Japan's Economic Fallout Part II - Economic Cost

In my first segment, an assessment of Japan's earthquake dealt with environmental cost.  As the crisis continues, we learn more specifics, such as radiation possibly affecting water supply.  As time passes, we will continue to assess the damage on the overall environment.  Now let us shift our thoughts to the possible economic damage to Japan and the global economy.

Certainly, this tragedy will negatively impact Japan's economic growth as reconstruction efforts stretch their declining credit status.  The possible damage to food and water will impact their domestic industries and their level of exports.  In addition, their fiscal problems are much greater than the U.S. and cleanup efforts will exacerbate their debt issues that supersede the U.S.  Their public debt is extremely high at $10.84 trillion in 2011, which remarkably represents 202.5% of GDP.  For comparison purposes, the U.S. is at 64.9% of GDP. Additionally, Japan's credit rating was already downgraded to AA- by Standard & Poor's and remains far below the U.S. credit rating of AAA, which is the highest possible rating.  This is important because it will be more costly for Japan to service their debt and resulting higher interest costs will hamper future investment and job creation.

The Bank of Japan, Japan's version of the U.S. Federal Reserve, embarked on an aggressive monetary policy campaign that have implications to the U.S. economy.  Soon after the earthquake, many Japanese insurance companies, sold significant portions of their U.S. dollar holdings for yen because they anticipated making large payouts to destroyed residences and businesses, who were covered through insurance.  This event caused the yen to dramatically appreciate and the U.S. dollar to depreciate.

That actually was a worst case scenario for Japan because they are an export-oriented economy with the U.S. being able to take advantage of a cheaper dollar to increase their exports at Japan's expense.  In order to prevent this from happening, the Bank of Japan was able to stabilize the currency markets by buying over 15 trillion yen ($184 billion in U.S. dollars).  They were also able to persuade six of the G7 nations, which is comprised of the U.S., France, Germany, Italy, Great Britain, Canada and Japan,  to assist by selling their yen holdings.  The combination of these efforts stopped the yen from rising and will make Japanese exports more competitive.

Even though the Bank of Japan's monetary actions quelled market pressure, there are still implications on trade and its impact on U.S. companies.  With severe damage to the nuclear reactor complex in northeast Japan, they have imposed rolling blackouts throughout the country to conserve energy.  This method is slowing industrial production and is causing difficulty to U.S. and global manufacturing that need those suppliers to meet their manufacturing, electronic, and chemical needs.  Depending on its severity and length, the cost of finished goods will continue to rise and that can lead to greater inflation and smaller profit margins. As of right now, it appears that overall production declines will not be severe, though.

There is also concern about radiation and its impact on food supply, but the impact is deemed marginal.  The U.S. Food and Drug Administration announced last week that it is temporarily halting food imports from Japan.  While this action should place upward pressure on food prices, it is not expected to have much of an effect since they only represent 4% of total U.S. imports.

So far, it appears that the crisis has been quarantined to primarily affect Japan.  The cost of reconstruction will be another obstacle for Japan and their attempts to reverse their economic malaise.  While some will point to increased economic activity that goes with reconstruction, we must not fall prey to the broken window fallacy.  It is true that jobs will be created in rebuilding or replacing nuclear reactors, along with fixing damaged facilities and roads.  However, this is simply diverting funding that could have been used in elevating current production, rather than replacing lost production.

On the other hand, relatively successful efforts in containing nuclear waste means that any damage will be moderate and should not be a lag on U.S. or global economic growth.  It is true that we might see a temporary rise in auto, electronics, and other durable goods, but it appears that it will not contribute a significant drag on U.S. economic activity.  Quick and decisive action led by U.S. intervention in containing the nuclear reactor crisis has helped to moderate the rise in economic cost for the U.S. and the world.  Unfortunately, the same cannot be said for Japan.

Japan Economic Fallout Part I - Environmental Costs

The global economic impact of Japan's earthquake cannot be underestimated with disaster efforts estimated to exceed Hurricane Katrina, which was estimated at $125 billion. The official loss of lives is currently at 8,199 as of March 20th, but there are still 12,272 more unaccounted for.  As we reflect on the economic implications of this catastrophic event, there are so many complex forces in play that it is too numerous to condense into one blog entry.  Therefore, this first part of the analysis will focus on the environmental damage to not only Japan, but also to the U.S. and Europe.

The environmental cost arising from Japan's nuclear power plant might have implications on its future viability as an alternative energy source globally.  Right now, it looks like the there has been limited success in cooling down the nuclear reactors., however there remains concern with Unit 3, which is one of six that were at risk of emitting radiation.  Transitioning back to the U.S., we can see the current sites of nuclear power in the U.S. shows where trouble areas extend across multiple regions.  While the double whammy of an earthquake and the resulting tsunami is creating current nuclear crisis, U.S. experts actually places the highest risk with the Indian Point Energy Center in Buchanan, NY, which is not along the coast like Japan.  There are concerns that many of the nuclear power plants throughout the East, South, and Midwest were constructed with design standards that might have been compromised due to the perceived low risk of an earthquake.  While there are safeguards that the U.S. can implement, they will be expensive and intensive.

As for Europe, the impact has already been felt in Germany where Chancellor Angela Merkel has switched her stance on nuclear power.  She has called for a moratorium of three months on whether to extend the life of its 17 power plants beyond 2022.  Even before disaster, many Germans were wary of nuclear power.  Expect other countries to reevaluate nuclear power and this can negatively impact global economic growth if another reliable source of alternative energy is not found.

When thinking about alternative energy sources, one must recognize its importance in economic activity.  If consumers see gasoline prices rise, along with electricity and other utility bills, then that will impact their overall purchasing power.  This could impact other industries if consumers decide to slash expenditures in entertainment, electronic goods, and other large ticket items.  Rising energy costs also affect businesses, especially those that are reliant on energy to produce their products.  Given the downward pressures of wages from a stagnant labor market, firms may have to bear those costs themselves and that scenario will dampen profit margins.  If these trends are significant and sustaining, then economic growth will be compromised in the future.

Despite these concerns, Dr. Glenn E. Sjoden, cautions Americans to not be overly concerned and believes that nuclear power is essential in meeting our future energy needs.  For the foreseeable future, Dr. Sjoden does not believe that any other alternative will come close to supplying global energy needs.  He also believes that current nuclear power development is superior in the U.S. and that the likelihood of a similar catastrophe is low.  In supporting this contention, he cites the heavy use in France where they have not experienced any problems for over 40 years.

In summary, policy makers in the U.S., Europe, and the rest of the world will have to carefully balance the environmental costs with the potential decline in living standards.  If world leaders decide that nuclear power is too risky and its use declines significantly, then we can expect productivity and living standards to fall.  Productivity is the ability to make goods and services in the most efficient way. Raising productivity is the key to improving economic growth and living standards.  When looking at energy, its use can impact productivity significantly.  If they decide to rely on traditional sources, such as crude oil, then consumers and businesses can count on energy prices to continue to rise.  While the U.S. continues to demand crude oil in disproportionate levels relative to the rest of the world, there is also rising demand in developing countries in China, India, Russia, and Brazil.  Their incomes and prosperity are quickly rising and energy prices will not dissipate in the near future if nuclear power is abandoned.

All Eyes on Saudi

As we see gas prices rise across the U.S., we can blame most of it to turmoil in the Middle East.  Uprisings in Tunisia, Egypt and now Libya threaten monarchial rule.  Markets have responded with crude oil prices rising beyond $100 per barrel.  One can speculate that some of the rise can be attributed to speculation as political risk significantly increases.  Political risk refers to the potential of disruption of governmental rule and usually occurs when rebellion or war takes place.  As clairvoyantly reported in the February 28th, 2011 edition of Bloomberg Businessweek, the future trend in oil prices lie with Saudi Arabia.

The oil reserves in Saudi Arabia vastly supersedes those in Libya and Tunisia.  Of course, unrest there impacted markets.  However, severe reverberations will be felt if opposition leaders are successful in disrupting oil supply in Saudi Arabia.  That is one of the main reasons why stock markets tumbled heavily on Thursday, March 9th.  Of course, market analysts are prone to overreaction and the current uprising is not that significant yet.  As pointed out by Bloomberg Businessweek, King Abdullah of Saudi Arabia has many resources at his disposal to quell any social unrest.

King Abdullah's main strategy is to lavish his people with the extensive wealth earned through crude oil revenue.  He recently announced $36 billion in jobless benefits, education, housing subsidies, and debt write-offs.  This is quite extensive when recognizing that Saudi Arabia currently produces between $592.6 billion and $622.5 billion a year in economic activity (gross domestic product).  It is still questionable whether these efforts will be enough to minimize significant income inequality that threatens to tear the social fabric of the country.  Saudi authorities are also implicitly pointing blame at current U.S. foreign policy of encouraging peaceful assembly as an universal right.  They believe the current stance of the U.S. is emboldening protest movements that now threatens their political stability.

It is difficult to measure the extent of income inequality in Saudi Arabia, but it is assumed to be high.  According to the Heritage Foundation's Index of Economic Freedom, their living standards are relatively high at $23,221 being their GDP per capita figure.  Certainly, this ranks below the U.S. and other advanced nations in Europe, but is above Mexico and other middle income countries.  Though, that can be deceiving and most analysts believe that income inequality is quite severe as pointed out by this study by economists from the University of California at Santa Cruz.  Despite the efforts from Obama and U.S. State Department officials, there have been slow efforts in addressing this gap and that is cause for the current turmoil.

As we look to the future, the tenuous U.S. recovery will be heavily contingent on how Saudi Arabia weathers the storm.  If King Abdullah is able to maintain order and hopefully direct economic reforms that can improve the plight of his people, then the spike in oil and energy prices will eventually moderate.  Otherwise, we can expect a sustained period of high energy prices that will punish consumers and businesses alike.  That is an alternative that could dampen economic prospects in the U.S. and globally.

Job Picture Brightens in February

The latest job report for February is promising as the unemployment rate fell to 8.9% from 9.0% in January and job creation of 192,000 is the highest level recorded since last May.   Even though the unemployment rate was three-tenths of a percentage lower than expected, it should be noted that economists were fairly accurate when they expected an increase of 190,000 jobs this month.  In particular, the private sector added 222,000 jobs, but the public sector continues to decline (30,000) as state and local governments tighten their belts.  Overall, this is a good start and a precursor to improved labor picture as the weather improves.

Private sector employment is a key indicator to a healthy labor market.  Most jobs are created by industries and organizations made up of private individuals, rather than government.  One attractive aspect is that over 68% of industries reported job gains, which is the highest since 1998.  This is a sign that business optimism is on the rise and they are expecting the U.S. economy to recover.

One potential negative is that Americans are more leery of the recovery than businesses.  It should be noted that economists was prescient in their job growth forecasts, but were wrong in predicting that the unemployment rate would rise slightly to 9.2%.  Even though it appears that a declining unemployment rate in this case is good, that should be tempered by the fact that many people are still discouraged.  As reported by the Economic Policy Institute, labor force participation rate remains low at 64.2%.  During a healthy labor market, we want to see that figure to be in the high sixties.  Another indicator that people are still on the sidelines is that the employment to population ratio has declined from 58.5% to 58.4%. Of course, the momentum can quickly change as the weather improves and business optimism continues.

As we look in the future, there are trends that will need to be monitored.  Should we be encouraged by higher business activity and greater optimism?  Or should we be concerned by the recent surge in gas and energy prices?  If the labor market continues to improve, then one can point to a stabilizing Middle East picture.  However if rebellion and disruptions become more significant in that region, that can reverse labor market optimism quickly.