Japan: The Canary in the Coal Mine

"When the canary dies, there is nothing to do but run for the exit" Anonymous

Japan’s economy appears to have fallen off a cliff in the fourth quarter of 2008. The decline in production, exports, shipments, the labor market, … all point to a recession of titanic proportions. Every data series I checked looks at least as bad as it did during Japan’s 1997 recession which took place amidst the Asian Financial Crisis. Most of the series are considerably worse. Flemming Nielsen of Danske Bank does an admirable job of summarizing the recent economic data and its implications for Japan in this note: Japan: Sharpest drop in industrial output ever.

Based on the data received over the past week, Mr. Nielsen expects a fall in fourth quarter output in excess of 5 percent (annual rate). He is most likely right, although I would point out two sources of upside risk to his forecast. First, given the sharp drop in production, imports are likely to fall sharply in December, making an arithmetic positive contribution to GDP. Second, inventory accumulation is large. He points out the large accumulation but seems to miss the potential impact on GDP. This impact could be even further exaggerated if prices fall, boosting real NIPA inventories. Neither of these risks is good for Japan, but they may support GDP.

In any event, Japan’s economy is in big trouble. I am much more concerned, however, with what Japan’s data has to say about the health of the global economy. All of the data releases discussed in Mr. Nielsen’s report are for November: Japan leads the world in the early release of economic data (it’s noisy and subject to revision but early). We have yet to see meaningful macro data in the other industrial countries for November.

The fall in Japanese production was driven by capital goods, intermediate (producer) goods, and motor vehicles. The fall in motor vehicle production, while bad, is not a surprise. We already knew car production was curtailed in the United States and Europe and there is no reason to expect Japanese car makers to escape the decline in auto demand.

The fall in capital and intermediate goods, however, is ominous. The decline in demand, long evident in the consumer sector, has reached the level of production. Capital goods are investment goods and intermediate goods, as the name implies, are necessary for production. Output is falling, is likely to fall much further, and the decline is not isolated in Japan.

Real Japanese exports fell 14.5 percent in November. The drop in exports was spread among Japan’s trading partners, with large falls to the United States, the European Union, and China. While trade data never lines up month for month perfectly, the large drop in Japanese exports implies a large drop in demand across the rest of the world.

The decline in Japanese trade is not anomalous. Since July, the Baltic Dry Index, the best timely indicator of shipping costs, has fallen like a rock. The index, which had soared to astronomical heights over the last several years, is now sitting at about ½ of its long-term average. The most likely candidate for the fall in the price of shipping is a sharp reduction in the volume of global trade.

In addition to the trade data, recent survey data in the United States seem to corroborate the Japanese story. The manufacturing reports for November recently released by the various Federal Reserve banks indicate a sharp fall in activity. Most of these reports have now fallen to record or near-record lows. Taken individually I would be inclined to discount them; but as a group and combined with the Japanese data, they indicate devastation.

Brace yourself. The data flow over the next month or two are likely to reveal a global economy that is significantly weaker than was previously known.