Japan and the Geopolitics of the Shale Revolution

The American shale revolution has been called a game-changer for the United States, but few people in Japan seem aware of the repercussions for the country's economy, let alone the potential impact on the global order. In the following, I take a look at some of the far-reaching economic and geopolitical consequences for which Japan and other nations need to begin preparing.

Thinking About the Unthinkable

From a macroeconomic perspective, the shale revolution will push the United States and Japan in opposite directions, reversing the economic relationship that supported Japanese growth during most of the post–World War II era.

By allowing the United States to cut back drastically on oil imports and ultimately reduce its dependence on foreign energy sources to zero (as an increasing number of observers believe it will do in the not-too-distant future), the shale revolution will at the very least halt the growth of America’s current-account deficit and possibly even reverse that long-term trend. For Japan, it will accelerate movement in exactly the opposite direction. The Japanese have no prospects for reducing energy imports any time soon unless their political leaders can summon the courage to reboot the nation’s nuclear power program, which appears highly unlikely. If regulators and politicians in Washington decide to open the floodgates to gas and oil exports from the United States, Japan’s already dwindling trade surplus with the United States will turn into a chronic and growing deficit—something our current government and business leaders could never have imagined a decade ago.

For Japan this historic reversal will be occurring against the background of structural developments that make the long-term deterioration of the country's current-account balance inevitable. As Japan's working-age population shrinks, savings must shrink as well, and the current account is always the flip side of the same coin. Now the Japanese public’s rejection of nuclear energy in the wake of the Fukushima disaster, combined with the US shale revolution, threatens to accelerate this trend in a manner no one anticipated. Under these circumstances Japanese interest rates are sure to rise, and the Japanese government will find it increasingly difficult to find buyers for its bonds.

Meanwhile, the US energy boom is likely to have major political and security repercussions as well. An energy-independent America will be less interested in Middle East affairs. And given the degree to which America’s role as upholder of the world order has revolved around its concerns over the Middle East, this raises the prospect of a less-engaged United States overall. Such a change will almost surely mean greater global instability. Instability means greater risk for international investors, and that risk will raise in global interest rates. In Japan, these forces will combine with previously mentioned factors to push interest rates even higher. A Greek-style debt crisis could be much closer than we think.

These are some of the far-reaching ramifications we can expect from the shale revolution. The key in such a situation is to force ourselves to think about the unthinkable. Unfortunately, this is exactly the kind of thinking that Japan’s decision makers have most consistently failed to do over the years.

Japan’s Dwindling Surpluses

For most of the period from 1998 to 2007, Japan posted an annual trade surplus slightly in excess of ¥10 trillion. During that time, the surplus climbed as high as ¥13.9 trillion in 1998 and dipped as low as ¥6.5 trillion in 2001. Under the impact of the global recession, the trade surplus fell below ¥3 trillion in 2008 and 2009, but in 2010 it rebounded to ¥6.6 trillion. History may record that as Japan’s last substantial trade surplus. In 2011, Japan’s balance of trade dipped into the red for the first time in 31 years, with a deficit of ¥2.6 trillion. When the final figures for 2012 come in, that red ink is expected to almost double, to ¥5 trillion.

In absolute values, this represents a loss of almost ¥19 trillion in a matter of 14 years. Put differently, that amounts to a disappearance of a mid-sized economy like Chile, Israel, or Portugal.

Recent changes in Japan’s current-account balance are equally troubling. After reaching ¥24.9 trillion in 2007, Japan’s current-account surplus is expected to fall to ¥4.3 trillion in 2012. That ¥20.6 trillion difference—roughly the sales revenue of General Motors and Ford combined— represents jobs Japan has lost in the intervening five years. Such a record would be enough to doom the reelection prospects of any American president.

Focusing on Japan's balance of trade with the United States—which the shale revolution promises to alter fundamentally—we see that major changes are already under way. While many in Japan continue to place their faith in exports to the United States as the key to economic recovery and growth, the fact is that this dynamic no longer exists in the real world.

For most of the decade beginning in 1998, Japan’s trade balance with the United States hovered in the area of ¥7 trillion or ¥8 trillion, reaching as high as ¥9 trillion in 2006. Following the global financial crisis, however, from 2009 onwards this figure has fallen to the ¥3–4 trillion mark.

Going into the 21st century, Japan’s trade balance and current account balance have thus undergone sudden and extreme changes for the worse in the space of just a few years. As many economic analysts have pointed out, the recent acceleration of this trend over the past couple of years is the direct result of rising imports of fossil fuels, necessitated by the Japanese people’s new aversion to nuclear energy. But this short-term trend masks a more fundamental problem: The Japanese economy has all but lost the capacity to create positive cash flow.

Between a Rock and a Hard Place

The deterioration of Japan’s current account is inextricably linked to another sea change: the end of Japan’s fabled excess savings.

The Organization for Economic Cooperation and Development forecasts that Japan’s household savings rate will be a mere 1.9% in 2012—a fraction of the rate forecast for Germany (10.1%) or even for the United States (3.7%). Here again, the real story is the scale and pace of decline. While the household savings rate of both Germany and the United States has dipped only about 1 percentage point since 1995, Japan’s rate has plummeted more than 10 points from its 1995 level (12.2%).(*1)

The public sector, of course, runs chronic deficits and therefore saves nothing. Only a relatively high corporate savings rate keeps the national savings rate at a robust 22.9%. But even that is 8.6 points lower than the 1995 rate. And the relatively high savings rate in the business sector is merely the flip side of a low investment rate, testifying to the decline in business opportunities. This, in turn, bodes ill for any substantial uptick in the household sector, which is where we need to see the savings.

Enter American shale gas and oil. As Japan boosts its imports of US fossil fuels, its dwindling trade surpluses with the United States will turn into deficits. The day the United States begins exporting fossil fuel to Japan in large quantities—whether it be extracted from shale or from conventional reserves in Alaska—will mark the end of an era for the Japanese economy.

Of course, some will point out that shale gas and oil are not the fundamental issue. It can be argued that if Japan must import fuel, buying it from its ally the United States offers clear advantages in terms of security. Moreover, if American natural gas ends up being cheaper than the gas we currently buy, which is indexed to the price of oil, then buying energy from the United States could benefit Japan's bottom line as well. I agree that it is preferable for Japan to depend on its ally for energy imports, all things being equal. And I can only hope that Japan, as an important US ally, is able to leverage its position to negotiate a favorable rate.

But the moment Japan becomes a net importer from the United States, it will awaken the world to a new reality that Japan is a waning economy with its potential for growth profoundly diminished. The US market no longer holds the key to Japan’s future economic growth, and there is no single country or market that can absorb Japanese exports as the United States once did. Japan has posted a trade deficit with China every year since 1988. Even if we end up buying our fuel more cheaply from the United States, this is unlikely to improve Japan's external balance appreciably if we can no longer sell Japan's goods to Americans

Once Japan’s current-account balance with the United States slips into the red, our current-account balance with the world cannot be far behind. Like a corporation whose core business chronically loses money, we will inevitably find ourselves strapped for funds.

One needs only recall the chain of events in Greece and Portugal to realize how difficult it is to prevent a steep rise in interest rates once such a crunch becomes clear to the world. When debt reaches the point where repayment of principal is basically a lost cause, that debt can only continue to snowball.

Geopolitical Repercussions

In the foregoing, I have outlined the downward trend in Japan’s current-account balance, explained how the expected increase in energy imports from the United States will accelerate that trend, and concluded that the consequences are likely to be an increase in Japanese interest rates and a rapid worsening of the country's fiscal situation. Now let us take a look at some of the political implications.

If Japan is indeed facing a severe fiscal crunch in the years ahead, now may be the government’s last chance to invest in strengthening coastal policing and general defense capability to counter China’s growing military power and territorial aspirations. Today, as Japan's social fabric remains unbroken and people retain some shred of hope for fiscal sustainability, it is probably possible to present the increased spending on deterrence against China as a net investment in Japan’s safety, reducing the country’s overall risks. As time passes, this will become increasingly difficult.

The predictions I have made also have implications for the Japan-US alliance. Throughout the post–World War II era, Japan has paid for its reliance on US military power by footing the bill for US bases in Japan. But the two sides of that exchange are bound to become increasingly lopsided in the years ahead. It is true that the Pentagon plans to channel more of its resources into the area spanning the Pacific and Indian oceans, but Japan’s deteriorating fiscal position will not allow it to contribute to that effort. This should persuade us to embrace any measures that can strengthen the Japan-US alliance at no added cost to us. On these grounds, we should welcome deployment of the Osprey hybrid aircraft, and we should make haste to provide constitutional recognition of the right of collective self-defense.

Japan should also start rethinking its overseas development assistance, on the understanding that its days of profligate check writing are quickly drawing to an end. We will need to narrow down our list of recipient countries and aid projects and rigorously focus our resources where they will do the most good.

Such are some of the political implications for Japan. But these pale in comparison to the global ramifications of the shale revolution.

A Ship with No Anchor?

The security relationship that the United States forged with key countries of the Middle East in the post–World War II era has been among the pillars supporting the international system. Its partnership with Saudi Arabia, the world’s largest oil producer (grounded more in mutual interest than in shared values) has played a particularly pivotal role. Among other things, this cooperative relationship kept oil prices low and when the United States and its allies kept up economic pressure on the Soviet Union.

One of the ways in which Saudi Arabia rewarded the United States was an arrangement under which it accepted payment for oil only in dollars, thereby channeling all oil money through the New York dollar market. The dollar became the only currency of settlement first for oil and then for other primary products, and this conferred on the United States what the French like to call “un privilège exorbitant.” The petrodollar system largely exempted the United States from the risks associated with fluctuating exchange rates and put other countries at the mercy of Washington’s financial policies.

Today, on the threshold of the shale revolution, this world order has already begun to collapse.

Washington’s decision to let Britain and France lead the air strikes that drove Libya’s Muammar Gaddafi from power in 2011 marked a historic retreat for the United States, which had dominated the Middle East for 55 years—ever since Britain and France had lost their regional influence in the 1956 Suez crisis. The same can be said of President Barack Obama’s decision to withdraw support for the Egyptian regime of President Hosni Mubarak during the Arab Spring, as described in David Sanger’s recent book Confront and Conceal. In opting to cut its losses, the administration revealed how little it valued the intangible Middle East assets that United States had built up during the postwar era.

In fact, the US retreat from the Middle East began even earlier with the withdrawal of US forces from Iraq and Afghanistan and the Obama administration’s “rebalancing” toward Asia. The shale revolution is bound to accelerate this trend.

I cannot offer hard facts and figures when predicting things that have yet to pass. However, I think few will argue with me when I suggest that the United States will be far less willing to intervene in the Middle East once it is able to supply its own fossil-fuel needs. And with the heavy anchor of the United States removed, the established order will begin to totter throughout the Middle East, including Saudi Arabia, which has successfully resisted the Arab Spring until now. Washington will doubtless call for international cooperation to keep things under control, but China and Russia are unlikely to go along. Then we will see how unstable the world can be in the absence of an undisputed superpower.

Preparing for the Worst

Daunted by growing risk, investors will pull out of foreign markets, and the trend toward globalization will reverse itself. The era of low and stable global interest rates will come to an end, and the scourge of rising rates will hit the weakest economies hardest. Japan, with its declining capacity to create cash flow, has good reason to fear this wave, and our dependence on Middle East oil makes us all the more vulnerable.

How well China will stand up to the challenge is difficult to predict. Beijing will doubtless do its best to institute a system for buying oil and other resources with renminbi, and other countries in East Asia will move quickly to beef up their renminbi reserves. This could vastly augment China’s political clout.

What all of this demonstrates is the need to think of the shale revolution in geopolitical as well as economic terms. Every nation that has benefited from the existing global system stands to lose if the United States ceases to function as a force for international stability. But multiple factors place Japan at particularly high risk. We must work now to minimize that risk.

First, our political leaders in Tokyo must transcend partisan differences to reach a common understanding regarding the peril ahead. They should also seek cross-party support for key policies that must be implemented soon if they are to be implemented at all.

In terms of foreign policy, we need to accelerate initiatives for cooperation with other “maritime democracies” while strengthening relations with the English-speaking world. The first bloc is important to us because they share our values and interests. The second is vital because it plays a key role in the flow of information, which becomes all the more important as the future becomes increasingly opaque. Japan’s foreign policy should double its emphasis on cooperation with countries like Australia, Britain, Canada, and India.

(Originally written in Japanese in November 2012. Title photograph: A shale oil excavation site in Texas.)