Japan's Service Sector Was Firing Up Before Disaster Struck...Then Disaster Struck...What's Next?

The chart and table tell the story of an economy that fell deeply into recession but has seen its service sector recover. The recovery in that sector is by no means full and the MFG sector, which is also on the mend, is short of what we expect when recovery is complete. Still, Japan's momentum was gaining pace when the economy was sucker-punched by a series of natural then not-so-natural disasters.

The disasters - The earthquake was stronger than the worst case scenario for that site. So was the resulting tsunami. The epicenter of the quake was so close to shore that the powerful tsunami it generated gave even Japan with its extremely well prepared network to monitor such things effectively no useful lead-time to respond. The tsunami/earthquake was a double blow in excess of what the nuclear generating plants in the area could withstand and now Japan has a full blown nuclear event in progress with no real way to tell how bad things will get or how long the crisis will drag on.

Damage - Clearly a large part of Japan has been destroyed; the land may still be there but in all too many cases nothing else exists. The human toll is staggering and its full dimension is not yet known. In trying to assess the economic impact there are too many unknowns to do a good job. But we do know that these affected areas produced about 8% of Japan's GDP. But portions of some of the cities in this area were completely wiped out. Beyond the human toll there is question of how many skilled workers were lost in this disaster. The economic focus is on the various manufacturing facilities in the region: some were swept away, others were damaged and others may have had key feeder facilities impacted even if the main plants were not affected at all. The transportation network is in shambles and after-shocks have continued. In several very real senses the damage creating part is not even over yet.

The economy as a process - Japan is above all else the country that invented just-in-time inventory methods. In true Japan style one plant depends critically on the one before it to execute its output in a timely way. This is industrial ballet. It is efficient; it saves capital since it keeps inventories at a minimum. But in doing so, it puts the vulnerability to disruption at a maximum. And this ballet has been severely interrupted. It is the supply-chain more than any a particular factory that we need to worry about in Japan. And in putting it that way we also raise question marks about firms overseas, both Japanese and non-Japanese, that are part of this chain as Japanese firms have insinuated themselves into many countries' supply chains.

Transportation - Locally, transportation networks have been knocked out by the quake or in some cases washed out by the tsunami. That is an additional consideration to supply chains. Quakes wreak havoc with rail transport and Japan has a lot of that. With aftershocks continuing the railroads are touch-and-go. Part of the transport problem is that some ports were obliterated, particularly Sendai. The ongoing nuclear incident is delaying repairs across Japan as are lingering aftershocks.

What's lost - The disasters effectively took a big bite out of Japan, out of its capital stock and its population. Japan has lost both a stock of wealth, capital, labor and labor skills along with the flow of services that would be generated by these lost stocks. We have yet to tally up exactly what has been lost and how what has been lost fits into Japan's and the world's economic network. There are some concerns about the impact on the semiconductor industry.

Impact on GDP - Certainly Japan's GDP will take a ferocious hit, at the end of Q1 and in Q2. Rebuilding will add to stimulus thereafter to lessen the blow. The yen has strengthened sharply, a factor- if it lingers - that could put further downward pressure on Japan's export oriented economy. Japan also sustained some heavy damage to some of its ports. That will further impact trade, in both directions. Japan's debt will soar even further on rebuilding costs. The cost of insuring Japan's debt against default already is rising. Japan's trade partners have taken to screening its food exports for radiation.

Pent up demand - But because of this damage from the quake and the tsunami the result is that people will have to rebuild their homes and replace lost possessions including automobiles; there will be a surge in demand to help Japan to recover.

Unknowns still dominate, but a drop in GDP, yes; a new recession, no - There are still many unknowns here but I don't see a disaster like this plunging the economy into recession since there is such a high degree of pent up demand that is generated and insurance funds (plus government money) to finance a re-start of growth. That is not to minimize the extent to which Japan's economy has been damaged. The whole economy will have to adjust to this big bite that has been taken out of it.

Nuclear wild card - The nuclear incident is the big unknown that could make things much worse and already is impeding the clean-up effort. But unlike other nuclear events, the area surrounding the troubled reactors has already been destroyed so the real risk of contamination is to areas father way which are safer because of that distance. Still, that risk lingers.

Rebuilding - The next question will be what to rebuild and where. Will Japan rebuild in those same tsunami-endangered areas? If not, where? Of what use is land where danger is only a rumble of the earth away? Have land values in Japan been reduced in some permanent way because of this disaster and its revealed risks and what appears to be a step up in activity or in the punch from it around the ring of fire?