Japan’s economic earthquake will be felt worldwide

An old mentor of mine once remarked that "the only sure thing in life is the unexpected." How true I thought after arriving in Tokyo last night.

One minute, Japan and the world were happily anticipating a quiet weekend amid continued recovery from the world economic crisis. The next, Japan was plunged into what Prime Minister Naoto Kan has called its worst crisis since the end of World War II. The global economy, already roiled by the Arab revolution, is now again in uncharted waters.

It is a measure of the damage done here in Japan that even now, four days after the quake, only about half the trains and metros in Tokyo are operating and some areas remain without service. In fact, the outlook dimmed further today as a third nuclear reactor at the Fukushima power site lost cooling. The Tokyo Electric Power Company has announced that power outages are likely and that this situation will continue until at least the end of April. Given the accuracy of the company’s forecasts so far, this could well mean until the end of the year.

With Tokyo and much of the rest of the country operating at half speed, the hit on the Japanese economy is going to be enormous and the knock-on effect on the rest of the world economy will be large and very significant in some critical areas. For example, about 40 percent of the world supply of the Nand semiconductors — critical to devices like cell phones and the iPad — are made precisely in the part of Japan most affected by the quake and tsunami. Those plants are down now, and it is not clear when they will be coming back on line. Nor are they something that can quickly be ordered up from another source. A large part of the world supply of silicon and specialty chemicals for the semiconductor industry — the building blocks for all semiconductor chips — is also made in Japan. So even companies like Intel, Samsung, and Taiwan Semiconductor Manufacturing Company could be significantly impacted.

The overall impact is expected to be at least several months of slower GDP growth. But those estimates could change substantially. For instance, most comparisons are being made to the Kobe earthquake of 1995, which caused only a relatively short term downturn in the Japanese economy. But that disaster had no impact on the energy situation. This quake will result in large increases in Japan’s oil imports which, combined with events in the Middle East, will undoubtedly lead to higher oil prices that will add to the economic drag both on Japan and on the rest of the world.

Also extremely important will be the effect on Japan’s public debt, already double its $5 trillion GDP. Mitsubishi UFJ Securities is estimating that the debt costs of recovery will add anywhere from 2 to 10 percent of GDP to the already massive public debt.

Now, here’s where the unexpected impact of the unexpected gets really interesting. There is speculation in Japan, that if the public debt should grow by 5 percent of GDP or more, the Japanese government would be reluctant to cover it simply through more borrowing. Rather, an attractive option might be for Japan to sell off a portion of its huge holdings of U.S. Treasuries to cover the cost instead.

That, of course, could result in a dramatically weaker dollar that would that would stimulate inflation and force the Fed to raise interest rates just at the moment when the U.S. economy appears to be gaining a little momentum.

It was Pericles who said that: "The important thing is not to predict the future but to be prepared for it." Globalization has made the economy more fragile. It’s time that the world’s major economies and global institutions prepare for that reality.