Major economies

On current trends, Japan’s gross domestic product will grow faster than that of the US over the next 10 years. As Japan’s population is expected to fall and that of the US to rise, the relative improvement in living standards will be even greater. This will be denied by many economists and journalists, for whom Japan’s relative weakness is an item of faith.

The habit of looking at the change in GDP and assuming that this provides a good guide to the success of an economy is to blame for the prevalent view. It is a deeply embedded and near-automatic assumption that has blinded commentators to Japan’s relative economic success. In the recent past, demography has posed a far greater challenge for Japan than for other G5 countries but that has now changed. If, in other respects, Japan can maintain its past progress over the next 10 years, then the improvement in its demographic balance will boost the growth of its GDP and its living standards. Read more

The dramatic expansion of central bank balance sheets as a result of quantitative easing produces two extreme views. One is that it will cause hyperinflation and the other that it has had no adverse consequences. Neither of these strikes me as at all probable. Hyperinflation is not a serious risk, at least in the developed world, but it does seem likely that QE has adverse consequences. Having instituted QE, central banks are understandably unwilling to talk about its dangers and adjust their policies for them. However, it has probably increased the risks of a pickup in inflationary expectations and the dangers that this poses for the economy.

As chart one shows, we have had an upward sloping yield curve for the past 80 years, i.e. borrowing through issuing bonds has been expensive. Governments have nonetheless chosen to fund this. If this wasn’t just a stupid decision, then the added cost of funding must have produced a large benefit for the economy. I think that this benefit was real in that it helped to moderate inflationary expectations. Read more

There is a widespread belief that “labour is steadily losing out to capital”. This was, for example, the title of an article in The Economist last year (4 October). With the important exception of the US, the data show this to be a myth.

The ratio of labour incomes to gross domestic product is commonly used to justify the claim. This has several faults. First, the data do not support it, as there has not been a general decline in the labour share of GDP. Second, the fluctuations in the labour share of GDP are not matched by compensating changes in the profit share. Third, a serious look at the issue would use another approach and consider whether labour has lost out to capital in their share of corporate output. Read more

Usually the Fed waits too long before raising interest rates. The pressure to delay is particularly strong today. One reason is the sharp decline in the trend growth rate of the US. As I have pointed out in these blogs, this is the result of a sharp fall in the growth of the population of working age and in productivity. In the decade prior to the financial crisis (1997 to 2007), the numbers in the US of those aged 15 to 64 grew at 1.38 per cent per annum and is now forecast to rise over the next decade at only 0.18 per cent per annum (chart one).

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Conventional wisdom, those wrongheaded comments that sound authoritative, is flourishing. Much comes from seeing gross domestic product as the measure of economic success. As Japan’s GDP has grown slowly this has led the unreflective to assume that the country’s performance has been poor. As readers of this blog will know, this seems to me to be nonsense. GDP is a fair measure of a country’s economic power, but changes in GDP per head provide a better guide to the progress of a country’s welfare and GDP per person of working age is a better guide to the success of economic policy. The number of Japanese aged 15 to 64 has been falling and this has limited the country’s ability to expand its GDP. If the changes in GDP per person in major developed countries are compared, Japan stands out for its success rather than its failure.

I am by no means alone in pointing this out; the former Bank of Japan governor, Masaaki Shirakawa has also regularly done so. Judging, however, by comments in the financial press we seem to have been talking to brick walls. The damage done from seeing GDP as a valid measure of economic success has been magnified by an association that is commonly made between low growth and deflation. It is widely believed that Japan’s economy has performed poorly and that this has been caused by deflation. It would be more reasonable, though not much more, to praise deflation for the relative success of Japan’s economy. Read more

Quantitative easing involves buying bonds and this increases the Bank of Japan’s assets and the monetary base which, depending on the precise definition used, is nearly the same thing. As a result of the BoJ’s aggressive QE policy, its balance sheet has grown from 30 per cent of gross domestic product at the end of 2012 to 60 per cent at the end of 2014. Over the past year it has grown relative to GDP by 14 per cent (chart one). This compares with a fiscal deficit of around 8 per cent of GDP. Japan’s central bank is thus buying more than 100 per cent of the securities issued by the government to finance the deficit. Read more

Japan’s national accounts show that non-financial business has been a net lender to other sectors of the economy at an annual rate of 7 per cent of GDP since 2009. The accounts on an income basis are published much later than those based on expenditure data and the latest we have for the former have only recently become available.

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In my last blog, I showed that the trend growth rate of the US indicated by its Incremental Capital/Output Ratio (“ICOR”) was only 1.6 per cent per annum. As the US population is likely to grow at 0.8 per cent per annum over the next ten to twenty years, this would allow gross domestic product per head to rise at 0.8 per cent per annum. As chart one shows, this is well below the post-war average and is almost identical to the growth achieved over the past ten years. Continuation of recent growth would probably disappoint most expectations.

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Bad policies breed even worse ones. The disillusionment of voters provides the link. Disappointment with the economy is reinforced by the conviction that “‘They’ don’t know what they are doing.” Voters want new policies and new people. Sadly, this does not usually produce sound policies advocated by those who have correctly analysed the faults of the past. Realism seldom offers the instant gratification sought by the disgruntled, and populist policies thus usually represent a retreat from reason rather than a rise in analytical rigour. When countries have embraced populism, the resulting policies have habitually made matters worse.

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Financial crises commonly arise when there is too much debt and asset prices fall from excessive levels. Examples are to be found in 1929 in the US, 1999 in Japan and 2008 worldwide. Hyman Minsky, in his famous book Stabilising the Unstable Economy, set out the three stages in the pattern of borrowing that involve increasing risk. It starts with borrowers expecting to be able both to pay the interest and to repay the principal from the cash they expect their investment to generate. In the next stage their hopes are limited to paying the interest and refinancing the principal when the repayment falls due. In the final stage not even the interest is expected to be covered and the expected profit derives solely from the hope of being able to sell the debt financed asset at a profit. When continually rising asset prices cease to be an article of faith, the house of cards collapses.

There is then a rush to sell assets which sets off a recession, as borrowers seek to repay their debts. Companies which wish to reduce their borrowing don’t just avoid new borrowing — they seek to repay their existing debt. To do this they need to generate cash. This means spending less than they earn, and their intentions to invest then fall short of their intentions to save. The attempt to improve private sector balance sheets can therefore be described as a balance sheet recession, whose severity can be moderated as fiscal deficits cause the balance sheet of the public sector to weaken, offsetting the negative impact that comes from the strengthening of private sector balance sheets. Read more

Since the financial crisis, growth has slowed in the developed world. It is often assumed that this is an example of cause and effect. I showed in my previous post that this assumption is improbable, as much of the slowdown is the result of changes in demography — changes which are themselves largely the result of birth rates, which predate the crisis by many years. The other major cause of the slowdown has been a decline in productivity. Taken together, demography and productivity appear responsible for a minimum of 79 per cent of the decline in growth among the five developed economies I focused on — the US, UK, France, Germany and Japan.

Increases in productivity usually require investment in new equipment, but the extent of any productivity improvement will depend not only on the amount of the investment, but also its effectiveness. Where investment declines, a fall in productivity is likely unless the change is offset by a rise in the efficiency of new capitalRead more

The worst postwar recession has been followed by weak growth. It is readily assumed that this is cause and effect. Such an analysis is both wrong and damaging. If the weak recovery is due to the recent recession, then its causes must be short-term rather than structural. This belief is behind the frequent calls for more fiscal or monetary easing and the resulting failure to discuss, let alone address the deeper structural problems.

Periods of slow growth can be caused by insufficient demand or insufficient supply. If demand is the problem, the resources of the economy are not being fully utilised. But, if supply is the constraint, then those resources have not been growing fast enough. Read more

Japan’s economic policy is a battle between those who want inflation, on one side, and the fiscal hawks on the other. Prime Minister Shinzo Abe’s decision to hold a snap election suggests that the inflationists, of which he is one, are currently winning. The market rose on the news of the election, so it seems that investors believe that inflation would be good for both share prices and the economy.

Inflation, as measured by annual changes in the consumer price index, is currently well over 2 per cent. But according to the Bank of Japan, prices for producers are actually falling relative to three months ago, after the effects of this year’s consumption tax increase are excluded. The central bank goes on to state that this is a reflection of declining prices for international commodities, and that the annual rate of increase for consumer prices is just 1 per cent after fresh food is removed from the calculations. Read more

Japan’s gross domestic product shrank in the third quarter of 2014 at 1.6 per cent per annum over the quarter and 1 per cent over the previous 12 months. This disappointed the stock market, which fell by more than 2 per cent. It then recovered almost fully the next day on the news that Prime Minister Shinzo Abe had called a snap election, designed to give him a mandate to postpone the increase in consumption tax otherwise due in October 2015.

Governments can boost demand by increasing expenditure or by cutting taxes. Disappointing GDP data do not therefore provide much reason for gloom unless the government appears unwilling to boost demand or the data reflect a problem of supply rather than demand. Read more

Japan cannot put its economy on to a sustainable path unless it reforms its corporation tax system. Fortunately, this is now under active discussion. Unfortunately, it is far from clear that the right changes will be made.

One sector of the economy cannot lend unless another borrows. The sum of the net lending and net borrowing in an economy must therefore equal zero. Japan’s government is a huge borrower and, if this is to be brought down to a sustainable level, the net lending of other sectors must come down by an equal amount. As chart one shows, it is the corporate sector which has moved into massive cash surplus since 1988, when Japan’s fiscal balance moved into a structural deficit. It is therefore the corporate sector which must take the brunt of any fall in government borrowing through a similar decline in the sector’s net lending. Current tax arrangements and regulations are the key cause of the massive cash surpluses run by companies which must be brought down if the fiscal deficit is to be reduced to manageable proportions. Read more

In two earlier blogs I explained why the cyclically adjusted price earnings yield (Cape) could not sensibly be applied to valuing Japanese shares. (One of several reasons is that Cape is only valid if profit margins are mean reverting over relatively short periods of time, such as 10 years or so, and this has not been the case in Japan.) This does not mean that they cannot be valued by other means. In this and the next blog I attempt one possible way to do this. Read more

The eurozone’s economy appears to have stalled. It was widely expected that growth would pick up to 1 per cent this year, but these estimates are now being toned down as the first two quarters of 2014 have been below expectations. The pattern shown in chart one (below) is, at best, one of stagnation. It is therefore agreed with near unanimity that the eurozone’s economy needs a boost.

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According to an article in The Economist on August 2, “economists trying to explain the feeble pace of America’s recovery regularly blame deleveraging”. This raises two questions: can the US recovery sensibly be described as feeble and, if it can, is deleveraging to blame? Read more

The UK has a seriously unbalanced economy, with little spare capacity and a slow trend rate of growth. To correct its imbalances, the current account deficit and the cash flow surpluses of the corporate sector need to fall. This would permit a fall in the fiscal deficit, but requires a fall in the real exchange rate and in the share of consumption in gross domestic product.

The fall in the trend rate of economic growth comes from a combination of a slower growth in the population of working age and a drop in productivityRead more

In the past governments have funded their deficits – for example, they have borrowed in the bond market rather than through treasury bills. This is despite the fact that, for the past 80 years, the rate of interest on bonds has been greater than that on Treasury bills; that is, we have had an upward sloping yield curve.

I suggested in a recent blog that this was because governments correctly perceived that there were considerable economic risks in not funding, and that it was worth paying the additional cost to avoid these risks. Quantitative easing, which is a form of underfunding, must therefore have increased these risks. Defenders of QE need either to argue that these risks have not risen or that the benefits we have received from QE outweigh the rise in risks. To be consistent, those who hold that no additional risks have been incurred must now hold that governments should not have funded in the past and must now stop. But their silence is deafening, and such views are implausible, being held, I think, in the hope of dissuading discussion rather than from any conviction that they would survive much debate. Read more