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Tuesday, November 28, 2006

What's Funny About Consumption in Japan?

This question was being asked yesterday by Morgan Stanley GEF analyst Robert Alan Feldman (the post can be found towards the bottom of the page).

Now as Claus Vistesen will undoubtedly hammer home at some stage Feldman does get some important parts of the picture which I have referred to in my last posts (and here):

The data on consumption have certainly been a disappointment this year. Although the nearly 4%Y/Y rate reached at the end of 2005 was clearly not sustainable, the sharpness of the slowdown this year has been a surprise. In addition, the deceleration in compensation (whether measured by compensation per worker from the national accounts or by hourly earnings from labor data) has also been a surprise ― especially with record-high corporate profits. The weak growth of wages is all the more puzzling in light of tightening of labor markets shown by a number of indicators. Yes, the weather has been weird this year, but that cannot be the whole story. What is going on?

So far, the number of people saying "That's funny" is small. However, the longer the anomaly of strong capex and weak consumption continues, the more likely will emerge others (like myself) who will claim that high capex and low consumption is the correct structure for the economy.



Why? The idea is simple: As Japan ages, there will be a much faster shrinkage of the labor force than of the population. Hence, each remaining worker will need a lot more capital in order to keep productivity growth fast enough to maintain living standards. Economic growth theory ― in contrast to standard macroeconomic theory ― tells us that high capex and low consumption is just what an economy needs when aging. The implication for investors is equally simple: Stop worrying and love the high-capex economy.


Well really he is getting very near. But then note this:

"As a practical matter, however, consumers and investors will need more time before they accept that consumption need not become the engine of growth."

Well I would put a lot more names on this list other than consumers and investors, people like Brad Setser, Nouriel Roubini, the IMF, the BIS, US Treasury Secretary Paulson, Trichet and the gang at the ECB etc etc. In other words Feldman has, inadvertently walked right into the current global imbalances minefield by suggesting that Japan, as an aged economy (and the first of many more to come) will have to be high capex, low consumption, and logically, to sell the product, dependent on exports. What happens if this ever sinks in somewhere?

Basically he is not quite right about the contrast between macro theory and growth theory, since even though the Solow model is supply side oriented, it is normally situated in a general equilibrium model which includes demand side components and hence generates relative prices.

So you really do need a general equilibrium model running in your head somewhere to get to grips with the implications of what he is arguing. One of the factors he doesn't seem to think about - and why should he, he isn't a theoretical macroeconomist - is how the changed relative balance of consumption and saving affects interest rates, and thus the cost of all that capex, which with low interest rates is much less, and then of course you need to get onto relative prices, and especially if deflation persists.

Curiously he mentions Asimov, and Asimov was interested in robots (he could also have mentioned Zamyatin who wrote a novel called "I Robot"). Now the interesting thing is to think about VERY HIGH capex, at the levels we might see when robots get to build the machines, and then start thinking about whether this would be expensive (which is the story Feldman is trying to sell the investors, hence the possibility of good returns) or whether this would in fact be very cheap, being funded by virtually give-away money with very little of the really scarce and relatively expensive input (labour) being required and with the other constraint being the cost of the raw materials and power that the robots need in order to go to work. Of course, whoever develops the robots can make an initial short term 'rent' ( a la Schumpeter) while they still have a monopoly on the technology, but again there are winners and losers, since some will try and build the technology and fail.

Anyway, this point aside, Feldman is clearly in the right ballpark, and all people now need to do is take the relatively simple step (a small one for them, but a giant one for humanity, perhaps) of thinking this through to a much more general level, and contextualizing all this in what has come to be known as the demographic transition. Now just who the hell was that who ever said that demography isn't important to economists?