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By Andy Xie 03.15.2010 18:20

Our Next Economic Plague: Japan

Disease

Growing old is hard, but watching formerly vibrant economies choke on

debt and wither away is downright ugly

Japan's nominal GDP fell 6 percent to 475 trillion yen last year, while its real

GDP declined 5 percent. Meanwhile, nominal GDP in the United States

decreased 1.3 percent to US$ 14.2 trillion and real GDP fell 2.4 percent.

If you travel across Japan and the United States, you get the impression

that America is in much worse shape: Americans cannot stop screaming

about their woes, while the Japanese face economic sufferings quietly.

Maybe this is due to cultural differences. Regardless, Japan is in dire

shape. Its nominal GDP is now lower than it was in 1992 when the nation's

property prices first began to decline.

Japan's status is frightening because its problems will spread to all of us in

the future. Everyone knows what it's like to grow old. And history is full of

examples of empires that grow old, wither and die. For modern economies,

though, this is a new concept.

There are clearly factors behind the aging of an economy. All of these

factors are now at work in Japan. And looking at Japan today, it's clear that

it's no fun for an economy to grow old.

People can postpone aging with expensive cosmetic products, Botox and, if

you are really desperate and rich, surgery. But are there ways to postpone

the aging of an economy, or avoid aging completely, sort of like Maggie

Cheung?

New Disease

Decades ago, the Netherlands had oil wealth. Strong export revenue

pumped up its exchange rate while its industries shriveled under high costs.

The Dutch took advantage of the high currency value and enjoyed life by

buying a lot and not working much. When the oil ran out, hard times hit.

Nowadays, when a country enjoys too much of God's gifts and forgets to

work for a living, it's called Dutch disease. When an economy exhibits senile

characteristics, I think it should be called "Japan disease."

Most analysts link Japan's problems to its super bubble in the 1980s. At the

peak, Japan's property values accounted for more than 40 percent of the

world's total. Land under the Imperial Palace was worth more than all of

California. Seven of the ten richest men in the world were Japanese

property developers. No doubt, Japan went overboard. But could that

bubble still be having such a strong effect two decades later?

Keynesian economists blame Japan's problems on its on-and-off fiscal

stimulus. They argue that, if Japan had kept the stimulus long enough in the

1990s, Japan's economy would be healthy today. Keynesians say an

economy is like a car without a battery: Momentum is everything. When an

economy stalls like a car hitting a rubber traffic cone, forward movement

can resume if one pushes hard and long enough.

Structuralists blame Japan's problems on a lack of reform. If Japan could

get rid of all bad debt, promote shareholder rights and deregulate markets, it

would trigger waves of efficiency that encourage innovation and power the

economy forward. The Koizumi government did embrace many reforms thatthe structuralists advocated. Japan did experience a period of growth. In

hindsight, much of the growth during the Koizumi era was due to a booming

global economy that increased Japan's exports. In particular, China's

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Our Next Economic Plague: Japan Disease

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English> Opinion> Magazine Columnist>Andy Xie> Our Next Economic Plague: Japan Disease

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demand for Japanese equipment and U.S. demand for Japan's cars were

probably more important than the reforms.

I think the Keynesians are totally wrong about Japan. Keynesianism is a

prescription for a short-term economic hiccup. It's like a painkiller, not a

cure. It tries to minimize output loss during a down cycle. It doesn't mean

much for an economy in the long run. Without Keynesian stimulus, an

economy is supposed to adjust properly. Using Keynesianism to explain or

cure long term economic problems is just plain wrong.

Unfortunately, most economists who run central banks today are in this

school of thought. They act while looking through a stimulus prism. When acrisis hits, it is right to pump some stimulus. But they are maintaining

stimulus in hopes of strengthening economies again. That's wrong.

Structural problems, in particular high indebtedness, are preventing strong

growth. Sustaining stimulus would lead to inflation, not high growth.

Japan's problems escape easy explanation or solutions. There are so many

and interlinking problems that the situation is intractable. Japan is just

getting old and older. Rebirth is possible, but it requires wholesale

destruction of a status quo that Japan is unwilling to give up. It's just not

worth it. When the price is too high, one prefers retirement to youth.

Aging Process

An economy ages in many ways. The most common are tied to the

exhaustion of factors such as production-labor, capital and resources. When

an economy begins to develop, labor is the abundant resource. Hence, it

makes sense to develop labor-intensive industries. When labor surplus is

exhausted, it makes sense to develop capital intensive industries. Whencapital stock is high enough, investment cannot drive growth anymore.

Economists call it diminishing returns, or more of the same yields less

output. This type of aging doesn't worsen. Economists say a steady state

equilibrium emerges when consumption and investment are balanced just

right, sort of like permanent middle age.

Moreover, youthfulness is possible for a mature economy. Through

innovation, an economy can produce more with the same inputs. This so-

called total factor productivity (TFP) is an elixir for a mature economy. It

determines how fast a rich economy gets richer. A 1 percent TFP is

considered mediocre, 2 percent is good, and 3 percent is super.

Many economists argue for freer and cheaper economic structure to

stimulate innovation. But, in the Internet era, innovations rapidly

disseminate around the world. It's not clear if innovation benefits can be

contained in any country anymore. For example, even though the United

States is more innovative than Europe, it hasn't outperformed by much. Itscelebrated prosperity during the Greenspan era turned out to be an old-

fashioned bubble, not a reflection of superior innovation.

Diminishing returns define the aging of an economy in relation to capital

accumulation. Population aging, now a more popular concern, is a relatively

new phenomenon. Merely decades ago, life expectancy was not high

enough for a society to have a large population of retired people. The world

is transiting from the old equilibrium of a small retirement population to the

new equilibrium of the retirement population similar in size to the working

population. The transition is an aging process. When the new equilibrium is

reached, i.e. the ratio of retired to working populations is stable, it is an

aged economy.

In addition to increasing life expectancy, a declining birthrate is another

modern phenomenon with major economic implications. Initially, a declining

birthrate is beneficial, as fewer resources are required to raise the young.

This is the so-called demographic dividend. For example, rising female

participation in the labor force can be attributed to the declining birthrate.

But when a low birthrate lasts two decades, it begins to decrease the labor

force, which reverses the benefits of the prior two decades.

Both aging and the reversal of the demographic dividend are in full force in

Japan. Its labor force is declining by 0.5 percent per annum and its

population of those aged 65 and over (now 23 percent), is rising by 0.6

percent per annum. In theory, the demographic headwind may decrease

Japan's economic growth rate by about 1 percentage point. The reality is far

worse, as Japan's long stagnation indicates, because of other changes that

accompany an aging society.

When a society ages, its resource allocation increasingly favors the old.

Healthcare costs, for example, rise exponentially. Broadly, an old population

is unwilling to take risks, which makes social or economic change difficult.

Underlying forces in an aging society favor unproductive expenditures and

less competition.

Rising social burdens in an aging society obviously fall on the working

population, i.e. the tax burden on the working rises over time. The

diminishing reward for work decreases labor supply, as workers choose

more leisure. A vicious cycle in labor incentives is quite possible.

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The changes in an aging society are far greater than what the arithmetic of

the so-called dependency ratio the ratio of non-working to working citizens

suggests. A society changes in many ways to become more conservative,

less hard-working, and less innovative. The society ages.

But Japan's problems will spread to other major economies. Major

European economies, for example, are not far behind Japan.

Unemployment and retirement benefits are more generous there, so the

loss of economic vitality comes more quickly.

Rising national debts in developed economies are driven by aging. The

benefits they promised during the high growth period cannot be supportedby government revenues anymore. They resort to borrowing to keep

promises. Japan's national debt at about 200 percent of GDP is the highest

in the world. Other developed economies seem to be on the way there. The

average fiscal deficit in Europe is 6 percent of GDP. Britain's is 12 percent,

and America's is 10 percent. While most analysts blame oversized deficits

on the recession, they could last for many years to come. Japan's deficit in

the 1990s was viewed similarly. With such high deficits, it won't take long for

them to catch up with Japan.

Graceful Aging?

Despite dismal economic performance, Japan may find ways to sustain an

aged economy, i.e. age gracefully. If you travel through second-tier cities in

Japan, you'll be impressed by how few young people there are on the street

and how old the workers are in the service sector. Indeed, most taxi drivers

seem to be around 70. Hotels and restaurants are often maintained by

ladies in their 60s and 70s. These are surreal pictures of an economy of oldpeople.

Tokyo presents a different picture. It seems as vibrant as other major cities

in the world. But its dynamism is from sucking young people from second-

tier cities. And as Tokyo is the nation's service center, its economy cannot

avoid symptoms of an aged society.

Aging has disastrous consequences for asset prices. Property, for example,

must be a permanent bear market. Declining population means declining

demand for property. As property is a long-lasting asset, permanent surplus

is likely, exerting a constant downward pressure on property prices. Japan's

property prices have been declining at about 7 percent per annum for nearly

two decades. The rental yield happens to be similar to the price decline.

Foreigners are enticed by Japan's high rental yield from time to time. Few

have made money.

An aged economy is a stagnant economy. Hence, corporate profits are

likely to be stagnant. Without growth, stocks should be very cheap, say,around 10 times earnings and 5 percent dividend yields. Japan's stocks

were trading at above 70 times earnings at their peak. They have been

falling for two decades. Foreigners are sometimes attracted to the improving

valuation of Japan's stock market. Periodic foreign buying causes market

upturns, but all have turned out to be value traps.

Aging gracefully seems to be the path that Japan is pursuing. Other

economies may not be able to do so. Italians have been demonstrating to

defend a retirement age of 55. Greeks are waging pitched street battles

against police to defend government benefits. Europe will have more trouble

than Japan down the road. The Greek debt crisis is a leading indicator for

Europe as a whole.

Is it possible to prevent or reverse economic aging? I doubt it. Declining

birthrates and rising life expectancy are powerful forces. However, it is

possible to slow the aging process. Immigration, for example, is often cited

as a solution. Immigrants are supposed to come from developing countries.

But aging is discernible in emerging economies, too.

China's demographics, for example, will be quite similar to those in

developed economies in less than 20 years. India may be another 20 years

behind.

Wrong policies could exacerbate the aging process. High property prices

during high growth periods represent the worst policy for the long term.

Japan's high property prices in the 1970s and '80s increased the cost of

child-rearing and decreased birthrates. China has both high property prices

and a one-child policy, so its long term consequences will be severe. While

Chinese people are excited about property now, the market could enter a

bear market worse than Japan's when the full force of aging hits, probably

in less than 15 years.

Aging is supposed to be deflationary. Japan's experience supports that

theory. However, deflation is possible only because governments can

borrow to cover the cost of aging. When debt is unsustainably high, inflationis inevitable. Inflation is a form of reneging on promised benefits. I'm afraid

the world is heading that way.




4/4

Caixin Reader 2010-06-08 23:41:33 post

Nice piece, just one comment: the Dutch had (and have) natural gas, which

caused the so-called Dutch disease, not oil.

IP:* Support(0)Oppose(0)

laotou00 2010-03-25 01:38:58 post

A very well written article. As in sports, carry-through is critical to launching the

projectile on the right path. Improper carry through still results in a successful

launch - but the goal is way off target. One of the major problems with financial

reforms, social reforms, and other policies is the absence of a lifecycle approach.

Too often we try to solve symptoms using the western medicine approach - an

injection (stimulus), some drugs (band-aid) but we dont address the systemic

lifecycle of the organism - be it a global economy, a real estate bubble, or Yunnans

water woes. Government is extraordinarily complicated and management of China

is quite possibly one of the most complicated and complex systems the world shall

ever face.



Just allow immigration of young people. Demographics solved.



Is it possible to prevent or reverse economic aging? I doubt it. Why not just allow

immigration of young people from Asia, Eastern Europe and Latin America?



a good analysis. However, Mr Xie does not go far enough. He ignores the

demonstration effect, which is perhaps the most pernicious of all the repercussions

of a societys ageing. Young people do flee the countryside and secondary cities

for Tokyo and Osaka but that does not save them for the trepidation with which

they approach life and which they see all around them, a trepidation that

characterizes old peoples uncertain hold on life and the world. Youthfulness and

youthful exuberance and lust for adventure is as much an endangered species in

japan as youth itself.


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