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

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

Fear and loathing in the global economy

Every once in a while, I read an article that is worth posting largely without comment. Tony Judt, a professor of European history at NYU, has written one such article, a review in the New York Review of Books of Robert Reich's Supercapitalism.

The key paragraphs:

But we have good reason to believe that this may be about to change. Fear is reemerging as an active ingredient of political life in Western democracies. Fear of terrorism, of course; but also, and perhaps more insidiously, fear of the uncontrollable speed of change, fear of the loss of employment, fear of losing ground to others in an increasingly unequal distribution of resources, fear of losing control of the circumstances and routines of one's daily life. And, perhaps above all, fear that it is not just we who can no longer shape our lives but that those in authority have lost control as well, to forces beyond their reach.

Half a century of security and prosperity has largely erased the memory of the last time an "economic age" collapsed into an era of fear. We have become stridently insistent—in our economic calculations, our political practices, our international strategies, even our educational priorities—that the past has little of relevance to teach us. Ours, we insist, is a new world; its risks and opportunities are without precedent. Our parents and grandparents, however, who lived the consequences of the unraveling of an earlier economic age, had a far sharper sense of what can happen to a society when private and sectional interests trump public goals and obscure the common good.

We need to recover some of that sense. We are likely, in any event, to rediscover the state thanks to globalization itself. Populations experiencing increased economic and physical insecurity will retreat to the political symbols, legal resources, and physical barriers that only a territorial state can provide. This is already happening in many countries: note the rising attraction of protectionism in American politics, the appeal of "anti-immigrant" parties across Western Europe, the call for "walls," "barriers," and "tests" everywhere. "Flat worlders" may be in for a surprise. Moreover, while it may be true that globalization and "supercapitalism" reduce differences between countries, they typically amplify inequality within them—in China, for instance, or the US—with disruptive political implications.

In the midst of an unfolding credit crisis that could wind up destroying major US banks and who knows what else, Professor Judt is sobering as only a historian of the European twentieth century can be.

Read the whole thing. (HT: Andrew Sullivan)

Japan's friends, kept at arm's length

The Japan Times today has two op-eds that illustrate Japan's troublesome ties with the US, its ally, and South Korea, its wealthy, democratic neighbor and former colony.

The first, by journalist Hanai Kiroku, calls for a US-Japan economic partnership agreement (EPA), to follow on the heels of the Japan-Australia EPA currently under negotiation. Given the scale of the economic links between the world's first and second largest economies, the benefits of a US-Japan EPA would be large -- and would undoubtedly have spillover benefits for both the search for a compromise in the WTO and the push for an APEC FTA.

But I fear that political conditions in both countries militate against the negotiation and passage of a US-Japan agreement for the foreseeable future. With economic insecurity on the rise in the US, and the president's trade promotion authority set to expire, a wide-reaching EPA with Japan could very well aggravate US fears of Japan's economic prowess -- imagine the screams that would emanate from Detroit.

In Japan, meanwhile, the opposition to an agreement would be more fundamental, as it would no doubt emanate from Japan's heavily protected agriculture sector. Hanai makes the sensible suggestion that since Japan is dependent on food imports anyway, it might as well conclude deals that ensure that imported food supplies will remain stable, cheap, and plentiful:

Japan's calorie-based food self-sufficiency rate is only about 40 percent, much lower than the comparable rates of other countries. Some fear that EPAs with major farm exporting nations such as Australia and the U.S. will lower the rate further. However, in my opinion, Japan should secure stable food supplies from overseas because of its low food-sufficiency rate. If Japan, through EPAs with Australia and the U.S., has both countries promise to refrain from one-sided restrictions on food exports, it will help strengthen Japan's food security.

For that to happen, though, Japan's political system will have to change: as long as rural prefectures are the LDP's power base, and as long as the distribution of power in the political system favors agricultural producers over consumers, any agreement that forces Japan's farmers to face substantially greater competition will be nigh on impossible. This kind of opposition has already emerged against the Australia EPA negotiations; imagine the opposition that would await EPA negotiations with the US.

The second piece, meanwhile, is Pyon Junbeom and Tsukagoshi Yuka, South Korean and Japanese scholars respectively, writing about concrete steps that South Korea and Japan can take to ease bilateral tensions and build a genuine partnership. I like this piece, because it seeks to craft policies that take into account intangible cultural and historical factors. As they write: "The root of anti-Japanese sentiment in South Korea is wounded pride. Koreans feel humiliated and insulted that they, a highly civilized society, were invaded by the Japanese, whom they believed to be barbarians." A sensible argument, but it leads me to wonder if even their modest recommendations will be difficult to implement. The kind of attitude they describe South Koreans as having seems like it would be difficult to overcome simply through Japanese apologies and other conciliatory measures. I don't doubt the value of a closer, more active Japan-South Korea partnership, I just doubt whether a South Korea intent on rectifying centuries of shame and a Japan feeling insecure as it watches its neighbors succeed will be able to forge a strong, dynamic friendship.

If Japan is to remain a significant player regionally and globally, however, it better start laying the groundwork for more constructive, open partnerships with its friends now, before it's too late.