Friday, March 18, 2011

Will Japan's Catastrophe Trigger a Worldwide Economic Depression?

Japan has just been hit by  biggest fall in stocks since the two-day fall of the 1987 global stock market crash.

Japan was already teetering on a bad economic situation before the current disaster. Their markets were already trashed.

Could this compound their problems and set in motion a ripple effect that will plunge the whole world into an economic meltdown?

We must not forget, that although China has surpassed Japan as the second largest global economy, it is still the third largest financial power in the world.

Still, just 16% of adults say America’s relationship with its former World War II enemy is not very or not at all important. 59% of Americans say Japan is an ally of the United States. Only 10% view the country as an enemy, while 24% think of it as somewhere in between an ally and an enemy. 46% believe America should help Japan militarily if it comes under attack, but 41% disagree.

So is the United States ready to help our second biggest financial trading partner master their disaster?

Japanese cash plays a crucial role in global bond and stock markets. Despite two decades of stagnant growth on home turf, Japan is the second largest foreign owner of US government securities, with nearly $900bn of America's public debt. This time it could be the rest of the world that takes a financial hit while the Japanese economy booms.

To understand how this could happen, we need but to follow the Japanese money. Savings by individuals and money held by Japanese insurers and financial institutions amounts to trillions of dollars in cash, much of which makes its way on to world securities markets. When natural disasters happen in Japan, individuals and companies need this cash to rebuild, and insurance companies need it for payouts.

Earthquake insurance is hard to get for most households in Japan, so much of the cost, estimated at $100 billion, will have to come from a mountain of ordinary savings held in Japanese financial institutions, much of it invested overseas. Japanese insurers will also have to sell overseas assets, but they will be spared the full cost because they have reinsured a lot of their risk with overseas insurance firms, who in turn have reinsured it with other insurers. This insurance trail is a global labyrinth. Japan's risk, it turns out, is the world's risk.

As was expected, when US markets opened on Friday, the sell-off of Japanese-held treasuries began. Bond prices fell and yields rose, although analysts say the selling was offset by buying from investors fleeing debt problems in the eurozone and unrest in the Middle East.

Within hours of the disaster the yen was sold off in record perportions. Japan's central bank says it will inject 15 trillion yen into the economy to stabilise markets, but that didn't stop the Nikkei index slumping 16% so far this week. This is the biggest two-day fall since the 1987 global stock market crash.

As stock markets plunge around the world, Ray Suarez talks with The Economist's Greg Ip about the economic fallout from the ongoing disaster in Japan on PBS Newshour.

Yet, all of this was predictable. In 1991 Peter Hadfield wrote a book, Sixty Seconds That Will Change the World, about the consequences of a major earthquake in the Tokyo area. Peter wrote that the rest of the world would come off far worse than Japan and that US treasuries would have to be sold to meet insurance claims and pay for rebuilding, resulting in falling bond prices and rising interest rates. The yen would then rise as these overseas savings were sent back to Japan. What a scam!

A model produced by the Tokai Bank in 1989 found that Japan, after experiencing severe short-term negative growth, would bounce back as the cash flowed home and the rebuilding began. It was the rest of the world, starved of this investment and hit with rising interest rates, that would end up in a recession.

However, today Tokyo's fiscal position, awash in debt that amounts to two years' worth of GDP, can ill-afford the generous injections it is making to stabilise markets and the spending that will be needed to restore infrastructure.

The immediate effect on the Japanese economy will likely be to send Japan into a worsening  recession, possibly escalating into a depression. However, if production of everything from cars to concrete will be ramped up to satisfy the expected demand, within a year the rebuilding effort could deliver growth.

The Japanese are tremendously energetic and disciplined race. They have more than a 1000 years of Martial Arts Culture and warrior spirit behind them. Even though their population is aging, they still have the capacity to recover quickly. They are a very able, talented, hard working people like the Chinese, Koreans and the Germans.

In the Grand Scheme of things, however, Japan has little natural resources and no essential strategic location. A World Wide depression will originate from a strategic and natural resource rich region like Middle-East or Central Asia, which sucks in major world powers with natural resources like oil, diamonds and gold.

Japan will face orderly stagnation or very very gradual decline, but is not a likely candidate for causing a World Wide event.

Do you believe the world is headed for a financial  meltdown? If so, do you think Japan's current crisis could be the beginning of a downwards spiral towards a global economic depression?

My readers and I would love to know what you think, so please let us know your opinion in the form of a comment, bellow.

Written By: Tom Retterbush

For more on this subject, read my post, Economists Fear US Apocalypse, which includes predictions from world famous economist Nouriel Roubini, who first gained national recognition after predicting the chaos wrought by the mortgage crisis and the collapse of the housing bubble.