Peter Franklin

Peter Franklin is Associate Editor of UnHerd. He was previously a policy advisor and speechwriter on environmental and social issues.

August 22, 2017

Do you have an economics textbook to hand? If so, chuck it out with the recycling because it won’t be much use for much longer.

In a fascinating post for Bloomberg, Noah Smith describes the Japanese economy as “the graveyard of economic theories”. And moreover, I’d argue, a graveyard that portends the future for other advanced economies.

The Japanese economy is well known for its combination of full employment, massive government borrowing, low growth and, most remarkably, low (sometimes negative) inflation. This isn’t supposed to happen, not for any extended period – let alone year after year, decade after decade:

“Basic econ theory says that as the labor market gets tighter, competition should push up wages, which will then boost consumer prices via increased demand and higher costs. In Japan, nothing of the sort has happened – wages and prices show little sign of rising despite the disappearance of unemployment. So much for the Phillips Curve.

“So Japan’s experience underscores one central, disturbing truth: Economists really have no idea how inflation works. It is simply a mystery. Macroeconomists have been thinking about inflation for decades, but no real progress has been made in understanding where it comes from or how to produce it with policy.”

Strange as it may seem, the Japanese government has been doing its best to kindle inflation (in order to avert deflation), but it’s been a struggle.

Smith looks on the bright side:

“…is Japan’s lack of inflation really such a bad thing? The country’s per capita growth is pretty low, but that’s just because of population ageing. Measured in terms of real gross domestic product per employed person, the country has been growing in recent years.

“In other words, despite a near-total lack of inflation, Japan has managed to grow and increase employment. That means Japan is in the midst of that rarest of situations – a disinflationary boom.”

For me, this is over-doing the optimism. Smith’s point about GDP per worker is perfectly true, but a country’s GDP has to support the whole population not just the workers. Furthermore, Japan’s labour productivity (i.e. GDP per hour worked) is the lowest in the G7 group of nations, lower even than Britain’s dismal performance.

This hardly bodes well for the future – a future that beckons for all countries with ageing populations. Japan is furthest along the downward sloping demographic curve, but Germany and Italy now have comparable birth rates and so look set to find themselves in the same situation.

An ageing population isn’t some extraneous factor that has to be statistically stripped-out to reveal the true picture. Rather, it is absolutely central to what is happening in our economies and to the unravelling of economic theory.

The direct economic impacts are obvious; pensioners work less and consume less, and (through primary expenditure and borrowing costs) they add to the tax burden on the working age population. But that’s not all.

In 1936, John Maynard Keynes wrote about the “animal spirits” of the economy – the dependence of ‘positive activity’ (e.g. things like enterprise, investment, innovation, consumption) on “spontaneous optimism rather than mathematical expectations”. Ever since, his argument has been used in support of counter-cyclical economic policy (i.e. governments splashing the cash when consumers and business don’t feel like doing so). But what if animal spirits are as relevant over the long-term as they are to the business cycle?

Japan’s population is set to shrink by a third over the next half-century. What do you think that does for a country’s “spontaneous optimism”?