Monday, September 1, 2014

Japan's Got Issues

In one of my previous posts, I discussed Europe's problems. In this post, I'm gonna discuss Japan's problems in a rather similar fashion. This post will be split up into eight different parts:
1. Japan's Geography
2. Japan's #1 Problem: Japan Imports All of its Food and Energy
3. Japan's Economic Model
4. Japan's Debt Problem
5. Japan's Demographics
6. Abenomics
7. What Can Japan Do?
8. Conclusion

1. Japan's Geography:
Japan is stuck on a set of islands that start in the East China Sea and touch the border of Russia from South to North). Japan consists of thousands of islands, but the four major islands of Japan are (from North to South) Hokkaido, Honshu, Shikoku, and Kyushu. As we can see in the geographical map below (left), most of these islands consist of harsh terrain that isn't hospitable to large populations (right). The small Kanto plain on the very right side (bordering the Pacific Ocean) contains the city of Tokyo and is also home to a third of the population, but notice how small the land mass is. The rest of the Japanese population is spread out in a similar manner with most of the population living on a very small space of land as most of the Japanese land mass is home to very few people.

Also note that in the geographical map above shows how most of the Japanese land mass consists of very rough and rugged terrain, which tells us that there's little arable land mass in Japan. It's also important to notice that there's little natural resources in Japan as well. So Japan has the economic problem of sustaining a relatively high population with little arable land and few natural resources. This is why Japan has, historically, gone back and forth between isolationism and imperialism. When Japan has united under strong centralized control, the result has usually ended in imperialism.

2. Japan's #1 Problem: Japan Imports Most of its Food and Energy
Due to Japan's geography, Japan is in a situation where it imports most of its food and virtually all of its energy. Before the 2011 Fukushima disaster, Japan received about a third of its energy from nuclear power. Post-Fukushima, Japan is now importing all of its energy. Japan was already importing much of its food as well and is now importing almost all of its energy. As I spoke about with China's geopolitical problems, there's serious tension between China and Japan over the natural resources (primarily oil and gas) that lie in the East China Sea.

Japan holds very little natural resources and the terrain across most of Japan is also very harsh. This is why Japan has historically alternated between periods of imperialism and periods of isolation. When Japan has come under strong centralized control, the country usually goes imperialistic and often begins to expand out into either the Korean Peninsula, Eastern China, or Manchuria (examples of time periods include the 16th century and the 20th century before World War II).

3. Japan's Economic Model:
Economically, Japan's growth model USED to be to China's current economic growth model. This culminated in extremely high growth rates in the 80's and early 90's, but also led to a massive increase in private debt and a massive asset bubble--the worst since China's asset bubble today. In the case of Japan, the Nikkei peaked near 40,000 and is still only near half of what it's peak was back in the late 80's. The Japanese Imperial Palace and the land within it was worth more than the entire state of California during this period.

The resulting crash led to a collapse of growth rates while the leadership in Tokyo decided to deal with the resulting fallout by having the public sector take on all of the bad private debts that led to the asset bubble. By taking this course of action, Tokyo rebalanced the Japanese economy over the following 20 years after the bursting of the bubble which led to the two lost decades Japan has faced. On top of this, Japan is still having difficulty growing at any significant speed while private debt has been transferred to the public sector.

Recall that the Chinese (and former Japanese) growth model works by turbocharging investment and growth by reducing the household share of income, which causes the national savings rate to go up. This forced Japan to rebalance its economy after the investment driven growth model resulted in a debt crisis. Recall that negative real lending rates were critical to the initial boom and Japan transferred resources back to the household sector by positive real lending (and interest) rates from 1990-2013. This led to a steady increase in the household share over the past two decades, but the lower growth rates resulting in the decade ending up as a "lost decade".

4. Japan's Debt Problem:
We must remember that when we think about debt, we must understand that all debt is a transfer of real resources. We must also remember that debt is created out of thin air as debt and money get created simultaneously by the banking system. All debt (and money) is, in some form or another, a claim on real resources. This means that every time debt or money is created, real resources are simply being transferred. What really matters is whether or not the productivity gains from the transfer of real resources outweighs the real debt servicing costs of the transfer. Note that the real cost of transferring real resources is the NGDP growth rate since the NGDP growth rate is the opportunity cost of not holding real assets.

Below, I've shown a chart of Japan's total debt/income ratio over the past few decades. As we can see, this prolonged deflation has actually increased the real burden of the Japanese debt. I'm also of the belief that the massive Japanese debt taken on over the past 40 years or so hasn't been used very productively. In other words, the Japanese debt burden is slowing growth because the transfer of resources hasn't (and still isn't IMO) being used productively. Japan cannot address its stagnation if it doesn't address its massive debt problem.

5. Japan's Demography:
Like much of Europe, Japan's fertility rate has been less than 2 since 1970 and has been less than 1.8 since 1974. In other words, Japan's population is rapidly aging while fertility rates continue to stay low. The Japanese workforce size peaked simultaneously with the bubble in 1990 and has been in steady decline ever since. In terms of demography, Japan was basically in the same situation in 1990 that China is in today. The workforce started to steadily decline as what became a boost to growth eventually turned into a larger and larger drag on growth. Also notice that this trend shows absolutely no signs of ebbing as fertility rates have stayed depressed.

The rapidly declining demographics doesn't just mean a drag on growth from a falling workforce, but it also means more dependents that have to be taken care of by a falling workforce. This implies larger and larger outlays into things like social security while tax revenues fall from a falling population and a falling workforce. In other words, the demographics will increase the structural budget deficit and place upward pressure on the national debt.

Basically, Japan's worsening demography makes all of their underlying problems a whole lot worse. Also note that due to Japan's rapidly aging population, we should expect to see household savings rates go negative as more people retire and pull out their savings.

6. Abenomics:
In order to fix the Japanese stagnation of the past 25 years or so, Prime Minister Shinzo Abe has laid out an economic platform that's supposed to get Japan out of its stagnation. Abenomics has three arrows and these arrows consist of:
1. Aggressive monetary policy to devalue the Yen sharply while stimulating exports
2. Fiscal stimulus involving a reduction in corporate tax rates to increase investment
3. Structural reforms

With regards to the first arrow of Abenomics, aggressive monetary policy will increase asset prices and devalue the Yen (it already has), but the impact on exporters really isn't all that clear. Recall from earlier that Japan imports almost all of its food and most of its energy. This implies that a further devaluation in the Yen would just cause a corresponding increase in food and energy costs. Although this policy of aggressive monetary easing will (and has) caused equity prices to rise while sending the Yen plunging, the result has been inflation led by a rise in input costs. Aggregate demand in nominal terms may rise as a result of this policy, but real demand will fall (and has been falling) from soaring input costs. On top of this, the people who get hurt the most from the devaluation in the Yen will be the elderly and we already discussed Japan's population.

The second arrow involves fiscal policy in a country where the real transfer of real resources caused by the massive debt is placing a heavy burden on growth. Keep in mind that none of this debt was ever written down as most of it has just kept being rolled over onto the government's balance sheet. Notice that Abenomics never deals with the debt problem and instead tries to reduce corporate tax rates in an effort to boost investment. It was these kinds of policies that created the misallocation of capital in the the late 70's and 80's in the first place and misallocating more capital doesn't fix anything. All it does is postpone the problems into the future.

The third arrow is really nonexistent. There hasn't been any structural reform--it's all been political hogwash.

7. What Can Japan Do?
The one advantage of Japan is that the Japanese government does hold a lot of different assets. The total amount of assets held by the Japanese government is about $6.6 trillion or around 130% of GDP. Japan can privatize some (or even all of these assets) in order to pay down its debt. That being said, the only problem this helps fix is the Japanese debt problem.

Japan can also try to take some natural resources that lie on the East China Sea, but there's a border dispute with China on this issue. Much of what happens depends on whether war breaks out or not. I discuss this issue in larger detail in my post on China's geopolitical problems.

8. Conclusion
Japan is in a very difficult situation both geopolitically and economically. The massive debt burden combined with a rapidly declining population represent a massive economic challenge that'll make it difficult to reverse the Japanese economic stagnation of the past 24 years while Abe and his economic program (Abenomics) don't (and can't) address the major problems.

The geographical situation of Japan doesn't help anything as Japan relies heavily on imports for key economic inputs. In order to maintain economic activity and sustain economic growth, the leadership in Tokyo will have difficulty maintaining a low cost of economic inputs for the country. In order to make sure Japan has these economic inputs, there's a real risk of war with China. However, Japan is building ties with the US and India to contain China and may very well have access to the natural resources that lie in the East China Sea.

Japan's primary advantages lie in its technological prowess and in the assets held by the national government. Japan should start privatizing some of those assets in order to pay down the debt while Japanese technology combined with US support could help Japan access many of the natural resources in its dispute with China.

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