From: Observatory Group [mailto:observatory@observatorygroup.com]
Sent: 30 July 2010 00:41
To: Gulabani, Nitin Jethanand
Subject: Japan-US Analogue I: The Ghost of Japan Returns?
Japan—US Analogue I: The Ghost of Japan Returns?
Observatory View
Earlier this year, when market participants were talking about the Fed’s exit, we had a conversation with a senior BoJ official about widespread investor views that the US had successfully averted to become Japan. Pensively he said, “Let’s hope your clients are right. But personally, I would not be surprised to see you writing about the Japan analogue series again at some point. But let’s hope they are right…” Well, here we are!
In the most fundamental sense, turning Japanese means that private-sector economic agents, both corporations and households, permanently lower their expected nominal growth trajectory. And as they adjust their views on the country’s growth potential, they continue to shrink their balance sheet. Then, deleveraging continues until the economy finds a new and lower equilibrium. In this regard, most BoJ officials think that the US is not out of woods yet.
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The focus of the US economic policy has shifted from a possible Fed exit to possible additional stimulus. For BoJ officials, what’s happening in the US economy is just about what they have expected. They would say:
· The successful prevention of a great depression in the spring of 2009 has masked real challenges facing the US economy — until now. The doomsday scenario was misplaced; we all know how to avoid a great depression. Japan was able to avoid it. A relief rally, fine. But you will then have to come back to planet earth.
· The current debate of whether or not the US economy will fall into a double-dip equally lacks nuance. BoJ officials do not think that genuine recession dynamics — characterized by a massive adjustment in employment and inventory — will return to the US in the near future. A great depression vs. an easy return to the good, old days. Robust growth allowing the Fed exit vs. a genuine recession. Stop talking in these extremes.
· The real challenge for the US economy is more nuanced: The economy will likely continue to grow, but it may be able to fly only at much lower nominal growth rates due to the continued need for massive balance-sheet adjustments. Despite unprecedented levels of fiscal and monetary steroids, the US economy is not and cannot experience a V-shaped recovery. On the contrary, it is noticeably subpar. Meanwhile, Japan, which does not face the need of balance-sheet adjustments, is the fastest growing G7 country.
· And the longer the US fails to return to the previous nominal growth trajectory, the likelier it is that economic agents will permanently lower their nominal growth expectations. That in turn could create a new round of deleveraging, which could prevent the US economy from returning to the previous growth speed.
In the most fundamental sense, what is often called Japan’s “deflation problem” is a permanent downward shift in the expected nominal growth trajectory, rather than just price behavior. Stated more intuitively, expectations about something you feel in your skin, not a logical construct, are much lower than before.
· Unless an economy is experiencing an exogenous price shock (e.g., oil shocks), only economists care about the real growth rate. Ironically in the “real” world, every economic activity from mortgage loans to business investment is booked nominally. What matters to your business and mortgage payment is your nominal cash flow.
· Before the financial crisis visibly weakened nominal growth in 2008, average annual nominal growth rates in the US were about 5.5%. Interestingly, the rates for the 20-year period between ‘88 and ‘07, the 15-year period between ‘93 and ‘07, and the most immediate 10-year period between ‘98 and ‘07 are almost identical — at 5.6%, 5.5%, and 5.4%, respectively.
· It is safe to assume that corporations and households had become accustomed to nominal cash flows consistent with a nominal growth projection of about 5.5%. Obviously, the share of nominal growth accounted for by the GDP deflator (or inflation) was greater in the earliest years of the 20-year period compared to the later years, although the nominal growth rates were virtually identical.
· For this debate, let’s use the most recent 10-year period, which Greenspan proudly declared a “great moderation.” This is the period in which your real purchasing power was greater than the preceding 10 years. Although your nominal cash flow was the same as before, you could buy more things! This feeling helped create a grotesque financial imbalance.
· During this period, the average annual nominal growth rate was 5.4%, with the GDP deflator (i.e., inflation rate) at 2.4%. The remaining 3% is real growth. Consciously or unconsciously, this growth profile must have been the basis for every economic decision.
· Now, conceptually speaking, as the first lesson of ECON 101 says, the economy grows only for two reasons; a resource expansion (the labor force, in our example) and productivity gains. If one assumes that US labor force growth is about 1%, the nation’s conceptual productivity growth rate (not a nitty-gritty cyclical productivity rate calculated by economists) must have been around 2%.
· In a broad conceptual sense, US consumers and business leaders had conducted economic activity roughly in synch with a nominal growth profile of about 5.5%, which consists of about 1% labor input growth, 2% productivity gain, and 2.5% inflation. Every economic decision, from Starbucks opening a new coffee shop on a city block where it already had two other shops to your neighbor Tom purchasing a MacMansion and immediately equity-financing his new purchase of a Mercedes, was based on a nominal cash flow projection of 5.5% nominal growth.
· This nominal growth rate is consistent with a nominal labor compensation picture. According to the BEA’s broad income data, the average growth rate in nominal employee compensation over the same 10-year period is about 5.3%. (If you use the data’s nominal disposable income growth rate, you get 5.5%.)
· This basic growth profile has changed dramatically since Q1’08. The average nominal growth rate during the 9 quarters from Q1’08 to Q1’10 is only 0.9%. Imagine the shock as your cash flow shifts from a 5.5% pace to about 1%!
· During the last 9-quarter period, nominal employee compensation fell dramatically from the previous 10-year average of 5.3% to -2.2%. Due to the time lag, the peak of employee compensation was Q3’08, but it tumbled 4% over five consecutive quarters.
· Nothing even remotely comparable happened in the past two recessions of the early 90’s and the early 2000’s. Both nominal growth and employee compensation experienced mild decelerations, but they returned to the long-term average within a year or two.
Now, let’s compare these numbers with Japan’s experience in the early 90’s. Japan’s GDP growth started slowing in FY91, but things got really ugly in FY92.
· Japan’s average nominal GDP growth rate over the period between FY82 and FY91 was about 6%. The rough breakdown suggests 1% labor input growth, 3.5% productivity gain, and 1.5% inflation. Japan’s real growth rate was about 4.5% — noticeably faster than that of the US (i.e., 3%).
· Like the US, Japan’s average nominal compensation of 5.8% over the 10-year period was perfectly aligned with the nominal growth rate of 6%. In both cases, growth in labor compensation was supported by genuine wealth creation, not a large price shock.
· Like their American counterparts, both Japan Inc. and average Suzukis had become accustomed to the nominal cash flow consistent with 6% nominal GDP growth.
· Okay, this is spooky. Japan’s average nominal growth rate fell from 6% to 0.96% in the first 9 quarters after things got really bad in FY92. Remember that in the US, it fell from 5.4% to 0.85%.
· During the same 9 quarters, Japan’s nominal compensation did not fall as fast as that of the US. Still, it slowed significantly from 5.8% to 2.8%. Back then, Japanese companies were much more hesitant to inflict pain on their workers.
· The economy has started picking up by FY94, and the 3-year period from FY94 to FY96, the average nominal growth rate of Japan was only 1.8%.
This is what “Japan’s deflation problem” really means — a significant loss of nominal growth trajectory.
· Unless some other private sector replaces the lost nominal growth, a country’s expected nominal growth trajectory will be permanently lower. And in Japan, no one stepped up to the plate. As the time went on without the emergence of private demand with a multiplier equal to that of the past, Japan Inc. and average Tanakas eventually lowered their expected nominal cash flow.
· This in turn meant a prolonged deleveraging, which of course prevented the economy from returning to the previous growth rate. Recall that the growth model had been built on an assumption that economic agents would enjoy 6% nominal growth, but suddenly, it became only 1.8%.
· The prolonged balance-sheet adjustment does not have to be noisy and collapsing like a financial crisis. This boring picture of growth being relatively stable but constantly falling short of expectations is Japan’s “Lost Decade.” As Shirakawa said repeatedly, it is not a constant state of zero growth. Japan had several cyclical ups and downs, but it never returned to the previous level of nominal growth expectations.
· All in all, the conceptual nominal growth profile in the mid-90’s was dramatically different from that of the previous 10 years. If you continue this exercise into the present time, you get the picture in which Japan keeps losing its nominal growth trajectory.
82-91 period
Q1’92-Q1’94
Mid-90’s
Now
Labor
1
0.9
0.5
0
Productivity
3.5
-0.4
1.7
0.7
Deflator
1.5
0.5
-0.4
-0.7
Nominal growth
6
1
1.8
0
Many Japanese policymakers fear that unless there emerges some private demand which has a multiplier equal to that of the unrealistically leveraged financial industry and US households, the expected US growth trajectory will inevitably decline.
· No BoJ officials would ever put any numbers, but we can do things more liberally. Just for a thought. Would it be possible for the average nominal growth in the US economy in the future to be about half of what it used to be? Let’s say that labor growth continues to slow a notch. A mild deceleration of consumer prices continues, although it stabilizes around 0.5%. Productivity falls to half of what it used to be, as was the case in Japan during the period in the mid-90’s.
98-07 period
Q1’09-Q1’10
Future?
Labor
1
0.9
0.8
Productivity
2
-1.3
1
Deflator
2.5
1.3
0.5
Nominal growth
5.5
0.9
2.3
· We cannot emphasize enough that this is not a serious forecast; it is a hypothetical. We are suggesting these numbers so that you can feel what happened in Japan — just to provoke thought. Such a shift in the basic growth dynamics is what is casually called Japan’s “deflation problem.” BoJ officials feel that non-Japanese investors (and some policymakers) do not fully understand that the US economy may be facing a similar challenge.
· Look around. Do you see new private-sector demand with a turbo-charged multiplier emerging? To end this exercise in a more upbeat note, Japan’s nominal growth became less than one-third of what it used to be by the mid-90’s. In the US, it would be less than half of what it used to be, even if the US turns Japanese…
Bottom Line:
BoJ officials did not think that the US would fall into a doomsday scenario. They do not think it would fall into a double-dip (in a classic sense of the word). However, they do fear that sluggish, subpar growth may continue for a long time, which in turn will lower the nominal growth expectations of economic agents. In other words, the US is turning Japanese, and not in a good way.
Jin Saito
jsaito@observatorygroup.com
July 29, 2010
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