Could the consensus be wrong?
With some notable exceptions, the conventional long run market view on Japan is bearish. It is that the government is facing a debt problem that sooner or later will bring about a collapse of the currency and the government bond market. Related to this is the view that Japan’s aging and declining population puts the country into a box from which there is no escape. Short term, Abenomics is fraught with contradictions and is at best a trade that is not likely to change much in the long run.
I certainly think Abenomics emphasis on fiscal and monetary expansion (Arrows 1&2) is a mistake. But the pessimism can go too far. No question that Japan in the 1990s, post the collapse of the real estate and stock market bubble, was a wounded animal. It was a land filled with insolvent (on a mark to market basis) banks, companies and consumers. It was an economy afflicted with so-called demand based “bad deflation.” The malinvestments of the nineteen eighties boom had to be liquidated. But the government policy was to ease the pain and slow this liquidation process. But nothing lasts forever. This is 2013 and balance sheets have been repaired. In case anybody looked, the unemployment rate is a low 4.1%, in recent years real GDP per capita growth has been equal to or better than that of the US and certainly that of the Eurozone. JGB ten year yields, even after the dose of cold water from Mr. Abe’s misguided Arrows, were still as of this writing below 1%. Not only that. Arrows 1&2, it turns out, cannot kill the yen. As this is written, the yen has dropped back down below 100.
Strong currencies are generally associated with strong economies. For a country that is falling apart, Japan is doing very well.
The global financial and analytical community should admit it. Japan is a mystery country.
Some Things You Aren’t Seeing Much of in the Financial Media
Abe’s third arrow – structural reform – if carried out successfully is deflationary. And that’s good. It will be what economists call “good deflation”. Many observers have described Japan as having a dual economy. One side of the Japanese economy is the modern, globally competitive export sector. Toyota is the iconic symbol for this sector. But the other side is a highly protected, highly inefficient mom and pop retail distribution and agricultural sectors. Even the export sector suffers from protectionism (this is not a misprint), high corporate taxes and restrictive labor practices.
Serious structural reform will bring about a wave of creative destruction, to use Schumpeter’s famous term, as the inefficient is swept away and resources including labor are redeployed. Prices in the affected sectors will go down. And economic growth will quicken. Attempting to force inflation on a Japanese economy that is undergoing deflationary creative destruction through structural reforms is an unnatural act. Moreover, even if the structural reforms continue to meet fierce political resistance – and the odds on that are unfortunately high – technological forces are likely to push Japan in the direction of beneficial and deflationary creative destruction. The acceleration of technology that many believe is a global phenomenon is a deflationary force. Japan is a part of that.
Stimulating the Japanese consumer and trying to produce inflation via expansionary monetary may also be an unnatural act. The Japanese typical consumer is affluent and older. Opening up the monetary and fiscal spigots to get this group to spend may be like handing out free whiskey to a group of teetolers. The government is not going to easily juice up this group’s spending. At the same time the government debt to GDP ratio is already precariously high. Somehow the concept of Ricardian Equivalence comes to mind. This concept, often ignored in economics, holds that consumers will restrain their own spending to offset increased government borrowing since they know they will ultimately be stuck with the bill to repay the debt. Aging Japanese consumers can see the burgeoning government debt and may quite rationally wonder if the government will ultimately “default” on its pension obligations. So Japanese consumers may simply increase their savings to finance their old age in response to Abe’s increasing government borrowings.
Fear of Deflation May Not Be Rational
The uncritical acceptance of Abe’s two percent inflation goal is nothing short of amazing. Low inflation is presumed to be a good thing, no questions asked. Deflation is bad, period. Actually historically there is a sort of precedence for this. Call it money illusion or whatever, but the general public has never had a positive attitude towards deflation whether it was the good or bad variety.
A brief review of late nineteenth century US economic history may be illustrative. Contemporary commentators referred to the period 1873-1879 and sometimes more generally 1873-1893 as the Long Depression. The US did not officially start computing national income and product account (NIPA) data until well into the twentieth century. But modern scholars have made estimates going back to 1869. There are some differences between the statistics of different scholars but the general conclusion is that there was no depression. There was some volatility to be sure but real GNP and real GNP per capita grew strongly over this period as prices declined, particularly in certain sectors. But in the absence of official NIPA data, contemporaries reacting to the decline in prices thought there was a depression.
The second half of the nineteenth century was actually one of incredible progress and strong economic growth. The gold standard provided monetary stability although a global shortage of gold until 1897 no doubt contributed to some of the deflation. But the second half of the nineteenth abounded in new inventions and creative destruction that were strongly deflationary particular for the affected sectors. I recommend David Ames Wells’ Recent Economic Changes: And Their Effect On The Production And Distribution Of Wealth And The Well-being Of Society and Kevin H. O’Rourke and Jeffrey G. Williamson’s Globalization and History: the Evolution of a Nineteenth-Century Atlantic Economy to anyone interested in this fascinating period in human history. I think Prime Minister Abe might benefit from reading these books. O’Rourke and Williamson talk about “transport innovations and the amazing decline in international transport costs.” Canals, railroads, steamships (which ultimately came with screw propellers, compound engines, and steel hulls), refrigeration, the telegraph, the opening of the Suez Canal in 1869—it’s a fascinating story of human progress. And a deflationary one of endless creative destruction.
The trouble is creative destruction creates losers. Like the American farmers of the late nineteenth century who thought they were getting a bad deal as the prices of their output were declining, at least in their minds, faster than their costs. They certainly thought they were in a depression.
Japan’s demographic problem is oversimplified and potentially not as negative as it first appears. I am relying in this section on a new book by Clint Laurent entitled Tomorrow’s World, A Look at the Demographic and Socio-Economic Structure of the World in 2032. There are a lot of things that make sense in this book.
Everyone knows by now that Japan has one of the lowest birthrates in the world, that its population is declining and aging and its government is way off the charts as far as debt goes. But there are two factors that need consideration.
The first is the extent of the probable decline of the working age population. Japan’s National Institute of Population and Social Security Research, cited by Japan bear John Maudlin, forecasts that Japan’s working age population will decline 17% over the next seventeen years. But Laurent takes issue with this based on two reasons. Reason number one is the likely extension of the working age. Japanese are among the healthiest and longest lived persons on earth. For the Japanese that’s the good news. But, it is also the bad news. According to Laurent, the average person faces the prospect of funding a 20 year retirement. This person cannot retire. Laurent calculates that this alone will make for an increase of 11 percent in the working population than would otherwise have been the case. Laurent’s reason number two is the female participation rate. Laurent estimates a rise in the female participation rate through 1932 from 60% to 68%. Japanese women are as well educated as men. Older women (aged 40 years plus) will rejoin the labor force as traditional attitudes give way to economics.
I would offer a third reason for relative optimism regarding the Japanese working population. Structural change, aka creative destruction, will release workers from low productivity jobs back into the job market.
Laurent’s second factor is also of great interest and partly related to the first. Economists, myself included, have done considerable hand ringing about Japan’s increasingly unfavorable worker/ retiree ratios (obviously less unfavorable the greater the working population.) But there is another way to look at this. Laurent calculates a dependency ratio, that is, the ratio of the working population to the total population. He forecasts that Japan’s dependency ratio will actually improve. The working age population is likely to decline more slowly than the total population and Japanese live births are not likely to jump upward. Laurent calculates that in the next two decades Japan will remain a country with one of the lowest dependency ratios in the world. Thus the typical Japanese household will have significant discretionary income.
The central message of this paper is that Japan is not hopeless and that if structural reforms are undertaken the Japanese stock market could turn out to be a very good long term investment. But this is no sure thing. The worst case scenario is that these reforms are not undertaken and Abe’s unneeded quantitative easing and fiscal expansionism causes a collapse of the JGB market. Remember it’s the change in real income per capita that should be the ultimate criterion measuring success or failure of the Japanese economy.
Japan desperately needs to abandon its state directed highly protectionist, highly interventionist East Asian economic model. Market forces will push it in this direction but so far the completely frozen political system has held up serious structural reform. This is Abe’s Third Arrow.
Investors in Japan should recognize that this is not a youth market. This is a “mature market”, as will be the markets of all the so-called advanced countries. Health care including drugs and biotech, labor saving robotics, old age facilities, technology, cruise ships, money management – not diapers or housing—are growth sectors. Betting on the export sector assuming a degraded yen is not a smart long term strategy.
There are those who believe expanding populations are a prerequisite for rising stock markets. Nobody really knows if this is true or not since populations have been expanding significantly for the last five hundred years. We don’t have any history on this. But I do not believe this is true provided countries take the necessary steps to participate in the continued acceleration of technology.