Japan loves risk (Noah Smith)

In the past year, Japan's exports fell 45.7%. Exports to all regions were hit - down 52% to America, 45% to China, and 46.7% to Asia as a whole. Japan's mighty national champions, its automakers, have been hit the worst: Toyota's exports are off 56.2%, Honda's 46.3%, Nissan's 62.1%.

That's absolutely stunning. It is catastrophic. Words fail.

What this should demonstrate conclusively is that world economies are much more tightly linked than many economists had thought. The "decoupling" hypothesis — the idea that booming Asia could keep chugging along while America and Europe fell — has been decisively smashed (subscription required), at least in the short run.

(As an aside for the more technically minded, the "decoupling" idea rested on the same faulty assumption as the bubble in American mortgage-backed assets, namely the assumption of constant correlation. When times are good, they are unevenly good, so correlations are low and economies appear to be decoupled, but as soon as things turn bad everyone falls together and correlations shoot up.)

In any case, what does this mean for Japan? It means that being a "surplus" country has proven to be just as risky, if not more so, than being a "deficit" country. Relying on exports exposes you to big shock and wild swings. The myth that Japan, as a nation or as a people, is more risk averse than other countries should thus be exposed as the outdated stereotype that it is. Over-reliance on exports, as it turns out, is similar to playing roulette. For the LDP, it may very well have been Russian roulette.

The last time the dice came up snake-eyes for exporters was a very long time ago — the 70s, in fact. But Japan was still a fast-growing country then, still playing catch-up to the West in technology and capital. Japan responded to the world recessions of the 70s by moving up the value chain, developing global brands and launching headlong into high-tech industries like autos, electronics, and machine tools. The recession was sharp but brief, the party quickly resumed, and the LDP lived on.

Today, that scenario is more likely to befall China than Japan. The record of the last two decades should decisively show that Japan is a fully developed country — it has hit the frontiers of technology and capital. There is no more low-hanging fruit. And that means that recessions are much more likely now to expose the structural flaws in the Japanese economy...of which there are, sadly, still many.

After the LDP goes, the DPJ will have two basic choices: fix structural flaws (the Bill Clinton approach), or encourage bubbles (the George W. Bush approach). I'd advise leaning heavily on the first approach, of course, but the problem is that structural flaws are often politically motivated. Powerful construction, agriculture, and small- and medium-sized business lobbies will use recessions as an excuse to delay reform, and booms as an excuse to ignore the need for reform. Without electoral reform that decreases the clout of these lobbies, the DPJ may find itself forced to turn to more dubious strategies of economic revival.

Whatever happens, though, let no one in Japan now doubt that export dependence is a very high-risk strategy for any nation.

— Noah Smith

Shop for Japan? (Noah Smith)

It has often been said, by this writer and others that Japan needs to "raise domestic consumption" in light of the current economic crisis. In actuality, this is a murky concept. There are a number of different reasons for this, and a number of ways it can be done.

Reason 1: Correcting international imbalances. "Surplus" countries (Japan, Germany, and especially China) produce more than they consume, "deficit" countries (the US and UK) consume more than they produce. This is unsustainable (obviously), and fuels dangerous bubbles. If Japan and the Surplus Gang consume more, the US can safely consume less without wrecking the world economy. Of course, it's too late to save the world economy this year, but if the imbalances persist, this will all just happen again.

So raising consumption is considered the safest way for Japan to help fix the international financial system.

Reason 2: Avoiding a steep drop in output. If Japan sells less to the world — as is now inevitable — it can either make less or consume more. Making less means Japanese companies must either go out of business, lay off workers, or cut wages; or, more likely, all three. It means Japan will be a less wealthy place.

So raising consumption is considered the least painful way to weather the global recession.

Reason 3: Reducing export dependence. Exports are dependent on external demand, and therefore subject to big, abrupt swings. It is difficult for the government to either predict or prevent these swings. Consumption in Japan represents only 55% of GDP, compared to almost 70% in the U.S. If Japanese people are really as risk averse as they are rumored to be, they would naturally like an economy that is less vulnerable to the wild storms of global demand.

So raising consumption as a percentage of output is considered a way to reduce future risk for Japan's economy.

There are other reasons, but these are the big three. Now the question becomes: How does Japan accomplish this feat? I am guessing that telling people to "get out there and shop," as Bush did after 9/11, will go over like a lead balloon.

The classic way of boosting consumption is to lower interest rates, which discourages saving. However, Japan's interest rates have been at or near zero for a long time, so there is no more ammo in that gun.

As I and others have noted, Japan's aging and shrinking population bodes ill for future consumption. It also makes it harder to strengthen the social safety net (since young workers are needed to pay for the pensions of old retirees). Immigration will not increase enough to compensate for this decline. Even the U.S., with over a million new immigrants a year, is aging. That leaves the much-discussed fertility rate.

Finally, there is trade. Increasing imports doesn't seem like it will raise Japanese output, but as I noted in an earlier post, it does. Output is measured in real terms. If you lower import barriers, you can get 20,000 apples per Prius instead of 7,000. That means you are richer, even if some domestic apple-growers go out of business. And it also helps reduce global financial imbalances and bias the economy toward consumption, as well. Of course, this is tricky. If you open up your country to trade with protectionist countries, as the US did with China, you can find yourself on the receiving end of a disruptive flood of cheap money. But free trade with relatively open, rich countries like the US and Europe, as well as with poorer countries like Southeast Asia and Latin America would be a great idea.

And then there's my own idea: harness wealth effects. Most Americans are homeowners. Far fewer Japanese people are. Changing regulations, especially taxes and land-use regulations, could increase that rate. The economic security afforded by homeownership could conceivably raise consumption rates, and the extra living space might encourage larger families.

In any case, "Shop for Japan" is not nearly as foolish a motto as "Shop for America" proved to be in the earliest part of this decade. Balance, in economics as in so many things, is the goal. And a more comfortable lifestyle for the hard-working, long-suffering people of Japan would not exactly hurt the electoral prospects of the party that could deliver it.

- Noah Smith

The can kicks back (Noah Smith)

In my earlier post, I stated that Japan's current-account surplus can vanish in one of two ways: either Japan can consume more (which it won't because of debt and demographics), or it can (over)produce less. That is true. But when the adjustment happens is not set in stone.

A casual observer might think that Nakagawa Shoichi's speech condemning protectionism might sound a little hypocritical, coming as it does on the same day that he threatened to intervene in currency markets to weaken the yen. But from the perspective of very-short-term Japanese national interests, the policies are complementary: the only way to stave off the day of reckoning I described earlier is to pump up exports. Naturally, that will only make the adjustment more painful when it happens, but given current electoral politics one could understand why the LDP isn't exactly planning for the long term. Instead of letting Japan take its lumps now and planning for a brighter future, it seems fairly certain that the LDP will fall back on the old "developing-country" export-promotion, and kick the can a few feet down the road.

But kicking the can carries another, little-mentioned risk. So far, American and British economists and executives have been holding the line against a rising protectionist tide, evoking the memory of "Smoot-Hawley" like a mantra. So far the line has held, as America's Democratic politicians have been too afraid to reach for the bazooka. But the consensus is badly fraying, with Paul Krugman saying he can see the case for "Buy American" provisions in America's stimulus bill. The monster is straining the bars of its cage. And if America's ire is ever roused against Japanese currency manipulation, the US will be far quicker to act than it has been against China; after all, US multinationals do not have their factories in Japan.

No one knows how much a modern-day round of "Japan bashing" would hurt Japan's economic model, but I suspect it would be more severe than nearly anyone can imagine. Japan's much-discussed "dual economy" relies on a compact in which the bureaucracy distributes the rents from world-beating export industries to a host of less efficient domestic industries and small businesses. In the 70s and 80s those rents came from the superior operational efficiency of Japan's auto, electronics, and machine-tool champions; in the mid-2000s they came from the costs saved when those champions moved their operations to China. If America closes its doors to Japanese imports, those rents will vanish and the compact will be broken.

So a best-case scenario for the LDP's kick-the-can strategy is a delayed, more-painful adjustment in maybe three or five years. A worst-case scenario is that American protecionism rises from the dead and smashes Japan's economic model like the hammer of a vengeful god.

In choosing to run the dreadful risk of delaying Japan's day of reckoning, the LDP has proven what many of us always knew — that it represents only a subset of the Japanese people, all its claims to the contrary.

- Noah Smith

The accounting reaper cometh (Noah Smith)

A specter is haunting East Asia. Consumption is falling in the world's "deficit" countries, as American and British consumers rebuild their balance sheets. The global current-account and capital-account imbalances are thus coming under immense strain. An accounting identity states that for the imbalances to vanish, one of two things must happen in the "surplus" countries: either consumption must rise, or production must fall. In layman's terms, Japan has for at least a decade been making more stuff than was efficient for it to make. Now either Japanese people must buy more of the stuff, or make less of it. As one of the two big rich "surplus" countries (the other being Germany — the Axis of Overproduction?), Japan will not be able to escape the adjustment. It is too big to continue to overproduce and hope that some other overproducer will start overconsuming.

The optimal solution, as most international economists have stated, is for China, Germany, and Japan to boost their fiscal sending by huge amounts — much more than America — to increase domestic consumption. China is already doing this. Germany, for reasons that I won't go into, is not. That leaves Japan.

The smartest way for Japan to raise consumption would be to expand social security and unemployment benefits. People plan for the future (they base much of their consumption on their "permanent income"), so government spending that is guaranteed in perpetuity is more effective at getting people to spend now — otherwise they may just squirrel their money away to guard against future tax increases. But thanks to its massive debt overhang and low birthrate, Japan will find it had to do either of these. The dead hand of the 90s reaches up from the grave to throttle our best hope of escape.

So what will happen in Japan? Gravity. Japan will fall to something closer to an efficient long-term production level. This means jobs lost, whether it's the cushy full-time type or the hand-to-mouth Dickensian temp type. It will mean big losses and industry consolidation — farewell to a few more of the corporate baronies of Japan's old entrepreneurial families. It will mean more angry street protests from the laid-off temps and more lonely suicides from the laid-off lifers. More divorces, fewer children. A spiral of lower consumption and higher unemployment. Empty apartment buildings, higher petty crime. Yakuza and foreign mafias taking over more neighborhoods. More teenage girls and married women turning to prostitution in the soaplands and deri-heru services, sometimes pushed by their parents and husbands. Families squatting together in cramped conditions. Rural ghost towns. Heat shut off in buildings in winter, people accidentally dying of malnutrition from eating cup ramen too many days in a row.

Accounting looks pretty ugly in real life.

And the thing is, there is very little Japan's government can do about this. For too long, Japan has pretended to be a richer country than it is, not unlike how American consumers used easy credit to pretend they were richer than they were. In fact, that same American deficit spending, funneled through exports or through China, was what kept Japanese wages and profits above what production-efficiency dictated. The bill has now come due; Japan must wash off its makeup, take off its go-go boots, and stagger out the back of the dance club. And this is a sad thing. Those whimsical economists who have studied the phenomenon of "happiness" — myself included — have generally found that happiness comes to people who are coming up in the world. Someone who makes $50,000 when last year they made $40,000 is more likely to be happy than someone who makes $100,000 but who last year made $110,000.

Japan, sadly, chose the short-term illusion of wealth over the chance to climb higher in the future. They chose it when they pulled the lever for the LDP.

But I'd like to end this dreary litany with a little hope. Falling back to an efficient level of income will be painful for today's Japanese people, but it had to happen. After this crash — the recession Japan should have had in the 90s — Japan will have nowhere to go but up. Leaner, more profit-driven companies will start looking for hires — hopefully something between the full-time and part-time positions of today. Women will find themselves on a more level playing field. There will be room for new industries, new entrepreneurs who are not the first sons of old entrepreneurs. Researchers will invent new technologies, and start companies to sell them — the nerds will win out. And if Japan changes its political system now...if it lays the pipes for a workng social safety net...if it dramatically cuts bureaucratic meddling...if it modernizes its corporate governance and legal system...then the rebound will be deep and lasting.

That is why right now, in the depths of Japan's despair, is the most important time to elect new politicians who focus more on building the future than preserving the past. Accounting says nothing about the day after tomorrow.

— Noah Smith

Dollars and yen(ts) (Noah Smith)

There's an interesting article in BusinessWeek asking whether Japan will intervene to push down the strengthening yen. The consensus seems to be that it will, even though such a policy is not necessarily optimal from an economic viewpoint, and may not in fact work. But a weak yen seems to still be an important part of Japan's industrial policy. Why?

While "classic" theory holds that currency intervention is always inefficient, a new school of thought holds that it's in fact very useful for developing countries. The reason, as Dani Rodrik explains, is that domestic exporters engage in "cost discovery" — holding down your currency gives your domestic companies the chance to find out what they're best at, which is good for long-term economic strength.

But Japan is manifestly not a developing country. And Japanese companies have by now had plenty of time to find out what they're good at. So at this point, an artificially weakened currency serves mainly to boost employment in Japan's export industries at the expense of (a) efficiency (what is Sanyo's core competency again?), (b) Japanese consumers, and (c) industries that serve the Japanese market.

Fine, you may say, that's a fair trade. After all, employment gets a boost. But does it? Employment levels are different from employment volatility, and exports are notoriously volatile (because terms of trade can change quickly). Even if a weak yen increases Japanese employment — which is far from obvious — it may actually make Japanese jobs less secure. A global downturn, or a rapid increase in terms of trade — both of which we are seeing now in Japan — can force companies to either default on their debts or fire workers. In the 90s, Japanese companies did the former; they are now doing the latter.

In other words, this is a pretty clear example where Japan's reflexive (and politically motivated) adherence to "developing country policies" has probably backfired. Just another way that reforming the country's sclerotic political system could yield real benefits for the economy and people of Japan.

— Noah Smith

Omission vs. commission (Noah Smith)

There's been some discussion on this blog about how much responsibility the LDP bears for Japan's current economic woes. Has Japan been helplessly swept up in a crisis of America's making? Or did LDP policies leave Japan more vulnerable than necessary to the storms sweeping the global economy?

The answer, as I see it, is "both." To understand exactly where the LDP's faults lie, it's important to understand the multiple channels through which global economic crises spread.

One channel of contagion is the financial channel; falling demand for assets in one part of the world reduces the price of those assets, which causes capital losses to financial institutions in other parts of the world. In the current crisis, those assets are U.S. mortgages, mortgage-backed securities, CDOs, CDSs, asset-backed commercial paper, and other various debt-related securitized products. And, remarkably, Japan's financial institutions have relatively little exposure to these products — much less exposure, in fact, than any other large rich country.

In other words, Japan dodged a huge bullet. If Japanese banks, hungry for profits after years of capital rebuilding, had jumped into US debt and derivatives markets as European banks did, Japan would now be facing a financial meltdown to rival 1990. The fact that Japanese banks didn't jump on the bandwagon is a huge coup. It's unclear how much, if any, of the credit for this goes to the LDP. A lot of it is simple luck and timing.

The Japanese economy, however, has still been hit hard, through the second channel of contagion: exports. Japan remains an export-dependent economy, one that is still structurally weak in many ways. How much of the blame does the LDP take for that? A lot, I would argue.

Many have noted that Japan's export dependence is a result of sluggish consumption growth during the Koizumi years, a weakness that continues today; the reason for that sluggish growth is less discussed. One reason is the demographic transition; Japan's market size relative to the world economy has shrunk. Whether the LDP deserves the blame for that is the subject of the ongoing debate about fertility.

A second reason for sluggish consumption growth is stagnant wages. Globalization takes part of the blame for that, but much of the effect is due to shifts in the labor market. As Japan's baby boomer men retire, many have been replaced not by full-time workers with lifetime employment guarantees and seniority-based wages, but by low-paid, insecure temporary workers. That helped Japan's companies cut costs, but it put a huge damper on consumption, because generational turnover has made mean wages fall automatically.

I blame the LDP not for allowing the rise of temp workers, but for encouraging the creation of a two-tiered employment system in the first place. Baby boomer salarymen, with their secure jobs and non-performance-based wages, were and are getting paid more en masse than their productivity justified. Which means younger generations are getting paid less than their productivity justifies. That's made Japan less efficient, and left it more exposed to an export slump than it might have been.

The LDP has done other things over the years that had the effect of suppressing Japanese consumption — nontariff trade barriers, restrictions on FDI, inadequate antitrust enforcement, etc. And of course, there were all the mistakes of the Bubble Era, which have left Japan's companies (and therefore domestic investment) in a weak position to this very day. The LDP should have been banished in 1993, giving opposition parties the chance to reform the bureaucracy and other broken institutions. Fifteen years of reform could have left Japan stronger in 2008, but that ship has sailed.

To sum up: Japan's lack of direct exposure to America's financial crisis offered it a golden opportunity to come out of the world recession with a head start on every other economy in the world. But because of decades of LDP failure to address other problems in the economy — sins of omission and commission — Japan missed that opportunity, and must suffer alongside everybody else.

The next key question is: Would the DPJ do better? Going by Ozawa's promises, I'd conclude that in the short term it would not. Japan's best hope now is for the long term - embarking now on a path of institutional reforms will make Japan much stronger ten or fifteen years in the future. Better late than never, I say.

— Noah Smith

Work equals force times distance (Noah Smith)

I am waiting in the departure lounge at JFK in New York for my flight to Tokyo. In the mean time, here is another contribution from Noah Smith. - TSH

Taro Aso, speaking before a parliamentary committee, recently said that "Japan's belief in hard work contrasted with that of the Judeo-Christian tradition," and that world religions could learn from Japan's work ethic. Interesting. Apparently he hasn't read Max Weber's The Protestant Ethic and the Spirit of Capitalism.

In any case, it's undeniable that Japan's workers work a lot of hours (though Australians work more, and the third, fourth, and fifth spots go to the U.S. Canada, and the UK - Weber gets the last laugh). And Japanese companies are famous for requiring unpaid overtime. But how much of that "work" is really "hard"? As software engineer Peter Gibbons points out in the film Office Space, it's easily possible to show up and punch the time card without getting anything done or even exerting serious effort. Twiddling your thumbs and surfing sports news while you wait for the boss to go home does not count as "work ethic."

Now, I'm in no position to know how much time Japanese workers spend twiddling their thumbs. But I am in a position to know that Japanese white-collar labor productivity is substantially lower than most other rich nations (including Asian nations such as Taiwan and Singapore). That means that whatever is getting done in all those long hours Japanese people spend in the office, it's not as much as it could be. Any physics student will tell you that work equals force times distance*; Japanese workers put in a lot of force without getting enough distance.

Japan's leaders should recognize this distinction. We all know the story of how government protection of Japan's domestic service sector has left it inefficient, but it's important to realize the real impact this has on the lives of Japanese people - parents who can't go home to be with their children, salaries that are lower than they could be, exhausting hours of work put in with not enough to show for it at the end of the day. Maybe Aso should take a clue from King Solomon in Ecclesiastes 4:14, and help the Japanese people to work smarter, not harder.

- Noah Smith

"It's the institutions" (Noah Smith)

Hi! First, of course, to introduce myself. My name is Noah Smith, and I'm an economics PhD student at the University of Michigan in Ann Arbor (specialty: urban economics and macroeconomics). Between college and graduate school I lived in Osaka, Japan for 2.5 years, from 2003-2006, where I worked as an editor and also a research assistant at Osaka University in Suita. I've been interested in Japanese politics, economics, and society for a while now, so I was happy when Tobias asked me to be a guest contributor.

Tobias's primary focus is on Japan's electoral politics and foreign policy, two areas about which I know relatively little. Like Tobias and many here, I'm eagerly awaiting the shape of a Japanese political "realignment" that I think must be coming soon; the pressure is building inexorably. But I think there's a big question that should be on our minds: If and when that realignment occurs, how will the victors — the DPJ or some new party or coalition — use their mandate to change Japan?

That is the question I want to try to answer.

True political revolutions bring not just a change in the style of management, but reforms to the institutions that shape the day-to-day workings of a society. Economists have long studied the importance of institutions in developing countries (see Dani Rodrik and Daron Acemoglu for example), but I see no reason why they should not be of crucial importance in rich countries as well. If we look at Japan's history, we find that its periods of greatest advancement — the Meiji and Taisho periods, in particular — involved big, sweeping changes to the institutions that governed Japan's economy and society. Those changes befell not just the institutions most commonly studied by economists — the electoral system, courts, public schools, and the bureaucracy — but social institutions like religions and the family. And, of course, it included the military, an institution whose importance would grow to encompass nearly all of Japanese life during the 1930s, only to vanish almost completely after World War II.

Today, Japan faces the problems of the twenty-first century with institutions that, in large part, were developed in the nineteenth and early and mid twentieth centuries. As challenges shift, institutions must keep up — but, as economists often note, institutions are "sticky." They don't like to change. Which is why the coming post-LDP political realignment is such an important moment: it will give Japan's leaders what is probably a once-in-a-generation opportunity to revamp many of Japan's institutions.

How should Japan's institutions change?

Effective institutions are a mix of what worked in the past and what seems wise for the future. Japan needs a political system that gives people more confidence in the leaders they elect and the parties to which those leaders belong. It needs a court system that is more participatory, and that elevates the rule of law above informal patronage- and status-based relationships. It needs a bureaucracy less corrupted by conflicts of interest. It needs universities that are more independently funded and more focused on research and undergraduate education. It needs religious organizations to take more active roles in building communities and providing social services like child care. It needs families that have enough time to spend together, where fathers are not separated from their wives and children by the demands of work.

If the party and leaders who take power after Japan's "realignment" can make these changes, I think Japan will be one of the world's leading nations in the twenty-first century, as it was in the twentieth.

Of course, that's just my opinion and my guess. But in the end, opinions and guesses are the driving force behind political change. I hope that mine, combined with what modest expertise I possess, can add to the discussion here at Observing Japan.

- Noah Smith