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mardi 15 mars 2011

The other story about Japan

As eyes are turned towards Japan's nuclear power plants, our thoughts and prayers go to the victims of this terrible tragedy. However I believe that the biggest implications of the disaster that struck Japan a few days ago will be economic.

Let's start by addressing one of the most idiotic statements of the week: that this event, as tragic as it may be, will in the end have positive repercussions and boost the Japanese economy. The misguided idea that destruction is somehow the best way to stimulate economic activity is as old as the econ profession. You would just think that by 2011 it would have gone away... Sadly it has not. To see newspapers around the world channel the moronic claims of such economists as Larry Summers is quite frankly sad. French philosopher and economist Frederic Bastiat brilliantly demonstrated the absurdity of this kind of thinking in his well-known "Parable of the broken window":

Have you ever witnessed the anger of the good shopkeeper, James Goodfellow, when his careless son happened to break a pane of glass? If you have been present at such a scene, you will most assuredly bear witness to the fact that every one of the spectators, were there even thirty of them, by common consent apparently, offered the unfortunate owner this invariable consolation—"It is an ill wind that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken?"

Now, this form of condolence contains an entire theory, which it will be well to show up in this simple case, seeing that it is precisely the same as that which, unhappily, regulates the greater part of our economical institutions.

Suppose it cost six francs to repair the damage, and you say that the accident brings six francs to the glazier's trade—that it encourages that trade to the amount of six francs—I grant it; I have not a word to say against it; you reason justly. The glazier comes, performs his task, receives his six francs, rubs his hands, and, in his heart, blesses the careless child. All this is that which is seen.

But if, on the other hand, you come to the conclusion, as is too often the case, that it is a good thing to break windows, that it causes money to circulate, and that the encouragement of industry in general will be the result of it, you will oblige me to call out, "Stop there! Your theory is confined to that which is seen; it takes no account of that which is not seen."

It is not seen that as our shopkeeper has spent six francs

upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way, which this accident has prevented

What Bastiat shows us is that the process of destruction and reconstruction may generate some activity but in no way does it lead to the creation and accumulation of wealth at the micro level, and this is what truly matters when gauging economic activity. When we think about economics, we focus on what we see and forget what we don't see: what we see in Japan are billions that will be spent on re-building but what we don't see are the billions that without this disaster would have been spent on other goods and services and would have contributed to actual wealth creation as opposed to reconstruction. If destruction has such beneficial effects, why wait for nature to cause it? Why not destroy or cities and monuments on a regular basis, why not solve the problem of unemployment by digging ditches only to fill them up again? Oh and FYI, the Kobe quake barely had any effect on Japanese GDP growth.

Then there is the problem of Japan's public finances: the government already has a debt equal to over 220% of its GDP. The debt level is so high that it doesn't even fit on regular charts (see bellow...). Japan manages to pull this of because it's debt is almost entirely held by domestic actors, which allows it to borrow at incredibly low prices: it's 10 year bonds pay a 1,3% coupon vs 2,5% for Germany! But even at such low rates, interests alone already eat up 25% of tax revenues. As the population enters old age and draws money from its retirement accounts, saving rates will plunge and domestic sources of capital will dry up. Japan will be forced to borrow on international markets where it will pay at least 5% on 10 year bonds. This is a disaster waiting to happen. In the words of Société Générale analyst Dylan Grice "It's like the Titanic has already hit the iceberg and you know it's going to sink, you just don't know how long it will take to go down". If Japan had to borrow on international markets, its cost of debt would spiral out of control and default would be inevitable.

The other meltdown

Unfortunately, the quake and tsunami may have accelerated Japan's descent into the fiscal abyss. The BOJ has already injected over $170 billion in the markets to keep them afloat. Add that to the massive spending that will be required to compensate the thousands of people whose houses are either collapsed or under water and what you have is a pretty dire picture of the road ahead...

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