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Japan's Economic Aftershocks

Interviewee: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
Interviewer: Jayshree Bajoria
March 16, 2011

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Japan's recent earthquake, tsunami, and unfolding nuclear crisis have put global financial markets on edge. Yet, while output will fall in the short term, Japan's economy--the world's third-largest--will rebound, driven by a boost in reconstruction, says Sebastian Mallaby, CFR's Director of the Maurice R. Greenberg Center for Geoeconomic Studies. Mallaby estimates the cost of reconstruction will be $100 billion, but he thinks it will not have significant macroeconomic effects. "$100 billion is not chump change," he says. "But when you think that the Bank of Japan [earlier this week offered] to pump $98 billion of liquidity †into the market--basically print $98 billion--I do not see as though it's going to have a major disruptive effect on capital markets." Despite worries in some quarters over Japan's ballooning debt, Mallaby says the Japanese government should be willing to increase the deficit for rebuilding. Also, he recommends government intervention "to counteract an undue strengthening of the yen" that could hurt the Japanese economy.

What will be the short-term and long-term effects of the earthquake and tsunami on the Japanese economy?

Normally, natural disasters in advanced economies have a two-stage effect. In the first stage, you have disruption, roads are destroyed, power grids are unreliable, and people can't get to work so you have a fall in production. In the second stage, because you've got destroyed roads, destructed power grids, and so forth, you've got to rebuild that stuff and you actually see a rise in production. So, on a kind of longer view, like nine months or something, the output you've lost in the first period is normally compensated by the extra output you had in the second period.

The question is whether this particular disaster would for some reason buck that typical pattern. I don't see really why it would, even though it is looking pretty awful in the near term, and obviously the knock-on effects from the radiation and the nuclear concerns are significant. Even with a lot of disruption in terms of potential radiation and people fleeing the major urban centers [close to] nuclear reactors, you're going to see a repeat of the familiar phenomenon where you do get disruption in the shorter term, and, to some extent, people then redouble their output when they come back to work.

[Some] people raise a concern that the cost of rebuilding is going to be borne to a significant extent by the Japanese government, which already has the highest debt to GDP ratio of any advanced country. They are going to see more government debt as a result of this, and some people fear that you could get a panic in terms of the Japanese government debt market, as people simply don't want to lend an increased quantity to Japan because it's already so in debt.

[T]he paradox of global supply chains is that although it means a kind of ripple effect from a disruption in one country around the world, it also means that you can adapt around those disruptions better because you have more potential places around the world where you can shift production to when one of your production bases is disrupted.

If you look at the plausible estimate of how much extra debt the government will have to issue to pay for this, it looks roughly on the order of $100 billion--a mixture of fixing the earthquake damage, the tsunami damage, and some ballpark estimate of disruption from radiation and [maybe] radiation [insurance] claims against the government. $100 billion in extra debt is a real amount of money, but it's small in relation to the gross debt of the Japanese government, which is probably around $10 trillion. So it's about 1 percent addition to the debt stock, which is another reason why I am relatively optimistic that the macroeconomic effect of this will be less significant than the human tragedy.

What will be the effects on the global economy?

One vector for how this affects the world is the global supply chain. The world is knit together by complex supply chains, and Japan is a part of that, being a major manufacturing center. It's possible that in the short term [there could be disruptions in the manufacture of] key parts of, say, automobiles, which are made in Japan and necessary for final manufacture of cars in other places such as the United States, so final manufacture could be disrupted abroad.

But the paradox of global supply chains is that although it means a kind of ripple effect from a disruption in one country around the world, it also means that you can adapt around those disruptions better, because you have more potential places around the world where you can shift production when one of your production bases is disrupted.

Do you think the Japanese government's attempts to raise money for reconstruction will affect markets elsewhere?

No, it's too small. Again, $100 billion is not chump change, but when you think that the Bank of Japan [earlier this week offered] to pump $98 billion of liquidity †(BBC) into the market--basically print $98 billion--I do not see as though it's going to have a major disruptive effect on capital markets.

There is a comparison [made] with the San Francisco earthquake [of 1906]. That earthquake caused money to be shifted to San Francisco to pay for reconstruction, which drained liquidity out of the financial markets in London and New York and triggered the 1907 financial crash--one of the biggest systemic disruptions to the American financial system in the twentieth century. People sometimes say, "Maybe this will do the same thing." They're fundamentally wrong, because in 1907, there was a gold standard, which meant that you had a limited supply of money in the world, and when money flowed to San Francisco it was literally scarce in New York. But now you've got central banks that have operating fiat currencies, and when you have a fiat currency of paper money, you can print it. And that's exactly what the Japanese central bank promised to do in the wake of this disaster.

Japan's finance minister has expressed concern regarding a rising yen, and some economists are worried that if the yen appreciates too much, officials may intervene in the currency markets to cap gains. How would a potential intervention affect the global economy?

The intervention would simply be counteracting a worrisome strengthening of the yen. The intervention would come in response to something that was destabilizing, and it would correct that instability. We're in a climate after the financial crash where we have seen central banks print money all over the world and a substantial share of opinion in the market believes that all this central bank money-printing is going to lead to inflation and disaster at some point, and it does spook people. The reality is that given a major shock like this, it's sensible for the central bank to provide emergency liquidity and provide some emergency correction to a strengthening of the yen that would [otherwise] hurt the Japanese economy.

The reality is that given a major shock like this, it's sensible for the central bank to provide emergency liquidity and provide some emergency correction to a strengthening of the yen that would [otherwise] hurt the Japanese economy.

What should the Japanese government do in trying to fix its economy in the aftermath?

It should be willing, as it has been already, to supply extra liquidity to the financial market. It should be willing to counteract an undue strengthening of the yen. It should be willing to act aggressively to increase the budget deficit in order to have the money to rebuild the damaged areas promptly. Now is not the time for being cautious or conservative. Now is the time for a bold response, and I've got every reason to think that they will do that.

How about red lines? Any policies that the government should stay away from?

In some crises, authorities panic and close the stock market for trading. That's generally a terrible mistake because it's easy to close it, but then it's extremely difficult to reopen it because traders have no idea what the correct price is once the market's been closed for a day or two.

That's one kind of panicky crisis response that you've seen suggested in some past major disruptions. The stock market has gone down 20 percent [on March 15 and March 16] combined in Japan, so it's already been a major sell-off. It's probable that people would say, "Enough, we don't like prices moving. We're going to have to close this thing." That would be a mistake.

There is some speculation that Japan's need to raise money for reconstruction might raise U.S. costs to finance its own budget deficit. Do you see any effect on the U.S. debt market?

[The Japanese government] should be willing to act aggressively to increase the budget deficit in order to have the money to rebuild the damaged areas promptly.

I'm not saying there's zero effect, because obviously, it's true that the Japanese need to repatriate money to pay for reconstruction. But in the scale of global capital markets, the amount of money that looks as if on first estimate will be needed, is not big enough to fundamentally disrupt prices. If it did become big enough to disrupt prices, the money being drained out of the capital market by the need to reconstruct will simply be put back in again by central banks that will print it.

The oil prices fell Tuesday (Bloomberg), the most they have fallen in almost five months. How do you think the unfolding nuclear crisis in Japan will affect oil prices going forward?

[If] nuclear power is disrupted in Japan, they're going to have to import more energy of another kind.† If they imported oil, that would have a marginal upward effect on the price. It's not a big effect, because if they replace their entire lost nuclear-generated electricity with oil, the import need would be on the order of half a million barrels a day. Which is not that much. Libya, for example, produces 1.5 million barrels a day. In other words, the effect of this Japan [crisis] is much smaller than the Libyan civil war.

Nonetheless, [one would have expected] an upward effect on the price. [And as a result of that], people expect some disruption and slowing of GDP growth in the short term. But that's a short-term effect, which would be followed by a bounce back once you get reconstruction. So, it's difficult to see why oil should be going down. I would put that in the category of overreaction in the financial market. People understandably freak out; the reporting on the nuclear stuff is particularly disconcerting. And people are just taking risk off in all directions whether it's commodities, equities, gold, what have you. There's just been a general retreat into cash. I suspect that some of that may be exaggerated.

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