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Japan and the world economy

Stock markets around the world tumbled again today, roiled by the continuing crisis in Japan, as well as other factors, such as the uprisings in the Middle East. Does this mean that Japan's disaster will have a hugely negative impact on the world economy, as well as its own? No. The stock market investors are over-reacting: they are in what is called a "risk off" (or risk-averse) mode. In the face of uncertainty, investors are fearing the worst.

Japan's economy is the third largest in the world, and it is very externally focused (exports drive growth), so of course any problems in Japan are likely to have effects worldwide. In particular, Japanese companies are key suppliers in the automotive and electronics industries. Gillian Tett in today's Financial Times wonders if global manufacturing supply chains will prove to be as inter-connected, complex and opaque as the financial networks were prior to their meltdown in 2007-2008. "With many Japanese factories facing temporary or partial closure, the earthquake has left investors facing an uncomfortable truth: in the modern world, it can be tough to assess how convoluted cross-border linkages really work, in manufacturing as in finance."

It's a valid point for Tett to raise, but I think it's over-stated. At its worst, this kind of analysis is fatalist, and says the world is just so damn global and complex, it's impossible to really understand. But specifically, money flows are not the same thing as the flow of goods: money and credit are much more fungible and by nature capable of taking on different forms that might be opaque. Furthermore, supply chains for cars and electronics might be disrupted, but it should be short-lived. Nariman Behravesh, chief economist at IHS Global Insight, says that "substitution will take place", and therefore production will not be seriously disrupted. In other words, the industrial buyers of Japanese supplies will turn to other producers, such as Korea.

The stock market is not a reliable indicator of economic health. The latest declines are driven by multiple factors, not just Japan. As the Financial Times noted, "Many investors argued that shares, which have nearly doubled after a two-year long rally, were long overdue a correction and markets could drop further in the coming days."

This is not to say that everything is fine and dandy in the world economy. Major Western economies have not been able to recover and restore robust growth. And now there are three major external factors at work that make the current situation especially serious: Japan, the Middle East and the Eurozone crisis (focusing on Greece and Portugal). It's just that the volatile swings of the stock market are like the wagging of a dog's tail: we shouldn't mistake it for the real force that is making it move. The economy's problems go much deeper.

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