In short, if the world economy is to get through this crisis in reasonable shape, credit worthy surplus countries must expand domestic demand relative to potential output. How they achieve this outcome is up to them. But only in this way can the deficit countries realistically hope to avoid spending themselves into bankruptcy.
Martin Wolf (2008)
It is not the first time that I am using this quote by the FT's chief economics commentator and I don't suspect that it will be the last. Of all the attempts by pundits and analysts to pinpoint the crux of the current crisis the observation above is the most important aspect in my opinion and I have argued as such several times (see also Rogoff and Obstfeld (2009) and Baldwin and Daria (2009)). However, I disagree with Mr. Wolf in one critical aspect. Specifically, I don't think that this is simply a question of it being up to them, as it were, in terms of how export dependent/oriented economies may succeed in pushing their growth path onto one increasingly driven by domestic demand. In this way, I believe that the export dependency of Germany and Japan (and a whole batch of economies which will now join them) are ultimately rooted in their demographic profiles where decades of below replacement fertility and rising life expectancy have now condemned them to an economic structure where the growth generated by domestic demand is virtually zero leaving external demand as the only meaningful way to create growth.
This does not mean that the combined external surpluses of these economies do not represent an important and potentially negative externality to the global economic system, but it does crucially mean that we cannot expect Japan, Germany et al to simply revert, through e.g. structural reforms, to a growth path driven by domestic demand that would allow them to suck up excess global capacity through an external deficit.
In order to focus the attention in this ongoing debate I will home in on Japan and concretely, a recent piece in which Martin Wolf actually fleshes out a specific way in which Japan would potentially be able to raise domestic demand to benefit of herself and the global economy. Martin Wolf's piece is worth pondering in its entirety, but in this context I am going to focus on the notion of high corporate savings and whether its release from corporate balance sheets holds the potential for spurring domestic demand in Japan.
My own view is that the underlying structural problem has been the combination of excessive corporate savings (retained earnings) and diminished investment opportunities, once catch-up growth was over. As Andrew Smithers of London-based Smithers & Co notes, Japan’s private non-residential fixed investment was 20 per cent of GDP in 1990, close to double the US share. This has fallen to 13 per cent after a modest resurgence in the 2000s. But no comparable decline has occurred in corporate retained earnings. In the 1980s, the challenge of absorbing these savings was met by monetary policy, which drove the cost of borrowing to zero and sustained wasteful investment. In the 2000s, the challenge was met by an export and investment boom, driven largely by trade with China (see chart).
Japan’s aim now must be to achieve domestically driven growth. The most important requirement is a big reduction in corporate saving. Mr Smithers argues that this will happen naturally, since savings are largely capital consumption, itself the product of the history of excessive investment. I would add that if ever an economy needed a market in corporate control, to shift cash out of the hands of sleepy managements, Japan is it. Not being beholden to Japan’s corporate establishment, the new government should adopt policies that would change corporate behavior, at last.
What follows is my take on this argument seen through the lens of a detailed look at the savings behavior of households and corporates in Japan.
Household Savings - (Dis)saving in Japan?
Standard life cycle theory states that consumers run down their assets into old age (dissave) and thus that a rapidly aging society at some point should move into a state of perpetual dissaving with the consequence in an open economy context being an external deficit (eventually). However, both in theory and in practice this is not so simple and Japan is a good example here. In this way and while the household savings rate (out of labour income) has indeed plummeted in Japan, the economy still has a large and persistent external surplus. Since we know that the government is mired in both current and future debt this has, by definition, to reflect a high level of corporate savings. Thus and with a low savings rate in the household sector the reduction in corporate savings holds perhaps the biggest potential for releasing domestic demand in Japan or so at least is the crux of Martin Wolf' argument as I see it .
click to enlarge
Most analyses on household saving rates in Japan do not move beyond the representation above which plots net savings as a share of net income. And indeed, this paints an unequivocal picture. The quarterly figure is highly volatile and subject to notable seasonality, but smoothed through a 12 quarter moving average shows us that since 2000 the savings rate of Japanese households have not exceeded 5%. More interestingly is of course is relentless downward trend which shows, more than anything, that the real economic conditions for Japanese households have changed significantly. This perspective which looks at the flow of savings is strongly underpinned by many empirical studies on the savings behavior of Japanese households. The most recent study is Horioka (2009) who presents a timely overview of the literature on the dissaving of the elderly in Japan. The evidence strongly suggests that Japanese consumers dissave into old age and as Mr. Horioka ends his article, this is likely to have important ramifications on global imbalances assuming, I guess, that as Japanese consumers steadily move into a state of negative saving the economy will move into a current account deficit. I assume further that this is what Martin Wolf expect would happen if corporate savings were released to the benefit of Japanese households since otherwise Japan would not do much to correct global imbalances.
Now, I cannot refute the amount of evidence presented by Horioka and thus the conclusion in the main. What I can do however is to respectfully take Mr. Horioka to task on the definition of savings and thus what is defined here as dissavings. In this way, Horioka notes that the main source of dissaving by elderly take the form of declining social security benefits, increase in taxes and social insurance premiums, and increasing consumption expenditures. Let us quickly dispense with the last one and agree that Japan has not experienced any meaningful consumption boom in a long time which suggest that dissaving is not likely to take the form of a surge in consumption in any meaningful way (I don't suspect this is what Horioka wants to argue, but it is important for me to point this out).
Since 1997 the growth rate in GDP and private consumption expenditures have languished at a depressing mean reverting trend around the zero percentage annual growth mark. This indicates quite clearly that whatever the extent to which aging households in Japan have dissaved through increasing consumption expenditures it has not been any meaningful driving force of consumption.
But what about the other two (increase in taxes and social insurance premiums). Are these really dissaving? I don't think so. Rather, these represent a transfer of saving from households to the government and thus an attempt by part of the government to reduce the future cost of age related liabilities and thus to compensate for a strongly negative net asset position by part of the government both in a current but more importantly, in a future perspective. In an aging economy this is exactly why we would expect the dissaving hypothesis to be in need of significant adjustment since there will be forced savings through the inevitable attempt by the government to stabilize the deteriorating fiscal situation.
As such, the representation above does not paint an adequate picture of household savings in Japan and while this initially may be explained in light of the fact that we should look at the savings of the entire Japanese consumer base and not only the elderly (retired) consumers the rapid and ongoing process of aging in Japan means that these two argument will inevitably converge over time, a point Horioka (2009) also makes.
Specifically, the account of dissaving above fail to take into account, at least, two important missing links. The first is the simple fact that the rate of savings out of total income is closely related to the annual growth in income which, in Japan's case, has exactly declined significantly in the same period in part because of the deflationary environment but also, I would argue, to reflect the changing productivity structure of the Japanese labour market with an aging work force.
Between 1998 and 2005 the change in the annual income flow to Japanese households was persistently negative and suddenly; a consistent savings rate in the same period of about 3-5% does not exactly come off as rapid dissaving. In fact, at no point in the graph above has the savings rate been below the annual growth in income which provides a very important qualifying perspective to the idea that the release of corporate savings either as a lump sum transfer or through a steady trickle of dividends would immediately be channeled into discretionary spending. I find this very difficult to believe, but in effect this will be subject to easy falsification if and when corporate savings in Japan became an important policy variable in terms of stimulating domestic demand.
The second missing link relates to the idea that savings may be defined in two overall ways, the first which is a flow perspective is described above and the second is a stock perspective. The best example of the latter is the asset meltdown hypothesis that envisions a sharp decline in asset prices as aged households grind down their stock of assets by selling them to a smaller and shrinking base of working age households who will not be numerous or wealthy enough to support asset prices at the given level.
In the context of Japan, I have argued before how there is no meaningful destocking of assets even if the growth of households' total assets have stalled significantly.
Despite the obvious drawback of only having data from 1997 and onwards the picture is quite clear. Between 1997 and 2009 the overall household balance sheet in Japan has remained pretty "stable" rising from trn 1285 JPY in 1997 to about trn 1440 in 2009 JPY (current prices). I choose to put stable in quotations mark here since the real thing to notice is the lack of expansion (i.e. debt driven asset expansions) by part of Japanese households to reflect the fact that there was no housing bubble let alone any other kind of bubble in Japan in the period in question. The main point is of course that despite a continuing decline in the rate of savings from a flow perspective, Japanese households are not (yet!) engaged in any meaningful de-stocking towards what ever end point the economy would reach if aging households and indeed the society as a whole began to run down its stock of savings.
In terms of composition, we find evidence of the often cited fact that Japanese households are quite risk averse Nakagawa and Shimizu (2000) holding between 50% and 55% of their total assets in either deposits or currency. In comparison, and while direct holdings of shares and investment trusts have indeed risen over the period, this entry still makes up only about 11% of the total balance sheet in 2009. Naturally, there is some cyclical effect here as the total share (value) of risky assets held directly in portfolio of Japanese households peaked in the years 2005 to 2007 at about 16-17%. Moreover, it is safe to conclude that if we include indirect holdings of risky assets through pension and insurance holdings, the picture becomes more balanced.
Looking at direct evidence of dissaving, we find none in the aggregate. Over the period in question the stock value of time, savings, and transferable deposits have gone up by 11% (i.e. a net addition of savings by the Japanese household) from some bn 665 JPY in 1997 to bn 742 JPY in 2009. Moreover, it is remarkable to see that the amount of currency held by Japanese households have increased by 40% in the same period. This suggests, more than anything, the risk aversion of Japanese households. Finally, I think it is worth to mention that although the amount of bonds held directly by Japanese households is next to none, Japanese households are naturally doing a substantial part of the heavy lifting in terms of financing the ongoing and almost perpetual deficit spending by part of Japan's governments. In this way, the large bulk of deposits as well as insurance and pension funds are very likely to be substantially invested (de-facto) in Japanese government bonds.
As an interim conclusion while a first glance suggests that Japan indeed is dissaving through its household sector, it is an argument which does not hold entirely up to scrutiny. It is important for me to emphasize two things. Firstly, I don't dispute the analysis in Horioka (2009) and thus the wide range of previous studies that have shown how the life cycle model of savings is well calibrated to a Japanese context. However, I do think it is important to differentiate it with the points above and particularly the notion that Japanese households, as a whole, do not seem to be rapidly dissaving to the extent that many claim. Secondly, I want to reiterate the point that I am not arguing that dissaving will never occur in the aggregate. What I am saying however is that looking at the dissaving of the elderly and concluding that this will lead Japan towards an external current account deficit misses the current and real effect from aging in Japan. Consequently, the picture of Japan at the present time running an almost perpetual external surplus is one of an economy fighting like hell to avoid obvious end point that would occur in the event of rapid de-stocking/dissaving.
Corporate Savings - Restraining Consumption through Retained Earnings?
Traditionally, economic models such as e.g. an OLG model set in an open economy context does not discriminate between the savings of corporates and households Rogoff and Obstfeld (1996) and Mason (1988) which is often because our economic models are set-up in a representative agent framework where the representative consumer is the sole shareholder of the representative firm and thus must be the sole beneficiary of whatever earnings (retained or otherwise) the company has. In a widely cited study Friend (1985) concludes that there is a moderate degree of substitutability between household and corporate savings which sounds about right to me.
In practice though and although principal agent problems and a thick corporate veil may make the direct link very sluggish, once foreign ownership of the domestic market cap is accounted for (about 20% in Japan's case I would say) there should no problem substituting corporate for private savings. In any case and to the extent that there is indeed a very long way from the dividends of Japanese corporates to the pockets of households it is, I assume, exactly here that Martin Wolf inserts his main argument.
As should be immediately clear here, it is not as if Martin Wolf is shooting blanks here although I don't suspect anyone really suspected that. Consequently, both the nominal value of retained earnings (manufacturers and non-manufacturers excl finance and insurance) as well as its share of total company assets have increased markedly since the mid 1970s. Since the second quarter of 1975 the nominal value of the stock of retained earnings has increased by a little over 270% while the corresponding figure for total assets is 163%. In terms of the share of total assets, the graph above does not tell the whole story as retained earnings as a share of total assets actually reached its low in the mid 1970s at around 5% declining from the mid 20s% in the 1950s. The average quarterly share of retained earnings relative to total assets in a post 1990 context is 14.14% with a steady upward trend throughout the 1990s and 2000s.
So far so good then.
However, as with the case of household saving above, once we dig a bit deeper in the analysis it is not certain that retained earnings constitute the magic bullet. First of all, the representation above is one of stocks and not flows and thus if we express it as flows we get the same picture as above with household savings; namely, that while the stock of savings (in the aggregate) is not being drawn down the flow of savings is steadily declining even if the flow of corporate savings is quite volatile.
Still, the flow of corporate savings have been impressive even in a post 1990 context where the average quarterly growth rate (yoy) has been 4.5% (with a correspondingly high SD of 6.7%). Moreovern, the relationship between the total amount of gross fixed investment on a quarterly basis and the stock of retained earnings is further indicative here. Between 2000 and 2008, Japanese corporates consequently kept an average of 183% worth of retained earnings on their balance sheet relative to the average value of quarterly gross fixed capital formation. As Martin Wolf evidently points out, this is ultimately a question of a secular decline in investment demand to which Japanese corporations only can do two things; dissave to match the decline in investment demand or let those savings flow out in the form of an external surplus. In the context of Japan and in strict sense of national accounting it is the latter route which has been chosen.
The more interesting question in terms of what those retained earnings are financing (i.e. on the asset side) is almost implicitly answered above although it is not as simple as it looks.
Consequently, conventional wisdom has it that the retained earnings of Japanese corporates are merely sitting on the asset side in the form cash and deposits and thus would be readily and easily available for distribution to shareholders. The more I look at the data however, the more this seems to me to be a myth.
The total amount of cash and deposits as a share of total assets held by Japanese corporates peaked in the first quarter of 1990 at 15.5% and has since declined to about 10% in the 2000s. Now, I might be missing an important liquid asset entry here, but it should serve to differentiate the picture somewhat of Japanese companies as cash hoarders.
Yet, the main picture remains in the sense that even if retained earnings have then gone to finance land acquisitions or the build-up of fixed assets the GDP entry of GFC shows with all certainty that investment activities in Japan have been in secular decline for the past 20 years as the nominal value of GFC peaked in the first quarter of 1991.
It is worthwhile to note however that of the main balance sheet entries on the asset side, "investment securities" is the one that has exhibited the strongest growth rate in a post 1990 perspective. This suggests that a large part of the incremental change in retained earnings in this period has been parked in yield bearing instruments be it government bonds or more importantly foreign securities which have helped Japan gain a substantial boost (far bigger than from goods and services exports) from a positive income balance. Since 2005, the stock of investment securities held by Japanese corporates has been approximately equal to 68% of the stock of retained earnings.
More generally, the flow of investment securities onto corporate balance sheets rose steadily until about 1999-2000 after which we observe a discrete bounce and a much more rapid (and volatile) increase hereafter. From Q1-00 to Q1-01 the stock of investment securities rose 25% and has since increased steadily to about trn 181 in 2008.
This last point in particular serves to differentiate the argument by Martin Wolf even if it is unquestionably true that the share of retained earnings used to finance the asset side appears extraordinarily large in the context of Japanese corporates. Moreover, I cannot of course say for certain what would happen in the event that those retained earnings became the subject of political attention as a tool to muster domestic demand.
Is it Optimal to Dissave?
The standard life cycle model tells us that it clearly is, and especially so when set in the context of a representative agent model aggregated to the macroeconomic level. Sure, we may incorporate bequest motives or uncertainty, but in the limit; dissaving on a microeconomic level will transfer itself to the macroeconomic level. Implicitly, this is the argument advanced when it is held that the retained earnings of Japanese companies can meaningfully be deployed to boost domestic demand in Japan and, most importantly, lead Japan towards an external deficit which would go some way to rebalance the global economy.
Let me be clear. I don't dispute the dissaving argument in itself; especially in a context where fertility "never" recovers (which may well be the practical case in Japan). However, and while dissaving certainly would be the fate for a closed economy, it need not be for an open one. In fact, it should take us very little time to agree that dissaving as a function of old age perhaps even to the extent that the economy moves into an external deficit is utterly undesirable from the point of view of the economy as a whole. Thus, it is my contention that aging societies are not, in the main, characterized by aggregate dissaving but rather by the fight against it. In Japan's case the high level of private savings reflected primarily in the level of corporate savings becomes a vital shield towards spinning further into negative trend growth and deflation.
Apart from this which is really my main observation on a theoretical level I have two additional points.
Even if we assumed that the retained earnings of Japanese corporates could be effectively channeled to the purses of households, would these same households increase spending? Put differently, what is the underlying demand here? Needless to say, I am quite skeptical here and moreover, it is important to remember that the rate of savings closely follow the growth rate in income. Thus, if suddenly income rose either through a lump sum payment or a steady trickle would the savings rate follow?
Finally, the extent to which Japan may become a global provider of spare capacity not only hinges on the trend of dissaving but also, by definition, on investment demand. This makes the whole issue much more complicated since what we are really looking for is a net effect and since both savings and domestic investment demand can be expected to decline with the transition into old age and it is the mutual pace between the two that determines the external balance. Consequently, empirical as well as theoretical studies have spent considerable time to pin down what this net effect is supposed to be. I will not go into the conclusions from this literature (my upcoming thesis will have much more on this), but merely note that we can observe how countries such as Germany, Japan, Finland etc are running external surpluses, why this surplus is critical for their growth prospects and thus why the salient features of an aging economy is not dissaving but rather the fight against it.
Once you get this point and extrapolate it to the issue of global imbalances and the convergence of the global age transition towards a, so far, unknown end point you should realize the tremendous mess we have to sort out. In fact, why don't I come full circle and finish off with a most recent quote from none other than Martin Wolf writing in his latest column;
Meanwhile, the eurozone as a whole, having lost its erstwhile internal demand engines, must now hope for faster growth of net exports. So do countries hit by the financial shock, such as the UK and US. So, too, does recession-hit Japan. So, not least, does China. Either the rest of the world has a spending binge, or these countries – which make up 70 per cent of the world economy – are going to be disappointed.
This seems self-defeating to me since there is no way that 70% of the world economy can rely on export driven recoveries let alone export driven growth strategies no matter what kind of binge came upon the rest of the world. Still, I completely agree with Martin that this is indeed the issue. And once you overlay this argument with some basic intuition of how demographics affect savings, consumption and investment you end up with the fundamental challenge for the global economy in terms of staging a comeback from the economic crisis.
So yes Virginia, demographics do matter!
 - Click on pictures for better viewing
List of References
Data for this piece can be obtained by mailing me and I will ship over my excel sheets. However, for those of you who want to check it out yourself here is the database on the corporate balance sheet data and in terms of household data you can get it from the website of the Bank of Japan (search for "household" and you should be able to dig out the relevant files).
Baldwin, Richard & Taglioni, Daria (2009) – The Illusion of Improving Global Imbalances, VoxEU research article (14.11.09) http://www.voxeu.org/index.php?q=node/4209
Friend, Andrew (1985) - The Policy Options for Stimulating National Savings, Conference on Saving and Capital Formation: The Policy Options Philadelphia (May 1985)
Obstfeld, Maurice & Rogoff, Kenneth (2009) –Global Imbalances and the Financial Crisis: Product of Common Causes, Paper prepared for the Federal Reserve Bank of San Francisco Asia Economic Policy Conference, Santa Barbara, CA, October 18-20, 2009
Horioka Yuji, Charles (2009) - The (Dis)saving Behavior of the Aged in Japan, Discussion Paper no. 763 The institute of Social and Economic Research Osaka University
Mason, Andrew (1988) - Saving, Economic Growth and Demographic Change, Population and Development Review, vol. 14 no 1 pp. 113-114
Nakagawa, Shinobu and Shimizu, Tomoko (2000) - Portfolio Selection of Financial Assets by Japan’s Households, Why Are Japan’s Households Reluctant to Invest in Risky Assets? BOJ Research Paperfff
Nakagawa, Shinobu and Yasui, Yosuke (2009) - A note on Japanese household debt: International comparisons and implications for financial stability, BIS Paper no. 46
Obstfeld, Maurice & Rogoff, Kenneth (1996) – Foundations of International Macroeconomics, MIT Press
Wolf, Martin (2009) - The Greek tragedy deserves a global audience, FT column January 19, 2010
Wolf, Martin (2009) - What we can learn from Japan’s decades of trouble, FT column January 12, 2010