"Never accept ultimatums, conventional wisdom, or absolutes." - Christopher Reeve, American actor
"I see the [ultimatum] game as simply providing counter evidence to the general presumption that participation in a market economy (capitalism) makes a person more selfish."
"For our take on "Brexit, we will keep it simple for our readers: From a game theory perspective and prisoner's dilemma, the only possible Nash equilibrium is to always defect. The United Kingdom "defecting" could mean, we think, taking business (and profits) from other European Union members in the long run. First mover advantage? Maybe..." - source Macronomics, June 2016
"Common law as a foundation for commercial economies
The reliance on judicial opinion is a strength of common law systems, and is a significant contributor to the robust commercial systems in the United Kingdom and United States. Because there is reasonably precise guidance on almost every issue, parties (especially commercial parties) can predict whether a proposed course of action is likely to be lawful or unlawful, and have some assurance of consistency. As Justice Brandeis famously expressed it, "in most matters it is more important that the applicable rule of law be settled than that it be settled right." This ability to predict gives more freedom to come close to the boundaries of the law. For example, many commercial contracts are more economically efficient, and create greater wealth, because the parties know ahead of time that the proposed arrangement, though perhaps close to the line, is almost certainly legal. Newspapers, taxpayer-funded entities with some religious affiliation, and political parties can obtain fairly clear guidance on the boundaries within which their freedom of expression rights apply." - source Wikipedia
"The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them." - source Macronomics, January 2017
Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response":
"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith
"In terms of validating the "recovery mantra", we believe that meaningful wage inflation is a necessary condition. When it comes to inflation expectations, demographics and additional components in different parts of the world such as Japan, the United States and Europe have to be assessed differently.
For instance, in the United States, the recent decline in apartment rents in some big cities points towards near term "inflation headwinds" for the stagflationary camp.
As a reminder, rising rents have been an important factor in keeping US inflation expectations alive given the importance of the shelter component in US CPI calculations which represents one third of headline CPI and 42% of core CPI. When it comes to assessing some of the drivers of inflation, labor demographics are a key driver of real long-term fed funds. Also the question of productivity growth is paramount we think, particular when one looks at the quality of the jobs created since the onset of the Great Financial Crisis (GFC)., mostly of low quality.
Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June this year in our conversation "Road to Nowhere":While the inaugural speech of the newly elected President Trump did focus on bringing jobs back to America and making America first, on that subject we read with great interest our former esteemed colleague David Goldman's take in his latest column published in Asia Times entitled "Donald Trump, American hero" and his take on "productivity":
"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016We concluded at the time:
"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street"." - source Macronomics, October 2016.
"The problem is how to protect Americans. The global supply chain is so closely integrated that it is hard to discourage some imports without doing real damage to American industries. The border tax proposed by House Republicans would prevent corporations from deducting imported inputs as costs for tax purposes. For industries like oil refining, that would create enormous distortions, while providing windfalls elsewhere. My own preference would be to use selected tariffs for products that benefit from government subsidies overseas, which is entirely permissible under World Trade Organization rules.There lies the crux of the problem, to make "America great" again, you need CAPEX growth and more importantly, "productivity" growth.
Ultimately, no government can protect American workers unless productivity growth resumes. American productivity growth has fallen to zero for the first time since the stagflation of the 1970s. Without productivity growth, American living standards will fall, irrespective of whether the government pursues protection or free trade. I have argued elsewhere in this publication that reviving military and aerospace R&D is the key to productivity growth." - source David Goldman, Asia Times, 20th of January 2017
In this week's conversation, we will look at jobs, wages and the difference between Japan and the United States, in relation to the "reflation" story or "Trumpflation".
- Macro and Credit - The wage / productivity paradox
- Final chart - International trade and Nash equilibrium
- Macro and Credit - The wage / productivity paradox
"Employers and employees deaf to government's calls for wage rises
No sign of a pickup in the rate of wage rises from New Year events
Prime Minister Shinzo Abe has taken the opportunity provided by New Year events such as those organized by Japan's economic associations to reiterate his calls for companies to raise wages. However, we see no sign from the response of either employers (and their associations) or employees (and their trade union representatives) of any pickup in the rate of wage rises at this year's spring wage negotiations. Any discussion of what is happening to the Japanese economy, inflation, or market factors such as interest rates will have to assume for the time being that there will be no marked increase in wage rises.
Deep-seated reluctance of employers to increase fixed costs
While Japanese business leaders share Abe's positive attitude towards wage rises in general terms, they appear to be slightly less enthusiastic when it comes to putting this into practice. A good example of this is the frequent inclusion by Sadayuki Sakakibara, Keidanren chairman, of the provisos "companies that enjoyed earnings growth last year" and "on an annual pay basis" when expressing his desire for wage rises. We see this as reflecting a deep-seated reluctance by business leaders to increase fixed costs. With companies facing increasing uncertainty, they may well be more reluctant to increase the base pay of their regular employees as this would amount to an increase in fixed costs.
The unions are also cautious about demanding wage rises
A certain reluctance of some trade unions to demand wage rises also appears to be an impediment to a pickup in the rate of wage rises. We think that the cautious attitude of the trade unions probably reflects the less optimistic view that companies now have of their growth prospects as well as the increasing uncertainty they face and that workers and their trade union representatives may tacitly prefer the stability of a job for life to a bigger increase in base pay (see our 21 October 2016 Global Research report Why is wage inflation so low despite a shortage of labor? - The ''base pay wall'' facing the Japanese economy).
Limits to how far working practices can be reformed without freeing up the market for regular employees
In view of the attitude of employers and employees, the only way to overcome obstacles to speeding up the rate of wage rises would be to free up the market for regular employees to make the cost of employing full-time employees a variable cost. Similarly, safety nets such as vocational training and greater provision of unemployment benefits would be needed to overcome the concerns of workers and trade unions about freeing up the labor market for full-time employees. It seems that, as freeing up the market for full-time employees touches on the system of lifetime employment that forms the cornerstone of Japanese employment and working practices, it is off limits for those seeking to reform working practices such as the present government." - source Nomura
"The biggest medium-term macro surprise?
We believe that the re-acceleration of wage growth could provide one of the biggest macro surprises for Japan in 2017. Investors appear to be increasingly coming around to our view that the Japanese economy is due for a solid, 1.5% pick-up in 2017, up from 1.0% in 2016. However, skepticism around the potential for higher wage growth—the key to Japan’s reflation efforts—runs deep.
Tackling Japan’s wage paradox
The doubts may be warranted, given that wage growth has remained stagnant over the past few years despite the unemployment rate plunging post-bubble lows and business surveys pointing to record tightness in the labor markets. We think the relative weakness of the wage indicators reflects both cyclical and structural factors. On the demand side, the slowdown in the economic recovery after the 2014 tax hike reduced wage pressures. On the supply side, the reserve of lower-paid, part-time and “non-regular” workers meant that there was still some “invisible” slack in the labor sector.
Approaching full employment
However, 2017 could mark an important inflection point as both demand-side and supply-side factors drive the economy towards full employment. We forecast the unemployment rate to drop to 2.9% by the end of 2017, and 2.7% by the end of 2018, from 3.1% today. There is already evidence that remaining labor market slack is quickly diminishing. Moreover, demographic headwinds will begin blowing much harder in the coming years, resulting in tighter labor supply.
Wages growth to double in FY17, reach 2% in FY18
The FY2017 Shunto spring wage negotiations are unlikely to result in significant base pay increases. But we still see the combination of tight labor supply and stronger demand lifting nominal per worker wages to around 1.4% in FY2017, and close to 2% in FY2018, up from the 0-0.5% pace of the past three years. Adjusting for job growth, we see nominal employee compensation holding steady between 2-2.5% and real employee compensation of around 1.2% over the next two years. This should support consumption.
But patient BoJ to keep rates on hold
Our optimism on the outlook for labor markets and wage growth underpins our above consensus inflation forecasts. We see Japan-style core inflation rising 1.2% in FY17 (0.9% on a CY basis), and 1.5% in FY18 (1.4% on a CY basis). If our forecasts are correct, the risks of early BoJ policy normalization, including rate hikes, may become an important theme in the markets in the second half of this year.
However, we remain of the view that the timing of BoJ “lift-off” remains far away and that the central bank will keep its rates targets under its Yield Curve Control (YCC) framework unchanged through FY2018. Running a “high pressure” economy is the best shot the BoJ has at re-anchoring inflation expectations and reducing future deflation risks." - source Bank of America Merrill Lynch
"Disconnect between job growth and wages
Investors are often perplexed by the disconnect between Japan’s headline wage data and the relative strength of its labor market indicators. As of November 2016, Japan’s unemployment rate stood at 3.1%, down from 4.1% at the beginning of the Abenomics recovery phase (November 2012). Meanwhile, the job-offers-to applicant ratio has been climbing steadily, reaching the highest level since 1991 (Chart 2).
Various business surveys also point to record labor market tightness. The employment conditions indices in the Bank of Japan Tankan reflect deep labor shortages, especially among non-manufacturing SMEs (Chart 3).
Despite robust job growth, total cash earnings data in the Ministry of Health, Labour and Welfare’s Monthly Labour Statistics (MLS) have been disappointingly weak. This measure, which tracks nominal wages on a per worker basis—picked up in the initial phase of the Abenomics recovery but has recently weakened and is stuck at around 0.4%, while hourly wage growth is tracking around 1% (Chart 4).
Digging into wage growth by component, the slowdown in 2015-16 was in part due to a collapse in bonuses (which is linked closely with corporate profits) (Chart 5).
But more importantly, the combination of aggressive fiscal tightening, coupled with a downturn in the global export cycle caused Japan’s economic recovery to stall, reducing cyclical wage pressures.
That being said, structural factors may be in play as well. Over the years, wage growth— in both per worker and per hour terms--has become less responsive to changes in the unemployment rate. In other words, the slope of the Japan’s Phillips curve has flattened, with the break coinciding with the onset of deflation in the late 1990s.
Part of this reflects a trend rise in lower paid, “non-regular” workers, which include various forms of part-time and temporary employment (Chart 8).
The main split in Japan’s dual labor market is defined by job status. “Regular” workers generally work full time, are directly hired by the employer, and receive bonuses along with a wide range of employee benefits.1 While regular workers enjoy an upward sloping wage curve, reflecting regular, seniority-based pay promotions, the wage curve for non-regular workers is virtually flat, resulting in a huge pay gap—average lifetime income for non-regular workers is about 60% of “regular” workers’ levels (Chart 9).
Please note that due to differences in classification of workers between the MHLW Monthly Labor Statistics and the Ministry of Internal Affairs’ (MIA) monthly Labor Force Survey (which does not cover wage data), from here on out we focus on employment and wage developments of part-time workers, which are a decent proxy for the broader “non-regular” category.
Based on MLS data, the part-time employment doubled from around 15% in March 1990 to about 30% today (Chart 8). The good news is that the pace of increase in the part-timers’ employment share has been slowing, with the rise limited to a relatively modest 1.6ppt between Q3 CY2012 and Q3 CY2016. But even such a small drag represents a powerful drag on headline per worker wages since part-timers receive lower pay and work fewer hours by definition (Chart 10).
On average, the continued shift towards part-time employment has subtracted about 0.5ppt from growth in total cash earnings per worker (Chart 11).
Had the part-time share stayed neutral, per worker wages would be tracking closer to 0.8%YoY—about double the headline figure.
Reasons for optimism
The popular view in Japan seems to be that the Phillips curve is dead and that the weakness in wage growth will remain entrenched. There is also a strong belief that the secular shift in non-regular/part-time employment is unlikely to be reversed any time soon, keeping wage pressures contained. We disagree, and believe that growth in total cash earnings per worker will pick-up from around 0.5% in FY16, to around 1.4% in FY17, before rising to around 2% in FY18." - source Bank of America Merrill LynchThe reason we have to disagree with Bank of America Merrill Lynch and their reason for optimism comes from our discussion from June 2013 in our post "Lucas critique":
"Robert Lucas argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:
"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes.
For an especially simple example, note that Fort Knox has never been robbed. However, this does not mean the guards can safely be eliminated, since the incentive not to rob Fort Knox depends on the presence of the guards. In other words, with the heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed. But a change in security policy, such as eliminating the guards for example, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies." - source Wikipedia
So, as one can infer from the point made above and in continuation to the points made in our conversation "Goodhart's law", Ben Bernanke's policy of driving unemployment rate lower is likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.
In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman, such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:
"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - source Wikipedia
In similar fashion to what we posited in our conversation "Zemblanity", both Keynesians and Monetarists are wrong, because they have not grasped the importance of the velocity of money. QE is not the issue ZIRP is as we recently discussed.
The issue with NAIRU:"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed." - source WikipediaAs we posited at the time, when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion.
On this occasion, we think's Bank of America Merrill Lynch's optimism is indeed leaning towards naivety because the older a country's population gets, the lower its inflation rate. While economics textbook would like to tell us that a slowdown in population growth should put upward pressure on wages and therefore induce inflation as labor supply shrinks à la Japan, as discussed in our June 2013 conversation Singapore-based economist Andrew Cates from UBS macro team indicated that demographics influence demand for durable goods and property. As per our conversation "The Great Wall of China hoax" like in Japan, at some point low-yield assets such as real estate become nonperforming.
Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":
"He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.
By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.
“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source BloombergSo if the "old" like in Japan still predominates the economy, we have a hard time believing the Bank of Japan will be able to control economic outcomes and it appears clear to us that their monetary policies have truly become ineffective.
- Final chart - International trade and Nash equilibrium
"International Trade game
Consider the following simplistic game of International Trade. Suppose there are two countries that can each choose between the two policies “Free Trade” and “Protectionism”. Because international trade in most circumstances boosts global growth it follows that protectionism is growth negative. Put differently, while in isolation a country can boost economic growth by playing the “Protectionism” card, the associated costs to the other country outweigh these gains. There are four possible outcomes (Figure 2).
One equilibrium is that both countries agree to play “Free trade” (NW corner of figure), where we say that both have GDP of 10 (arbitrary units). Suppose now that Country 1 unilaterally plays “Protectionism”, in which case the outcome in the short term is the SW corner of the chart where this country boosts GDP by 2 to 12 at the expense of Country 2 that sees a 3 decline in GDP to 7. Note that world GDP declined by 1 as protectionism is distortive and thus creates inefficiencies.
However, the SW corner is not a sustainable equilibrium as Country 2 stands to benefit from playing the “Protection” card as well – i.e., retaliate – as they can increase GDP by 2 at the expense of country 1. That moves us to the SE corner – the “Trade Warfare” outcome - where each country has GDP of 9, a loss of 1 from the “Free Trade” equilibrium. Hence there are only two sustainable equilibria in this international trade game – “Free trade” in the NW corner, if both countries agree and commit, or trade warfare in the SE corner if they do not.
What this means is that the new administration’s intentions to restrict international trade are almost certainly negative for US economic growth in the longer run. Of course what prompted the coming US pushback against imports is that, even though trade boosts the economy, there are winners and losers. Thus we are unable to say unambiguously that the country is better off in utility terms just because that is the case in dollar terms." - source Bank of America Merrill LynchIf the second country rejects protectionism, like in our case of the Ultimatum game, then neither countries receives any money, and this dear friends, it means to us lower global trade which is indeed bullish gold, in the end (hence our recent positive stance), but we ramble again...
"The philosophy of protectionism is a philosophy of war." - Ludwig von Mises