Japan's Economic Earthquakes

See the post of 27 July on the Tohoku earthquake and the auto industry at the Autos and Economics blog It focuses on the Japanese economy, but I decided to put in a link rather than paste the article here in its entirety.

Earthquakes, tsunami and nuclear power: behavioral economics

The following are quick reactions, not tight argumentation.

At a forum on the earthquake today at Washington and Lee I was surprised by the interest in nuclear issues as opposed to the quake and its direct impact on people and the economy. So far no one has been hospitalized for radiation exposure; outside the plant levels remain below those that cause significant public health concerns as long as they are not permanent. And there's no sign of a Chernobyl type incident that would poison large swaths of the archipelago. The inside of the plant may be a different story, but since the reactors will never be restarted that's not a substantive issue. In the end, the most likely scenario is thus that no one will be made ill by the reactor problems. Ever. Nor will there be long-standing economic repercussions. And that is ironic if we think of the routine but small-scale disasters that accompany coal mining (most well out of view of video cameras) and the known impact of particulate matter and acid rain, or even the rarer but still frequent level of industrial accidents in petroleum extraction -- and then there's carbon footprint. Nuclear power does not make sense from a financial perspective; it is not cheap power. But it is safer and does make environmental sense compared to the alternatives.

Meanwhile people in the earthquake zone continue to die because of exposure, malnutrition and lack of access to needed healthcare. Virtually all (if not all) of these deaths are of the elderly, particularly those with chronic health issues. But they are far from zero. In addition, people will die because of the rolling power blackouts, due to an increase in accidents and delays in emergency services (which would be an issue even if none of Japan's plants were nuclear ones).

Even stranger, this nuclear issue seems to have drowned out the unfolding tale of roads being made passable, power lines reconnected and food being delivered. That causes no fear reaction, and so leads to none adrenalin rush that can come from sound-and-sight bites on the news. Yet the story has drama, particularly as any single scene is being replicated across a wide swath of Japan.

It even seems to have drowned out the story of 22,000 dead and missing, a number that surely will rise to over 30,000. It saddens me that people are forgetting that in their fascination over nuclear plants.

We cannot build human society trying to protect ourselves from every conceivable disaster. Earthquakes of M9 near densely settled populations are one such; it may be a generation before there is a recurrence, and tens of generations before there is a recurrence in Japan. But M7 earthquakes (1/60th the size of the Tohoku quake) are not so infrequent, and if they occur near an urban center (as did the 1995 Kobe earthquake of M6.9) are horrific enough.

They are a threat worth evaluating. Furthermore, we know how to build so as to mitigate the impact (including any associated tsunami) of earthquakes of M8 and below. Japan has done that. We need to recognize that the shake-resistant construction, the ocean-side seawalls and sirens, the emergency drills, and the disaster response infrastructure all saved untold lives. Indeed, in a "normal" earthquake disaster Japan would have seen neither a major loss of life nor even a long-lasting economic disruption to the affected region. Unfortunately the areas of the US similarly at risk – the west coast in general and California in particular; the Mississippi valley south of St. Louis; and Charleston SC – are ill-prepared. The demand for an adrenalin rush from the nightly news makes that response less likely.

Earthquakes and Debtquakes Don't Equate

Shots by an out-of-town TV crew of the Sendai train station, with the "bullet train" shinkansen tracks covered with rubble and a new train undergoing a test run still derailed a few miles away, highlight the damage of the quake away from the coast. It will be a long time before that train runs again. But they also highlight what wasn't rendered inoperable, the road network. Some places require detours, and it's slow going, but it goes. As a modern society, Japan – particularly rural Japan – relies on cars and trucks, not trains. And as a modern society – and not a developing country – roads form a network, with multiple routes in and out of all but the most isolated mountain valley or coastal cove. Getting food and emergency supplies in (and refugees out) will be a slow process, but as each day goes by it will be less so. [To track progress, see a map that Honda and Google have jointly created of roads known to be clear.]

As noted in my previous post, Japan's is a large, service-dominated economy, and while the prefectures of the Tohoku and northern Kanto region most affected by the quake have a population of 10 million people (depending on where you draw boundaries), that's in a country of 127 million, separated from Tokyo by a distance similar to that of Boston from New York or Paris to London. Again, depending on boundaries, the share of GDP ranges from 4% to 8%. That's substantial, but even a place as close to the epicenter as downtown Sendai seems to have been spared the specter of collapsed buildings. Stores don't have any way to restock their shelves, but that will happen in due course. As order is built out of the initial chaos, production will resume; the direct impact thereafter will be 1% or less of GDP, and for the country as a whole will be fully offset by expenditures on recovery.

Parts of the Tohoku region may never be rebuilt. One city was totally destroyed by a 1908 tsunami only to be rebuilt behind the supposed safety of a high floodwall; I personally hope people won't bet against another tsunami happening on the same once-a-century schedule. A handful of ghost towns might be a fitting memorial to the victims of the disaster, but are not substantial from the perspective of the economy as a whole.

Back on topic: manufacturing is more interconnected across geography than are services. Automotive News reports that Honda had been unable to reach anyone at several of its suppliers in the regions, sobering but hopefully a reflection of other priorities this past weekend. In any case, between shattered roads and the lack of utilities they aren't going to be producing this next week, so it's better for their staff to focus on cleaning up the random damage of their and their neighbors' homes. All too many workers will have relatives of whom nothing is yet known. Yet a number of factories in the area have already reported "only minor damage," while noting that debris-filled roads, downed power lines and empty gas stations make that moot. [Source: the Japanese-language mag2.com email magazine 自動車ニュース＆コラム that provides a daily summary of published automotive stories.] But surely there is damage at multiple factories, in the auto industry, in semiconductor manufacturing, and elsewhere. That will echo up and down the supply chain. Previous cases (an earthquake in Niigata in 2004 at M7.0, the 1995 earthquake in Kobe at M7.3) suggest most problems will be over the next month even within the region, while most firms have alternate suppliers. This quake has no precedent in size: it's 350 times larger than the Kobe quake, affecting multiple prefectures. So there will be more of an impact. But for goods production, factories were running below capacity in Japan (and in the US and in Europe). To some extent they'll be able to make up for lost output once back in operation – that is, in the interim domestic competitors will gladly pick up the slack. All of that mutes the impact on GDP.

One difference is that infrastructure may be harder to fix; there's too little information to know. Roads are one issue, and they're more important than rail. Ports may or may not need time to be cleared. Natural gas transmission lines, gasoline storage facilities, all that will need fixing. But cell phones are already operating in much of the region, albeit poorly., while in some places people apparently never lost internet access.

Outside the region directly affected by the quake, however, it's electric power that looms large, and its shadow will last longer. In principle utilities elsewhere in Japan ought to be able to pick up the slack; in practice that's not an option because the (unscathed) western half of Japan operates with alternating current at the US-standard 60Hz frequency, while Tokyo and areas further east use the 50Hz European frequency. The grids can't be interconnected. Tepco (Tokyo Electric Power Company) has no chance now of getting permission to restart the reactors that weren't operating at the time of quake, even if they replace the backup generators and other equipment washed away by the tsunami. I've heard nothing of the fate of coal-fired plants in eastern Japan, but if turbines were destroyed they too may remain offline for months. Japan has higher electricity prices than the US (well, almost every country does…) and so factories and offices and households tend to be more sparing in their use than are we. Conservation will be accordingly more costly: they already are relatively efficient in their usage, leaving for example buildings relatively cool in winter and warm in summer. Reliable electric power is the biggest hitch I see to speedy recovery for the economy as a whole.

Let me close by returning to one canard that crops up with some regularity: that Japan as a highly indebted nation can't afford to rebuild. Nonsense.

First, speaking as an economist Japan has a surplus of domestic savings; that's why they have a trade surplus and why Japanese institutional investors have been major purchases of US debt. No one inside Japan wanted to borrow. That will change, but not to the point of making Japan need to turn to the rest of the world for finance. The economy remains mired in deflation; nominal interest rates remain accordingly low, at 1.165% per annum for 10-year bonds – actually down since the earthquake. While at some point deficits will need to be pared, that is a chronic but not yet debilitating problem. With debt issued in yen, its own currency, and held domestically, Japan's case is simply not analogous to that of Greece last year or Thailand in 1997.

Furthermore, those making this claim are making a repugnant ethical judgment: that Japan as a rich county ought not use its resources to help the unfortunate. It is virtually impossible for people to buy insurance against natural disaster: there is too little information for insurance companies to price coverage, indeed they often find it hard to state what the risks are. Governments however can provide such insurance through the tax system.

Japan is not a poor, starving nation that literally cannot mobilize the resources it needs to cover basic needs. Rather it is a rich nation with hundreds of thousands of starving people. It can afford to provide relief, and it can readily raise taxes down the road by an amount commensurate to repay any short-term issuance of debt – it helps that it has extremely low tax rates by international standards.

Now most people making the argument about "too much debt" haven't thought through the implications of what they're saying – that seems to be the case of people approaching the issue from a finance background. But a well-trained economist doesn't have that excuse, we're taught to look behind the facade of jargon and theory to the underlying assumptions of models. If economists make this claim, it's because they don't have the courage to say what they really mean: "tough luck, northern Japan, we don't think the government should do anything to help."

That's not my stance, and I'm thankful that it's not the stance of Japanese politicians. Aid the region they will, and Japanese society will be the better for it – even if taxes have to be raised a tad down the road.

Earthquake and Economy

I've spent a couple hours watching the news from Japan, switching between TBS and NHK, both available via internet. Having watched footage, it's still unimaginable. The tsunami hit Rikuzentakata, population 23,000. It just … vanished. Hopefully most fled between the short interval between the initial quake and the tsunami, but aerial photos of occupied cars being washed off a highway in the initial wave suggest that interval was too short for some.

The magnitude of the damage is unknown; the focus remains basic rescue. A quick check of the Japan Meteorological Agency web site shows over 150 aftershocks big enough to be listed, many over Magnitude 6 – under normal circumstances strong enough to have made the news. It's not clear yet whether cooling can be restored at the Fukushima nuclear power plant before a partial meltdown – the initial reports suggest "no". Elsewhere fires burn out of control, with no ability to do more than watch from a distance. Amazingly, many elevated roads seemed to have survived both the quake and the tsunami passing underneath; wooden structures hit with water however just … disappeared into debris.

Indeed, writing 12 hours after the above -- 10 am US East Coast on Sat 12 March, midnight of 12 March in Japan -- power is already back on in parts of Sendai, with traffic lights operating amid light traffic. Japan's earthquake codes seemed to have done their job: no scenes of the pancaked buildings familiar from Haiti or New Zealand. Indeed, at least some ferro-concrete structures appear to have remained standing in areas otherwise swept clean by the tsunami. The earthquake itself seems to have caused damage far less than the size of the quake might suggest; it was the tsunami that was inexorable in force. Disruptions there will be, but there is nothing to suggest wholesale destruction of physical productive capacity. Factories will likely stay shut until aftershocks die down – one friend was kept awake all night yesterday by the constant shaking 150 miles away in Chiba. The worst damaged nuclear power plant has managed to start pumping in sea water; it will never operate again, but a catastrophic meltdown now appears less likely.

For now the productive capacity that matters are the hospitals: they're accepting patients on a triage basis in all but the worst-hit places along the coast. And the information is getting out, it seems the internet remains operable in areas away from the coast, even while electricity remained cut.

So what to make of it as an economist? Here are quick thoughts.

First and foremost, this wasn't the big earthquake that everyone feared: it was not a repeat of the Great Kanto earthquake that hit at 12:01 pm on September 1, 1923. The city erupted in flames, as charcoal was the primary fuel for cooking lunch; tens of thousands were asphyxiated in the following firestorm. On average the Tokyo area has been hit by a major quake once every 50 years -- it's now been almost 90. So while there were casualties in Tokyo proper, and not all the subways are operating, Japan's major population center effectively escaped damage. The other two major centers, Nagoya and the Osaka-Kyoto area, were unaffected -- with Tokyo, those three metropolitan areas account for over half of Japan's population. Nevertheless, Sendai is a city of 1.0 million, so the earthquake may have produced tens of thousands of casualties.

This will obviously have a short-term effect on the economy; production in the region will cease for some time to come. Initial very partial reports suggest damage at factories in the area, including several Toyota subsidiaries that specialize in small cars. Ports facilities are damaged (or just gone) while roads are impassible. Given the complex overlay of supply chains in many areas of manufacturing, this will hit production elsewhere in (and outside of) Japan in a manner that is yet impossible to delineate. Now many plants were away from the coast and designed to withstand moderate earthquakes. This one was not moderate. So between clearing roads and making basic repairs, it may be a couple weeks before anything can restart. It's not possible to do more than note the issue – it could be much worse.

This is in a context of recovery from a recession. The most recent data, for Oct-Dec 2010, showed negative growth; projections (e.g., Morgan Stanley MUFG) were of 1.5% growth this quarter. The short-term impact will be small this quarter, because it's largely over. Nevertheless the disruption to manufacturing throughout the country, and the short-run loss of most output for the remainder of March in the northeast, could push the economy back to nearly zero. The short-run impact will appear mainly in next quarter's data.

Japan however is not a manufacturing power – or not primarily one – but a service economy, as is true of the US and the European economies. Hospitals in most of the country will continue to treat patients as always, restaurants will continue to serve lunches and dinners, schools will do their thing. There is no particular reason that the Sendai earthquake and tsunami will change those in the (economic) majority of Japan. Indeed, refugees may boost demand elsewhere, partially offsetting the collapse of activity in the areas directly affected by the temblor.

Then the rebuilding will begin. Since the Japanese economy operates below capacity, and youth in particular are underemployed, this won't be at the cost of other production, or at least not on a one-for-one basis. In other words, on a net basis the boost in employment would offset most if not all of the jobs lost. Of course Japan is running a large deficit, but unlike the US there is no unreasoned panic about debt and deficits. Interest rates remain close to 1% on government and high-quality corporate bonds. If the government needs to 10% of GDP, then it can probably do so without much problem. Yes, in the long run the deficit needs to be turned into a surplus. Short-run needs will dominate for another year or so. And since the Kan government was close to collapse, unable to pass legislation, trimming the deficit wasn't going to happen anytime soon.

So a year from now … the economy will be back on track. There are uncertainties. What will be the impact on markets of insurance companies liquidating portfolios to pay claims? Or (my at present uninformed guess) will they be partially bailed out? Beside China, the economies of Japan's major trading partners are growing slowly; next year will surely be better... Will the disaster speed political realignment? My guess is it will – after all, Japan's politics can't get worse, can they?

This isn't good news. It's just not as bad as the news could have been.

Mike Smitka, Lexington VA

Fiscal Implications of Japan's Greying

Aging and Retirement: All retirement is fundamentally pay-as-you-go (pay-go)

Don’t read your ability to save into an entire economy’s ability to do so!

While individuals can save for retirement, a society cannot: with few exceptions goods and services must be consumed when they are produced.

Because retirees in Japan are increasing in absolute numbers and as a share of the population, the slice of output going to retirees will increase (else times for them will be grim and brief). The flip side is that those in the labor force must therefore reduce their consumption: the old can consume only to the extent that the young do not. At a societal level retirement is thus fundamentally, everywhere and always, a pay-as-you-go system.

Modest exception exist. Housing can be stored, but except as your own residence its value is uncertain.  Japan also has significant international assets, which can be drawn down to increase the consumption of imported goods. Neither change the qualitative analysis, because housing depreciates (lots of bad construction) while the share of trade in Japanese GDP (and assets relative to GDP) is small.

To rephrase, unless those working reduce their consumption, either through voluntary savings or involuntary taxation, retirees cannot increase their consumption. Furthermore, the three-generation household headed by a matriarch or (more rarely) patriarch is now a distinct exception in Japan. Instead most consumption will be procured directly by the elderly, using resources which they and not their children control.

Intrafamilial reallocation still dominates the provision for youth: in most cases (other than education, which is subsidized by the government) the goods and services children consume come from parents voluntarily reducing their consumption. At one time that was also true of the elderly (though for most of human history the share of individuals who “retired” was extremely low; people worked until death, even if they did not work themselves to death.  Hence the pity long held forth for the childless widow, the exemplar of which is the story of Ruth in the Hebrew scriptures, with her entreaties to be adopted into Boaz’ household.

The most important variable is thus the ratio of retirees to those working. The greater the (relative) number of retirees, the more that those working must tighten their belts in order that retirees maintain their standard of living. Note that the ratio of dependents to workers in Japan will not be at unprecedented levels, given the large share of young dependents in societies with rapidly growing populations such as Japan in the 1930s. This is an important reminder: there is  nothing intrinsically unsustainable about Japan’s grey future. It is the minimal role of that the family will play that is qualitative different from the (many!) high-dependency societies of the past.

Before looking at numbers, note four margins of adjustment. One (1) of course is to thrust retirees into comparative poverty. If nothing else, that represents noxious ethics: Japan’s baby boomers worked long and hard for a pittance while building the foundation of today’s prosperity. Nor are they retiring into riches -- Japanese public pensions are stingy. "Sharing the pain" may be politically important – but remember, though those over age 65 will be the most important part of the electorate. Back to ethics: why should workers today with a five-day work-week and homes full of the appurtenances of modern life not sacrifice a little? Plus tomorrow's retirees have been, well, promised retirement. So there is inequity to this in the burden the young will bear, but generational inequity is inevitable when the age structure of the population changes in the magnitude that Japan’s will.

Another (2) is to increase the participation rates of those of working age, specifically by facilitating the continuation of careers of women. Now that is already happening, as today’s young women (age 25-29) are either not marrying, or marrying but not quitting work, but older women are still largely relegated to part-time and other less-productive work. It is not yet clear whether that will continue as women in that cohort age – and because of low birth rates, each succeeding cohort will be smaller. This will be insufficient to offset aging.

Then (3) Japan can encourage immigration. However, the primary economic benefit of immigrants is that Japan will not have expended the resources for their initial upbringing and education. Once in Japan they would be less productive than the native born due to language, social and other barriers. So it probably will take at least 3 immigrants to replace 2 retirees. Furthermore, they will insist on marrying and raising families, further lessening their impact on the societal challenge of providing for dependents. Finally, they will themselves age and retire. So immigration is not a solution, though it can shift the time profile of the greying of Japan.

Last, we (4) can cheat a bit by adjusting pension rules to force older Japanese to delay retirement. This clearly shifts the ratio of retirees to workers, or to put it another way, workers pay more years of taxes and collect pensions for fewer years. Now this is an implicit tax, forcing older Japanese to change their behavior in a manner that lowers their utility, hence my use of the word “cheat.” It may however be politically acceptable in a society that is more oriented to the production of services rather than goods, as long as there is a realistic attitude to allowing earlier retirement disabilities. And as a quick back-of-the-envelope calculation, with people working 40 years (ages 25-65) and retiring 20 years (ages 66-85), a one-year shift adds 2.5% to revenue and cuts 5% from expenditures. That is an overestimate, because it ignores the bulge of baby boomers who are now starting to exit the labor force, and the slow increase in realized longevity. Furthermore the experience of Europe suggests that the level of disabilities rises sharply in the face of such policy changes, in part because retirement seems to be a luxury good and today’s society is (thankfully) well enough to consider it as an option.  But there are those whose jobs involve physical labor or whose bodies otherwise wear out. My sense is that fiddling with the retirement rules is a likely component of any policy response.

We could do the same thing at the young end of the spectrum, restricting access to schooling to encourage youth to go to work. I don’t think that’s a policy option worth further examination, politically unacceptable, penny-wise but pound-foolish. Plus it would be offest by the steady decline in the number of youth.

But how big are the numbers, really? The easy part – assuming away changes on the above margins! – is to examine the ratio of retirees to the labor force: the actual age structure of the population is fairly clear, since all those who will be in the labor force in 2030 (and most of those in 2035) have already been born. Another challenge is the magnitude of consumption by those retired. While pensions are easy to estimate, health care costs include many imponderables. Data exist on all these, but collecting and then fitting them into a consistent framework is a task that far exceeds my own resources.  So let’s simply assume that retirees on average consume as much as workers. The ratio is then key.

At present there is roughly one retiree for every three persons of working age. That ratio will deteriorate to one retire per two people of working age circa 2030, and will peak circa 2055 at about one retiree for every 1.25 potential workers (after 2055 changes will moderate as the baby boomers die). Now the dependency ratio will not shift as much, because retirees are not the only dependents. The policy adjustments noted above would further mute the impact.

But we can at least grasp the order of magnitude. Using the shift from 3:1 to 2:1, the resources required on a per worker basis are thus likely to need to go up by 2/3rds. With close to 15% of GDP in transfers, that implies a 10% net shift in savings, taxes and expenditures.

With stable incomes, personal savings rates are unlikely to change much; indeed, the impact of low wages and unsteady jobs has probably been to lower savings. Some modest trimming of expenditures is likely, if only because it would be politically necessary, but the government has already pared public works 50%; modest cuts in support of agriculture, consolidation of schools and local government functions as the countryside depopulates – maybe 2% of GDP can be found.

That implies that most of the adjustment must come from "enhancing" revenues, on the order of 8% of GDP. Add in the 4% of GDP required for debt sustainability (see the blog post below) and you get a 12% of GDP tax increase. Some of this will be collected via a forced postponement of retirement; much must take the form of a shift in the consumption tax and other taxes. With current revenue at around 34% of GDP, that would boost aggregate taxation towards 46%. This is still well below the highest levels found in Europe, and so is not a prelude of economic Armageddon. It surely will pose a major political challenge.

Now other approaches can be used to estimate the cost of retirement, by examining pensions and healthcare costs by age and combining that with demographic projections. The bottom line seems, after much more effort that I've just expended, to also be around 10% of GDP. So I am fairly comfortable that I have the right order of magnitude – that the adjustments imposed by a greying population are large but not infeasible.

One final note: can productivity increases help? That depends on whether retirees' consumption can be held fixed in real terms, which is basically what they were promised, or whether they will be politically powerful enough to increase their consumption in line with society as a whole: they get the same slice of a bigger pie. My hunch is that the latter is closer to what would transpire: politically it would be more difficult to hold benefits in check and to mandate later retirement if wages are rising strongly. However, I do not believe that productivity will henceforth rise at the 2% rate seen across the more prosperous part of the OECD, as I’ve argued that already on this blog.

Debt Sustainability: No Crisis, but Complacency Ill-advised

The following is based on discussion in my Japan’s Economy class on Wednesday, 8 December 2010.

It is possible to run a small deficit forever, as long as the growth rate of total debt is below the growth rate of the economy.

Note that here “deficit” is based on the budget inclusive of interest payments on debt – which means that the current operating budget must be in surplus. I do not try to address the issue of sub-national debt here. Nor do I try to calculate the extent to which the netting out of government assets to move from gross debt (nearing 200% of GDP) to net debt (100%) is appropriate. For example, BOJ bond holdings are offset by money, and so aren’t owed to the public.

Conveniently, Japan’s net debt is (order of magnitude) 100% of GDP which makes the arithmetic straightforward. As long as the economy averages 1% growth, then the amount of debt can growth by 1% of GDP without the debt-to-GDP ratio (D/Y) deteriorating. Since D/Y = 100% then 1% growth of debt = 1% of GDP in additional debt. All Japan need do is lower its deficit from the current 9% of GDP to 1% of GDP.

Note that 1% growth is a pessimistic number, so I’m not “cooking the books” in favor of sustainability. However, if interest rates rise, then the budget surplus must as well. No sign of that near term!

In order of magnitude, half of that change will come from growth boosting (income) tax receipts. The other half (≈4% of GDP) needs to come from some combination of expenditure cuts and tax increases. Since Japan is in comparative terms lightly taxed, it is clearly possible to enhance revenues without large side effects. but the government is also small in size, so paring expenditures is likely more difficult though politically necessary (“cut waste” before raising taxes).

Now using gross debt instead of net debt doesn’t change this story much – in fact, the arithmetic means that with 1% growth you can run a 2% deficit and not see conditions deteriorate.

But in the background interest paid on debt also doubles, so it’s not a pleasant tradeoff: if interest rates were 3% then with 100% D/Y you need to run an operating surplus of 2% of GDP (hence a deficit inclusive of interest payments of 1% of GDP). With 200% D/Y interest payments double to 6% and so to keep yourself to “only” a 2% deficit requires that you run an operating surplus of 4% of GDP. Ouch. Furthermore, the impact on the budget and the deficits of a short-term spike in interest rates is amplified. With higher debt levels there is likewise less leeway to issue more debt in the face of a recession or a major natural disaster.

The more long-run debt the government issues, the less temporary changes in interest rates matter – my back-of-the-envelope calculation with 2009 data found an average debt maturity of around 5.5 years. Major disasters are to be expected: Tokyo suffers a major earthquake on average once in 50 years, but the last one was in 1923…

Furthermore, the above analysis is well recognized by both political parties (the DPJ and the LDP) and by the general (voting) public. There is however all too good a recollection of the disastrous timing of the last round of budget consolidation – reduced expenditures and a major tax increase all started April 1, 1997, and this was followed by a deep recession, a banking crisis and the onset of chronic deflation. To date this agreement in principle hasn’t been matched by an agreement on specifics, specifically timing.

Since 2011 doesn’t look like it will be a year of robust growth, and there has to be an election by summer 2013, my own judgment is that action won’t be seen until fall 2013. By that point (since tax increases won’t be instantaneous, part of the lesson of 1997) debt/GDP will rise another 20-25 percentage points.

Still, (i) there is no crisis and (ii) the numbers are in the range of political feasibility (raising the consumption tax to 10% will bring in an additional 2+% of GDP in revenue). instituting a tax ID system would close the remainder of the gap.

It helps that Japan is a large economy, has no debt denominated in foreign currency, and indeed has substantial foreign reserves and private foreign assets. Constituents of the European Monetary Union (and sub-national governments everywhere) face a different issue: while institutional investors may want to hold assets denominated in the currency of their debt, they don’t have to hold the assets of any particular sub-national entity (and the smaller the entity – Greece and not Spain – the less the need).

Hence I won’t start worrying until we get through the next election and the timing is still bad.

Productivity Growth: Why Japan's Will Remain Low

This is the initial sketch of a line of argumentation. I will return to it periodically over the next several weeks.

Japan's baby boomers are set to retire as they hit age 65 -- unlike Europe and the US, 77% of men below that age remain in the labor force (and 50% of men age 65-69). [see the post below on women's LF participation for the distaff side of the story] That will have many side effects, from the labor force (boosting the demand for younger workers) to capital markets (decreasing private savings with the potential to increase interest rates and exchange rates). These are perhaps best analyzed by focusing on the demand side. (I think that is best done with the assistance of a DSGE model to help highlight the multiplicity of channels for interaction, even if we should not rely on such models as more than loosely suggestive, they're simply to complex to be sure what assumptions matter, and in all cases force offsetting adjustments that are both too strong and too smooth to be credible because to solve them requires that they convergence to a steady state.)

Alongside such shifts are long-run supply-side trends. The obvious one is the shrinking size of the potential labor force, only partially offset by the ongoing increase in female labor force participation. Investment surely won't cease, and the likely rise in capital per worker means that GDP per worker will continue to rise. The net of the two will be a small number, perhaps 0. What happens to productivity is thus crucial to aggregate growth and important for per capita and per worker growth.

Among the better-off end of members of the OECD (the rich countries' club), that has converged strongly around 2% pa. Why should Japan be different?

I argue here that it will be significantly lower for two principle reasons. The first is that young workers will be a smaller share of the labor force, and that most of the gain in human capital comes at younger demographics. Part of that is the standard diminishing returns argument. However, I think that it is also difficult for those who are older to change. That is because at higher incomes the opportunity cost of learning (or retraining), which I believe to be a time-intensive process, is also higher. Can old dogs learn new tricks? -- I like to think so. But will they? -- I see lots of reasons why they would choose not to.

A second reason is that at the firm level higher productivity is realized only in modest part by organizations changing their structures and product lines in an organic manner. Instead the bulk of gains are via exit of those low in productivity and entry of new firms (or business units) that are high in productivity. Now in a dynamic, growing economy the two are only loosely linked: with growing demand, you don't have to have exit in order to have entry. The old order can simply fade into obscurity [wanted: an appropriate aphorism]. Not so in Japan today.

Let me use real estate and retailing as examples. In 2007 the local express train station in the Tokyo suburb where I lived continued to have a camera shop; so did a shopping street (shotengai 商店街) where I had lived 25 years before. But by then film cameras had been relegated to a small coterie of hobbyists; these two stores were less than busy. Why did they not exit? -- in a slowly growing economy (with a falling population) the opportunity cost of doing so is high. In a normal world, as we're used to thinking of things, you could turn your store to some other line of business, or sell it to someone who wanted an office or even house close to a station. In the Japan of 2010, such business sites have almost zero market value.

Now in this particular example the size of the shops is small, no bigger than the office in which I sit while I write this. Even in a world of small-scale retailers they are on the small end of the spectrum. Casual empiricism suggests however that the same issue affects retailing and office space as a whole, even if not as strongly. In a market that is moving about as fast as its aged residents (25% over age 65), the benefits of exit are sharply diminished. That however impedes the "churn" of new for old firms, particularly if the new need to invest in new structures and new locations and new types of capital. Inevitably they would be marginally better -- but the word "marginally" is the operative one. When the old refuse to retire, the young have less room to maneuver.

What I have sketched is an exercise in pure logic, not (yet) backed by data or models other than my informal prose one. The logic can surely be extended to other margins of adjustment, including capital investment. Of course many factors affect productivity independent of the above. My own sense is that they reinforce rather than offset the opportunity cost story above. One possibility is that the rise in contingent labor (part-time and contract work) among the young is a prelude to a "lost generation" who will not find positions as the "boomers" retire and so will not benefit from the to-date-normal process of human capital accumulation with tenure. Ditto the shift in schools, with the 5.5 day school-week giving way to "yutori" (feel-good!) education that will not position Japan's youth for a lifetime of learning. My sense is that health care has also entered an era of diminished returns, so that the needs of the boomers in that area will detract from the ability of the economy to provide goods and services to those who are younger, who will literally be a generation working to support their elders as much as themselves. But offsetting this are Japan's foreign assets, which will allow the country to run a (modest) trade deficit forever. To put it in an archaic manner, the Japanese economy in its senescence can clip coupons.

Let me end this initial draft with my own sense that, however speculative the line of argumentation, I will in fact be able to tie it to empirical indicators that will undergird its validity. But what of magnitude? My hunch is that Japan will be looking at productivity growth in the range of 1.0%-1.5%, that is, up to a full percentage point lower than other OECD countries. If other factors repress investment -- crowding out as falling savings meets still-large deficits -- then this implies that Japan will see average GDP growth decline to under 1% pa. Now today's young will face higher tax rates to pay for their parents retirement (surely a more equitable alternative than forcing children to provide directly for their parents, but that's a different issue...). So per worker output will not grow, per worker income will fall. Japan won't cease to be prosperous, assuming that the politics of governing this process don't go severely awry.

Ha Japan's sun already set?
As an economist, that's too bad, because Japan is in the vanguard of the aging world, and these sorts of issues cry out for analysis. Unfortunately economics as a field is however not immune to market forces, and with Japan out of the limelight it will be very difficult to marshal the resources needed to do that sort of work.

Mike Smitka