Japan: What is The Economist Missing

According to the Economist it WAS just possible to find a nugget of good news about Japan’s economy on November 19th. However rose-tinted glasses, they suggest, were needed to spot it. On a day which saw another round of declines in the share prices of Japan’s biggest bank the Organisation for Economic Co-operation and Development (OECD) changed its mind about the economic outlook. Yutaka Imai, an OECD economist, said the organisation no longer expected Japan’s economy to contract this year. Instead, he said, it was likely to remain flat.

That zero growth is an improvement is a telling indication of Japan’s economic mess. Mr Imai was in Tokyo to talk about the OECD’s newly published survey of Japan. New data since the survey was completed makes the OECD’s economists slightly more optimistic about this year. But this has not altered their broader assessment: that the economy is in serious trouble. The prospect is for virtually no growth till the end of 2004. There is no sign yet of an end to deflation, now in its third year. And the problems created by Japan’s crisis-ridden banking system are in ever more urgent need of attention.

Besides the banking sector, the OECD identifies deflation, fiscal policy and the burgeoning government debt, and the uncompetitive nature of much of the economy as areas in need of urgent remedy. With the downside risks greater than they were, and no sign of an end to deflation, the OECD thinks monetary policy needs to move into uncharted territory. It urges the Bank of Japan to consider a range of new measures to tackle deflation. It also says that inflation-targeting might eventually have a role to play.But the OECD is far more concerned about the large part of the economy that is not export-oriented. Japan has what the organisation describes as a dualistic economy: the domestic, or protected, part of the economy is “remarkably unproductive”, which reflects poor resource allocation underpinned by, above all, poorly enforced competition law and regulation.

Reform is beginning, in some areas at least, to move in the right direction—though the OECD describes much of this as “timid”. So far, the ambitious reform plans of the prime minister, Junichiro Koizumi, have been more noticeable for their absence than their effectiveness. The OECD is not, on the whole, prone to exaggerate gloom. That is why its report on Japan makes such depressing reading.
Source: The Economist
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Let's run this last paragraph again. The reform is begining. After ten years we can really believe that things are so simple. And even after ten years they remain 'timid'. Plans are ambitious, but remain notable for their absence of effectiveness. Our learning curve doesn't seem to be very steep at this point.

One of the problems with the Japan debate is that much of the material fails to tackle the problem head-on. For instance the well-publicized Federal Reserve research report "Preventing Deflation: Lessons From Japan's Experience in the 1990s" rather surprisingly manages to miss one of the most important factors driving the Japanese deflation: DEMOGRAPHICS.

So all of this is like Hamlet without the prince. And the OECD report which forms the basis for the Economist article isn't any better. It simply ignores the problem. Non of this analysis then really helps us understand why Japan government debt is growing out of control - after all with deflation even government supplied services should get cheaper, and why raising interest rates at any point is going to be difficult.

Many of the arguments rest on the assumption that eventually Japan will solve the slow growth problem. Well, I wouldn't be too sure, if the problem is a wrong diagnosis how the hell do you expect the medicine to work (although they did just discover that statins may reduce c-reactive protein as well as cholesterol, so there is hope, it's just that this reduces economic policy to a lottery).

At one level Paul Krugman is surely right, if Japan could spark inflation then things would get easier (although not necessarily for all those old people who are net savers), trouble is it seems it can't. Japan lived for fifty years on short term credit being wiped out by a steady inflation in land and property values, but when the labour force numbers hit the ceiling all that came to a fairly unpleasant end. I doubt it can start another assett driven buble, if it can't it isn't for want of trying. But if there's no petrol in the bike tank, then all the kick starting in the world won't help.

Another problem is the assumption that the Japanese are simply living on credit. Were things so simple! If you want to talk about debtor nations then you need to talk about the US, and all those dollars the Japanese have on deposit inside the Federal Reserve System which partly pay for those nice fat trade deficits. The IOU's are going from the US outwards, Japan is a net international creditor. And if one day push comes to shove and the Japanese take their money home, the first impact will be on Wall Street.

Another typical misunderstanding seems to relate to the debt service problem, and when it might begin to look problematic. When should we expect a risk premium on Japanese Government Bonds that really starts to bite. The problem here is that the Japanese govt though the postal bank and savings system effectively buys it's own bonds (or constrains savers institutionally to supply the funds which makes this possible) so they are, at present relatively immune to these downgradings. Japan is not Argentina.


That is the Japanese savings rate isn't just cultural, it's also structural, it's been engineered. Which leads to another misconception. The late-great Rudi Dornbusch was prescient enough to foresee that in the case of Japan "one day there will be a creditors strike, the investors leave for foreign assets (just as with any delinquent emerging market) the currency crashes, the debt crashes....".

But with Japan, as ever, things are not so simple. This creditors strike will not be as easy as it sounds. Cultural factors do have a role, and it is hard to see Japanese citizens abandoning their country anytime soon (again the Japanese are not the Argentinians). So they will attempt to keep paying the debt. As for the currency, there are relatively few Yen in international circulation, the MOF has seen to that as part of an explicit policy, so for the time being Japan has more control over its own currency than any other country. If the Yen does come down it will be because the MOF, or the MOF plus Washington want it that way. Of course one day everything will snap. Put another way all this will continue until it can't.