On wage growth in US and Japan and China’s shadow lending

I had four big topics in today’s links: Japan, China, Ukraine and Spain. I want to concentrate here on the two Asian countries over the European ones. The wage issue in Japan is an important one because it informs the policy choices in the US and Europe. And the Chinese slowdown is having a big impact on commodity markets, softening growth prospects in emerging markets and commodity exporters.

Here’s what’s happening in Japan. The country has been in an economic funk for two decades with multiple inter-related problems: wage and price deflation, demographics, structural rigidities, stop-go fiscal policy, large government debt, and zombie corporates. Shinzo Abe came to power with a mandate to shake up the economic system in order to get Japan’s economy growing again. The problem was that there is no consensus about how to do so.

The Wall Street Journal has a good article about the duelling views driving Abenomics.

The next big test for Abenomics comes Wednesday when Japan’s major companies decide whether to raise base salaries for the first time in years. Prime Minister Shinzo Abe has cast a spotlight on the question, with his unusual public campaign pressuring executives to lift worker pay.

Behind that push lies a little-noticed rift among the academic economists shaping the battle to end the country’s long slump. The heart of the debate: Have stagnant wages been a cause, or a result, of deflation? And will lifting wages cure the disease, or, absent other fixes, just create more ailments?

“I believe wages hold the key,” Tokyo University Prof. Hiroshi Yoshikawa told The Wall Street Journal recently. “Japanese wages started to fall in 1997-98, and that has caused deflation to take hold.” That’s the core argument of his book, “Deflation,” published in January 2013, the month after Mr. Abe became premier.

The book contradicts the driving thesis of Mr. Abe’s closest economic advisers, who had persuaded the prime minister that the single most important factor behind the vicious circle of falling wages and prices was an overly tight money supply, and that the solution was shaking up the Bank of Japan.

In essence, one set of advisors, the ones closest to Abe, believe the problem is a monetary one because wage ‘inflation’ would just mean problems for employers, who would be forced to cut employment. The other set of advisors is saying that a monetary solution that pushes down the Yen and pushes up prices would be a tax on consumers without wage increases and the economy would stall. I side with the second view, one reason I believe Abenomics will fail as I see Abenomics more geared to the first view.

But Abe has been pushing on the wage front in order to hedge his bets. And there has been some payoff in the annual labor negotiation round in Japan. The problem, however, is that the wage increases are not very large – $26 per month. And the unionized wage labor rounds have less importance in Japan due to the decline of unions. The wage agreements have to be a signal taken up by a host of other employers, including small business. And it is doubtful that this will occur.

The reason I side with the second group can be seen from sentiment surveys. Business sentiment is high and consumer sentiment is at all-time lows. This tells us that the increased government deficit and decrease in Yen has been beneficial to the business sector but has yet to filter through to households. Stocks are soaring as corporates make more money, but average Japanese are not making more and so consumer sentiment is weak. With the consumption tax coming on 1 April, I expect to see a fall in consumption growth unless we also see wage growth in Japan. The increase in consumer prices only makes this situation worse.

These same issues drive the policy debate in Europe and the US. Last Friday, I mentioned Tim Duy’s piece on how the Fed tightens before wage growth has a chance to become sustained. What the piece reinforces is the notion that policy is captured by business interests. Wages are seen as labor ‘costs’ to business. And when they increase that is seen both as a net negative for business and fuel for embedding inflation. As a result, policy is geared toward reducing wage ‘inflation’ such that as soon as wages have a chance to rise, economic expansions get cut off. The result is an economy geared toward asset price inflation to maintain consumption and economic growth, a policy paradigm which is destabilizing and that will ultimately fail due to the high levels of household debt.

I have pointed to the decline in disposable income as a sign of weakness going forward.

Personal Income 

However, in the US, the hawks see something else happening. This chart from Deutsche Bank shows wage costs rising.

wages-and-unemployment.png

And you can see the narrative surrounding the chart just looking at it: wage inflation is inversely correlated to the unemployment rate. And because the unemployment rate is dropping, wage pressure is rising. That is bad and means the Fed is behind the curve and will have to tighten more aggressively than anticipated. Vincent Reinhart, Morgan Stanley’s Chief Economist says that the long-term unemployment problem is structural and so the U3 rate of 6.7% is indeed a good measure for discerning how much slack there is in the system. His contention is that the US economy’s potential is now only 2%, with 6% unemployment representing “full employment”.  That’s where this is headed in the US.

In Europe, the whole idea in the periphery is to get wage and price cuts to boost competitiveness. Japan has seen wage and price cuts though and the deflation that Japan has seen has become embedded. So again, Japan informs the policy debate. The orthodoxy in Europe is actually trying to recreate the Japanese scenario in the periphery by forcing through internal devaluation as a policy response to the European sovereign debt crisis while others are saying this will lead to embedded deflation and a Japanese style outcome. I think the second group are right and that the eurozone’s institutional rigidities including the ECB’s non-monetisation clause and the lack of fiscal space mean the outcome could be worse in Europe than Japan when a cyclical downturn hits.

That brings me to China. The biggest source of global growth concern has to come from what’s going on in China. The short story here is that China has seen the level of malinvestment from its infrastructure and export-led growth model skyrocket. And a housing bubble has developed to boot. The Chinese, concerned about the ill effects of this, have decided to rebalance the economy toward a domestic consumption-led model. Given the low levels of consumption in China and the poor demographics, this transition is fraught with peril and necessarily means a growth hiccup as it occurs.

What we are seeing right now in China is that the crackdown on excess credit, particularly in the shadow banking sector is having an impact. Shadow lending is falling sharply as a percentage of total lending. The FT reports “on-balance-sheet bank loans accounted for nearly 64 per cent of new credit issuance in China in the first two months of 2014, up from 55 per cent last year. At the same time, lending by trust companies fell from nearly 11 per cent of new credit to just over 5 per cent.”

The result is a lessening demand for industrial metals and raw materials for infrastructure capital expenditure. And this is roiling commodities markets. The last I heard Shanghai’s copper market opened limit down over 5% as prices are hitting 4-year lows. Iron Ore is also taking it on the chin. This level of commodity volatility will have a spillover effect into emerging markets. I believe the EM problems have much more to do with vulnerabilities exposed by the slowdown in China and the commodities market than they do with the Fed’s tapering. And so the lack of demand and fall in price of these commodities will cause another wave of emerging market volatility to come sooner than later. At that point, we will see whether the off-balance sheet issues in EM show corporates to be as sound as they appear on paper.

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