COVER STORY: JAPAN
By Michael Shari
Although it inflicted unspeakable horrors upon an aging, hard-working population, Japan’s recent earthquake is breathing new life into a deflationary economy.
The symbolism was lost on no one when the Japanese started using the terse shorthand “3/11” to refer to the Tohoku earthquake, tsunami and nuclear power plant failures that killed at least 13,000 people on March 11 and left more than 17,000 others missing. A combined brute force more lethal than any felt in Japan since the atomic bomb attacks on Hiroshima and Nagasaki has left the world’s third largest economy at a critical turning point in its history.
Many economists see this jarring blow as being of a sufficient order of magnitude to dislodge Japan from the economic malaise that began in 1991 with the bursting of the bubble of asset inflation. Japan’s economy has grown at a dismal average rate of 0.5% to 1.0% a year, compared with Europe’s 1.5% to 2.0% and an average of 3.0% in the US, according to Daiwa Capital Markets. Perpetuating this torpor is what Masamichi Adachi, a senior economist at J.P. Morgan in Tokyo, calls a “3-D” structural problem of deflation, debt and demographics.
Optimists believe that under the right leadership, Japan could begin to re-create at least a semblance of the East Asian Economic Miracle that it pioneered in the 1960s, 1970s and 1980s, when its economic growth steamed along at between 4% and 15% a year. That was the result of a World Bank–financed postwar reconstruction effort and an ambitious economic development plan cobbled together by Japanese bureaucrats who “succeeded beyond their wildest dreams,” notes Richard Bush, director of the Brookings Center for Northeast Asian Policy Studies in Washington.
The one certainty today is that, after a bitter but short contraction of three to six months, starting with what JP-Morgan Securities Japan predicts will be a 3.5% dip in the second quarter of this year, Japan’s economy is almost certain to enjoy at least a couple of years of very strong GDP growth. This will be driven by lavish spending to rebuild rail lines, roads, buildings and other infrastructure that was damaged in the Tohoku region. The government expects to spend as much as 25 trillion yen ($297 billion), which is about 5% of gross domestic product, with about 10 trillion yen of that amount spent in the coming year, according to Daiwa Capital Markets.
The economic boost from the rebuilding efforts is expected to be about three times that from the massive reconstruction effort that followed the Kobe earthquake in January 1995, the last major temblor to have wrought havoc upon Japan’s main island of Honshu. The estimate is based on the fact that the Kobe quake caused only a third as much damage as Tohoku, although it killed nearly 6,000 people. The subsequent reconstruction of roads, houses and other damaged infrastructure in southwestern Honshu boosted annual GDP growth by between 50 and 70 basis points for two and a half years, estimates Robert Madsen, a senior fellow at the Massachusetts Institute of Technology’s Center for International Studies. The economy also got a boost from higher-than-usual spending in anticipation of a planned tax rate hike in 1997. That would translate into a GDP growth rate of about 1.25% or 1.5% for at least a couple of years, says Madsen: “2012 and 2013 are going to be impressive years. The question is whether it can stretch beyond that.”
Madsen estimates that Japan’s economy could keep up that relatively brisk pace for several years, although the apparent growth would reflect in part the contraction that Japan is already feeling.
Crisis Provides Opportunity
Unlike the Kobe quake, he says, the Tohoku temblor caused economic damage on a national scale. The reactor failures led to rolling blackouts that are cutting deep into manufacturing nationwide because a hertz difference between the power grids in the tsunami-ravaged northeast and the still-undamaged southwest regions of Honshu prevents them from sending electricity to each other. The result could be that the GDP contraction drags on for six months.
“You could make a case that this gives them an opportunity to make some big changes,” says Josh Feinman, global chief economist at Deutsche Bank Advisors in New York. “They are 15 years further into their economic malaise since the Kobe earthquake. Maybe they are a little more humble.”
It could also give the Japanese the reality check they need to wriggle out of their 3-D trap. A likely first step would be to allow prices to drift upward, which is already starting to happen with higher food prices following the leakage of radioactive water into the rice paddies, vegetable fields and fisheries in the vicinity of the damaged Fukushima Daiichi nuclear power plant. Next, prices for many other goods may be driven higher by rising energy prices as Japan becomes increasingly dependent on imported crude oil, diesel fuel and liquefied natural gas to replace lost capacity from nuclear plants, which supplied more than a quarter of Japan’s electricity before 3/11. Japan was already vulnerable to oil prices, which were driven above $100 a barrel by political turmoil in the Middle East. In late March, LNG was being diverted from Korea to Japan, according to Daiwa.
“We hope this will at least bring an end to the deflationary mentality and a move to an inflationary environment and a more normal policy,” says Chris Scicluna, deputy head of economic research at Daiwa in London. This would prepare the Japanese, says Scicluna, to overcome one of the outstanding taboos of economic policy, which is a reluctance to increase the consumption tax from the current low rate of 5%. Many economists argue the rate needs to be closer to the European average of 20%. The government would have to use the cost of reconstruction as an excuse, but the results could be startling. “At a stroke, they can return public finances to more stable path,” says Scicluna.
Support is already mounting in the private sector for such a move. At a press conference in Tokyo on March 31, Tadashi Okamura, chairman of electronics manufacturer Toshiba and also chairman of the influential Japan Chamber of Commerce and Industry, broke with precedent by calling for an increase in the consumption tax rate for a three-year period starting in April 2012 as “the best way for everyone in Japan to shoulder the necessary costs to rebuild the devastated areas,” according to Japanese wire service Jiji Press.
Raising consumption tax would pave the way to breaking another taboo—hiking interest rates from the rock-bottom levels. Low rates have allowed the government to sustain a massive debt that is equivalent to 199% of GDP, which Madsen argues is unsustainable in the wake of 3/11.
But the most important policy changes required for Japan to resume its growth course will have to address the aging and shrinking of Japan’s workforce, says Scicluna. That would address a weakness that is expected to subtract 0.9% a year from annual economic growth through 2017, according to OECD statistics. At the current rate of reproduction, the labor force gets older every year, and it has actually been shrinking since 1996.
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Because of the decline in the workforce, “Japan can only boost its trend growth rate through higher productivity,” says Scicluna.
Japan’s response to humanitarian relief operations brought signs that public opinion on immigration may be changing. Isamu Sato, the mayor of Kurihara, one of the many towns northeast of Tokyo that sustained heavy damage on March 11, asked Israel to send a medical team to supplement Japanese medics who were stretched thin on the ground. In response, a 53-person team arrived on March 27, including 14 doctors, and set up a field hospital. And the health ministry waived a restriction against foreign physicians working in Japan for the first time since the Kobe earthquake.
Need for Bold Leadership
Adachi believes the public probably favors relaxing immigration laws even more than the bureaucrats do. “People want to take a positive view beyond this tragedy,” he says. And that disparity illustrates perhaps the biggest hurdle Japan faces to sustaining the economic boost that the reconstruction efforts will provide: aversion to change among the country’s political leaders. Few analysts would disagree that Japan will need a stronger government than that of current prime minister Naoto Kan to get the economy back on track. Many observers see Kan, who had been in office only nine months before the earthquake, as having failed to show strong leadership or engender confidence since then. This is largely due to the uncertain nature of the nuclear disaster, which has prevented Kan’s spokesman from giving clear answers to direct questions about the dangers of the radioactive water released into Japan’s fisheries and the water table of northeastern Honshu, the main island of the archipelago, notes Madsen.
According to Bush, the ideal outcome would be for Kan’s Democratic Party of Japan to form a coalition government with the Liberal Democratic Party, which had held power nearly continuously from its formation in 1955 to its electoral defeat at the hands of the DPJ in 2009 and has accumulated a wealth of experience and expertise in managing the country’s bureaucracy. But Madsen sees such cooperation as unlikely because of “fractures” within each of the two parties that he says are greater than the political divide between them. He expects Kan to call an election within six months and make way for a new administration that would be run by a new set of politicians who are carrying less baggage. That could mean more room to negotiate taxes, interest rates and immigrations laws.
“I am optimistic because the Japanese have a history of overcoming adversity—some from beyond their control and some self-made,” says Richard Samuels, who is director of the Center for International Studies at the Massachusetts Institute of Technology and also director of the MIT-Japan Program. “I also think that young Japanese will make nation-building their anthem—a phenomenon missing since the 1960s.”
But the new Japan will need time to find its feet. First, it will have to find new homes for more than 70,000 people who fled from towns around the nuclear plant and are now living in school gymnasiums. “We have to provide food, water and other basic needs,” says Nobumitsu Hayashi, the World Bank’s executive director for Japan. For now, the nation will have to keep its people alive.
Here are four scenarios for the long-term economic prospects of Japan in the wake of the Tohoku earthquake, ranging from optimistic to pessimistic.
Return to growth—one-quarter contraction
The damage caused by the earthquake, tsunami and radioactive contamination causes the economy to shrink by 3.5% during the second quarter of this year, and then the reconstruction of damaged infrastructure makes the economy grow by 1.25% to 1.50% for two years from 2012 to 2013. Sometime this year, a stronger government comes to power after a new election or the formation of a coalition with the opposition Liberal Democratic Party. The government raises taxes and interest rates.
Domestic savings fall and consumption levels rise. The economy grows by 1.50% to 1.75% from 2014 to 2016, and then continues to grow by 1% to 1.25% for a couple of decades. That would give the government time to strengthen the financial system and keep printing bonds.
Strong fiscal tightening—two-quarter contraction
Efforts to contain radioactive contamination in the Tohoku region achieve only limited success. The economy contracts over the second half of this year. But the stimulative effect of massive spending on infrastructure in the parts of the region that are still inhabitable makes the economy grow by 1.25% to 1.50% in 2012 to 2013. A new government comes to power backed by a political consensus sufficient to enable it tighten fiscal policy forcefullly enough to make substantial progress in shrinking the government deficit, achieving constant GDP growth of 1% to 1.25% for at least two additional years.
Current account problems
Radioactive contamination severely hinders the reconstruction of the Tohoku region, leading to a debate over the safety of nuclear power that forces much of Japan’s nuclear power industry to shut down. Japan is forced to import petroleum products for power generation at a time when unrest in the Middle East is pushing oil prices higher. Prices for many products in Japan start rising for the first time since the early 1990s, leading to expectations of higher inflation or even stagflation. To pay for reconstruction, the government raises taxes and interest rates. Higher interest rates start to turn Japan’s trade surplus, which is a component of the current account, into a trade deficit. Policymakers begin to perceive the current account surplus as unsustainable. Political consensus forms around relaxing Japan’s stringent immigration laws, which allows the workforce to grow—and adds about 1% to annual GDP growth. After an initial contraction, Japan achieves strong economic growth, potentially as high as 3% a year, in the decades to come.
Return to stagnation—three-quarter contraction
The government fails to contain radioactive contamination, reclaiming only a piece of the Tohoku region. The economy contracts for three quarters. The stimulative effect of reconstruction drives only one and a half years’ GDP growth at annual rates of 1.25% to 1.50%. Then a new government falls short of pursuing fiscal tightening and loses the confidence of the business and political elite. Manufacturing moves to China. Households return to their frugal spending habits. The government continues to run fiscal deficits. Japan suffers a third “lost decade” at annual GDP growth rates of 1.0% or less.
Sources: Massachusetts Institute of Technology, the Brookings Institution, JPMorgan, Daiwa Capital Markets and Deutsche Bank Advisors.