Real inflation? – or time to revive old concepts?

Issue

The "flash" release of consumer prices in central Tokyo for November show Japan's CPI is back in positive territory for the first time in 15 years, with accompanying headlines. Never mind that the current level is barely positive (and that for most of the period the level was barely negative); we're told that Abenomics is working.

That judgement is premature. To date the rise in consumer prices is limited to energy (including the hike in electricity prices thanks to the nuclear shut-down) and imported goods (the weaker yen). While the overall index shows a 0.9% year-over-year rise, that falls to 0.2% once food and energy are excluded. Then there are import prices; TVs contributed 0.1 percentage points to the total, while overseas "package" vacations were up 12.6% in price. However, domestic services are the biggest part of consumption, and health care costs dropped 0.9% relative to November 2012. So in my reading the data provide no indication that the rise in consumer prices will continue after these one-time effects – the nuclear shutdown, the yen depreciation – work through the economy. [See here for the data.]

Theory

That reading is contingent upon an underlying view of inflation dynamics. At one time discussions divided into "cost-push" and "demand-pull" inflation. First, that approach relied upon an arbitrary separation into demand-side and supply-side factors. Second, it provided no help in understanding hyperinflations, something that was ignored by the parochial Anglo-American base of the profession.

For that task, the monetarist framework developed by Irving Fisher and later used by Milton Friedman worked well. However, Friedman's framework had its own defects. The core accounting identity MV = PY worked only as long as the velocity of money V was stable, which turned out to be a function of the tightly regulated US financial system. (Today central banks appear to have little control over the left-hand side, with shifts in monetary policy offset by changes in the willingness to hold money. Money, in other words, is endogenous.) Meanwhile, at low levels of inflation it provided no guidance on how a change in money might be split among changes in the price level P and output Y. That's today's world.

Then came the stubborn US inflation of the 1970s. The "push-me, pull-me" approach helped not at all, as both seemed to be at play, and offered only vague policy advice – did it really suggest using wage-and-price controls? Instead a new expectations-based approach seemed to work better: as long as expectations of future inflation remained strong, inflation was self-reinforcing. It also proved easy to introduce (rational) expectations into formal models using a monetarist framework, and of course novelty is important for up-and-coming economists to make their mark. The new models generated excitement, and also appealed to the conservatives who read stable-policy rules (rather than central bank discretion) into the monetarist framework.

Now the anti-inflationary actions of the Bank of Japan in the mid-1970s and the US Fed in 1979-82 seemed to fit both the expectations framework: high interest rates were viewed as a credible signal of a commitment to lower inflation, and a period of high rates did indeed lead to a sharp (and most important for the model, enduring) drop in inflation. Of course a more conventional "Keynesian" model generated the same initial results, because high interest rates clearly cut into (aggregate) demand by repressing business investment, housing and consumer durables. But such models had been discredited and the new expectations/monetarist models seemed to work.

Japanese inflation

Back to Japanese inflation. There's no indication inflation expectations are now higher. Long-term bond rates remain extremely low, and have fallen rather than risen, which is not consistent with a stable 2% inflation rate down the road. Surveys show consumers expect 2% inflation – but discomfiting to the expectations view, that has been the case for many years. The more aggressive Bank of Japan policy has led to some substitution from money into foreign assets (hence the weak yen). Trade deficits reinforce depreciation. Yet the current account (trade plus net capital) remains positive; Japan is a global rentier, earning substantial foreign income. So I don't think the asset reallocation will continue forever. Over the long run the yen will not stay weak – though the time horizon is too long and uncertain to make speculation profitable, particular as asset returns outside Japan are also part of the story. The bottom line remains that the "push" of depreciation is one-time, and if anything will reverse.

Now energy prices may go up, or they may go down – no betting there. However, natural gas prices in Japan remain unusually high, given prices elsewhere. That suggests that over time energy prices will decline, as import capacity improves and power plants shift to that cheaper source. With virtually all of Japan's nuclear generating capacity shuttered, there's no upside to prices, only downside. So again, the "push" from that end is one-time and if anything will reverse.

So expectations aren't leading to direct price hikes, the direct impact of monetary policy has been minimal, and "push" from the indirect portfolio effect and from Japan's failed energy policy won't continue.

What of "pull"? The impact there is through labor markets and product markets. While labor indicators are improving, all measures point to flat wages and continued excess capacity in product markets. But since Japan is a service economy, wages really are key. Were the economy to keep growing – ah, but in April we have the consumption tax increase. So with the uncertainty that introduces (or rather, the certainty of slower consumption growth), wages won't rise in this year's shunto (annual large-firm spring wage negotiations).

Conclusion

Perhaps come 2015 there will be "real" inflation, when "push" and "pull" are muddied and ongoing price increases are reflected in expectations and wage changes. For an economist two years is the distant future. I wasn't presented with a crystal ball when I marched to receive my PhD – all I got was a handsome piece of paper in Yale blue. To the extent that I can peer into the future, it is because I rely on the momentum of an entire economy and a model of how pieces interact. Errors from being a little off in reading those forces cumulate, and the future typically includes surprises that add to the size of the error term. Momentum means there's little value in updating this story monthly, and I chose not to become a "house" economist whose job mandates doing so anyway. My sense is it won't be worth revisiting the inflation story until summer 2014, when more is known of the impact of the consumption tax increase, of energy prices and policies, and of shifts in big-firm employment and wages.

Addendum: I deliberately kept narrow the overview of shifting macro viewpoints: no mention of a Phillips Curve, no mention of Real Business Cycles, much less how these all come together in one or another flavor of DSGE. If you're an economist that's not central, you know the other pieces. If you're not, these other pieces complement rather than overturn what I do trace.

Autos and Industrial Policy

In the online NBR Japan Forum (and in a chat with a retired vice miniser of METI – the Japanese Ministry of Economy, Trade and Industry [経済産業省]) – I hear about how electronics, hybrids, and yes, fuel cell vehicles will turn around the [domestic] Japanese auto industry, including suppliers who can use their cumulative engineering and manufacturing skills to profit from this.

As evidence, they point to the Prius as a huge success, including as the top-selling vehicle in Japan.

This faith in new technologies as the industry's salvation is wrong on three counts.

First, it relies upon a mistaken definition of the industry. As Klier and Rubenstein show in their 2008 book, Who Really Made Your Car?, the vast majority of employment – 3 jobs to 1 – is in parts manufacturers, not the car companies. Twenty-five years ago the Detroit Three sharply reversed their vertical integration, with GM and Ford spinning off Delphi and Visteon. In Japan, though, that process of dis-integration began circa 1950, when Toyota as part of its de facto bankruptcy spun off Denso. According to its Census of Manufactures [工業統計表] in Japan the employment ratio is on the order of 4:1.

Furthermore, while high-tech is sexy, it is not the name of the employment game. Mundane-seeming items such as wire harnesses and seats are the most expensive individual items purchased, and while I've sat through engineering presentations on new technologies they incorporate, they remain comparatively labor intensive in their manufacture. As bulky items seats are almost universally made within a short truck drive of an assembly plant, but harnesses come from the Philippines (where they are the biggest single source of manufacturing jobs), China and Mexico. But it is mundane parts that comprise the bulk of a vehicle's purchased components.^[1] To make it worse, the electrification of parts makes it possible for new firms to become suppliers; while it may not affect domestic employment, firms such as Panasonic now supply much more than car audio, to the detriment of incumbent suppliers. In addition, even if Japanese parts firms were to dominate the high-tech end of the industry (they don't at present), it wouldn't halt the shrinkage of the domestic car market, which is driven by demographics. (See my August post, The Decline of the Japanese Auto Industry.) Success in high-tech parts won't stem the erosion of domestic jobs.

...high tech won't stem the erosion of domestic [Japanese] automotive employment

Second, to me it is not clear that Japanese suppliers are ahead of the game. There are certainly individual suppliers (and particularly specialized sub-suppliers) that dominate their particular niche. The 3/11 supply chain disruptions provided examples where a single Japanese plant supplied the global industry. However, when it comes to transmissions, or headlights, or turbos, or many other items, Japanese firms may be major players, but in the [confidential] "benchmarking" competitive analyses that I see as a PACE judge, they seldom appear on the leading edge. One reason may be that, despite 30 years of Japanese assembly operations in the US, suppliers remain parochial: when I visit firms I am the only non-Japanese in the room, unlike in the US or Europe. Yes, the better firms have R&D outposts around the globe, but careers are made or broken at headquarters, recruitment from the outside is highly unusual, and a "not invented here" attitude is all too common. Let me caution that this is based on a small set of personal observations. I hope I'm wrong: there are many talented people in Japan, but their value is best realized when they're embedded in the global network of automotive engineers.

Third, while eventually electric cars or fuel cell vehicles may be a big share of the market, it's unclear that they warrant effort today. That's not the perspective of Toyota Chairman Uchiyamada, as conveyed for example in Bloomberg. Yes, Toyota has sold 3 million Prius (is the plural Prii??) over 15 years. But with 75 million vehicles on the road in Japan and 250 million in the US, strict hybrids are a scant 1% of the fleet.^[2] The share is growing, and if we include vehicles that aren't marketed as hybrids (such as those with start/stop alternators robust enough to boost acceleration and recapture braking energy), the share is larger. Nevertheless, the reality remains that hybrids have not been a market success.

Quite simply, putting two complete, interconnected drivetrains in one vehicle drives up cost and weight. They must be sold at a premium to make a profit, while offering only a modest performance improvement. They also face a moving target, as "standard" gasoline and diesel engines continue to get better – thanks for example to turbos that permit downsizing. Hybrids don't offer sufficient benefits to be a strong value proposition. In some markets, such as Europe, almost none are sold; efficient, tried-and-true diesels dominate. In Brazil, with the wide availability of ethanol and CNG, new cars are designed and assembled to use any mixture of gasohol at minimal incremental cost, and to switch seamlessly to/from CNG and gasohol. Who needs a hybrid to save money? Hybrids likewise fare poorly in China. So far, however, global markets are diverging, not converging, undermining the business case for hybrids, battery electrics and fuel cells.

markets are diverging, not converging

I'm left with a feeling of deja vu from encounters with the "magic bullet" mindset that prevailed at GM 25 years ago. At that time executives, including the visionary Roger Smith who brought us $19 billion in robot-ridden factories that promptly closed, and the Saturn venture that neither made money nor drove the Japanese from our shores, were searching for the "secret" of Japanese management. Once they had that miracle cure in hand, GM with its high-powered MBAs and PhD engineers would in short order leapfrog the competition.

Japan has lots of great engineers and competent managers. I hope they aren't forced to devote themselves to the Sisyphian task of making money from fuel cells.

mike smitka

Note 1: Japan has a monthly survey of manufacturing [生産動態統計] that provides output data on 42 separate components. As is inevitable, definitions are about what was made, not what will be made, and so do not highlight "high tech" from commoditized parts. The only new items included are airbag modules and electronic braking systems, but plain vanilla frong airbags and antiskid braking systems are now comparatively mature technologies. No electronics per se are listed, and while car audio, car navigation systems, and automotive lighting appear under electrical equipment, semiconductors and sensors are broken down by type and not end use, so there are no data specific to (for example) engine and stability system electronics.

Note 2: The Prius sells well, but at least in the US it is driven in large part by successful marketing rather than by its fuel efficiency. At its initial launch, a variety of movie stars took a fancy to it – unlike the hybrids of other firms, it was a visually distinctive separate model, not merely an externally invisible option on an existing vehicle. The media picked up on that, giving Toyota perhaps $100 million in free advertising. Its distinctive style and associated image continues to be important. I'm writing this in a coffee shop next to a Prius owner. A day earlier he'd mentioned taking it in for repairs, and the other person at the table commented "I should have pegged you as a Prius guy." In other words, a Prius is a personal statement, a lifestyle statement, not a decision based on a rational calculation of miles driven versus incremental fuel efficiency versus purchase price. Furthermore, the automotive press reported in the first few years that Toyota did not seem to be making money on the Prius. That may still be true of a base Prius, but because of successful marketing, that's not what purchasers want. Their purchasers are an upscale demographic, and sales are dominated by cars loaded with options that generate far better gross margins. If people purchased the Prius to save money, it would be the base version that sells – but of the 102 for sale in my region of the Shenandoah for which prices were provided on cars.com, only 3 are base versions, the majority are Prius Three or pricier.

Auto Supplier Price-fixing and Japan

The conspiracy of Japanese wiring and electronics suppliers to put the screws to Toyota and other customers has now led to the largest antitrust action in history. What we know appears stupendous in scope. To date 20 suppliers have paid fines totaling $1.6 billion in the US (an additional $347 million in fines in Europe and Japan brings the total to $1.95 billion). Some 21 executives have pleaded guilty to felony antitrust charges including jail time and financial penalties. Wired participants, secret locations, coded communication and an expanding list of auto parts and firms, spanning 10 or more years and at least 4 continents. Wild!

...once customers have been screwed for a while, it starts to feel normal

Then there's what we don't know. To date all of those charged have pleaded guilty. As a result, the Department of Justice (and their counterparts in Japan, the EU, Canada, Mexico, Korea and Australia) have not had to enter detailed charges into the public record. With no trial, no evidence need be made public – and even though every corporate law firm in Detroit is racking up billable hours beyond their wildest imagination, those involved have done a truly impressive job of keeping their mouths shut.

And with cause: private lawsuits in the US can seek treble damages, and at least 45 such have been filed (and for now consolidated in the District Court in Detroit). The fines that firms have willingly paid suggest those fines are well below the maximum – though back of the envelope calculations suggests DOJ used a rule of thumb of 8% of revenue for the early wire harness settlements. These and other firms may however have benefitted from the antitrust Amnesty Plus program, which provides for low or even no fines for those who 'fess up' early and help the prosecution. So the amounts could easily hit $5 billion. However, without evidence, such suits will go nowhere, and Federal courts have put a stay on those suits while criminal investigations are ongoing. Attorney General Holder has indicated that the Department of Justice is far from concluding their work; for their part, the Europeans raided six companies this month. But then there are those wiretaps of phones and tapes of meetings: it appears that the DOJ is limiting itself to central players, and going at them with such ironclad cases that they can avoid wasting resources on the morass of a jury trial.

NPR segment …Nine Suppliers Plead Guilty… [mea culpa: they interviewed me]

In some ways, the industry invites conspiracy. The design and engineering process for a new vehicle involves so many components that doing a full start-from-scratch purchase for each part in a vehicle is administratively infeasible; purchasing departments just aren't large enough. So when a Toyota comes out with the next generation Camry or a Ford the next F-150, they will naturally lean towards the incumbent supplier – they know the engineers, they will have the manufacturing capacity. With suppliers involved in the actual design process, they have to be selected before specifications are firm. Yes, the car companies pursue outside bids to try to keep the process honest, and when there is an entirely new component it's a fully competitive bid. Likewise firms with new technology can get their foot in the door – and those are exactly the firms I see as a judge of the Automotive News PACE award competition.

With so many vehicles under development – in the US alone carmakers will launch 365 new vehicles between now and 2015 – it's clear that purchasing departments have fallen down on the job of tracking costs. But these are not the highly engineered items where at present one or two firms control the technology, such as turbos or common rail diesel systems. When I look at a list of the components named in the guilty pleas, they are for the most part not items where new technology is changing the game: starter motors, alternators, seat belts, wire harnesses. While new materials are coming, in the case of harnesses leading to thinner gauges and now even lighter-weight and cost aluminum wires, these products are mature. But this is necessary: you can't readily fix prices when a good isn't a commodity. When you know your and your competitors costs are similar, then you can agree on what the price could be and the level at which your conspiracy can fix it.

Part of the reason is again administrative: car companies with few exceptions have no internal manufacturing capability for the items they procure. They thus rely upon comparisons with past prices, adjusted for changes in the price of materials and known or anticipated productivity improvements. Therein lies the opportunity for a cartel: once suppliers have started screwing their customers, the car companies can come to believe that it's normal. Bids look sensible given past prices. Since harnesses with their miles of wire and hundreds of connectors are one of the most expensive component purchases a car company makes, companies always seek outside bids – but thanks to the conspiracy either find few firms express interest, or come in with ridiculous prices. [For an example see "Ford Alleges…" Automotive News, Aug 5, 2013] This should raise suspicions, but apparently did not set off alarms. While Toyota was firm mentioned in initial guilty pleas, the list of victims now includes most of the industry's major firms. Toyota's purchasing department may have been overwhelmed in its go-go years of the noughts (ending with the early retirement of the firm's top 4 executives), purchasing departments throughout the industry clearly were not up to the task of sniffing out carefully coordinated price fixing.

With wire harnesses, 4 suppliers dominate the Asian market, with Delphi Packard (yes, the name I use is anachronistic) a strong contender elsewhere (and as the one major player not named in this segment, finding that it's suddenly gaining market share in Nagoya). So how did the conspiracy arise? In Japan (as elsewhere) suppliers share panels in engineering conferences and industry associations; ironically, as I found in my own PhD research in the mid-1980s, they may even play golf together at events hosted by their customers. Put them together in the ex-pat supplier community in the US and informal interactions become more likely. Or at least that's my supposition of how things got started, and why it remained undetected in some cases for a full decade.

With stays on the private lawsuits, with uncontested guilty pleas in all the criminal cases, and with those involved so far keeping their lips sealed, few details have come out on the US end. It may be that journalists in Japan can find out more – what goes into the public record may be different, Japan's Freedom of Information Act is stronger than that in the US, and when plied with drinks officials and mid-level auto industry managers may be more willing to speak less-or-more off the record. Journalists and stock analysts should also be asking Toyota about their purchasing operation, about how they could be bamboozled out of so much money and how they're working to fix that. Finally, all should be lauding the Japanese Fair Trade Commission, which in its pursuit of this case is showing that it is more capable than in the past – handling the domestic side of a multinational price-fixing conspiracy – and is willing and able to act in the interest of consumers.

Mike Smitka

Justice Department Press Release

The Rise of Women in Japan's Labor Force

...it's too late for less male-centered policies...

A concurrent set of posts on the NBR Japan Forum is on the role of women in the labor force. At younger ages, the shift towards greater participation is dramatic, a 30 percentage point jump among 25-29 year olds. Participation for women age 30-34 is following in parallel, with about a 13 year lag:

However, this is less economically meaningful than at first glance. Women are not going to be able to save Japan from its demographic challenges. Of course it is these very same women who are not having lots of children. But more to the point, these young women are now the only daughters of an already smaller generation of women.

So even a continued increase in women pursuing careers — already apparent among younger women — will only have a modest impact on the shrinking of the labor force. There are simply too few in these age brackets, and the number is falling yearly. Hence despite the rise in participation, the total number continues to decline:

Policy changes could smooth things, and from a microeconomic perspective (and a lifestyle perspective) could bring many benefits, particularly to women. [For an amusing portrayal of the challenge of a stay-at-home father, albeit in a US context, see Kim Stanley Robinson's Forty Signs of Rain. But from a macroeconomic perspective it's too late for less male-centered policies around the workplace and the home to make a difference.

Nikkei Bubble on Slate

...real vs nominal...

Matt Yglesias has a Slate post on the 1987-91 Nikkei bubble. His core graph, drawn from the St. Louis FRED database, is on the left; I've shorted the time period to go from 1965 through 2001 to match the SNA1968 nominal GDP time series. The same series, divided by nominal GDP, is below. The same series, divided by nominal GDP, is below. There’s still quite a bubble, but relative to GDP stock prices had been even higher in the early 1960s — and except around the time of the oil crisis tracked nominal GDP from 1967 until 1985.

...mike smitka...

[Data: for nominal GDP I used the seasonally corrected series available at the Economic and Social Research Institute. I set the nominally adjusted series equal to the Nikkei series for 2013.Q1. I used the SNA93 series from 1994.Q1 and the SNA68 series for all earlier dates, again adjusting so that the old SNA series would generate the same point in the first observation where they overlap.]

Labor Force Update

Participation is higher across the board, though the "M" for women persists. The exception is the 20-24 age bracket, where lower participation reflects women attending 4-year colleges (75% of young women attend some sort of post-high-school education, including junior colleges and technical schools).

The data show the rise of post-secondary schooling for men, but also a drop in participation of 25-29 year olds since the banking crisis, by 2+ percentage points. Older brackets dropped about 1.5 pct pts. Data for women in older age brackets. Except for the age 70+ bracket, all have risen, but only over the last 6-7 years for women around retirement age. Over the last 50 years we see the advent of retirement as the norm for men age 65-69, but with some reversal the last 6-7 years, similar to the shift in participation by older women.

This is my favorite graph, highlighting the monotonic rise in labor force participation by younger women, first by women in the 25-29 age bracket, then (starting about 15 years ago) in parallel by women in the 30-34 age bracket. Now that seems to have spread to women in the 35-39 bracket -- another year or two's data will help clarify...

Where oh where can I put my savings?

...where oh where to save...

I've started to play with the latest yearbook of system of national accounts data for Japan. I plugged the 2011 numbers into a spreadsheet but have not gone back to revise earlier data, 2008-10 are a bit different from what I used for the graph. The qualitative story remains the same: where oh where can companies put their excess savings? Now the data are old, the current account in early 2013 is smaller so savings-investment balances must have changed as they're the other side of the accounting. But until the next revision, well, we really don't know. And (sadly) the data don't come out quickly.

...mike smitka...

Bond Vigilantes: Japan Isn't So Special

...here, too, Japan looks ordinary...

As I grew up as an economist, I heard from one and all that Japan was special. First, despite its small size, it was going to take over the global economy; as the 19th century had been Pax Brittanica [though with precious little peace], the 21st would be Pax Japonica, to be accomplished without colonies but with other large, developed economies as competitors. Underlying this success, and its clout in export markets, was a set of management practices that rendered its firms superior: governance by insiders who looked to the long and not the short run produced wonders; the MBA-finance skill set contributed almost nothing to this success, so mayhap the lack of such individuals in senior management was salutary. Japanese consumers were odd, too, they didn't buy cars, they shopped at mom-and-pop stores, and they insisted on eating expensive domestic rice. Then there was the bubble, peculiarly Japanese, and the lack of rapid recovery, due to the incompetence of the BOJ and the peculiarities of its Cabinet system that gave the bureaucracy undue power and resulted in on-again, off-again fiscal policy that produced deficits but not growth. All of these positions held a grain of truth, but now look silly – an overreaction, but making that case is not my purpose today.

So how about Japan government debt? – the media and even not-so-conservative politicians in the US and Europe are fixated on reducing deficits in the face of excessive governmental debt. They are reading Greece as a general case. Yet it is a small country whose debt is not denominated in its own currency, and most of that debt is held abroad. It has also been running trade deficits, has an inflated public sector and social security system and on and on. No one has to hold Greece's debt, almost no one held enough that they couldn't dump it. And dump it they have.

If Greece is in fact exemplary then Japan should be in worse shape. It has run large deficits for two decades, without a crisis as an excuse. While the previous government passed a tax increase, the first stage of which will take effect in April 2014, it's not clear the current government won't invoke an "economic conditions" escape clause. It's population is aging, indeed already aged. And however bad Greece might look – debt of 112% of GDP in 2007 – Japan's gross debt is worse, at 214% of GDP in 2012 (OECD estimate) versus 181% for Greece.

Yet carrying this logic to the Japanese government bond (JGB) market has been a disaster. Someday someone will get rich shorting JGBs, but to date that strategy has instead proved a "widow maker". [Google the term and you'll find lots of hits, going back years. Two examples are from Reuters and BusinessInsider].

10 yr JGBs	10 yr US Treasuries

But is Japan special on this front? Not if we look at the US. We have somewhat lower levels of debt, somewhat smaller structural deficits, but they are difference in degree and not in kind. (For Japan, the normal figures lump in local government debt as well as the debt held by the Bank of Japan and other semi-governmental entities.) Sure, we have Republicans and Democrats unable to pass little things such as a Federal budget … the Japanese have had the DPJ, and – lucky them? – now have the LDP-Komeito coalition back in power. Meanwhile, Japan has escaped from its bubble, and the US economy is growing. Despite all the hype about the US debt-deficit pairing, bond prices can do nothing but rise. For those looking at Chinese real estate, or anything in Europe, both countries continue to look like safe havens, or (for both economies do have problems) at least havens. Here, too, Japan looks ordinary.

The Cassandras making this case in Japan and in the US may not be believed. But both look rather ordinary, and those among the Cassandras in the market are quite happy to keep taking the bond vigilantes' money.

...mike smitka...
平成２５年元旦