Japan is Getting Interesting

(Cross post from Alpha.Sources)

As regular readers of Alpha.Sources will know I have become quite fond of 'Japan-watching' as a discipline and as the pundits' commentaries and general economic data keep coming in I must say that it is getting exceedingly more interesting. Clearly, I have an impetus here and in essence I feel that I am on to something and I will keep poking and scratching accordingly; so should look at the next round then? Let us by all means begin with some recent data ...

First of all the picture of consumer spending is shining bright as ever, this time as a derivative of dropping retail sales figures in November. (From Bloomberg)

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.''

In terms of coherency of arguments we might want to hold on to the one made by Jan Lambregts as he points out that things, in terms of the BOJ's ability to raise, not exactly are adding up. Meanwhile, we also have the recent numbers on industrial output and wouldn't you know it; here Japan shows a quite impressive progress, (from Bloomberg).

Japan's industrial production unexpectedly rose to a record, backing the central bank's assessment that the world's second-largest economy is strong enough to withstand higher interest rates. The yen rose.

Factory output in October climbed a seasonally adjusted 1.6 percent from a month earlier, the Ministry of Economy, Trade and Industry said in Tokyo today. Gains were led by autos and semiconductors as production rose 7.4 percent from a year earlier, the biggest jump in more than two years.

Toyota Motor Corp., Japan's biggest company, said this week it increased output in October by 16 percent because it expects overseas demand to climb. Central bank Governor Toshihiko Fukui said yesterday the lowest interest rates among major economies will have to rise to ensure the economy keeps expanding.

Notice especially the central bank governor Fukui's discourse about how the economy surely is on its way to become resilient enough to sustain an increase in the interest rates which for the record is still running at a staggering 0.25%. Now dear reader I can certainly understand if something in your mind is not adding up but I can assure you that by applying the right tools we can break this nut. Let me first get one point across the board here which has to do with the nature of economic growth in Japan. In short, how would we explain growth in an economy where total output is going up while domestic output is down driven by declining domestic consumption? Yep, you got it; export driven. This is of course not very complex but we need to ask ourselves why Japan's growth is export driven and more importantly why/whether it will continue to be so as we move along. As such there are two rivalving analyses here ...

1. The first explanation is roughly based on the ideas of business cycles in the economy and seems to be the mainstream way to see this. Following this it is by defintion only a matter of time before the upbeat trend in the corporate sector spills over into the private sector and thus pulls up private consumption in order to achieve a balanced growth path. As such a recent commentary from Morgan Stanley's Global Economics Forum argued the following;

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.

Notice particularly the idea of the 'gap' closing here as it is precisely this kind of dynamic I for one do not see in Japan as we move along. This is also from where we get all the mixed messages from monetary policy watchers since it is presumed that monetary policy should act counter cyclically as the economy gains momentum in order to keep the economy not to spiral out of control and thus make the bust on the other side even more severe. However, it is of course increasingly getting difficult to defend a raise since domestic consumption stays persistently low. In essence this kind of analysis ends up as one big waiting game in which the prediction of the transition towards a 'sustainable/balanced' growth path (i.e. one based on domestic consumption too) amounts to circular reasoning based on arguments about how domestic consumption is bound to go up at some point.

2 . The second explanation is the one I have been forwarded in my observations on Japan and essentially I argue that the current environment in Japan is a result of the structure of the Japanese society with the world's oldest population. This is in fact all I am arguing at first hand which crucially means that we should not expect any hikes by the BOJ anytime soon and also that private consumption will continue to drift gradually downwards. So am I trying to re-write the economics textbooks here? Well not yet at least ... I am sure that at some point as the effects of the global demographic trends become clear there will be a theoretical showdown between growth and business cycle theory on the one side and another pardigme which is way more sensitive to the demographic changes which display a very real transmission mechanism with the macroeconomic environment.

On that note let us also take a look at a recent piece from, yep you guessed it, Morgan Stanley Economics Forum (Robert Alan Feldman) about the peculiar nature of private consumption in Japan. Now let me say initially here that Feldman's piece comes really close to an explanation of what we are seeing here and he is really getting a lot of things right in my opinion. The first important thing is that Feldman seems to want to address head-on the conundrum of why corporate investment (CAPEX) is increasing while private consumption remains low. Notice also in particular Feldman's recognition that business cycles are of little use here ...

What is “funny” at the moment? Consumption is decelerating while capex is accelerating and profits are still rising ― all this after what has already been the longest expansion in post-war history. There is a problem of consistency here. Corporations are predicting an outright decline of profits in the second half of the year. But if firms are so worried about profits, why are they investing so much?

(...)

Cycles are cycles, goes the mantra, and if things are good today, they have to turn bad tomorrow. If we have not seen the downturn yet, it must be coming soon. So, consumption swings wildly, and firms continuously undershoot profit estimates. 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.

Wow, that is certainly interesting is it not? Hands down, Feldman is the first semi-influential commentator I have seen who have argued this to be a structural phenomenon and consequently I feel we have already taken a huge step forward here. Now, for the sake of argument I will skip through to Feldman's conclusion in which he reveals his fundamental case for optimism;

The key reason for my optimism is simple: The combination of aging demographics and structural reform has created a new dynamic in Japan. This new dynamic will keep capex and productivity rising, and obviate the need for as much consumption growth as would have been necessary at an earlier stage of Japan’s economic history.

This is of course where I disagree a bit with Feldman but let us still scrutinize this a bit. A new economic dynamic in Japan driven by changing demographics which influence the use of input variables to production (i.e. high CAPEX) thus maintaining high productivity growth and indeed economic growth detatched from the need to rely on domestic consumption. Or as I put it above in fewer words above; export driven ... and this time it should seem pretty clear that the export nature of growth is a structural and indeed inevitable result primarily caused by the ageing of the domestic population.

So why do I disagree with Feldman? Well, in order for Japan to run on exports others need to run deficits, this should be fairly clear for even non-economists. This is of course all migthy fine but the problem is that Japan is not the only country in the world with a rapidly ageing population and the need to run a surplus in order to grow. In fact, this is beginning to look alarmingly much like an explanation of what we like to call global marcroeconomic imbalances; or as Edward Hugh neatly puts it;

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?

Food for thought I should say?

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.