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    China Business
     Apr 20, 2012

Japan's demand conundrum
R Taggart Murphy introduces the accompanying article by Michael Pettis.

My salary was reduced 10% on April 1. Are students bitching about my lousy teaching? Have I been less productive on the research front? Less willing to shoulder my share of administrative burdens? All this could be true - or not - but has nothing to do with my pay cut.

From slacker to Nobel Prize winner, every one of my colleagues at the University of Tsukuba, northeast of Tokyo, is seeing his or her salary fall. As are all professors at all of Japan's national universities. And, indeed, everyone in Japan who is paid, directly or indirectly, by the Japanese tax-payer - or, more precisely, paid by all the borrowing the Japanese government has been doing since taxes now cover less than half the Japanese government's expenses.

After all, that's the point of the exercise. With the outstanding


debt of the Japanese government topping 220% of GDP, something's got to give - or so they say. Not that cutting the salaries of civil servants is going to do anything measurable to solve this debt problem, but at least it's a gesture in the right direction. Particularly when Prime Minister Noda, backed as he is by the Ministry of Finance ("MOF") and much of the ruling Democratic Party of Japan, is seeking to push a very unpopular hike in the consumption tax through the Diet.

Maybe if all those bureaucrats and us useless professors are seen to suffer, the ordinary salaryman, shop owner, housewife, and construction worker will be a bit more willing to suffer along with us - swallow hard, tighten their own proverbial belts, and endure a 5% increase in the price of everything they have to buy.

Ah yes, suffering. The Japanese have blown wads of money on white elephants - the bridges to nowhere, those endless concrete river banks and pointless sea walls that have wrecked the Japanese countryside, not to mention the cushy amakudari posts for retired bureaucrats and all that - and now everyone (including the odd gaijin professor here and there) has to suffer.

Problem is - it's not clear how all this suffering is going to "fix" Japan's fiscal problems. People usually react to pay cuts and tax hikes by buckling down, spending less, and saving more. Companies see this happening and put investment plans on hold, hoarding cash and doing what they can to get by with fewer people while paying them less. The government is not the only employer in Japan cutting wages.

So where is demand to come from if both households and companies go austere? After all, consumption taxes only generate revenues if people buy things. Orthodox Keynesian economics calls for the government to step in to fill the demand gap when households and companies can't or won't spend, and as the irrepressible [Nomura Research Institute chief Economist] Richard Koo has been reminding us now for well over a decade, it was lots of government spending over the last 20 years that kept Japan from tipping over into depression. But that's how we ended up with cumulative fiscal deficits at 220% of GDP, a number that has all kinds of folks fretting about endgames, calamities, meltdowns and other such scenarios.

Now, the Japanese government still pays only a 1% annual interest rate to borrow money for 10 years, and even if the yen has gotten a bit weaker in the past few weeks, there has been no global flight from the Japanese currency. So neither the bond markets nor the foreign exchange markets show any discernible sign of factoring apocalypse into their pricing.

But who is to say that awful things might not soon happen if policy makers don't get serious now? When getting serious involves hiking taxes, cutting paychecks, and freezing all those white elephants dead in their tracks, however, demand is going to collapse, and with it any chance of higher tax revenues.

Unless that demand comes from overseas. You won't find many people saying it openly, but the only way this tax-hiking, pay-cutting plan is going to work is if Japanese companies start exporting more (or to be precise, export more than Japan imports). In other words, Japan is going to have to fall back on that old tried-and-true recipe that has been around since the Korean War: export-led growth.

But export-led growth only works when somebody out there absorbs the extra exports - or to put it more precisely, somebody out there increases their current account deficit (or reduces their surplus) in exactly the same amounts with which Japan intends to increase its current account surplus. (The current account measures all current financial flows - as opposed to investment/capital flows - to and from the rest of the world. It consists of payments for trade in goods and services plus transfers - foreign aid; overseas workers' remittances - and dividend and interest flows. Because of all the extra oil Japan has been importing to make up for the post-3/11 loss of nuclear energy, Japan is now running a trade deficit. Interest and divided income are sufficient to keep Japan's current account in the black for the time being, but those will not last forever.)

At a time when practically everybody is trying the same thing Japan is - cutting back on spending at home - news that Japan intends to pile on by increasing its own current account surplus will not be greeted with accolades elsewhere, which is why few of Japan's public spokesmen are willing to draw the dots explicitly.

Michael Pettis has now done so, in the accompanying article. [See China set for stormy seas, Asia Times Online, Apr 19, '12]

Pettis, a professor at Peking University and a Senior Associate at the Carnegie Endowment, brings a China-based perspective and his article begins with an analysis of the "rebalancing" in which China is said to be engaged. The rebalancing of which Pettis writes is a supposed shift away from an export/investment driven economy to one led by consumption. (This may sound familiar to Japan observers, since such a rebalancing has also been a purported goal of the Japanese government for close on 30 years now.)

Pettis is skeptical. His skepticism stems from his unusually keen appreciation of macroeconomic accounting principles, principles that cannot be violated as long as money is used to conduct economic affairs between countries. Although these principles can and should be understood by anyone with an elementary grasp of macroeconomics, they are usually ignored or deliberately misconstrued by politicians who do not want to explain, for example, precisely what has to happen for a trade deficit to be reversed. (Hint: Becoming "more competitive" or slapping tariffs on imports will not in and of themselves do the trick.)

Here are the core principles. An economy with more domestic savings than domestic investment runs a current account surplus. The savings have to be invested overseas, otherwise they are either invested domestically or they are destroyed, putting the savings/investment gap - and the current account - back into balance. Conversely, a country with more domestic investment than domestic savings by definition runs a current account deficit. If the extra investment is not financed by foreign savings, it does not happen, in which case there is no gap and thus no current account deficit.

Why? Because the current account is precisely equal to the capital account plus changes in official international reserves. A country running a current account deficit cannot do so unless money comes in from overseas to finance it. If a country cannot beg, borrow, or steal the financing, it cannot run the deficit any more than you can spend more money than you have; you have to get it from somewhere. Similarly, a country running a current account surplus has to be exporting capital (or accumulating international reserves - ie, claims on other countries) since by definition it is being paid by foreigners.

Now we get to the most important principle of them all - until we start doing business with the moon, the sum total of all the national current account balances must be zero. If a country increases its current account surplus - which will happen automatically if its savings exceed its domestic investments - then another country's current account deficit must increase (or its surplus decrease).

What happens if no such country exists? Then the country seeking to increase its current account surplus cannot do so and its savings are destroyed (or its bankers find increased domestic investment opportunities, perhaps because its government builds white elephants).

Pettis applies these principles to what is going on in China and the likely outcomes of that country's policy mix. He notes that China's current account surplus has declined since 2007 from 10% to 4% of GDP, but says that is not because of any decline in savings (another way of saying rise in consumption) but because of an increase in domestic investment.

Other things being equal, he expects the decline of the current account surplus to reverse itself. Why? Because "Beijing is finding it impossibly hard to raise the consumption rate", and because "it is extremely important that it reduce the investment rate before debt levels become unsustainable" (if this sounds familiar to us Japan types, that's not a coincidence.)

But of course other things are not equal. Because China can increase its current account surplus only, as noted above vis-a-vis Japan, when other countries are willing and able to increase their deficits (or reduce their surpluses).

Looking around the world these days, one wonders who is going to do that. The Europeans, where the countries of peripheral Europe are being forced to cut back on all kinds of spending; ie, forced to save more? The United States, where both the Barack Obama stimulus package and the George W Bush tax cuts will come to an end soon, while presidential politics degenerates into a "more austere than thou" circus? Remember, less spending means more savings and thus, other things being equal, reduced current account deficits.

So we come to Japan, where Pettis notes that all the austerity talk out of Nagatacho and Kasumigaseki threatens to put Tokyo on a direct collision course with Beijing.

There is one serious problem with Pettis' analysis. He writes of the early 1990s that "rather than privatize assets and transfer wealth directly to the household sectors, the Japanese [began rebalancing] by having the government assume private sector debt." Yes, the government did assume private sector debt (if one can call the Japanese banking system "private"; given pervasive Ministry of Finance control, better to write "nominally private") but I have no idea what assets Pettis is referring to.

Equity and real estate assets that had been run up in the late '80s bubble lost as much 80% of their value over the subsequent decade, and as to the "assets" built after 1991 and paid for by Japanese government debt, the revenues from many of these airports-in-sight-of-each-other, bridges-to-nowhere, and billion-dollar tunnels lopping off 10 minutes from commuting times don't even cover their operating costs, much less their up-front investment.

While Richard Koo is absolutely right that shoveling money into the economy in the form of these "assets" kept Japan from depression, there is effectively no way to "privatize" most of them - no one would buy them. It is not a matter, as Pettis seems to think, of "reluctance" on the part of the Japanese authorities "to solve its debt problems by privatization".

Alas, however, this misunderstanding re-enforces Pettis' broader point - that the policy mix being debated in Tokyo today and seemingly championed by Prime Minister Yoshihiko Noda can succeed, if implemented, only by restoring Japan's trade surplus - and thus increasing its current account surplus. That, in turn, can only happen if counterbalancing deficits increase elsewhere - or surpluses elsewhere go down, which if Pettis is correct about China, is a non-starter.

It has been 90 years now since John Maynard Keynes pointed out in The Economic Consequences of the Peace that squeezing money out of people does not bring prosperity. What may appear to work for the individual household, company, or even country produces only misery when everyone tries to do it at the same time.

That's how we got the Great Depression. For some decades after that catastrophe, the world seemed to have learnt its lesson. But hearing what is coming out of Washington, Beijing, Tokyo, Berlin, London, Frankfurt and Brussels, one can only assume the lesson has been forgotten.

The only hope Pettis offers is a possible "reduction in commodity prices, including oil, which will help absorb some of the changes in trade balances". But he doesn't "see much other relief". Nor do I, short of global elites collectively re-discovering that making ordinary people poorer is not a formula for prosperity.

R Taggart Murphy, a former investment banker, is professor in the MBA Program in International Business at the University of Tsukuba's Tokyo campus and an Asia-Pacific Journal coordinator. He is the author of The Weight of the Yen (Norton, 1996) and, with Akio Mikuni, of Japan's Policy Trap (Brookings, 2002).

(Republished with permission from Japan Focus.)

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