The Great Japan Debate

by: Macro and Cheese

I've been hoping to see Japan pull itself out of its slump for a long time. My wife and in-laws are Japanese, my children carry Japanese passports. I spent a dozen years there, most of that time active in the Japanese markets. I absolutely love the country. So you can imagine how pleased and intrigued I was to learn from my wife that the New York Times had run a long article titled "The Myth of Japan's Failure."

My excitement didn't last long. The author, Eamonn Fingleton, cites a number of points that have nothing to do with Japan's economic health. Japan's life expectancy rising by 4.2 years from 1989? Advances in internet infrastructure? More skyscrapers? Strength of the yen? A growing trade surplus? A 4.2% unemployment rate?

It's hard to see how any of those factors, or any of the others brought up by the author, are true signposts of Japanese economic vigor. The US life expectancy has risen by more than five years over the same period, and we're hardly a bastion of growth. Does anyone on the planet not have internet? Yes, Japan's skyline is increasingly punctuated by skyscrapers, but that's more a function of new earthquake-proof technology and population density than anything else. And besides, if you can't pick up a few buildings for your $11.5 trillion in deficit spending, what can you buy?

Truth be told, a strong currency and increasing trade surpluses are more symptoms of an export-dependent economy than they are a sign of health. In fact, the government has been fretting over the price of its currency for years, and well they should, because the currency is frightfully expensive. The OECD estimates that based on purchasing power parity, the yen is 54% overvalued, meaning that the same $100 jacket in the US costs $154 in Japan.

Japan has intervened to sell the yen rarely in recent years, not because it doesn't want to, but because it can't. This predicament is due to Japan's current account surplus. It is ironic that a country infamous for a debt to GDP ratio in excess of 200% now owns more than $1 trillion in US treasuries, generated by its trade imbalance. To correct this absurdity, Japan would like nothing more than to sell off its T- bonds, but it cannot, because that would mean selling dollars to buy yen. This transaction would make the yen even stronger and aggravate the competitive burden Japan's exporters already face.

Indeed, some of Japan's exporters have been throwing in the towel. Faced with a stronger yen, Honda Motors (NYSE:HMC) recently announced that its luxury sports car, the NSX, would be produced in our very own Ohio. The sleek competitor to Ferrari is Honda's highest end, one step down from its Formula Ones, built not in a state of the art plant in Japan, but in cheap-labor Ohio, thanks to the dollar's bargain price compared to the yen. This will be great for jobs in the US-but for Japan, not so much.

And that leads us to Japan's fabled unemployment rate. The latest reading was 4.5% and rising, still low by our standards, but then, the rate of the two countries are apples and oranges. According to the BLS, the US government organization that computes the US unemployment rate, the main difference is due to the tendency for women who lose their jobs to exit the labor force, rather than try to look for a new job. The BLS also cites the large number of temporary workers that are not considered to be employed and are therefore not "unemployed" when their positions are eliminated. The BLS concludes by saying that "a more broadly defined rate which takes these other elements of underutilization into account increases the Japanese rate beyond that of the U.S. rate."

We can't forget that Japan is the country that prided itself in "lifetime employment." That noble goal is a thing of the past, but there's no question that Japan does everything it can to avoid laying off its heads of household, the population that makes up the vast majority of its employment survey. Japan's unemployment rate bottomed at 2% during its boom in the '80s, and has peaked at 5.5% twice, during the past decade. The rate stands only 1% below that peak, and no one would argue that Japan's 20-year economic turmoil has been anything less than wrenching.

But the real story is the phenomenal onus of debt that has accumulated after two decades of Keynesian government stimulus spending. This strategy has allowed Japan to avert a major depression so far, but the can has been kicked so far down the road that the country is now at a dead end. To make matters worse, the predicament that Japan is facing is severely exacerbated by demographics. Beginning three years ago, Japan's population has literally begun to shrink, and with each woman bearing just 1.3 children, this trend will only accelerate.

In a crisis defined by debt to GDP, Japan is caught in a vice. Not only is debt continuing to rise, but also there will now be pressure on Japan's GDP to fall. It's not that Japan isn't capable of producing things, it's that there will be less people to produce them. That means that the debt burden per capita will continue to rise, along with the need for the working-age population to support the fast-growing number of elderly.

The Japanese are hard-working, cooperative, resourceful, and highly competent at producing things. A country that can come through a world war and completely rebuild in a single generation is surely able to work its way out of its current situation. But given the scope of the debt problem, Japan's righting itself is not a question of months or years, it's a matter of decades, and unless the Japanese start having a lot more children, it will take more than a few of those.

Disclosure: I do not currently maintain any positions related to Japan and have no plans to initiate any Japan-related positions within the next 72 hours.