverage apart from protectionism, which given the fact that many of the domestic industries in trouble are export dependent could prove disastrous.

This brings us to AS-AD and Takenaka. I'll let Feldman explain:

The aggregate supply curve comes from the relationship of nominal wages (and other cost components) to the price level. At a given level of nominal wages (or interest costs or oil prices), a higher level of prices would imply higher profits, and therefore more output. Thus, the AS curve is upward sloping relative to the axes just mentioned. The intersection of AD and AS curves generates an equilibrium. In order to raise the price level (i.e., to stop deflation), one can use either the AD or the AS curve. This is where things get interesting.

Traditionally, the AD curve is seen to respond more to monetary and fiscal policy than the AS curve. (Indeed, the latter is assumed to be inert with respect to policy changes.) However, this is precisely the assumption that appears to fail in Japan today. Indeed, fiscal policy over the last decade was aimed largely at keeping inefficient producers (in construction and real estate) in business, thus artificially pushing the supply curve far to the right side of the diagram, while pushing the demand curve only slightly to the right. The small movement of the AD curve may be attributable to (a) Ricardian equivalence, which pulled private demand inward when government demand moved outward, and (b) low return on capital, which lowered the multiplier effects of government programs. Ironically, according to this view, both monetary and fiscal policies actually worsened deflation.

The AS-AD approach is very much in concert with the ideas that Minister Takenaka has been proposing ever since he was the driving force behind the Economic Strategy Council of 1998. The report of that council, whose report was shelved by PM Obuchi because of the political consequences, was dusted off and improved in Mr. Takenaka’s "thick bone report" or June 2001, and reasserted in the sequel of June 2002. Moreover, the identification by the PM himself of the need for industrial restructuring lies very much in the spirit of the AS-AD approach. Because of the long association of this thread of economic theory with Messrs. Takenaka and Koizumi, the AS-AD approach is likely to be the driving force in the new cabinet. The negative effects on the economy from supply-side policies are likely to be offset by tax cuts and/or expanded unemployment benefits.

In other words, and to put it bluntly, the axe is coming out. The so called NPL (non-performing loan) problem is going to be resolved - over other peoples dead bodies. As Robert Feldman accepts in a later post "An aggressive stance on NPL disposal will inevitably create deflationary and recessionary pressures, thanks to large-scale unemployment". To attempt to accommodate this the government is also said to be preparing an emergency fiscal package to try to offset the recessionary effects of the NPL solution.

This is where, in my book, we hit the one variable too many problem. This problem has nothing to do with a well known problem in systems of simultaneaous equations. No, my version of this refers to the number of variables we economists seem able to hold in our heads when contemplating policy outcomes (a recent example of this was seen in Argentina where what appeared to be a miracle cure for hyper-inflation, the peso-dollar peg, had only one drawback, it's impact on Argentine external trade - and it is here, and only here that some similarities between the two sitautions can be seen, in the incapacities of relatively overpriced home industries to compete in their own domestic markets). The variable which seems to be being omitted from the calculations here is that of the projected consequences for national debt dynamics.

Japan already has an extremely difficult and onerous situation with its government debt, a situation which is only made liveable by the very low current interest rates. Now the resolution of the NPL problem seems to involve numbers in the region of 8% of GDP (estimates vary, and only time will tell). To this will have to be added the cost of any fiscal expansion (which could be relatively large given the size of the anticipated problem) plus any drop in revenue from the ensuing recession (which again could be large).

My point here is that this latest twist in anti-deflation policy in Japan, could be a one-shot, all-or-nothing play. Remember Japan's population is aging rapidly. Pressure on national debt can only mount in the future. (Economists like lead-lag situations, but in demography the lags are truly important: 20 years or so before any benefits can be seen. And remember even if the birth rate went up, during the first 15-20 years that would only make the problem worse as the dependency rate actually increased.) At the same time savings in health and old-age care have associated consequences for female labour market participation rates as women stay home to care for relatives. All in all a kind of negative feedback spiral. So that if this policy turn fails, and if the analysis is wrong (and if, for example demographic, pressures have a large part to play in telling the Japanese story) then it may well fail, the future for Japan and its people looks bleak indeed.

All this brings me back to the title of this piece, and its associations with Pearl Harbour. As Stephen Roach has been reminding us all for some time, the global economy
isn't exactly highly stable right now. In fact balanced-on-the-edge might be closer to the point. So what could be the consequences for a fragile global economy of a sudden and dramatic collapse in Japan. Put bluntly: would some of the flying debris find its way to New York and Frankfurt.

A minor nineteenth century economist once expressed the view that previously the the world had been over-interpreted while the real point was to change it. From where I'm sitting we abound in projects to change the world, it's on the interpretation side that we're a bit weak. Ill thought out ideas are extremely dangerous. Look at Argentina and the Peso-Dollar peg and you'll see what I mean.

So I'll close this with one thought. At the present moment reviving Argentina seems a Herculean task, not least because the responsible political class has lost all moral authority. How did it lose it? By defending with the aid of $40 billion from the IMF an untenable idea. If the Argentinians had not been asked to sacrifice so much so pointlessly during 2001. Let's hope we're not about to make the same mistake with Japan.

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