Japan's two faces

Some time ago, Samizdata linked to "Is Japan Faking It?", an essay by Eamonn Fingleton arguing that Japan's problems were nowhere near as bad as we here in the west seem to think. It's about as contrarian as you can get these days without completely losing sight of reality, but it was worthwhile reading nonetheless. Not because I agree with it, but because it's plausible enough to be true, which in turn forces you to think about what's really going on the Japanese economy. It is certainly true that the reflexive reaction to Japan now consists of chanting the from the Holy Basketcases Hymnbook, starting with "All Debts Great and Small." This is an abrogation of thought and analysis in favor of convenience. I too have often been guilty of this, so I took Fingleton's article as a starting point for re-examining Japan, focusing in on some of the out-of-consensus calls he makes.

In terms of fundamental data, I find the article wanting. To get an overview of macroeconomic data, I highly recommend the OECD's database. All data I will be using here is taking from the spreadsheets you can download from that page, unless otherwise noted. To start, there's this claim in Fingleton's article:

The latest "disaster" is Japan's allegedly out-of-control government spending. But Japan's budget problems are grossly exaggerated. OECD figures show that in the first eight years of the 1990s, Japan actually ran large budget surpluses. Since then the government's position has deteriorated somewhat but is still no worse than many other nations.

This is relatively easy to find in the OECD data, and it's simply not true. This graph shows the government balances as a percentage of nominal GDP for the US, Eurozone, UK and Japan. As you can see, Japan has been running a budget deficit since 1993. This also holds true if you look at the other OECD budgetary indicators, such as cyclically adjusted deficits and the primary budget balance. This latter is the deficit the government is running excluding debt servicing. The very low interest rates that the Japanese government is paying on its debt have kept debt servicing from becoming an additional problem. Even looking at gross or net financial liabilities his line of reasoning does not hold up. The footnotes the OECD provides in its spreadsheets note that these latter number are not necessarily comparable across countries due to differing methodology. Still, even if the level is not perfectly comparable, the first derivative is. Fingleton also claims that:

Living standards increased markedly in Japan in the so-called "lost decade" of the 1990s, so much so that the Japanese people are now among the world's richest consumers.

Japan's consumer have been amongst the world's richest, although perhaps not on a purchasing power parity basis. However, the OECD does provide data on this as well. Net household wealth as a percentage of disposable income has been shrinking in Japan over the last decade. What's missing here are the disposable income numbers, and unfortunately the OECD does not provide them. However, this data we can find in the Statistical Handbook of Japan 2002. Scroll down to figure 12.2, where you will see that real disposable personal income saw its last significant increase in 1991, and even that was less than 2%. In comparison, real DPI in the US has been growing at a 3-6% pace over the last ten years. So here too Japan has been losing ground, rather gaining it.

Another aspect of Fingleton's case rests on Japan's superior trade performance during the 1990's. He points out that the trade surplus has risen by a factor of 2.4 since 1990. Japan's current account is also showing a healthy surplus, while the Japanese savings rate is the envy of the industrialized world at 8.7% according to Fingleton, while the OECD data puts it even higher. There is a trap in talking about trade balances in terms of "surplus" and "deficit" as I have done just now (and as is usually done) because those terms have connotations of "good" and "bad." The trap is that a trade deficit is not necessarily a bad thing. It depends on the circumstances. Let's scale the example down to a household. As a result of the job you're doing, you add to your hoard of little green bits of paper. Now suppose you decide you need a new hammer. You could go to a mine, get your own iron ore, smelt it, bang it into shape and use wood you cut down to make a hammer out of it. Chances are you're going to go to yuor hardware store and choose from one of dozens of hammers someone else has produced for you. In order to obtain the hammer legally, you then hand over some piece of green paper to the store and go back home with your new hammer. You've just increased your personal trade deficit. Unless you sell more goods than you buy, you have a trade deficit. Cause for panic? Not really, as long as you continue to earn enough bits of green paper to finance your trade deficit. This applies in a wider sense to the US economy as well: as long as the sum total of value added in the US economy grows sufficiently to finance the purchases from abroad, there is not a problem. Americans give green pieces of paper to the Japanese and get shiny consumer goods in return. It's the aggregate wealth of the US economy that has made this possible. To keep this working, not only has the US economy to produce enough wealth, but it also requires a continued willingness of the part of the Japanese to trade shiny consumer goods for green pieces of paper. As long as they're happy to do that, there is no problem and both sides benefit.

A similar story also applies to the current account balance, where again the US is importing capital while Japan is exporting it. In essence, the low savings rate in the US is compensated in part by the Japanese sending their money to the US. This is one of the things Fingleton points out as a positive for Japan. The large capital outflows indeed enable the Japanese to buy stuff abroad. But they're not doing it because they want trophies on their mantlepieces (well some of them might), but because they want to earn money. And because they're sending their capital to the US, they're also giving an implicit vote of no confidence in the Japanese economy. Actions speak louder than words, and these actions mean that the Japanese think they can get a higher return on their capital if it is invested in the US than in Japan. So the current deficit could become a problem if for instance another region in the world gets its act together and becomes the preferred destination for international capital. This does not seem likely in the very short term, but you never know. Congress could suddenly raise taxes or pass regulatory bills that affect American companies' competitiveness, and money might go elsewhere. Right now, America is still the default place to invest your money though.

The high savings rate in Japan is extolled by Fingleton as a great positive. It could be, but it isn't. And the reason for that is the broken banking system. The people are saving money, but the banks aren't lending. One of the key tasks of a healthy banking system is to provide risk capital to entrepreneurs, and this is simply not happening in Japan. The banking system is seriously broken; the Bank of Japan has been printing money (metaphorically) at a tremendous rate. The monetary base has been expanding at a 30% year-on-year rate for some time now, but the broader monetary aggregates are not picking it up. M3 and M4 are growing at 1 to 2% year-on-year. So despite the creation of large amounts of additional yen, this is percolating into the broader economy. The money multiplier is dead in Japan for now. And that's because both the banks and industry are in a mess. As a final comment on the high savings rate, it should be pointed out that Japanese savers are getting virtually no nominal return on their savings, and haven't been getting return for many years now. The Zero Interest Rate Policy of the Bank of Japan has ensured that both lending and borrowing rates are very low. The real return on cash is slightly positive, but it's still puzzling that the Japanese would be so risk-averse as to put so much of their income into an essentially dead asset. As Fingleton points out, the net national savings position of Japan is considerably lower than the government's, if you count personal savings too. So he's right that there is no solvency issue at the moment, but that's looking at the country as a whole. If interest rates ever go up, the debt servicing burden on the government will become very onerous very quickly. Sure, Japan can afford it, but only by transferring money from private to public coffers. This means taking money away from the consumers and giving it to the government by taxation. This is not going be popular or short-term positive for the economy. What we're seeing is perhaps a case of Ricardian equivalance, which states that the timing of how government debt is financed has no impact on the real economy. So whether you tax now or issue debt now (to be paid later) makes no difference. A perpetuity of $50 at 5% interest has a present value of $1000. So whether you pay $1000 in tax now or $50 in perpetuity makes no difference. But the people who'll be paying off the debt will in the end be the children of the people who issued the debt and presumably benefited from it. So an intergenerationally altruistic household will put the $1000 in non-levied taxes to buy the bonds issued and then use the coupon income to pay the $50 perpetuity. Do real people really think like this? There is some evidence that in the aggregate the expectations of future taxes are influenced by current debt issuance and levels. So a high savings rate would not be a surprise in such a context.

If the monetary base is expanding so rapidly but broad money supply isn't, where is the money going then? It's certainly not going to Japanese consumers, nor does Japanese industry seem to be benefiting much from it either. It's not going into real estate or land, nor is the stock market benefiting. Instead, the money is going into funding the JGB bubble. JGBs (Japanese Government Bonds) have real yields that are surprisingly low for a country with a fiscal position as dire as Japan's. It's partially due to the structure of the Japanese savings system, which tends to invest disproportionately in JGBs, as well as the printing of money by the Bank of Japan. At some point, this bubble will have to burst, just like the Dot-Com Bubble in the US and Europe burst.

One last point of criticism of Fingleton's piece is his comparison of the deflation currently rampaging through Japan and the US experience in the latter half of the 19th century. There are some significant differences between the two situations. First and foremost is the structure of the economies. Even back then, the United States was attracting foreign direct investment (FDI) to finance the growth of the economy. In fact, the United States has pretty much throughout its history run trade deficits, with the exception of the depression years of the 1930's. (Sorry, couldn't find a link). While the US was importing capital, Japan is exporting it now. Furthermore, he quotes LaFeber as saying that the 25 years to 1897 were "economic hell" because of persistent deflation. The date chosen is no coincidence, as that is the year in which the US returned to the gold standard at the pre-civil war parity. During the war, the US had three currencies: the greenback, the Confederate dollar and the yellowback. The yellowback was the original US dollar backed by gold and continued to be used in the West. Both the greenback and the Confederate dollar were fiat currencies (i.e. not backed by gold or any other metal. Virtually all currencies now are fiat money). After the war, the greenback and the yellowback needed to converge again, and this process took till 1897. It took so long because to restore the price level more quickly would have caused a massive recession. This long period of deflation was engineered and deliberate, and the US economy grew during the period. Japan's economy has not grown much in the last ten years. (Data taken from this dataset compiled by NBER's MacroHistory project. More information on post-civil war currencies can be found here. Inflation data downloaded from Global Financial Data.)

I'm not impressed with Fingleton's case. Japan's economy does have serious problems, and I simply don't buy his analysis. However, this article is title Japan's Two Faces, and that's where I think he does have a point, although it is not as controversion or contrarian as his call on the economy. There are some really, really good Japanese companies, and they've been doing pretty damn well over the last ten years (and before too). Some of them are well-known names in the West, such as Toyota and Sony. Others are doing well again after having come to the brink of collapse; Nissan had to be rescued by the French, for instance. Japan's corporate landscape shows a mixed picture. In general, the companies doing best are those that have been exposed in full force to the rigors of the international marketplace. That forced them to become well-run, modern companies, exactly the kind that the rest of Japan is still lacking. As the Japanese market becomes more open (and not just to Chinese imports) and red tape is slowly abolished, market mechanisms will force more Japanese companies to become competitive again or face death. As long as bank are not willing to foreclose on non-performing loans though, this is not going to happen. So it's certainly not all gloom and doom in Japan. But it's exactly that part of the Japanese economy that has been most exposed to Western-style free markets that is doing best. Japan has a deep base of knowledge and excellence in products that need to be unleashed, quite literally. As long as the arcane, indeed pre-capitalist, structures and linkage continue to prevail, the spread of Good Companies in Japan will remain limited. The risk is rather that the bad, zombie companies will infect the good ones by undercutting them. If you're essentially dead and have no hope of paying off your debts, why not sell below cost? At least you'll get market share and you can pretend to be alive for a bit longer. Good companies are then forced to compete with the zombies, and can't last very long usually. Bankruptcies are sorely needed in Japan.

Not all of Fingleton's arguments are on the mark in the company area either. For instance, the supercomputing lead Japan has is not directly related to manufacturing expertise. Rather, the US and Japan took differing approaches to supercomputing about a decade ago. US researchers thought that by bundling together lots of cheap computers, you could create a cost-effective machine that is very fast. The Japanese continued the "old-style" supercomputing tradition, which has proven superior.

Finally, where Fingleton goes off into fantasy land is when he posits that the Japanese have deliberately been talking of crisis to get the rest of the world off their backs. It's supposed to be part of a centuries-spanning plan that would put Asia back in the number one position in the world, having been supplanted by the West, and specifically the US. That's just nonsense. Japan is not welcoming China's exports "with open arms," but instead there's an enormous amount of bellyaching about Chinese exports. Japanese versions of Ross Perot with their Giant Sucking Sounds are popping up all over the place. Instead what's happening is that Japanese companies are trying to create better profit margins, and that means shifting commoditized manufacturing offshore to China, which is becoming Japan's reservoir of cheap labor. It's benefiting both countries, of course: Chinese become wealthier and Japanese companies become more efficient. But the adjustment process is painful. Rather than a sinister long-term plot, it's just another sign that Japan is slowly rejoining the world economy by opening up a bit. It's becoming more western, more free-market, even if only at the margin. There is a core of good companies upon which Japan can build to try to regain its economic strength. It's up to the Japanese government to take further action in liberalizing the Japanese economy and opening it up to market forces.