Senior Executive Fellow
During the year following the introduction of Bank of Japan Governor Kuroda’s “Quantitative and Qualitative Monetary Easing,” the two greatest miscalculations made by many private sector economists were that the trade deficit increased significantly despite marked yen depreciation, and that consumer price increase was unexpectedly large. In fact, the Nikkei Center’s ESP survey, which agglomerates economic outlooks made by private sector projection institutions, shows that over 70% of institutions predicted in March of last year that the trade account balance would “move into the black within a few years,” but by March of this year the survey’s responses had changed, such that two thirds opined that the balance “would not move into the black in the next few years.” Furthermore, the average estimated rate of consumer price increase (excluding fresh foods) was corrected upwards significantly during the same period, from 0.3% to 0.8%.(*1)
Let us look first at the increase of the trade deficit. As I have pointed out in a previous opinion piece, “exports will not grow despite the cheap yen” for three reasons: 1) the global economic recovery remains sluggish; 2) even with a somewhat depreciated yen, the outflow of Japanese companies’ production to overseas bases will not change; and 3) some industries have lost their global competitive edge. However, exports have remained even weaker than I had predicted, and so a supplementary explanation is called for. First, while the global economic recovery is rather sluggish, the recovery of capital investment stands out as being particularly so. This has a very adverse effect on a capital goods exporting country like Japan. Second, in the past Japanese companies’ overseas expansion resulted in the increased exports of capital goods and parts to their overseas bases (so-called “induced exports”), which meant that overall exports did not decrease very much. This time, however, there is not much induced export to be seen. The quality of parts and machines which can be locally procured is increasing, and local contents are rising significantly. This can be understood to mean that Japan’s globalization has proceeded to the next level.
Third, as we can see in Figure 1, the trade account balances by industry show that while increased imports of mineral fuels due to nuclear power plant stoppages caused large deficits in the trade balance, we also see that exports do not increase significantly despite the weak yen (NB: this figure is yen-based, and so exports are bloated due to the cheap yen). In particular, transportation machinery and electronics, which at one time were known as Japan’s two large exporting industries, are struggling, with the latter seeming to have a declining trend. It goes without saying that this reflects the weakening competitiveness of Japan-manufactured electronics typified by flat-screen TVs and smartphones. We must face the fact that one of Japan’s two large export industries is not increasing exports despite the weak yen, and in fact imports are increasing, and this will affect the economy significantly. (*2)
Turning to look at rising consumer prices next, the greatest factor pushing up prices is of course the rise in energy and food prices due to the cheap yen. This effect should have been clear to anyone, however, and it is not an excuse for private economists to claim it “exceeds predictions.” While it is true that the yen depreciated even further after March of last year, when the yen hit the $1 =100 yen mark due to quantitative and qualitative monetary easing, the June ESP survey showed an outlook of prices rising 0.3% in 2013, and therefore the cheap yen alone cannot explain the observed price increase sufficiently. Economists were unable to predict that consumer price excluding food and energy would increase steadily as well (+ 0.8% as of February, 2014).
Is this what the Japanese government and BoJ call the “manifestation of momentum to escape deflation”? Based on the fact that rising price categories outnumber falling price categories, this may just be the case (although, compared to rising crude prices, yen depreciation affects more item categories). However, looking at the change in CPI (Figure 2), what is most surprising is the positive year-on-year contribution of durable goods, including high tech products such as TVs and computers. Back during Japan’s reign as the world leader in electronics, those prices pushed down CPI markedly, reflecting the increased productivity of high tech products and harsh price wars. With an increased share of imports among electronic products, yen depreciation is now pushing up the prices of consumer durables.(*3) This overlooked structural change goes a long way toward explaining economists’ predictions missing the mark.
Based on these changes, the cheap yen had a greater impact on consumer prices than past heuristics show, and there is likely a longer time lag as well. In that case, even without further yen depreciation consumer prices should continue to increase year-on-year at more than 1% (not counting the effect of consumption tax increase) for the next while.(*4) These two surprises, i.e., faltering exports and rising consumer prices, seem to have conflicting effects on the success or failure of Abenomics, and it turns out that they were two sides of the same coin, i.e., the decline of the Japanese electronics industries. Therefore, while the undercurrent of yen depreciation, Abe’s emphasis on “bold monetary easing”, and BoJ Governor Kuroda’s unexpectedly successful “quantitative and qualitative monetary easing” may have been triggers, two significant structural changes were underlying everything: the effects of the decline of Japan’s industrial competitiveness and the tide of the trade balance receding into the red.(*5)
The above facts have already appeared in the data, and other experts have expressed views similar to mine in their writings. However, if the above two points are accepted as a consequence of the decline of Japanese electronics, a third hypothetical and unfortunate conclusion would rise to the surface: the potential growth rate of the Japanese economy will continue to fall even further.
Known as growth accounting, economic growth can be divided into contributions due to labor input, capital input, and other factors affecting productivity, i.e., total factor productivity, or TFP. With Japan’s declining population, labor input cannot be easily increased (though higher labor participation of women and the elderly will certainly help), nor can capital input increase in the short run (given how unproductive Japan’s capital is, the merits of such increase are dubious to begin with), and focus should be placed on TFP. Among major industries, electronics has made the biggest contribution to raising TFP over the years (automobiles have been extremely competitive globally, but their TFP increase has been unexpectedly small). Figure 3 shows TFP increase rate during 2000-2010 taken from the JIP database, which was developed by professors Fukao of Hitotsubashi University and Miyagawa of Gakushuin University. The graph shows that the electronics sectors have overwhelmingly high TFP increase rates. (*6) There is no current TFP data by industry available, but based on the trade conditions, it is easy to infer that the TFP increase rate of electronics has likely fallen significantly.
While public spending, as the second arrow of Abenomics, is seeing a marked increase and is helping lead the Japanese economy out of the doldrums, what we should be paying attention to is the fact that construction has always been an underachiever when it comes to productivity.(*7) Putting these two facts together, Japan’s potential growth rate, which was said to be around 0.5%, may have the rug pulled out from under it as the TFP falls. As collateral evidence of this, although Japan’s real GDP of Oct-Dec 2013 was only slightly lower than its peak before Lehman Brothers crashed (Jan-Mar 2008), Feb 2014’s unemployment rate was 3.6%, equal with the lowest point of that time period. Had potential GDP been increasing steadily during that period, the supply-demand gap would have widened at the same GDP level as six years ago, and the unemployment rate should have increased. The fact that this did not happen implies that potential GDP barely increased at all.(*8)
Even if this hypothesis were correct and a good environment for escaping deflation were available—with a shrinking supply-demand gap despite low growth and the possibility of rising prices—this cannot have been the true intent of Abenomics. I am particularly concerned about the sustainability of the government budget. Despite the government’s stated goal of bringing the primary balance into the black by 2020, in January of this year, the government mind-bogglingly admitted that it would not be able to meet its own goal according to its own estimates, writing in the Mid- to Long-term Estimates of the Economy and Budget that even in an “Economic Revival Case” the primary balance in 2020 would have a 2% deficit relative to nominal GDP. Furthermore, this case is based on the ultra-optimistic assumption of achieving more than 2% real GDP growth in most years as well as a consumption tax hike to 10% in October next year. Recalculating with more realistic assumptions, the deficit will certainly be even larger.(*9) If that is the case, then instead of putting off the tax hike and relying on public works, Abe should fire his third arrow of growth strategy immediately and push forward in the direction of increasing Japan’s potential growth.
1) Meanwhile, the outlook for fiscal 2013 real GDP growth rate was raised from 2.2% in March 2013 to 2.8% in August, but it was again revised down to 2.3% in March 2014; things had essentially gone as predicted.
2) Figure 1 combines the customs data of electronics devices with those of “computing devices (peripherals included)” and “computing device parts”, both of which are categorized as “general machines”, and gives them all the broader definition of “electronics.”
Large electronics manufacturers showed significant improvement in performance during FY2013, this was a result of the benefits of yen depreciation and the following measures: (1) placing focus on social infrastructure businesses such as heavy electrical machinery; (2) placing focus on service sectors such as solution business; (3) cost-cutting through severe restructuring.
3) In the past, TVs and computers fell by more than 20% annually as a matter of course. As a result, durable goods’ contribution to consumer price often reached -0.3 to 0.4%, but since Japan’s “deflation” has averaged less than 1% over the past 15-plus years, most of it was due to the fall of durable goods.
In the February 28th edition of the Nikkei Shimbun, the Nikkei Center’s Nobuyasu Atago pointed out in the “Economics Classroom (Keizai Kyoshitu) ” column that consumer prices (including imported goods) of PCs and TVs were rising faster than domestic producer prices (domestically produced goods only), which suggest that the cheap yen has a great impact.
4) The effect of exchange rates on consumer prices can have a different time lag depending on the item category in question. For example, the effect of exchange rates and crude oil prices on gasoline is almost instantaneous, whereas the effects of government resale price regulations on imported wheat had a half-year lag for foodstuffs. Durable goods can have an even longer time lag.
Before coming to this realization, I believed that the year-on-year increase in consumer price would hit its peak at the beginning of the current year. These days, many say that expectations of early additional monetary easing in the financial market are receding (by the beginning of this year, many anticipated additional easing to take place in January or February), and these shifts in prices are the underlying cause.
5) The turning point of the exchange rates was November 2012. Around that time, the concern over the European debt crisis had started to subside, and the market’s relief led to the yen’s depreciation. As it happens, the Japanese yen is backed by monolithic net external assets and is considered in the international financial market as a safe asset. For this reason, when market nervousness is on the rise (in market parlance, “risk off”), the yen is bought en masse and becomes appreciated. Conversely, when nervousness wanes (“risk on”), the yen is sold and the currency tends to depreciate.
6) Because, unlike the US, Japan’s ICT revolution has not brought improved productivity to user industries, performing a TFP breakdown results in the producer of ICT, i.e., electronics, standing head and shoulders above the rest. For more details, refer to Tsutomu Miyagawa “Japanese Economy’s Productivity Innovation” (Nikkei Publisher, 2005) and Kyoji Fukao “20 Lost Years of Japanese Economy” (Nikkei Publisher, 2012).
7) This was seen most clearly in the 1990s, when large-scale public investment was undertaken as an economic stimulation measures. At the time, the correlation between per capita GDP and per capita public investment by prefecture was clearly in the negative, and public investment was being used as a means of income redistribution. An increase in public works should of course cause an increase in construction jobs, but construction had the lowest labor productivity growth among major industries. The poorer the region, the more public works it received, which resulted in it falling into the “public investment trap” and becoming even poorer in the long term.
8) Common sense, as well as the employment DI in the BoJ’s Tankan report, would tell us that 3.6% unemployment is essentially full employment. Even so, according to the Cabinet Office’s estimate there was 1.6% oversupply to GDP in October to December 2013 (before Lehman Brothers there was overdemand). Of course, if we get particularly picayune, there are likely issues of labor participation rates and working hours, but essentially this means that capital stock is in oversupply. However, I suspect that their calculation includes facilities closed down during the Lehman shock and nuclear power plants which cannot easily be restarted, thereby leading to overestimation in potential GDP.
9) For a country which has a labor population decreasing by 1% every year, a goal of real 2% growth is incredibly challenging. The truth is that there is no advanced economy which sustains an increase of more than 3% labor productivity annually. Of course, with a supremely effective growth strategy, 2% growth is not absolutely impossible, so I won’t criticize the government for setting its aim high. However, as professor Takao Komine of Hosei University asserts, “goals” and “assumptions” are entirely different things. It is fine for an employee to dream of becoming CEO one day, but living a CEO’s lifestyle on the assumption that a CEO’s paycheck is in the offing will only lead to an early bankruptcy.