The magnitude of the economic impact from the March earthquake and tsunami has come into focus in recent weeks. Already the disaster's impact has spilled out beyond the stricken area and is spreading across the country. The ultimate effect on business conditions will depend to a large degree on how Japanese industry and government cope with five sources of secondary damage: (1) suspension of production at disabled industrial facilities, (2) constraints on electric power consumption in eastern Japan, (3) the prevailing mood of economic austerity, (4) exaggerated fears of radiation from the Fukushima nuclear reactors, and (5) sources of funding for the government's relief and reconstruction budget.
Identifying the Threat
Some six weeks since the Great East Japan Earthquake and tsunami that devastated much of Japan's northeast coast, people are coming to understand the full extent of the disaster's likely impact on the Japanese economy.
Initially the focus of the nation's concern was the direct damage from the tsunami in the Tohoku district and the spread of radiation from the damaged facilities at Fukushima Daiichi Nuclear Power Station. Only later, as businesses attempted to resume routine operations, did it become clear that various bottlenecks were seriously impeding normal economic activity.
For example, even factories remote from the hard-hit Tohoku region have been forced to suspend operations because essential parts have stopped coming in from Tohoku plants. Automobile and electric equipment manufacturers have been particularly affected by this breakdown in the supply chain, but similar problems have cropped up among manufacturers of food, steel, chemical, petroleum, and pulp products, all relatively important industries in the Tohoku region. This is an example of indirect, or secondary, economic damage resulting from the disaster, but it is only one example among many. In the following I would like to consider a wider range of secondary effects and their possible impact on the Japanese economy in the months ahead.
Five Sources of Secondary Damage
The secondary economic damage from the earthquake and tsunami can be divided into five basic causes. In the following, I will examine each in turn.
1. Interruption of Production
The first source of damage is the aforementioned disruption to manufacturers' supply chains. In Japan's manufacturing sector, the major corporate groups often have subsidiaries and suppliers scattered all over the country. As a result, even companies headquartered far from the Tohoku district are likely to have suppliers located there. In a March 14–18 survey of companies in and around Osaka, far from the immediate disaster, close to 90% of respondents indicated that they were concerned about the impact on their own business—with 75.6% saying that the damage was already in evidence and 12.2% directing their concerns toward the future—while only 12.2% said that they did not expect to be hurt. A comparable survey in the relatively unscathed Nagoya area yielded similar results. A major reason companies outside the Tohoku district are this concerned about the impact of the disaster on their own businesses is that they are connected to the Tohoku region through their supply chains.
2. Restrictions on Power Consumption
The nuclear accident at the Fukushima Daiichi Nuclear Power Station seriously compromised the generating capacity of Tokyo Electric Power Company, which operates the facility. During March, TEPCO began implementing rolling blackouts in the densely populated Kanto district, which includes Tokyo, in a bid to avert massive outages by keeping electricity demand from exceeding the utility's much-reduced generating capacity. These measures appear to be sufficient to avert a worst-case scenario through April.
But businesses know they are not out of the woods yet. They understand that as the demand for electricity rises in the summer months, they will be forced to adopt ever more stringent measures to limit power consumption. Initially the government had called on big businesses to prepare for a 25% cut in peak power consumption during the summer, based on TEPCO's own forecast of 46,500 megawatts in generating capacity. Since then, TEPCO has upped its estimate to 55,000 megawatts by securing a variety of additional power sources. But since the new forecast still falls well short of last year's peak load of 60,000 megawatts, the government is calling on big corporations to cut consumption by 15%.
Even a 15% reduction in electricity usage by big manufacturers could have a negative impact on corporate profits and affect employment. By my own estimate, the slowdown in production and sales caused by a 15% cut in electricity consumption in the Kanto and Tohoku districts will lead to a 22% drop in business profits and a 0.25 percent point increase in the unemployment rate.
3. Mood of Austerity
Non-manufacturing industries are also facing serious aftereffects, but for different reasons. In this case the main culprit is a national mood of austerity, in which consumers feel compelled to deny themselves luxuries or frivolous expenses. In part this reflects an atmosphere of mourning, but fear of further aftershocks is also a factor. The tourism sector has already been hit hard by mass cancellations of travel, lodging, and other reservations from abroad. As of April 8, some 560,000 such cancellations had been recorded. These trends are bound to have a profound impact on business profits in the non-manufacturing sector. Indeed, the effect on employment may be more severe here than in the manufacturing sector. Once factories are up and running again, manufacturers can go back to producing and exporting their products as before, but non-manufacturing industries must wait for domestic demand to recover, and that cannot happen if consumers are reluctant to spend.
4. Lingering Fears and Prejudices
Of all the trials facing Japan in the wake of the March 11 disaster, none is more difficult or daunting than the ongoing spread of radiation from the damaged nuclear power facilities in Fukushima. Recent government statements have indicated that it could be six to nine months before workers are able to cool down the reactor cores and stanch the leakage of radioactive material. Most people's immediate reaction was that this is far too long. The longer the crisis continues, the more difficult it will be to dispel rumors and lingering fears of radiation. This has already had a devastating effect on Japanese exports of agricultural produce. At the same time, all the work that has gone into reviving regional economies by promoting international tourism has been undone overnight. Between the time of the earthquake and the end of March, the number of foreign travelers visiting Japan plummeted 75% from the same period the previous year. If this situation persists for a year, it could cost Japan as much as 860 billion yen in domestic consumption.
Reconstruction Costs and Fiscal Risk
Government spending to aid reconstruction cannot be considered secondary damage per se, but the repercussions of massive increases in government spending and debt could create serious obstacles to Japan's economic recovery. This is why fiscal risk must be counted among the less obvious sources of secondary damage. Let us examine this hidden threat.
The Japanese government is currently drafting plans to increase spending on public works under a series of supplementary budgets for post-quake reconstruction. It seems that the first such budget, allocating upwards of 4 trillion yen for emergency relief and reconstruction needs, is to be financed without recourse to deficit-covering government bonds, but the next one is almost sure to rely on such bonds and result in further expansion of Japan's already massive fiscal deficit. In terms of fiscal risk, the key question now is whether Prime Minister Naoto Kan can make up his mind to push through a tax hike a little farther down the road.
Prior to the earthquake, Kan had been meaning to call for an increase in the consumption tax to finance social programs, a plan he was to announce in June this year. As soon as the earthquake and tsunami hit, however, the prime minister changed course and tabled the tax hike, ostensibly out of a need to focus on the disaster. This was a critical strategic blunder on Kan's part. Instead of raising taxes and easing international concerns over the Japanese government's debt risk, the prime minister is now seen as using the disaster as a pretext for putting off tough but necessary measures. Kan had a golden opportunity to secure the world's confidence by standing firm on taxes amid the pressure of emergency conditions. Instead, he took the easy way out.
Now the big concern is that the same politicians who are stressing the need for massive government outlays to prop up the economy in the disaster's aftermath will insist that Kan abandon all thought of a tax increase and embark on a policy of financing the reconstruction with deficit-covering bonds alone. In that case, Kan will find it difficult to withstand the pressure. The post-disaster crisis has made it more important than ever for the government to take a strong stand and show the world that it is capable of raising taxes and rebuilding its finances.
It will take time for Japan's stricken economy to turn itself around. Economic growth can be expected to linger in negative territory through the first half of 2011 and remain flat in the third quarter, during the summer months, with growth resuming around autumn. The magnitude of the contraction in the first half of 2011 will hinge largely on the severity of electric power rationing. The strength of the rebound later in the year will depend primarily on the efficacy of the government's supplementary spending packages.
One important variable is the extent to which falling corporate profits caused by the temporary suspension of production are reflected in capital-investment and employment trends. If the effect is greater than expected, then the second-half recovery will be a weak one. The current forecast for fiscal 2011 calls for 0.1% real growth in GDP. Depending on how the situation unfolds, that estimate might have to be revised downward.
Over the past 15 years or so, the Japanese economy has had to struggle mightily after each major recession to regain its pre-slump strength in terms of real GDP. After the 2008 financial crisis, the Japanese economy did not make up the ground it had lost until the end of 2010. After the IT bubble burst in 2001, it took nine quarters for real GDP to return to pre-bubble levels, and it took approximately the same amount of time after the East Asian financial crisis of 1997. Because the potential output of the Japanese economy is in decline as a result of a shrinking population, it is all the more difficult for Japan to recover lost economic ground.
As the foregoing suggests, there are any number of reasons for pessimism with regard to the Japanese economy. But it is important to understand that there are grounds for optimism as well. The Japanese economy may be facing a crisis of historic proportions, but over the years it has been just such occasions that have spurred the nation to throw off the chains of the past and implement bold and successful reforms, thereby emerging stronger than before. Let us hope that the current crisis provides the impetus for the changes that Japan needs to thrive in the years ahead.