Understanding Japan’s Disasters

NEWPORT BEACH – As we all struggle to comprehend the economic and financial impact of Japan’s calamity, it is tempting to seek historical analogies for guidance. Indeed, many have been quick to cite the aftermath of the terrible 1995 Kobe earthquake. But, while that example provides some insights, it is too limited to understand what lies ahead for Japan, and excessive reliance on it could undermine appropriate policy responses, both in Japan and abroad. First, let us consider the similarities between Japan’s current tragedy and that of 1995. Both involved terrible earthquakes that resulted in tremendous human suffering and large-scale physical damage. Both required the Japanese government to display considerable agility in its rescue efforts. Both triggered multiple offers of help from friends and allies around the world. In both cases, wealth destruction was accompanied by disruptions to daily economic life. There are also important forward-looking similarities. As with the aftermath of Kobe, the current focus on rescuing survivors will be followed by a huge reconstruction program. Massive budgetary allocations will be made (2% of GDP in the case of Kobe). Affected households will receive financial assistance to help them restore some normalcy to their lives. Roads, housing, and much other infrastructure will be repaired and upgraded. These similarities have led several economists to provide early predictions of the national and global economic consequences, including a sharp V-like recovery in Japan’s growth rate in 2011, as the initial downturn is followed by a surge in economic activity, implying a rapid recovery in Japan’s tax base and level of GDP. Such predictions counsel caution against over-reaction by policymakers outside Japan. Rather than immediately incorporating Japanese developments into their thinking, policymakers should treat the effects on the global economy as “transitory” – that is, temporary and reversible – and thus “look through” them in designing their responses. But there is a risk that this approach could understate the Japanese disaster’s domestic and international consequences. As such, it could contribute to insufficient responses in Japan itself – from the government to individual companies and households – as well as in other countries. Indeed, such a mal-diagnosis could delay what I believe will be an eventual solid recovery in Japan. Five factors suggest that Japan faces a uniquely difficult and uncertain set of challenges. First, the economic damage from Japan’s three calamities (a horrifying earthquake, a devastating tsunami, and a nuclear crisis) may well be double that of Kobe. And, unlike Kobe, these calamities did affect Tokyo – indirectly, fortunately – where some 40% of Japan’s industrial production is located. Second, Japan’s public finances are weaker than in 1995, and demographic factors are less favorable. Domestic public debt today stands at roughly 205% of GDP, compared to around 85% in 1995. The country’s sovereign rating is AA-, not AAA, as it was 16 years ago. This erodes the flexibility and ultimate effectiveness of fiscal responses. Third, benchmark interest rates are already near zero, and have been for a while. This undermines the potency of monetary policy notwithstanding bold and imaginative efforts by the Bank of Japan to inject liquidity into the economy. Fourth, the addition of destabilizing nuclear uncertainty to the terrible impact of the natural disasters amplifies the reconstruction challenges. Given the damage and dangers, it will take time for Japan to restore fully its power-generation capabilities, affecting the potential GDP growth rate. Food safety is also a concern, as is the economic impact of nuclear uncertainties on the Japanese psyche. Finally, Japan’s external environment today is more challenging. During the post-Kobe reconstruction period, world demand was buoyant and global productivity surged, owing to China’s gathering boom, America’s information-technology and communications revolution, and political and economic convergence in Europe. Today, aggregate demand in advanced economies is still recovering from the global financial crisis, while systemically important emerging economies like Brazil and China are tapping their policy brakes in order to counter economic overheating. Meanwhile, on the supply side, countries are dealing with high and volatile commodity prices, including an oil-price spike as a result of the Middle East uprisings. If this analysis proves correct, it implies that Japan’s reconstruction challenge will be more difficult than after the Kobe earthquake. Negative wealth and income effects this time around will be more severe, and the recovery process will probably take longer and be more complex. At the national level, this calls urgently for a degree of unity and decisiveness that has been absent from Japanese politics for years. Without it, the authorities will find it difficult to communicate and implement a medium-term economic vision that puts rapid sustained growth, and not just reconstruction, at the core of the policy response. Japans disasters will add to the global economy’s headwinds – be they the impact of the initial fall in consumption in the world’s third-largest economy, or disruptions to global supply chains (particularly in technology and autos). And Japan’s nuclear crisis will mean greater uncertainty about nuclear power in other countries. There is also a financial angle, the importance of which depends on the mix of new government borrowing, debt monetization, and repatriation of Japanese savings that is used to fund Japans reconstruction program. The greater the repatriation component, the larger the negative impact on some financial markets. So, as tempting as they may be, analytical shortcuts are best avoided at this early stage. It will take time and thorough analysis to specify the true consequences of Japan’s triple calamity, including the longer-term impact on its economy and that of the rest of the world. The Japanese have shown admirable courage in the face of unthinkable tragedy. I have no doubt that a successful reconstruction program will lead their country to recovery. In the meantime, however, the urgency of restoring a sense of normalcy and hope to a dramatically wounded society warrants thoughtful and deep analyses. Mohamed A. El-Erian is Chief Executive and Co-Chief Investment Officer of PIMCO, the global investment management company. Copyright: Project Syndicate, 2011.