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This article deals with the economic impacts of the earthquake in Japan. There are enough sources on the web that deal with the destruction and loss of life. We wish the people of Japan well in this difficult time.

Japan is having a grave crisis and the Bank of Japan (BOJ) announced that it will provide "massive" liquidity to the banking system in order to assure citizens and the international community that the crisis will remain one of massive damage and not massive deflation.

This response is similar to what they did in the Kobe earthquake of 1995. Then, the economy continued to be deflationary as the government spent massively (¥2.7 trillion) to rebuild. The yen rose 21% in the three months after the event. The reason it rose is that Japanese investors repatriated assets in order to fund rebuilding. The same should happen now.

The problem for Japan is that they have been providing substantial stimulus, monetary and fiscal, yet today their economy still remains somewhat "deflationary." They have been trying to inflate for some time. Here is a look at their money supply and bank credit growth (from Michael Pollaro of The Contrarian Take):

(Click to enlarge)

(Click to enlarge)

As you can see from these charts, money supply (green line) has grown substantially since 2008 yet bank credit has been largely flat, perhaps just starting to grow. This is not what is supposed to happen. They were supposed to have growth and inflation. In fact this was not supposed to happen here either, but it has. Japan is "different" from the U.S. but money and credit expansion and fiscal stimulus have largely achieved the same results.

So what does a government do? The BOJ achieved its immediate goal of providing the cash that they expected businesses and individuals would need post-quake and pre-rebuilding. The government is talking about another massive rebuilding effort which will be financed through deficit spending, thus further increasing national debt as a percentage of GDP (currently the highest of any first world economy).

The short-term impacts of this tragedy do not look good for Japan. The shutdown of many of its nuclear reactors are resulting in rolling blackouts which will affect industrial production. According to the latest reports this has implications throughout the economy as large manufacturers shut down plants. It isn’t clear that other energy producers will be able to make up the required supply of energy. Because the supply chain in Japan is tight, this will have a multiplier effect that will work its way through their economy. We will have to watch and see if their low capacity utilization can take up the manufacturing production slack. It depends on the availability of power.

The 1995 Kobe earthquake didn’t seriously impact the economy in 1995 ($102.5 billion in damage, 2.5% of Japan’s GDP at the time). The next year was a negative year, and I suspect the debt incurred to rebuild Kobe and a wind-down of government spending had something to do with that, but I can’t confirm that at this time. Here is the historical GDP:

(Click to enlarge)

It appears that in 1995 most property owners in Japan didn’t have earthquake insurance (3% in Kobe and 16% in Tokyo at that time). According to an article this morning, Boston-based AIR Worldwide estimated the quake caused insured property losses of $15 billion to $35 billion. "They estimated about 10% to 12% of commercial property exposures are insured against earthquakes outside of Tokyo. AIR’s number doesn’t yet include estimates for the loss caused by the tsunami. But on Saturday, AIR said it had examined prefectures most directly affected by the tsunami, and concluded that $24 billion of insured property had sat within three kilometers of the shore in those areas. Of that amount, $5 billion was within one kilometer of the coast."

So, who is going to pay for it? According to recent reports: the local governments and ultimately the national government. Look for massive deficit spending since the scope of this quake seems to be far greater than in Kobe. Then 6,000 people were killed and Kobe was a major port. According to the Wikipedia article, Kobe never regained its former status as a port. One wonders about the productivity of farmland inundated by the tsunami or businesses whose factories have been destroyed. It takes time to rebuild.

It is often said in the media that there is a silver lining to such destructive events because it will stimulate economic activity that would not have otherwise occurred. Some see that price inflation may be the result which is seen to be a positive thing.

Stepping up policy easing efforts may help accelerate the end of deflation in Japan, according to Edward Lincoln, a New York University professor who directs the school’s Center for Japan-U.S. Business and Economic Studies. Price pressures may already emerge as a result of a jump in demand for goods after the quake.

"If the Bank of Japan takes this opportunity to follow a somewhat more expansionary monetary, that would also underwrite a shift toward inflation rather than deflation," said Lincoln, who was an adviser to then-U.S. Ambassador to Japan Walter Mondale in the Clinton administration. "There’s no guarantee."

First, it is obvious that destruction is never a good economic event. What it means is that trillions of yen of valuable capital has been wiped out and is gone forever. The rebuilding will certainly "stimulate" economic activity for some, but the loss is permanent. This of course is Bastiat’s famous "Broken Window Parable." If such destruction was a good thing for the economy, then would not complete destruction be the answer to our economic problems? You know the answer to this ridiculous idea.

Second, more deficit spending by the government to rebuild will place a burden on many future generations of Japanese people. It can only result in greater taxation because as the younger generation birthrate is declining and the population of older generations is growing, the result can be higher taxation and (more) stagnation or inflation and stagnation which robs savers and eventually will lead to the equivalent of a monetary earthquake (destruction of the yen, also known as hyperinflation).

Earthquakes never happen at a good time. Massive government spending will give the appearance that GDP is growing (GDP just measures spending, not where the money comes from), but their economy will continue to stagnate. At some point the BOJ will face a dilemma. Perhaps that time is now. The problem is that their deficits have been funded by the savings of Japanese citizens. At one time they had a very high rate of personal savings, but today it is low (about 2% from 14%). At some point, the pool of savings will be tapped out by the government and they will have to monetize debt or sell BOJ bonds in the international markets. And those markets are getting crowded.

I do not wish to overlook the horrific devastation in terms of loss of life and destruction of property. They are also facing the possibility of a release of radioactivity in the atmosphere. It is a blow to them and to the rest of the world. These are difficult times. I wish them well.

This article originally appeared in The Daily Capitalist.

Source: Japan's Struggle to Recover