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?

Consumption Decline in Japan

My friend Eddie Lee mailed me this morning about this news:


Japan's retail sales unexpectedly fell for a second month, reducing the likelihood that consumer spending will accelerate and lead to an increase in the lowest interest rates among the world's seven biggest economies.

Receipts at retailers fell a seasonally adjusted 0.2 percent in October from a month earlier amid warmer-than-usual weather, the trade ministry said today. Sales of winter clothes and electronics led the decline.

The retail ``report does make it somewhat more difficult for the bank to move because things aren't exactly adding up,'' said Jan Lambregts, head of Asian research at Rabobank International in Hong Kong. ``The Bank of Japan is taking an optimistic view on the economy.''

Now as Eddie says "i just found it a little amusing ..."

".. Bank of Japan Governor Toshihiko Fukui ``doesn't have the ammunition to back up'' a December interest-rate increase, said Kirby Daley, a currency strategist at Societe Generale Group's Fimat unit in Hong Kong. ``We are continuing to make excuse after excuse after excuse for why the consumer isn't coming to the table and it constantly is the weather in Japan.''

... ``The newspapers are saying that the economy is recovering, but that hasn't filtered down to households yet,'' said chain store association spokesman Masahiro Watanabe. Declining receipts at the nation's supermarkets are due more to restraint on the part of consumers than price competition, he said."

Exactly, something other than the weather is at work here, and the Japanese Stock Market seems to sense this:

Asian stocks fell, led by Honda Motor Co., on concern sales are slowing in the U.S and Japan. Li & Fung Ltd., a clothing supplier to American retailers, contributed to the Hang Seng Index's biggest points decline since the Sept. 11 terrorist attacks.


And following the line of thought expressed in Eddie's sense of humour, I couldn't help chuckling to myself at this point:

"``It's unavoidable to adjust interest rates in order to sustain economic growth for a long time,'' the BOJ's Fukui said today at a meeting of business executives in Nagoya, central Japan."

I was chuckling since what he was presumably trying to tell the poor guys who had assembled to listen to him was that afahic it is unavoidable to *raise* rates, whilst what they may well have been wanting to hear is that given weak consumption it is, in their view, unavoidable to go back to ZIRP.

Really Japan is becoming the big test for all the various imbalance theories. Once people finally accept what is actually happening in Japan vis-a-vis rising median age and consumption then the whole global picture will have to adjust, since these ages are set to go up even further and don't look set to come down again anytime this side of 2050, if ever. Meantime you can almost hear the pain as the neurones grind away while people try to figure this amazingly simple detail out.

The Fiscal Position In Japan

Glancing through the OECD Japan Economic Survey 2006 section on the Japan's current fiscal position, I couldn't help having some inconvenient thoughts.

Now as explained here, societies with high median ages and large fiscal deficits (like Japan, Germany and Italy) really face a very special problem: they need to generate sufficient economic growth on a sustainable basis (and since with high median ages they have comparatively low propensity to consume from additional income, and a comparatively high propensity to save, this means export-driven growth) to create sufficient revenue for the exchequer to be able to balance income and expenses. None of the three usual suspects have been able to achieve this balance in recent years - and they have therefore seen their net financial position deteriorating - so it is clear that if they are going to be able to convince the financial markets that long term their position is sustainable, then they need to be able to change course, and demonstrate an ability to maintain the change. This, I take it, is what all the fuss about the 'sustainable recovery' is all about.

The curious thing is that despite all the fuss about the fact that this has been the longest boom since the Izanagi cycle of the late 1960s you tend to read comparatively little about this problem, or about the macro implications of addressing it.

The OECD estimate the current level of the debt/GDP ratio at around 170% of GDP. Now this number is highly contested, since they do have assets in a social security fund, but, otoh, if you count these, so the argument runs, then you also need to take into account implied liabilities, and from here on in there is a large accounting and political wrangle.

I am inclined to take the same view as the Standard and Poor's guy who was very un-impressed by recent attempts by the Greek and Italian governments to reclassify upwards their GDP values by incorporating estimates for the informal economy (an attempt we should note which did to some extent cut ice with Almunia at the EU Commission, I guess those who inherently want to be convinced are grateful to anyone who can offer them a reason why they should be). Basically the S&P's guy said that all this makes little difference since what matters with sustainability is revenue and expenditure, and how they balance. This is what determines the dynamic of the debt, and informal activity by definition doesn't pay tax.

So the same goes for Japan. What matters isn't really the exact number to be attached to the debt/GDP ratio (which in any event is large) but whether the relation of expenditure to revenue is moving towards a balanced path or whether they are spiraling out of control. In the context of population ageing this issue is huge, since obviously stagnant GDP opens the possibility that such debts may NEVER be payable, something which no-one yet seems to want to contemplate, but this doesn't mean that at some point or another markets won't wake up, and maybe with a jolt.

(Incidentally, just a little side dish at this point. We have had a series of red-herrings in the great ageing debate, and one of these is the issue of stock market meltdown. In fact this confusion comes from applying a time horizon which is far too long - so many studies focus mechanically on the 'magic number' of 2050 - and a rigid idea of the life cycle theory, whereby people dis-save as they get to the oldest-old ages. What we can see is that you need to look at a much shorter time horizon - I would say 2010 to 2020, wasn't Keynes's big 'discovery' the ability to distinguish between short, medium and long terms, something which despite the frequent use of the 'in the long run we are all dead' quip, few seem to think about. Sometimes I think that, in economic terms, we live in something of a fools age. The other point would be that before we reach the dis-saving age - if we ever reach it, in fact the oldest old seem to be very spendthrift, so somehow I have my doubts here - we go to an age of increased saving, this is what we are seeing in the older countries across the globe. People are being very mislead here by the savings decline in the US. So I think that rather than stock market melt down what we may see is a very low rate of return environment - remember I am talking 2010-2020 - and the real issue is about what the pension funds can realistically offer their clients if this environment holds).

So I think that at some point the markets will wake up, and this is one of the reasons that I have become so interested in Hungary, since this may well become the first case in history of a country which finds itself stuck on just such an unsustainable (or rather self-evidently unsustainable, since Japan and Italy, IMHO, are already on unsustainable courses, but no-one wants to recognize this) path. Hungary may become the case where this conclusion becomes hard to avoid. I say may, and I mean may, but since the *possibility* exists this certainly makes it worth following for this reason alone, apart from everything else that can be learnt there, and the pure technical fascination of the situation for anyone interested in macroeconomics, it is just such a classic case in some senses, but a classic case with a new, and potentially deadly, ageing twist.

The thing is that if people do start to wake up over Hungary, then eyes will turn to Italy, and if there is a crisis in Italy, then this will obviously lead to a reconsideration of what exactly is going on in Japan. I think I am tentatively outlining a scenario (or possible scenario) here.

So to close, just one or two details on Japan:

Limiting the growth of government spending is the priority in addressing the serious fiscal problem. The FY 2001 Structural Reform and Medium-Term Economic and Fiscal Perspectives set an objective of freezing public expenditure at 38% of GDP through FY 2006, and this target is likely to be achieved. Such spending restraint, which was achieved in part through cuts in public investment, aimed at the goal of a primary budget surplus for the combined central and local governments in the early 2010s. On a general government basis, the primary budget deficit has fallen from 6.7% of GDP in 2002 to an estimated 4% in 2006, with about half of the decline due to structural factors, and the rest accounted for by the economic expansion.

What we should note here are really two things. Firstly that despite everything Japan is still running a substantial fiscal deficit, and that really this deficit hasn't reduced hardly at all if you take into account the fact that half of the saving has come from increased revenue during the boom, and that the other half, which has been a real reduction, may well reverse if 'automatic stabilizers' are applied during the downturn.

Then there is this:

The Reference Projection for the FY 2005 Reform and Perspectives shows a primary budget balance for the combined central and local governments in 2011. However, a balance would not be adequate to stabilise the level of public debt relative to GDP in the long run if the nominal interest rate on government debt exceeds the growth rate of nominal output. While the economic expansion and an end to deflation may push the nominal growth rate above the interest rate in 2006, assuming that growth remains higher would not be prudent for setting a medium-term fiscal objective. Indeed, population ageing will tend to slow output growth while possibly increasing the interest rate. In sum, stabilising the public debt to GDP ratio is likely to require a primary budget surplus for the general government of between ½ and 1½ per cent of GDP.

The point about interest payments is important since of course if rates were to rise in Japan this would put even more pressure on the budget deficit, since the costs of the debt would rise for the Japanese government, which is another reason why some at the finance ministry may be urging the BoJ to exercise caution in raising rates. Indeed Japan may already be in some kind of trap here, given the continuing weakness of domestic consumption. Fortunately (from this point of view) rates are not likely to rise (IMHO) and I fully expect Japan to be back in Zirp either sometime in 2007 or in early 2008.

Checking up on Japan

(A crosspost from Alpha.Sources.)

Time is indeed a scare ressource and as such I have not been on the spot with some reporting on Japan as the third quarter came out a week ago. This is consequently to make amends on that but also to react on some interesting comments on Japan I have found in the week gone by. Let us begin with the economic data then and to that end Edward Hugh really has the all arguments ready at hand. At first hand we have good news here as Japan managed to expand for the seventh consecutive quarter. Yet the story has not changed much as Edward also points out;

So the picture remains pretty much the same, strong export lead growth sustained by capital investment, with shrinking domestic consumer demand. A big part of the burden was carried by growing investment demand.

Furthermore, the crucial point is that the lack of consumer spending does not seem to want to push up even in the light of increasing corporate bonuses. This obviously links up with the monetary situation in Japan where the central bank just cannot find the justification to raise rates. This, subsequently, is also keeping a lid on the Yen despite talks in high international circles about how the Yen should be a bit more willing to adjust to the fundamentals. More accurately in my book though, some are beginning to speak of being too much in a rush to normalize monetary policy. Another very interesting aspect of the Japanese economy deals with the tightening of the labour market. Many commentators have claimed this to be a result of a recovery in the making but I believe that we should rather look at it as a structural evidence of a shrinkening labour force. Following this is the discussion about why the tightening labour market is not pushing up inflation/wage growth; as Edward explains ...

One thing which is striking here is the way in which, despite the inevitable labour market tightening as the population shrinks, wage drift and inflation remain incredibly tame. This is an indicator of just how far the reform process has actually gone in Japan, since there seems to be absolutely no room whatever for wage-push inflation. This is also something of a warning for those who simply argue that more structural reforms will cure the problem, since in the case of Japan at least they seem to have been tried and found partially wanting.

What is most interesting here is that if we don't look at demographics in Japan's case we end up with a very thin line of argumentation in which we are down to musings about when the positive growth cycle begins in Japan and consumer spending picks up again ... take for example one of the latest pieces on Japan from Morgan Stanley's Global Economics Forum.

As shown in preliminary Jul-Sep GDP numbers, the contrast between the corporate sector and the household sector has intensified, and this gap is not likely to close for some time. We assume that it will take a year or more for a positive growth cycle to develop, as momentum on the corporate front gradually spreads to the consumer and household level.

On what is this assumption above vested, that is the only thing I ask. When, for example, will people recognize that the life-cycle component of the consumer spending behaviour story is important? It seems wholly unreasonable to me to claim that the situation is any better a year from now based on business cycle analysis. Morgan Stanley claims to be bullish on the economy and cautious on prices (wage growth) the latter position mainly driven by high productivity. On this we are approaching the issue from two sides ... we both agree that prices and wages are not going to pick up anytime soon. However, where I, and also to some extent Edward above, are arguing that consumer spending will remain low and thus keep the core index and wages down as a function of the structural and lasting changes in the labour market structure, Morgan Stanley argues that;

Trying to predict when wages will rise and what the catalyst will be is a difficult task, but if the Japanese economy has been running about a year behind the US economic cycle since the bursting of the IT bubble, it should take about the same amount of time as it did in the US. The US economy bottomed out in early 2002 and wages began to rise just this year. This suggests that the labor distribution rate in Japan is not likely to rise until F3/08 at the earliest, and only then if a knock-on effect from increased hiring does in fact finally translate into higher wages. In such a case, we would expect nominal wages to run more or less flat during the forecast period and for real wages to continue to decline during this time. Accordingly, we maintain our cautious stance regarding consumer spending.

The most decisive answer I can provide here is that Japan is not USA; actually far from it and precisely because Japan is such a special case in terms of population dynamics we cannot expect the economy to behave according to the textbook explanation of business cycles. Once again I am ending this with a point about where to begin our analysis. I am not for example dismissing the recent articles from Morgan Stanley; people are definitely scratching some of the right places but if we want to get this right we need to begin with the beginning and in Japan's case that is quite simply demographics.