August 17, 2005

Watching Japan.  The past few weeks have been very interesting in Japan.  There is a major political shake-up going on, centered on, what else, the economy.  Prime Minister Junichiro Koizumi has been leading a valiant effort to reform the Japanese economy since his election in 2001.  He is seeking to modernize the Japanese financial and labor markets as well as the entire Japanese government.  His biggest opposition has come from within his own party!

Last week the old guard of the Liberal Democratic Party, which Koizumi heads, pulled together with the opposition and defeated Koizumi’s push to modernize the Japanese Postal savings system.  As promised, Koizumi called for quick elections.  The elections in Japan will take place on September 11^th.

This is a very risky move for Koizumi because, in part, the Japanese economy appears to be stalling…again.  Getting reliable current economic data for Japan is a bit of a challenge, but those in the know think that the Japanese economy will probably grow in the 1.2 to 1.8% range.  Not great compared to U.S. growth rate in the 3.5 to 4.0% range.  But, at least Japan is doing better now than it was in the 1990’s when it’s average annual growth rate was around only 1%.

Politically Koizumi also has some “foreign policy” issues that might cause him problems in the polls.  The point is it’s not certain at all that Koizumi will win the election.  Katsuya Okada, leader of the opposition DPJ (Democratic Party of Japan) has called the upcoming election the “most important general election since the end of World War II.”  Economic reforms, or the lack of them, may play an important role in the outcome of the election.

For certain the up tick in Japanese economic performance is due to the (limited) reforms Koizumi has been able to push through.  Yet so much remains to be done.  Japan has a huge fiscal deficit.  With Japan’s aging population government health care costs and social security spending are sure to increase in the coming years.  Thus, Japan has got to get its economy growing again.  The IMF has argued that Japan needs to increase its productivity to get its economy moving again and to help correct some of the “global imbalances” that exit:  i.e. to be able to continue to buy U.S. Treasury bonds.

It will be an interesting autumn in Japan.

How High Will They Go?  The Fed’s Open Market Committee decided earlier this month to raise short term interest rates, again.  This is the 10^th time since June of last year that the Fed has hiked its target for the Fed Funds Rate, currently sitting at 3.5%.  The question everyone seems to be asking is:  how high will the Fed go?

Well…in order to answer that question, we have to ask another question:  why are they doing this?  Is there persistent inflation the Fed is trying to control?  No.  So what are they up to?  The answer is it is the “forward looking Fed.”  The Fed is, basically, worried that the U.S. economy might start to grow “too quickly.” 

If you look at the data you can see why they are worried.  Not only is U.S. output growing at a nice healthy rate, worker productivity continues to advance.  Usually these are wonderful things to have happen…but, just like anything else, too much of a good thing can be bad for you and remember, in economics, everything is relative.

If the economy grows too quickly it can put strain on capacity and thus costs are likely to increase.  Increased costs will then be passed on to consumers (usually) and you have inflation.  Productivity, on the other hand, if it does not increase fast enough will mean real labor costs are increasing.  These higher labor costs are again, usually passed onto consumers in the form of higher prices, throwing even more gas on the inflation fires.

So the Fed is a bit worried.  Yes, higher energy prices don’t help, but it is really the capacity and productivity issues that are their main concern.  Remember in all of this: there are huge measurement problems.  We are not exactly sure how “fast” the U.S. economy can grow before capacity gets constrained.  Also, there are various measurements of labor productivity:  some show productivity increasing at moderate rates, others show productivity advancing very strongly.  So…remember this is not an “exact science” by any stretch of the imagination.

Having said that, watch for the Fed to keep raising short term rates throughout the rest of year.  Also, keep an eye on long term rates.  If they start to increase (which they haven’t thus far) that might slow the economy down a bit and thus lessen the need for the Fed to continue to raise short term rates.  Also, watch housing prices.  Some in the Fed argue the Fed has to keep raising short term rates in an attempt to “let the air out” of the housing asset bubble.  If housing prices start to moderate, this again would reduce the need for the Fed to continue to raise short term rates.

Own Price Elasticity of Gasoline.  In addition to teaching Macroeconomics to the daytime MBA students I am also teaching Microecon to our Evening and Executive MBAs.  One of the micro topics we, naturally, talk about is own-price elasticity of demand (how sensitive are buyers to changes in price of a good).  One of things I try to point out is how much elasticity can change over time.  For example:  gasoline and energy.

Own price elasticity of gasoline is relatively inelastic in the short run.  If the price of gas increases, we still buy the same amount of gas:  we still have to get to work, to the grocery store, etc.  Ah…but, over time, demand becomes much more elastic.

In the 1970’s with the big run up in energy prices, it took us a few years to start driving more fuel efficient automobiles, demanding more efficient appliances, etc.  Might the same thing happen this time around?  If gasoline and oil prices stay at their current levels or go even higher (which is likely) how elastic will demand become?

Will it mean the end of the SUV?  Will the Hybrids finally “be worth it?”  Will we start to see more Natural Gas refueling stations in suburban areas?  It will be interesting to watch.  It will also be interesting to see who is the first to take advantage of these changing market dynamics.

Sometimes, although rare, microeconomics can be interesting too!

All the best,