Friday, March 18, 2011

The Economic Calculus of Japan’s Tragedy...

Satyajit Das Mar 17, 2011 2:39PM The behaviour of financial markets over recent days confirms British Prime Minister Lloyd George’s observation that "financiers in a panic do not make a pretty sight". While workers in the Fukushima nuclear plant risked death trying to bring damaged reactors under control, financiers cowered in fear. Oscillating between boom and doom, they sought opportunities to benefit from death and destruction.

Instant experts on the nuances of nuclear power generation and the Japanese economy have crowded the airwaves providing ‘analysis’.
In perhaps the most bizarre moment to date, Guenther Oettinger, the 57-year-old former premier of the German region of Baden-Wuerttemberg, told a committee of the European Parliament that the earthquake-damaged nuclear plant was now "effectively out of control" and foretold "further catastrophic events". He urged people to leave Japan, stating that the "whole thing is in God's hands". Financial markets plunged, in part at his comments.

Curiously, Mr. Oettinger had no special information or any expertise in nuclear power generation. His spokeswoman later clarified that: "He just wanted to share his concern and that he was really touched by all the images of people and the victims ... "

As little is known, much, it seems, must be surmised. Without concrete data, people have drawn parallels with the 1995 Kobe disaster (known in Japan as the Great Hanshin earthquake).

The Cost of Tragedy

The only known is that the earthquake, tsunami and its aftermath have destroyed significant infrastructure and inflicted heavy loss of life. The death toll likely to reach several thousand and the destruction of 60,000 homes and other buildings testifies to the scale of the disaster.

Initial estimates suggest that the three most affected prefectures account for a combined 6-8% of Japanese Gross Domestic Product ("GDP"). This is roughly half that of the earlier Kobe earthquake, making it economically less significant. The affected region has manufacturing plants (cars, chemical, electronic and beer), energy infrastructure (as everybody now knows!) as well as agricultural, forestry, and fishery industries.

Losses are currently estimated at between US$100-200 billion. Kobe resulted in approximately Yen 10 trillion of damage (around US$102 billion), equating to around 2.5% of Japan's GDP at the time. These are only the direct costs. When the full economic, social and human impact is factored in, the real damage will be much larger.

The disaster has disrupted economic activity. A number of industries have been forced to suspend production temporarily. The major issues are the supply of electricity, water, transport, telecommunications and other essential services.

A few days after the disaster, over 1.3 million households had no power or running water. Relief efforts have forced authorities to close some expressways to normal traffic to allow relief supplies to be moved into the disaster area. The government has urged people to conserve power to aid the relief effort and reduce the pressure on electricity generation capacity. Power outages are likely and are expected to continue for some time, as the loss of output may be as high as 20-30% of total capacity.

The problems resulting from the Kobe earthquake were different, as it was one of the world's busiest ports. The earthquake and damage to the port affected Japanese trade more directly. However, Kobe did not affect energy supplies for the country.

Parallels to Kobe may be misleading for other reasons. In 1995, industry was more heavily based in Japan. High cost structures and a strong Yen have forced Japanese manufacturers to relocate to lower cost locations within Asia or closer to their markets, like the US and Europe. This means that the effects on production may be smaller.

Global supply chains are also now more flexible. This may allow manufacturing to be quickly relocated, minimising disruptions. However, Japan also makes vital components, not available elsewhere, which will disrupt production for a variety of other products throughout the world.

The ‘joker in the pack’ is the problems at the nuclear power plants. At a minimum, given the risk of further problems and the impact on other facilities (including safety checks), further disruptions to power supply cannot be ruled out. This may be significant in a country where 30% of electricity is generated from atomic fission.

Japanese growth, which has been lack lustre in any case, may slow in the short run. Given the high levels of intra-Asian trade (estimated at 40-50% of all trade within Asia), this is likely to adversely affect Asian growth, although the degree is unknown.

Japan is also the third largest economy in the world and the slowdown will affect the global economic outlook. However, as Japan is only around 6% of global GDP, the effect should be modest, but may compound problems elsewhere, such as weak employment, European debt issues and also rising inflation in many countries. The key dynamic here is the overall effect on global demand and supply in aftermath of the crisis.

Re-Model, Re-Build

Another known is that the cost of reconstruction will be high. Optimists see this a catalyst to restarting the moribund Japanese economy. The key issue is how the rebuilding will be financed.

The level of insurance cover is limited. In the case of Kobe, only 3% of property was insured. The level of coverage in the current disaster is estimated at around 15-25%. The rest will have to be financed by governments and individuals drawing on savings.

The government could finance the reconstruction from existing emergency reserves or cuts in other spending. Alternatively the government could pay for rebuilding by raising money through the sale of bonds.

Financial market have assumed that Japan will instead sell its overseas financial investments including US government bonds (holding of around US$900 billion) to finance reconstruction.

Japan currently has net foreign assets worth 57% of its GDP, against net foreign assets of 16% in 1995 at the time of Kobe. If such liquidation and repatriation occurs, then the volumes may be larger than 1995.

The ‘repatriation thesis’ sees US interest rates rising as the Japanese sell US$ bonds and the Yen increasing in value as the dollars are converted into local currency.

But it is not clear that this actually happened following the Kobe earthquake. Currently, there are no signs that the government, insurance companies or private investors are selling or plan to sell foreign assets to finance the rebuilding. Investors are acting on the anticipation of anticipation of events.

There are a number of reasons to believe that the repatriation thesis is speculative. Investors will be reluctant to sell foreign investments as they typically provide higher returns than Japanese assets. The government may prefer domestic financing, to avoid an increase in the value of the Yen, to maintain Japanese export competitiveness. As this was already a concern before the disaster, the imperative to avoid any increase in the value of the Yen will be significant.

The Bank of Japan has already threatened intervention in the currency markets if the Yen stars to appreciate. In addition, the Bank of Japan has injected larger than expected amounts of liquidity into the money markets and reaffirmed its ongoing program of purchasing government and corporate securities. This has two objectives – trying to maintain confidence and also maintain interest rates down at already microscopic levels to keep the Yen weak.

Further On Up The Road

If, as expected, the government chooses to finance the rebuilding by raising debt, then attention will be on the increasingly parlous state of Japan’s public finances.

Even before the disaster, Japan’s government borrowing was over US$12 trillion, around 200% of its GDP, although net borrowing is around 140%. This debt reflects the effect of two decades of government spending in unsuccessful efforts to restore the Japanese economy to health after the crash of the ‘bubble economy’ in 1989.

Japan’s tax revenues now cover less than 50% of its annual expenditure, requiring the government to borrow the rest. Debt is 20 times the Japanese government's annual revenues.

Japan has been able to sustain this high level of debt for several reasons. It borrows in Yen and from domestic investors, who constitute one of the largest investment pools in the world. The ability to meet interest commitment on this debt is based on low interest rates. Japanese government bonds now pay around 1.5% per annum, having paid rates below 3% for the last 15 years. Investor have accepted low rates because of low inflation or deflation (falling prices) and the absence of other attractive investment opportunities. Since1989,Japanese shares have fallen 75 per cent and Japanese property has fallen in value by 50-70% before adjustment for inflation.

While the additional financing needs for reconstruction will be accommodated in the short-run, it brings forward the day of reckoning. The cost of reconstruction may add additional debt, of as much as 5-10% of GDP.

The major rating agencies – S&P and Moody’s - have maintained Japan’s credit rating at ‘AA’, only slightly below the highest grade of ‘AAA’. However, both agencies have pointed out that the additional costs of the crisis exacerbate deep-seated, existing problems.

Japan’s current debt position is very different from the time of the Kobe earthquake. In 1995, Japanese government debt levels were much lower (net government debt was around 25% versus 140% today). In addition, the global economy was in a more robust position with stronger economic growth. These factors helped Japan absorb the effects of the Kobe disaster.

The high levels of government debt have been accommodated because of high levels of household and corporate savings. But on present estimates, an aging population and low economic growth means that soon domestic private savings will be less than that required to fund the government’s needs. Japan’s current account surplus is also under increasing pressure due to slowing global economic growth and the high value of the Yen.

Traditionally, Japan has been able to finance its government borrowing largely from domestic investors, with foreigners only holding about 5% of the Japanese Government Bonds. In coming years as its own savings pool declines, Japan will need to tap foreign investors. The disaster will accelerate the process.

Japan three problem ‘Ds’ – depression, deflation and demography – have now been joined by two new ‘Ds" – disaster and destruction. The toxic combination is exposing another ‘D’ problem for Japan – debt.

Unintentional Uncertainties

The economic effects will not be confined to Japan, increasingly affecting other countries.

Japan has historically been an important source of finance for borrowers globally, including Australian banks. Japanese investors purchased around 20% (Euro 1 billion) of the debut debt issue of the European Financial Stability Fund, providing financing for the bailout of deeply indebted European countries.

To the extent that savings are now redirected directly or indirectly (through the purchase of Japanese government bonds) towards reconstruction, these funds will not be available to finance foreign borrowers. This contracts the pool of global capital available and its cost.

Policies adopted to deal with crisis and reconstruction may destabilise currency markets. In a world of low growth, countries have used currency values as a means of gaining competitive advantage. To the extent that changes in capital flows affect currency values, attempts by individual nations to cheapen their currencies will increase volatility and affect growth.

Historically, Japan has been a large aid donor. In 2008, to increase its political and economic influence and meet the increasing rise of China, Japan revamped its aid effort creating the Japan International Cooperation Agency ("JICA"). The agency has an annual budget of more than $10 billion, comparable to that of the Asian Development Bank and the US Agency for International Development. This is additional to its commitments to supra-national and multi-lateral organisations, like the IMF and World Bank.

It is not clear what the current disaster means for these aid programs. Any retrenchment will have significant impact on recipient countries.

In the short run, as the affected nuclear power plants are damaged probably beyond repair, Japan may have to import additional amounts of LNG (liquid natural gas) or oil underpinning higher prices for these commodities affecting global inflation and growth.

The problems of the nuclear reactors may also have a long-term impact on power generation. To the extent that it slow downs construction of new and planned nuclear power plants, it may affect the availability of electricity, frequently in emerging countries that face power shortages. This could retard economic growth.

Always Uncertain

In recent months, two events – the political upheavals in North Africa and the Middle East affecting oil prices and the Japanese tsunami disaster – have highlighted the challenges of economic forecasting. Even inside information from an ‘expert network’ would not have helped.

The events highlight what economists Frank Knight and John Maynard Keynes termed the distinction between ‘risk’ and ‘uncertainty’. As Keynes put it: "By ‘uncertain’ knowledge … I do not mean merely to distinguish what is known for certain from what is only probable … the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence … about these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know."

A major nuclear incident would, of course, change the outlook dramatically with wide and largely unknown ramifications. The rush to don HazMat suits and plot the direction and speed of the radiation plume would give new meaning to the term "momentum".

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Saturday, March 12, 2011

Let's Take A Higher Road...

For over 2500 years, and possibly more, the world has been debating personal, social and economic conditions, from a less than ideal perspective of inter-tribal differences. Can we possibly transcend our tribal allegiances of special interests, whether labor and workers, of the egalitarian vein, on the left, or business and corporations, of the competition and profit vein, on the right, and find a higher road? I think we can, with, “A transcendent theory of responsible semi-philanthropic government”. I mention semi-philanthropic government, in no small sense, as when we truly address our global condition over the last thirty years, we’ve actually evolved from a system of capitalist free-markets, to a more integrated system of Marxist/socialist/capitalism, with all our socialization of global finance and trade, to the tune of trillions of dollars of national debts, and especially now, with the massive socialist bail-out packages being put on the table, which will further socialize the already over-socialized system.

All we have do is ask, “Have we acted responsibly?” My answer is, “Absolutely not!” From Nixon, through Reagan, Bush I, Clinton and Bush II, we’ve seen and been nothing but irresponsible, to our fundamental ideals, of sound government and finance. How could we have lost our way so badly? My answer is, we spent so much time fighting and warding off Marxism, socialism and communism, our simple fears of, we actually forgot to build further on our fundamental ideals, and instead, adopted financial evolution by accident, and hap-hazard in-attention. Both political parties allowed the policies and philosophies of the moment, to control our destinies down roads any sane nation, would have never traveled, with irrational de-regulations of other-wise sound markets and trade, to massive profligate increases of finally un-repayable debts. So, now we arrive at the grid-locked arguments of two special interest groups, with their un-resolvable differences.

Whether we look at this enigma from the perspective of social responsibility, or economic survival, we must develop a new and transcended philosophy of government, economics and politics, capable of bridging these diverse differences. When I mention “A transcendent theory of responsible semi-philanthropic government”, it no longer looks utopian, as it once did, as it’s actually the forms of governments, many nations of the OECD capitalist world, have now adopted, so it allows us to discuss such a topic, with a new sense of responsibility, as opposed to our present profligate irresponsibility. Now, what would such a transcendent vision look like? I’ll state it bluntly first and explain later, “Governments should use money, to reduce prices, and increase wages and profits”. Now, at this moment, all educated people would yell and scream, “This is impossible”, yet I say, “No, it is not.”, and I have more than one proof of its full possibility. Let me here enter just one of the transcended ideas of responsibility, first offered by Plato, some 2400 years ago:

“The citizen of the ideal state will require a currency for the purpose of every day expenses; This is practically indispensable for workers of all kinds and for such purposes as the payment of wages to wage earners. To meet these requirements, the citizen will possess a currency which will pass for value among themselves, but will not be accepted outside their own boundaries. But a stock of some currency common to the Hellenic world generally i.e., of international currency, will at all times be kept by the state for military expenditures or official missions abroad such as embassies and for any other necessary purposes of state. If a private citizen has occasion to go abroad, he will make his application to the government and go; and upon his return if he has any foreign currency left over in his possession, he will hand it over to the state receiving in exchange the equivalent in local currency”.

Also, if you go back to one of my earlier posts at: where you will see a similar transcendent idea put forward by our very own Benjamin Franklin. And here again is the same transcendent idea of Paul Einzig and J.M. Keynes, put forward by Paul Davidson:

“Elsewhere(Davidson) I have developed in detail a proposal for reforming the entire international payments system via an international clearing union that provides for capital controls and other necessary and sufficient conditions to permit the establishment of a golden age in the 21st century. The main proviso of my proposal are:

1. The unit of account and ultimate reserve asset for international liquidity is the International Money Clearing Unit (IMCU). All IMCU's are held only by central banks, not by the public.

2. Each nation's central bank is committed to guarantee one way convertibility from IMCU deposits at the clearing union to its domestic money. Each central bank will set its own rules regarding making available foreign monies (through IMCU clearing transactions) to its own bankers and private sector residents(21). Ultimately, all major private international transactions clear between central banks' accounts in the books of the international clearing institution.

3. The exchange rate between the domestic currency and the IMCU is set initially by each nation -- just as it would be if one instituted an international gold standard.

4. Contracts between private individuals will continue to be denominated into what ever domestic currency permitted by local laws and agreed upon by the contracting parties.

5. An overdraft system to make available short-term unused creditor balances at the Clearing House to finance the productive international transactions of others who need short-term credit. The terms will be determined by the pro bono clearing managers.

6. A trigger mechanism to encourage a creditor nation to spend what is deemed (in advance) by agreement of the international community to be "excessive" credit balances accumulated by running current account surpluses. These excessive credits can be spent in three ways: (1) on the products of any other member of the clearing union, (2) on new direct foreign investment projects, and/or (3) to provide unilateral transfers (foreign aid) to deficit members.

7. A system to stabilize the long-term purchasing power of the IMCU (in terms of each member nation's domestically produced market basket of goods) can be developed. This requires a system of fixed exchange rates between the local currency and the IMCU that changes only to reflect permanent increases in efficiency wages.(22) This assures each central bank that its holdings of IMCUs as the nation's foreign reserves will never lose purchasing power in terms of foreign produced goods, even if a foreign government permits wage-price inflation to occur within its borders.

8. If a country is at full employment and still has a tendency towards persistent international deficits on its current account, then this is prima facie evidence that it does not possess the productive capacity to maintain its current standard of living. If the deficit nation is a poor one, then surely there is a case for the richer nations who are in surplus to transfer some of their excess credit balances to support the poor nation.(23) If it is a relatively rich country, then the deficit nation must alter its standard of living by reducing the relative terms of trade with major trading partners. If the payment deficit persists despite a continuous positive balance of trade in goods and services, then there is evidence that the deficit nation might be carrying too heavy an international debt service obligation. The pro bono officials of the clearing union should bring the debtor and creditors into negotiations to reduce annual debt service payments by [1] lengthening the payments period, [2] reducing the interest charges, and/or [3] debt forgiveness.(24)”

So, you see, transcendent ideas of social, economic and political conditions are nothing new. It’s just the wise sages of the world have never been listened too. Don’t you think it’s about time? Now, can you see why my statement, “Governments should use money, to reduce prices, and increase wages and profits”, is thoroughly true? The clearest representation of this new transcendent possibility of responsibility is best represented by the words of all these great sages of transcendent ideals, by realizing they all offered, at differing times in history, a chance for all citizens of planet earth, a way out of the great conflagrations of tribal arguments, through realizing money, and money itself, as an autonomous tool of governments, can be used far beyond its present irrational status. Money can function as a fundamental transcendent ideal of social, market, trade and political actions, when organized through thorough exchange clearing mechanisms, having the ability to reduce global debt structures, i.e., self-liquidating national debts, as per Keynes Bancor System, or Paul Davidson’s ICB(international clearing bank), among all the others. These exchange clearing mechanisms can be instituted either externally or internally, according to the needs of each individual nation, but responsibly instituted, they must be, to reduce prices, and increase wages and profits, responsibly and successfully, while reducing overall global costs, achieving full and true subsidiarity and sustainability, and not their false ideological counterparts... Also, to top it off, here’s a few of my own proposals of external and internal exchange clearing:

“A Few IFA Proposals - Conventional - Unconventional by Lloyd
“Ah yes, Edward. Quite a problem we seem to be in. Since Edward asked this question, I thought I might stick my head out and see how many chop it off. Somehow, I feel they may not since we are all in such a quandry... "What this means is that the seesaw analogy fails: Europe cannot go up while the US goes down: both need to descend together. So the problem here is architectural (any suggestions Lloyd?):"

As I stated in one of my posts at: MacroMouse and in thorough agreement with you Edward, "We have never been here before." Due to the vast imbalances in global ppp's, wages, debts, trade, wealth, exchange rates, etc., which have evolved since the collapse of the Bretton Woods System in 1971-`73, we face the most serious challenge since, oh who knows when, forever. So what would I do with the international financial architecture? If enough serious minds are willing to admit something needs to be done, then there are definately several answers.

The goal, of course, is to rebalance the entire global system. How? Well, many forms of external exchange clearing have been put forth since Plato first advocated it, though none overly appeal to me or many others, as suggested - they reduce too much autonomy. Therefore, I suggest several different forms of conventional exchange clearing and several unconventional forms of internal exchange clearing - which allow a higher degree of local autonomy. I see no other way to otherwise rebalance the massively out of balance system. If we had originally, in 1971, rebuilt the then broken system by making balanced floating exchange the law of the land, we wouldn't be here, but we didn't. Just for the record, we could have made a 10% to 20% maximum balance band law the IMF would have been mandated to follow when nation's ppp's drifted out of balance, that they should have been mandated to rebalance, even though we had abandoned the pegged system. A rebalancing framework could have and should have been set up at that time, even if it meant loaning, or using a standby agreement until hostilities ended, the money needed by the U.S. to finish the war, etc. It would have been smarter than destroying the entire system as has nearly happened. There were many ways to rebuild a workable system at the time, it was just the acrimony over the war that prevented such a wise course. I mention this for background on what now must be done.

I have only recently come across enough information and empirical evolution to possibly offer a few new and different answers. I am no where near ready, but I can set the framework. At the outset, moral hazard must be guarded against most in the workings of any new system. As Alfred Marshall suggested, we could use his units of purchasing power as a solid standard of a new architecture. I suggest a very large basket[20% of GDP] of commodities, production, goods, and services as the new standard for all nations. This large 20% is required because I further suggest using many forms of derivatives contracts and bond contracts as insurance for the new system of clearing - to satisfy the large financial interests. I suggest this be a minimal financial computer controlled international clearing architecture - politics removed after implementation. To implement, all capital markets must be either closed[short term] or laws of gradual rebalance must be written into the architecture implementation and evolution. This way all nations can maintain their sovereignty and autonomy more than other already advocated systems. If the laws and computer programs are properly written, the world can evolve over a given timeframe to a new global balance of all thus mentioned markets. Rebalancing is a simple accounting trick if enough financing is forthcoming, to do so. It will take much new IMF financing, but the rebalancing will recreate so much new credit productivity, it will pay itself back over time just as the massive public financing of global WWII did.

”There is also internal exchange clearing, a non-conventional system, that I have written George Monbiot about. There are several of these variations, also, but for now I will enter my e-mail to George:”

Earlier today I came across an article of yours about a meeting, to come up with an alternative to capitalism other than the other failed system - totalitarianism. I'd like to make a suggestion that there is a way to build such an architecture. BTW, you are my favorite author. The system I am talking about is already here, almost but unrecognized, as yet. On the one side we have what I refer to as Minsky's Heinz `57 capitalisms. On the other we have the Heinz `57 totalitarianisms. None of these are satisfactory. Yet, the answer lies somewhere in the middle between the two. BushCo wants to implement an outrageously totally free [for the corporations that is] capitalism. China, on the other hand is moving from totalitarianism toward BushCo's totally free corporate capitalism. If it goes all the way this would be a big mistake, as the perfect mixed market capitalism lies in between.

What I'm talking about here is the world has a chance to help China develop the first perfectly balanced mixed economy of public and private enterprise. I use this example as the developed nations will not yet listen to common sense. Now, I know from reading your books and articles you can easily grasp this. If China were to naturally evolve to a state of 20% public enterprise markets and 80% private enterprise markets we would have a chance to witness something truly amazing in economic history, if properly organized at this % mix. As, at this total market mix the 20% public enterprise market could be used to keep inflation/deflation permanently in check throughout the 80% private enterprise market, thus allowing a fiat money system unlimited potential. I mention this about China as it is the only experiment in the world heading toward and most likely to reach this % threshold. It would be a great loss to the world if we do not recognize this once in earth's lifetime chance to grant the world a new path. E=1/5X is a formula for perfect competition capitalism.

The 20% public enterprise mix must be a total % market organization of all production, goods, and services in order to check inflation/deflation throughout the 80% totally free private enterprise side. A triple entry banking system can be set up to finance. Alfred Marshall, at the turn of the century, mentioned such a similar mix with his "units of purchasing power". This is the same thing, so to speak, at a much expanded macro level. If you can actually see this system, which I think you can, you must see the advantages a fiat system would possess when inflation/deflation can be market controlled, it frees the printing press to have free reign to build an unbelievably wealthy, healthy, strong, and viable moral capitalism.

If China were to discover this capitalism key, the rest of the world would be forced to emulate - gladly as debts and taxes would vanish or could be used productively. They most likely will cross the 1/5X threshold sometime in the near future as they are privatizing at a fast rate - almost 50% already. There is no need for them to cross it in disarray as is the case with many of Europe's social democracies and Russia's failed transition. They only need be shown the simple facts. Please dialogue with me to work out the details. The world needs us George.

I wrote three books about this system through the `80's and `90's. Trouble is they are very crude web published material - not enough free time. I am now retired and have the time to finish. My work will be rewritten and republished this winter. My first paper will be 20 to 30 pages long on global credit productivity - a totally new macroeconomic subject.”

I didn’t mean to make this post so long, but the dynamics involved in understanding how theoretical transcendental ideals of, “Governments should use money, to reduce prices, and increase wages and profits”, is very difficult for the un-initiated to wrap their heads around, as it sounds paradoxical, when in fact, it is not. If all try to figure the dynamics involved, in the above ideals, we can truly solve all the world’s problems, and successfully institute a new “Imperative of Responsibility”___A Higher Road…