The Nikkei Financial Daily, 30th September 2005

There is a strong temptation for journalists to give priority to the interesting over the important. This has been a marked feature of recent reports on the economy.

After fifteen years of economic disappointment, references to its continuing problems do not rate as news. A decade ago the budget deficit rose to over 5% and the national debt ratio was just under 100% of GDP. The problems that this would cause were regularly aired in the press. Now that the deficit is over 6% and the debt level 170% of GDP, it is seldom if ever discussed. The problem has not disappeared, it has just ceased to be news.

This is in marked contrast to the current debate on the US budget deficit. While this is only around two-thirds of the Japanese level it is the subject of frequent doom laden articles.

The victory of Prime Minister Koizumi in the recent election is another example of the way in which the interest of events distorts comment. The result was probably of great political importance, though commentators seem divided as to how. Some hold that it will stimulate reform and others that it will hinder it by reinforcing the dominance of the LDP.

With regard to the economy, however, it seems unlikely to be of any real significance. The privatisation of the Post Office may have important long- term consequences, but it is hard to see it having any impact over the next few years. Indeed, its most obvious feature, which is that a large injection of equity capital will be needed once the organisation ceases to be guaranteed by the government, will provide problems for the stock market, which nonetheless responded positively to the election.

Recent data and the unresolved long-term economic problems, show that the stock market’s confidence is built on very insecure foundations. This was illustrated by the revision of the data on GDP and the new figures on industrial production. The former were good and the latter bad.

What seems to be happening is that household savings are declining and this is helping consumption and the domestic economy. Further declines in this savings rate are possible, but the rate appears to be low and a continued boost to the economy from this source seems unlikely, looking out 12 months or more.

The currently fashionable claim, which is that the economy is now set to grow from domestic rather than international demand, is thus dependent on consumer incomes rising or on a rise in domestic investment.

Consumer incomes in Japan are very low when compared with those of other mature economies. For consumption to offset a fall in the budget deficit, consumer incomes need to rise faster than GDP. This means that either wages must rise relative to output or interest rates must go up.

Unfortunately, both these changes would hit profits and, if companies reacted by reducing investment, the economy would probably fall back into recession.

What makes the management of the economy even more difficult is that companies invest far too much in the domestic economy. The standard way to ignore the problem is to claim that Japan’s capital stock is old and needs to be replaced by a further rise in the investment ratio. The OECD for example, remarks that “…the rise in the capital output ratio was largely due to shrinking output. Firms postponed new investments, allowing the average age of the capital stock to increase from less than ten years in 1990 to 12 years at present and reducing production capacity by 10 per cent from its peak.”

I find this explanation to be simply incredible. Japan spends nearly 16% of its GDP in private non-residential investment, compared with 10.6% in the US. It has therefore 50% more capital per unit of output that is under one year old and similar ratios have been in place for the past decade.

The reputed old age of Japanese plant simply reflects the fact that it is written off more slowly than US plant, despite the large scale scrapping claimed by the OECD. It is thus highly probable that profits are being overstated.

So long as household savings continue to fall the Japanese economy will probably be supported by consumption but, for a sustained recovery, exports remain the key. Japan thus remains highly vulnerable to any slowdown in China and the US but, in the absence of such bad news, the economy should remain reasonably well placed for the next six months or more.