The Japanese Earthquake and the Broken Window: Investment Implications

Includes: CAT, DXJ, F, VALE
by: Philip Mause

When I was in Junior High School, we used to play softball wherever we could, and one afternoon I hit a line drive which broke the window of a neighbor's car. I bravely fessed up and then did something really stupid. I had read something in the newspaper about economics and so I tried to put a good face on it by explaining to the neighbor that the broken window would actually help the United States economy by employing glass makers, window repairers, insurance adjustors and so forth. Unfortunately, I cannot provide you with the precise response I received because it would violate various guidelines this website imposes against the use of obscene language. However, I can assure that my foray into macroeconomics did not make me any new friends.

Before I go any further, let me express my sympathy for Japan and its people. I was the beneficiary of their generous hospitality when I traveled there in the early 1990s, and I hope they will emerge from this disaster with the resilience they have always exhibited. I will seek out ways in which to offer assistance as our nation should and as we each should as individuals. This has been a tragedy and the human suffering has been and continues to be terrible.

Economic analysts are trying to determine exactly what a disaster of this kind means in terms of economic growth, currency markets, etc. and it strikes me that we are, in some ways, back to the parable of the broken window. Frederic Bastiat was, I think, the first to think this problem through. His insight was the shopkeeper whose window was broken would, of course, replace it and that replacement would, of course, create economic activity, but the argument that broken windows create economic growth was a fallacy for a very important reason. If the window had not been broken, the shopkeeper would have had more money for other things and might have bought an extra chair, a necklace for his wife, a new sport coat, or any one of a number of other items which he, now, would not be able to buy because of the need to spend money replacing the broken window.

Bastiat's analysis assumes, of course, that, if the window had not been broken, the shopkeeper would have spent the amount necessary to fix the window on something else. Of course, this is not necessarily the case. Depending upon the shopkeeper's marginal propensity to consume, it is possible that, in the absence of the broken window, the shopkeeper would have saved all or most of the funds necessary for the repair. A similar analysis can take place on the production side. If all glassmakers are operating at full capacity, then the shopkeeper's order will merely displace another order and will not lead to the production of more glass. But if there is slack in the glass industry, then the order will likely increase production.

So, what is likely to happen in Japan? The Japanese economy has enormous slack and its citizens have a very high marginal propensity to save. The government already has an enormous debt load, but the yen has appreciated in value to the point of threatening export trade and deflation has been a concern. It is almost inevitable that the Japanese government will make an enormous expenditure on reconstruction and that the Central Bank will, if necessary, monetize a large portion of the additional debt the government will have to incur. Japan will have to import considerable quantities of construction materials or the raw materials necessary to make cement, structural steel, etc. Japan's net exports will almost certainly decline as it imports more and as more of its economic activity has to be devoted to reconstruction rather than export production.

The yen is likely to decline for all of these reasons, and Japan will finally start to experience some inflation. After a period of uncertainty, the Japanese situation as well as the ongoing EuroZone sovereign debt problem will lead the dollar to appreciate as "the last man standing" in a room where everyone else has either passed out, tripped and fallen, or crawled into a fetal position. US companies that compete with Japanese automakers, construction equipment makers, steel producers, etc,. will pick up sales in Japan, in the US because of reductions in Japanese exports or elsewhere in the world by displacement. Oddly enough, after a period of disruption, Japanese and world GDP will be higher because some money that would otherwise have been saved will be spent and some capacity that would otherwise have been unused will be put to work. The stronger dollar will put a brake on inflation and will encourage the Federal Reserve to keep rates low. It will be harder to get the Chinese to revalue because the stronger dollar will make it harder for them to export to other parts of the world.

The investment implications are bullish for construction related raw materials (NYSE:VALE) and for Caterpillar (NYSE:CAT) and other construction equipment manufacturers. In addition, Ford (NYSE:F) and other automobile manufacturers will benefit as Japanese car makers have to focus on replacing cars destroyed in Japan. The scary problems with the nuclear reactors will probably give the coal and natural gas industries a boost in the competition as a source of base load electric generating capacity. Because all of this is happening at a time of slack capacity utilization, it will tend to boost world GDP considerably.

Disclosure: I am long F, VALE.

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