The Aftershocks for the U.S. Economy from the Disaster in Japan

As the damage to Japan and its economy from the recent natural disasters deepens, we can begin to see serious potential aftershocks for our own economy. In certain respects, the United States relies on our broad and intricate financial and trading relationships with Japan. China has surpassed Japan as the world’s largest buyer of U.S. Treasury securities. But Japan remains the world’s largest, diversified investor in the United States, counting its large holdings of U.S. stocks, corporate debt, real estate, and plants and factories, as well as government securities. Now, in an unanticipated downside to globalization, the aftereffects of the natural disasters are beginning to disrupt the two countries’ normal financial and trading relationships. And that will create new upward pressures on U.S. interest rates, put new downward pressures on U.S. stock prices, and cause unexpected losses for many U.S. companies.

These concerns reflect the prospect that the terrible earthquake and tsunami will prove to be unusually destructive for the Japanese economy. The damage to the country’s power grid may extend the economic costs far beyond the communities directly devastated by the disasters, slowing agriculture and industrial activity across up to one-third of the country. And with the frightening news that Tokyo’s water supply contain radioactive iodine dangerous to infants, the radiation from crippled nuclear power facilities could bring economic activity to a halt in much more of the country, and for some time to come.

If this comes to pass, the aftershocks for the U.S. economy could be quite serious. The disaster and its disruptions for the Japanese economy have already begun to cut into the earnings and incomes of Japanese companies and citizens. To cover rising debts and other unexpected expenses, Japanese investors have been converting some of their foreign assets to yen, and then bringing those yen back home. Most of these liquidations involve American assets: Japanese investors hold some $211 billion in U.S. stocks and another $134 billion in U.S. corporate debt. Moreover, if the earnings of Japanese companies and the incomes of Japanese investors continue to shrink with the crisis, private saving in Japan will fall — and that’s just as Japan’s budget deficit soars. The result will be that most of the savings that Japanese companies and individuals manage to accumulate will go to finance their own government’s deficits, not to buy our assets. And if the crisis deepens and persists, rising outflows of Japanese holdings will depress U.S. stock prices and raise the interest costs for U.S. corporate borrowers.

The largest Japanese investor in the United States, of course, is the government in Tokyo, which holds some $1 trillion in U.S. government securities. As a long crisis drives up government spending in Japan and drives down revenues, a budget deficit already equal to over 8 percent of the country’s GDP will rise sharply. At a minimum, Japanese government purchases of U.S. Treasury securities will dry up. And if the crisis worsens, Japan may become a major seller of U.S. government securities. This will put considerable pressure on U.S. interest rates, potentially increasing our own deficit (through higher interest costs), and almost certainly slowing our economy.

The potential problems are not limited to finance. Japan accounts for about 5 percent of U.S. exports; and major exporters will feel the pinch. Those likely to feel it first include makers of aircraft and their parts, medical equipment, pharmaceuticals, and computers. It’s not all bad news for U.S. exporters, because the current strong yen tied to Japanese investors cashing out some of their foreign financial assets will leave Japanese producers less competitive in other markets. More grimly, while U.S. exports of foodstuffs also are taking an early hit; U.S. food producers will step into the breach if more of Japan’s domestic food supply becomes contaminated.

The potential costs for the U.S. economy also include disruptions in U.S. supply chains that involve Japan. With holdings of $260 billion in U.S. industrial and commercial operations, Japan is the second largest foreign direct investor in the U.S. economy, just behind Britain. Sony, Toyota, Honda and other large Japanese enterprises operate here to serve the American market; but they still produce most of their most sophisticated parts in Japan. Japanese production of many of those parts already is disrupted. If conditions worsen, it will cost U.S. jobs as Japanese production and assembly here slows or even stops. And by the way, American companies are also the largest foreign direct investor in Japan, so a deepening crisis in Japan also will reduce the earnings of U.S. businesses operating there.

The United States is not the only economy exposed to economic aftershocks from the Japanese earthquake and tsunami. Japan is the largest foreign direct investor in China, having transferred a good part of its manufacturing base there over the last decade. Unlike U.S. companies which have invested in China mainly to serve the Chinese and third-country markets in Asia, Japanese enterprises in China produce mainly for the home, Japanese market. The sharp downturn already beginning to unfold in Japan, then, will cost China jobs and growth, especially in southern China.

In the end, it’s the American economy that is most interconnected with Japan’s, so the United States is most exposed to collateral economic damage from the recent, terrible natural disasters.