The Macroeconomic Aftermath of the Sendai Quake

What’s at stake

In days following Japan’s devastating earthquake and tsunami, television and Internet images have been among the most shocking in recent memory. While we are all still struggling to come to grips with the devastation, destruction, and death that occurred in Japan, a debate is already emerging about the extent of the economic impact of the disaster for the Japanese and the world economy.

Assessing the immediate impact

Greg Ip writes that for all the horrifying images and news out of Japan, the consensus seems to be that the economic consequences will be small. This, after all, seems to be the lesson of other disasters. If so, then the sell-off in global markets in recent days is overdone. The indirect economic damages may be caused by the direct damages to physical infrastructure (for example, the damage to the fishing fleet in the Sendai area), or because reconstruction pulls resources away from production (for example, the problems experienced by several industries as a result of rolling blackouts instituted to redirect electricity to the affected area) but Ilan Noy reviews the literature and finds that there is no evidence from recent data that even large natural disasters have any measurable adverse impact on the national economy of rich developed countries like Japan.

James Hamilton argues that in assessing the economic consequences, it's useful to draw a distinction between narrow-swath and wide-swath disasters. In a narrow-swath event like 9/11, the destruction was horrific but was narrowly focused, leaving intact the response infrastructure and allowing immediate access to the impacted areas. In a wide-swath event like Katrina, the nature of the disruption made it very difficult logistically for any emergency or relief operations to function, and returning to some sort of normalcy was a very difficult process. In the current situation, Japan's damaged infrastructure includes electricity generation and transportation. Fear of radiation could hamper not just immediate relief efforts, but could profoundly influence all kinds of spending patterns, which I could easily see exerting big effects on demand in addition to the obvious considerations on the supply side.

Greg Ip argues that this assessment fails to capture an important reason disasters can be economically debilitating: uncertainty. Damaged infrastructure, lost capital stock and lost output are only part of the cost, and not necessarily the largest; there is also the uncertainty surrounding how big those costs will ultimately be. Earthquakes and nuclear disasters are, individually, rare; in combination, they are unprecedented. Any investor or business watching events unfold in Japan is groping to quantify the ultimate impact: how much infrastructure has been damaged? How many people will have to be evacuated? How long will the disruptions last? In econo-speak, Japan’s disaster is an example of Knightian uncertainty.

Impact on world production

Stephen Roach argues the disaster may produce some disproportionate supply-chain effects in autos and information-technology product lines such as flash drives, but any such disruptions would tend to be transitory.

Paul Krugman notes that you really need to think of China, Korea, Japan and so on as being part of an East Asian manufacturing complex – and it’s not clear yet just how much damage will be done as Japanese chips and other components are an important part of world manufacturing. Michael Schuman argues that this supply chain problem may be short-term, as companies find new sources of components, and there is enough spare capacity in Japan and elsewhere to replace production lost to quake damage. But that doesn't mean the disruption won't be costly.

Impact on world bond markets

Paul Krugman writes that he’s terrified about the possible loss of life; nervous about the disruption of world production; but not worried at all about the impact of Japanese borrowing on world bond markets. Japan will clearly have to spend hundreds of billions (dollars, not yen) on damage control and recovery, even as revenue falls thanks to the direct economic impact. So Japan will become less of a capital exporter, maybe even a capital importer, for a while. And this, so the story goes, will lead to soaring interest rates. The story about rising interest rates would be right in normal times. But we’re not in normal times: we’re — still — in a liquidity trap, with short-term rates up against the zero lower bound. Government borrowing doesn’t have to come at the expense of private investment, driving up interest rates; instead, it just mobilizes some of those desired but unrealized savings. And yes, this does mean that the nuclear catastrophe could end up be ing expansionary, if not for Japan then at least for the world as a whole. If this sounds crazy, well, liquidity-trap economics is like that — remember, World War II ended the Great Depression.

What’s moving the yen?

FT Alphaville reports that the yen reached historic highs against the dollar late Wednesday. One of the prevailing theories (still) is that Japan’s disaster will increase repatriation flows by insurers to meet claims, or that Japanese companies will repatriate foreign earnings to help rebuild — all boosting the yen. This school points to what happened after the 1995 Kobe earthquake to illustrate their case. Nomura have already dismantled the theory — pointing to a vastly different global monetary situation in 1995. What’s more, actual repatriation of assets in 1995 looks to have been relatively small.

Felix Salmon argues that what we’re seeing here is a function of ultra-leveraged hedge funds unwinding their carry trades. If you borrowed yen and invested in higher-yielding currencies like the Australian dollar or the South African rand, you made lots of money so long as the rate of appreciation of the yen was lower than the interest rate you were getting in the target currency. But when the yen starts to appreciate dramatically, you get margin calls, which force you to buy a lot of yen in an illiquid market, which in turn drives the yen up even further, which in turn not only increases the size of your margin call but also triggers a large number of stop-loss orders and other triggers embedded in exotic FX options.

The case for coordinated yen intervention

The FT reports that the yen fell in early Asian trading on Friday after the G7 agreed on joint intervention.World finance ministers had held a conference call on Thursday evening to discuss Japan, raising the possibility of large-scale
co-ordinated currency intervention for the first time in a decade.

Gavyn Davies argues that there may not be many occasions where co-ordinated foreign exchange intervention is the right thing to do, but this is certainly one of them. In the aftermath of the Kobe earthquake in 1995, the yen temporarily surged by almost 20 per cent against the dollar, and a repeat of that episode now would greatly add to deflationary pressures in the economy. Although the currency is not atan extreme in real terms against the rest of worldand Japan is actually better placed than it was in 1995 from that point of view, deflationary pressures are now more entrenched, and there is no scope for cutting interest rates to offset currency strength. In 1995, short-term rates entered the crisis at 1.75 per cent, which offered some scope for conventional monetary easing. They may not be able to cut interest rates below zero, but they can intervene to inject liquidity instead as direct sales of yen in exchange for dollars have exactly that effect. In consequence, and somewhat unusually, foreign exchange intervention supports the desired direction of domestic monetary policy, rather than working against it.

The impact on the normalisation of monetary policy

Ralph Atkins argues that itis still three weeks until the next interest-rate setting ECB governing council meeting – so a lot could happen – and there is no need for its members to take any decisions just yet. But the arguments for an ECB rate hike have not necessarily changed. Mr Trichet and his colleagues have talked about anchoring inflation expectations and averting “second round effects” – the threatthat higher inflation caused by commodity and oil prices becomes entrenched by feeding through into wage increases. But there is also a strong sense in Frankfurt that, with the eurozone economy growing at a steady (but not spectacular) pace, the “normalisation” of monetary policy is overdue, all the more so given what we now know about the dangers of leaving borrowing costs too low for too long.

Tim Duy writes that the Fed failed to mention the unfolding crisis in Japan in its policy statement certainly because little information is known about the economic risk or they don’t perceive it to be the primary risk in the US outlook. Monetary policy continues on autopilot – they still plan that QE2 will end as expected at which time policymakers will turn their attention to policy normalisation, setting the stage for a rate hike in 2012.  Watch for signs that the downside risks (oil, Japan, Europe, etc.) are evolving in such a way that they are impacting actual data, with the weak reading on consumer confidence being a cautionary tale.  But if the data holds up, with steadily improving labor markets and improving inflation measures, the next test for monetary policy will be the end of QE2.

The long-term impact on energy prices of the nuclear fiasco

Michael Schuman argues that over the long-term, it seems highly likely the nuclear fiasco will undercut what had been increased interest in nuclear power around the world, and that will have major implications for global energy markets. The Monkey Cage dig out interesting data on whether the explosions at the Fukushima Daiichi nuclear plant will undermine political support for nuclear power plants. A good case study comes from the opinion surveys from the 1986 Dutch elections before and after the Chernobyl accident. The Chernobyl accident happened less than a month before the elections. The Dutch National Election Study surveyed voters both just before the accident and right after the election on both their attitudes towards nuclear plants. The average voter opinion shifted rather dramatically towards opposition against more nuclear plants after the Chernobyl accident. Moreover, voter opinion pretty much stayed there for the next decade.

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