Monday, January 10, 2011

Issue XXII - Lost Decade

Dear Readers,

As the economic recovery drags on at a turtle-pace, several commentators have begun to make the inevitable predictions of a “lost decade.” This description is often thrown about when discussing Japan during the 1990s – although as Japan’s malaise continued into the 2000s, “lost era” is perhaps a more accurate description. Before this description is applied to the US, it is helpful to look first at whether the performance of the US economy over the past decade truly mirrors that of Japan. Moreover, what should be the metrics by which developed economies are measured against each other? By these measures, does the Japanese experience of the 2000s even qualify as a “lost decade?”

In the United States, the economic history of the 2000s began with the bursting of the technology bubble that, combined with September 11, created a circumstance about which former Federal Reserve Chairman Alan Greenspan said “historically can result in the undoing of a society.” In response, the Fed quickly initiated a series of aggressive interest rate cuts. Other central banks around the world followed suit in order to prevent, as several central banks directly stated at one point or another, a prolonged period of Japanese-style stagnation. Most economists, all the way up to Greenspan himself, did not anticipate the extent to which these interest rate cuts would inflate bubbles in the housing and credit markets.

After the housing collapse and subsequent credit crisis in 2007-08, central banks once again acted quickly to ease monetary policy and prevent a prolonged period of low growth. In addition to cutting rates to zero, the Federal Reserve initiated a program of quantitative easing in March 2009 and expanded the program by $600 Billion in early November 2010. One of the reasons given in defending this practice was to expedite the current recovery to the point that it becomes self-sustaining. This would prevent a double-dip recession that could, in turn, lead to a repeat of the Japanese experience.

As often as one may hear that the Fed is trying to prevent a “Japanese experience,” it is helpful to establish whether Japan truly underperformed given its circumstances. Since 1990, the Japanese economy has faced a real estate collapse and subsequent banking crisis more damaging than the recent US recession, battled deflation, and dealt with unfavorable demographics. While the banking problems are largely behind it, deflation and an aging population have continued to linger. Through that, Japanese GDP growth averaged 0.6% over the past decade according to the World Bank.

In general, the rationales behind much of the economic policymaking since at least the 19th century have been dominated by “lessons learned” that are drawn from throughout the course of economic history. However, it is debatable whether the example of Japan is an economic scenario that should be avoided entirely. Daniel Gros, Director of the Centre for European Policy Studies, stated recently that “the basis for the scare story about Japan is that its GDP has grown over the last decade at an average annual rate of only 0.6% compared to 1.7% for the US. The difference is actually much smaller than often assumed, but at first sight a growth rate of 0.6% qualifies as a lost decade.”

If that is the case, GDP growth in much of the Eurozone might also fit the popular definition of a lost decade. According to the World Bank, in the 2000s Germany experienced nearly the same growth rates as Japan (0.6%) and Italy was even worse (0.2%). France and Spain performed somewhat better, but the Eurozone as a whole was not much better off. With sovereign debt problems now engulfing the continent over the past year, growth rates for the 2010s will likely not be much better.

Nonetheless, while this may look like economic stagnation on the surface, it elicits the often-asked question of how to properly measure the economic performance of developed countries against one another. The answer lies in the economic trajectory of countries that industrialize, as emerging markets transition into developed countries. The development of industry brings hundreds of millions of people from the countryside into the cities, fueling a rising industrial sector. All of a sudden, a former farmer or migrant might be a factory worker, contributing a bigger, and more easily measured, piece of a national GDP. This happens to millions of workers who are within the “working-age population” (WAP), those who are not too old or too young. Therefore, a more accurate measurement of the economic performance of developed countries might be GDP per member of the WAP as opposed to the widely-accepted GDP per capita. With regard to Japan, this is important because of demographics.

In Japan, that 0.6% average GDP growth was achieved despite a contracting WAP. This number is shrinking rapidly as the Japanese population declines, as birthrates have fallen since the 1980s and Japanese couples have chosen to have children later in life - and have had less of them (the same trends that are currently taking place in the US). When charted, the Japanese population is taking the shape of an inverse pyramid, with the greatest percentage of its population over 60 years old. Consequently, Japan actually performed better than the US and most European countries during the 2000s based on GDP per WAP (GDP/WAP). Indeed, these demographic differences are relevant to comparing the US not only to Japan but to the developed economies of the Eurozone as well. By the GDP/WAP figure, many European nations, especially those with shrinking populations, have also done better than the US.

As mentioned, the difference between Japan and the US over the past decade was about one percentage point in favor of the US on an annual basis, but in terms of working-age population growth rates, the difference was about 1.5% annually. This is because the US’s WAP increased by 0.8% on an annualized basis (though not necessarily the workforce, if one considers illegal immigrants and such). In Japan, this same figure contracted by 0.8% annually over the past decade. Additionally, another reason the “lost decade” has been expanded to include the 2000s is that Japanese unemployment has remained more or less constant over the past decade. It has held around 4-5% even after the late 2000s recession. Compare that to the US, which approached 10% in 2010, although it fell slightly based on data released last week. Therefore, despite a stagnant unemployment rate and falling WAP, Japan managed to eke out growth. The point is not that the Japanese model is one to be emulated, but the fact that it has managed to grow in such an economic environment should be looked at by the Federal Reserve and corporate leaders who seek to squeeze out growth from an environment of deleveraging, increasingly unfavorable demographics, and stagnation.

What does this mean for the next decade? The use of GDP/WAP as presented here suggests that it can be used to predict the growth rates of the G-7 and other developed countries based on the growth/contraction patterns of their WAP. These can be predicted for at least two decades onward, as WAP consists of a country’s population aged 20-60, so the future workforce that will enter at age 20 has already been born. In the case of a few nations, particularly the US and the UK, immigration trends should be factored in, but obviously this cannot be predicted as accurately as the number of new births. Based on these facts, Japan will continue to fade as a major economic power, especially within Asia due to the rise of China. Nearly all of the Eurozone members are showing similar trends to Japan, albeit at an earlier stage. The WAPs of Germany and Italy are already in decline, and they and the rest of the Eurozone will have similar growth rates over the next decade. In the case of Germany, the decline will be even faster than Japan beginning shortly after 2015. In contrast, the US, UK, and France are likely to grow faster because the WAPs of all three are continuing to grow, even if it is at a slower pace than in previous generations.

There are two main takeaways from this confluence of demographics on economic growth. First, the popular notion of a Japanese-style “lost decade” may be misleading even if applied to its nation of origin. The slow growth in Japan was not entirely due to what one commentator described as “insufficiently aggressive macroeconomic policies.” Since Japan’s banking crisis in the 1990s, the stagnation has arguably been more demographically-caused. While these demographic trends have played a big role in Japan’s difficulties over the last two decades, the US will not be confronted with the same degree of difficulty in that respect due to an increasing WAP. Second, a decline in the growth rates of many developed countries appears to be unavoidable, particularly in the Eurozone, as the WAPs decline. Even in the western countries that are still in good shape in this respect (US, UK, France), population growth rates are declining. Within Europe, even some of the countries that are viewed as healthier because they have not experienced the debt problems that swept the continent in 2010 will eventually succumb to this, Germany in particular. For countries such as Italy, which have existing debt problems and an already-declining population, the outlook is even worse, with stagnation perhaps being a best-case scenario. Add in the inevitable austerity measures and budget cuts that will need to take place, and stagnation begins to look optimistic. In either case, it is going to be an interesting decade as governments throughout the western world will need to come to grips with these trends.

Respectfully Yours,

Matthew R. Green

January 10, 2011