jk- combine demographics with the process of economic development. emphases added
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?
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 that the 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 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 a crisis 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.
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. When capital 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. Its celebrated 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.
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 supported by 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.
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 old people.
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, inflation is inevitable. Inflation is a form of reneging on promised benefits. I'm afraid the world is heading that way.