No. 19 — May 12, 2000


Weekly Review

--- by Douglas Ostrom

Will consumers loosen their purse strings when their incomes are flat or falling? Will businesses resume spending on plant and equipment even though they are judged to have too much physical capacity already? The fate of the Japanese economy over the next few months appears to hang on these questions. While a number of short-term indicators are looking up, sustained growth depends on individuals and companies behaving in ways that seem somewhat illogical at first glance. Not surprisingly, nearly all analysts have couched even moderately upbeat economic forecasts in qualified terms.

The Economic Planning Agency captured this unsettled state of affairs in its April economic report with the following assessment:

The Japanese economy has not yet got[ten] out of the severe situation, as the recovery of aggregate demand remains weak. However, activities continue to improve moderately, through the influence of various policy measures and of the Asian economic recovery. As positive activities by firms have begun to be observed, there are gradual movements towards an autonomous recovery.

In other words, do not expect too much too soon. However, the next major news from EPA may make such guarded optimism harder to maintain, although that would be the appropriate reaction. Most private-sector forecasters — foreign and domestic — believe that the agency will announce in June that price and seasonally adjusted annualized gross domestic product jumped about 10 percent in the January-March period. Roughly half of this surge will reflect the so-called leap-year effect, a consequence of the economy having had an extra day to produce output in the first quarter. Even after accounting for this factor, the gain in real GDP likely will more than erase the 5.5 percent contraction registered in last year's fourth quarter (see JEI Report No. 11B, March 17, 2000).

Yet EPA officials as well as most business analysts are cautious about the economy's near-term prospects. One reason is the fickle Japanese consumer, who generated 62 percent of nominal GDP in the October-December quarter. Total cash earnings remain below the year-earlier level, and unemployment, which registered 4.9 percent on a seasonally adjusted basis in both February and March, is at a record high. Indicative of these constraints, the Management and Coordination Agency's Family Income and Expenditure Survey has reported year-to-year declines in its key measure — spending by salaried workers' households — in seven of the past eight months, including an unexpectedly large 2.7 percent drop in March following a leap-year-related gain of 2.9 percent in February, the first improvement since July 1999.

Nonetheless, many experts think that consumer spending is poised to take off. Analysts at J.P. Morgan Securities Asia Ltd. note, for example, that increases in personal consumption lag rising consumer sentiment by an average of two quarters and that, for whatever reason, people are becoming more optimistic. In the January-March period, EPA's index of consumer confidence — where a value of 50 (rarely achieved) is regarded as neutral — registered 42.2, up from 41.5 the previous quarter. With the latest rise, the index has gained for three straight quarters and is at its highest level since July-September 1996.

The main reason for the improvement is greater optimism about job prospects, even though consumers still are very pessimistic on this score, with an EPA reading of only 34.7 regarding employment. The more buoyant sentiment, such as it is, may be due to increasing overtime hours, which in the manufacturing sector rose at a double-digit rate in March for the fourth straight month on a year-to-year basis. Not only does overtime put extra money in workers' pockets, but it also may foretell additional hiring over the near term, increasing the likelihood that unemployment could be close to a peak.

On the capital spending front, most analysts argue that corporate Japan has yet to absorb the extra capacity that it added during the "bubble economy" years of the late 1980s and again in 1996, when the economy appeared to be recovering rapidly. If so, firms should be investing in plant and equipment at less than the rate of depreciation, which is estimated at between 8 percent and 10 percent of GDP. Yet even the fourth quarter's depressed GDP figures put nominal capital spending at 14.4 percent of aggregate output. That points to expanded productive capacity unless the depreciation number is far too low.

What may be happening is that businesses have not recognized the economic — as opposed to the physical — depreciation of their equipment. Thus, they may be carrying on their books at close to face value equipment whose use no longer makes economic sense, even if it never has been uncrated. Recent rates of capital spending relative to GDP might be plausible in light of this scenario.

This argument does not imply that an increase in capital spending is in the offing, however. The recognition of economic depreciation could trim reported profits dramatically. Inasmuch as considerable research indicates that plant and equipment expenditures rise with profits, the required adjustment suggests, if anything, a decrease in business investment.

What firms actually do could be different, of course. In the fourth quarter of last year, a seasonally adjusted 9.9 percent jump in equipment orders other than for ships or from the electric power industry, a major leading indicator, hinted at an upturn in capital spending this year. Still, EPA is predicting a 1.6 percent quarter-to-quarter fall in orders in the January-March period after a 2.5 percent month-to-month drop in February.

The recent ups and downs of EPA's equipment index suggest caution regarding an increase in plant and equipment expenditures this year. On balance, an uptick in business investment is at least as uncertain as a sustained improvement in consumer spending, although positive omens exist for both. In each case, however, the optimistic scenario assumes that certain actions will be taken in the face of compelling reasons to behave otherwise. That could happen, but even EPA is not willing to bet on it.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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