Andrew Smithers: Plenty of pain, no sign of gain

The mismanagement of Japan’s economy has caused no shortage of suffering for the Japanese people. But the “no gain without pain” argument is economic nonsense, says Andrew Smithers. Other countries faced with deflation and stagnation must learn from Japan’s many mistakes –

Japan provides sound reasons for global concern. This is not solely because of the knock-on effects that a weak Japanese economy has for the rest of the world. Nor is the only additional issue our natural sympathy for the Japanese people as they face up to the unnecessary grief that mismanagement of their economy has caused.

Another major concern is that much of the advice being given to the Japanese government, from domestic and overseas sources, would, if accepted, exacerbate rather than alleviate the economy’s problems. It is as if the lessons of the last century, including those learnt so painfully in the 1930s, have been forgotten.

If, as may well happen, other major countries start to suffer from the deflation that has dogged Japan over the past decade – and if popular calls to deal with the situation are as ill-informed as they have been in the case of Japan – then there are grave dangers facing the world economy today. Not only could the developed world slip into deflation but the initial policy response could be damaging rather than helpful.

Japan’s real GDP is now lower than it was at the start of 1997. There are only two explanations for this. Either Japan’s economy can’t be managed to achieve growth or it has been very badly managed. It is clearly a vital matter to decide, for Japan and the rest of the world, which explanation is correct.

Japan clearly has the physical capacity to grow. There are only two ways in which an economy could be doomed to stagnate on a semi-permanent basis, however competently it was run.

The first possibility is that the inhabitants are wildly profligate. Savings are an essential condition for prosperity. No country can otherwise have a reasonable expectation of achieving growth. But the Japanese are in fact a model of prudence. They have long had the highest national savings rate of all the G7 countries. (OECD data show that gross savings, relative to GDP, are nearly 80% higher in Japan than they are in the UK.)

The other possibility is that the population might be falling so rapidly that stable GDP would nonetheless mean rising living standards. This also provides no explanation for Japan’s stagnation. The population of those of working age is indeed falling. But it is not yet falling nearly as fast as output per head is growing in other G7 countries. Furthermore, none of these other countries is saving and investing as much as Japan.

Since neither of these conditions applies to Japan it is a tough but reasonable conclusion that Japan’s economy has been badly managed in recent years. It is also a fairly conventional interpretation.

There are, however, several sharply different views about the policies that Japan should have followed to get itself out of trouble. It is only when one considers the widely differing views about the cause of policy failure that one starts to have sympathy for Japan’s policymakers.

It also provides cause for reflection should other countries get into difficulties. Japan has failed to grow because of a failure to introduce sensible policies, but it has also been discouraged from doing so. It is therefore vital to show how foolish much of the advice it has received has been. Unless this is done, there is a high risk that other countries will be encouraged to make similar mistakes.

There are basically three schools of thought regarding the policies that Japan should have followed but hasn’t.

Probably the most vocal are those of the “no gain without pain” school. This group is commonly found among stockbrokers, financial journalists and in letters to the press.

A second group argue, correctly in my view, that “no gain without pain” is economic nonsense, but then, wrongly in my view, that further fiscal stimulus will provide a solution.

A third group, to which I belong, sees the sole solution of Japan’s problems in monetary easing.

I don’t wish to be unkind to any views, but it is very difficult to avoid this with regard to the first group. This is because I have yet to encounter a coherent economic explanation as to how the reforms that they call on Japan to make would in any way benefit its economy.

The standard argument seems to run as follows: Japan has a lot of companies that are barely profitable and being kept alive by bank loans. If the banks were forced to cut back on these, the companies would shut. The result would be that the remaining companies would face less competition, their profits would rise and they would increase investment and set the country off on the road to recovery.

This argument suffers from what is known as a “fallacy of composition”. This is because it fails to allow for the fall in demand, as well as capacity, which would accompany the closure of inefficient plants and companies.

If inefficient capacity is closed the result is, by definition, that there is, proportionately, a greater reduction in employment than in capacity. It follows that, unless the savings rate changes, domestic demand will fall by even more than capacity.

As Chart 1 shows, profits rise and fall with capacity utilization. Thus if capacity utilization does not rise as capacity is scrapped, neither will profits nor, in consequence, will companies have any incentive to invest.

Furthermore, when companies are sacking people and jobs are hard to find, the savings rate tends to rise rather than fall. There will also be no help from overseas, unless the costs of those plants that remain in business actually fall. This may well occur through falling wages, but only at the cost of a further consequential fall in domestic demand.

If markets worked completely smoothly, a real devaluation of the yen could swiftly and easily take place through falls in prices and wages. In the real world, though, far less misery is caused and far less damage done to output if the real devaluation results from a change in the nominal value of the exchange rate.

The key problem with the “no gain without pain” school is that it fails to understand that the reason Japanese companies have poor profitability on new investment is not that their costs are too high but that they invest too much.

Corporate profitability results from a combination of costs and capital efficiency. All output must be someone’s income. It is either the income of employees or the return on capital, including the amount needed to pay for depreciation. Profits will be high either if the profit share is high, or because capital is used efficiently and relatively little is needed for any given output.

As Chart 2 shows, the profit share tends to be stable in mature countries. In Japan the profit share has fallen steadily as the economy has reached maturity. It is not, however, depressed and is currently rather higher than, for example, in the US. Cost cutting is not likely therefore to result in a rise in the profit share of output.

As Chart 3 shows, Japan is currently investing rather more, as a proportion of its GDP, than the US or other mature economies in plant and equipment. It has, however, a population of working age that is falling, while the US has one that is rising. If Japan is to achieve the same return on capital as the US, one of two changes must be made.

One is that the proportion of output going to profits must rise and real wages must therefore fall. It would require a fall of around 35% in real wages to get profitability up to US levels.

As this would cause a collapse in domestic demand and GDP it would not be desirable. It is fortunate therefore that it is also highly improbable. The proportion of output going to profits tends to be stable in mature economies. The US provides a clear example of this. As Chart 2 shows, the profit ratio to output over the past 46 years has been between a maximum of 30.6% and a minimum of 24.5%. Today, Japan’s profit ratio is similar, though marginally higher, than the US at 28.6% and, as Japan is so clearly a mature economy, no significant change is now likely, as well as being undesirable.

The other is that labour productivity must rise fast enough, relative to the US, to offset the effect of demography. This would require Japanese productivity to rise by around 1.5% to 2% faster than that of the US. This is almost certainly impossible, though it would not, unlike a change in the profit ratio, be undesirable.

In recent years, the rise in Japan’s productivity has lagged that of the US and it would take a marked change in Japan for the rate of productivity improvement to catch up with that being achieved in the US.

The proponents of additional fiscal stimulus rightly point out that the “no pain no gain” school is based on a fundamental misunderstanding of economics. They correctly identify Japan’s problems as being caused by a weakness of demand rather than of supply. There are, however, major weaknesses in the case for additional fiscal stimulus, which in turn explain why a budget deficit of 8% of GDP has so far failed to put Japan on the path to recovery.

The fundamental problem is that Japan’s demand weakness is a structural rather than a cyclical matter. Because of its unusual demographic balance, Japan has a naturally high savings rate and, with its falling working population, only a very weak ability to absorb investment profitably in the domestic economy.

This is illustrated in Chart 4. This compares the actual distribution of Japan’s population by age group with the situation that would occur if the population were stable. It can be seen that Japan has a lot of people in their 30s and 50s, which are naturally high-savings ages.

It has, however, relatively few elderly people as yet. It is these retired people who spend their savings. Equally, few young people are coming into the workforce which, as a result, is shrinking. This limits the scope for profitable investment in Japan’s domestic economy.

It is important to realise that Japan’s structural savings surplus does not result from the fact that it has an aging population. If the population were aging steadily, both savings and investment would naturally tend to fall. It is the odd way in which Japan’s population is aging that gives rise to the natural savings surplus, and it is one that will continue for 15 years or so.

Japan must export its excess savings and thus run a much higher current account surplus than it does today. It is impossible to absorb the excess savings by running a huge budget deficit, as this would have to continue for the next 15 years or so, raising the already excessive national debt/GDP ratio to incredible levels.

The wish to stimulate demand by fiscal means may also be unworkable, even in the shorter term, without a change in monetary policy. Fiscal stimulus in a single country with an open economy will usually have an immediate impact on demand and output, particularly if it comes as increased government spending.

Unless, however, monetary policy accommodates the change in fiscal policy, the resulting increase in demand will push up the exchange rate. In due course this will have a negative impact on net exports and overall demand will fall back to its pre-stimulus level, with the added disadvantage of a higher budget deficit.

Over the past decade, Japan has exhibited just such a pattern of economic spurts being set off by rises in government deficits, only to find the impact falling away. When the budget deficit was 2% of GDP, the fiscal enthusiasts argued that a rise to 4% would get the economy moving. When it was 4% they called for 6%, and now it’s 8% they want yet more.

It follows that the only way to get Japan back on the road to recovery is through monetary policy. The question that gets most frequently asked is how can monetary policy be eased now that interest rates are zero?

The answer is that quantitative easing needs to be introduced. Unfortunately the Bank of Japan has been most reluctant to introduce such measures with sufficient vigour for them to be effective.

Happily, there are more certain and quicker ways to achieve the same end and, as they do not involve any action by the central bank, they could be implemented without that organization having a change of heart.

These ways forward were set out in a fascinating speech by vice-minister Haruhiko Kuroda at a seminar organized by the US National Bureau of Economic Research in Tokyo in September, 2002.

Kuroda pointed out that there are three different ways in which the authorities can readily intervene in markets for economic management. They involve changing the short-term interest rate, the interest rate on government bonds or the foreign exchange rate.

The vice-minister argued that with short-term interest rates at zero, intervention there no longer had any influence. He therefore suggested that the Japanese government should lower the long-term rate by ceasing to issue bonds and either borrow directly from the commercial banks or raise all the required funds through the issue of short-dated Treasury bills.

I was pleased to read this speech, as I had made a similar proposal in an article in the September 2001 issue of the Japanese journal Genron. But there seems to be little short-term likelihood of the Ministry of Finance changing policy in this way. If, however, Japan continues to disappoint the optimists, then we must hope the policies that vice-minister Kuroda and I have advocated will be introduced.

Andrew Smithers is chairman of Smithers & Co, a London-based global investment consultancy that he started in 1989, and a regular columnist on finance and economics. He previously spent 27 years with SG Warburg & Co, heading the investment management business that later became Mercury Asset Management. He is the co-author of two books: Valuing Wall Street, with Stephen Wright (McGraw-Hill, 2000) and, in Japanese, Japan’s Key Challenges for the 21st Century, with David Asher (Diamond Press, 1999).