Politics

The Return of Japan

Two weeks ago, we discussed Germany’s apparent early steps to return to regional power status (see WGR,  The Return of  Germany, 2/10/2014). In this week’s report, we will examine Japan’s steady evolution to regional power status.

We will begin with a discussion of Japan’s geopolitical situation, focusing on its particular goals for maintaining power and influence. We will cover how the U.S. resolved Japan’s goals after WWII in such a way that maintained regional stability. However, as U.S. policy moves from hegemonic domination to regional power balancing, dislocations appear to be developing in several parts of the world, including Asia. Japan is reacting to America’s changing policies by becoming more assertive. We will discuss how Japan’s policy is evolving and how these changes could increase the odds of conflict in the region. As always, we will conclude with potential market ramifications.

The Geopolitics of Japan

Japan is an island nation, an archipelago of four major islands along with 6,800 smaller islands. Its land mass on the four large islands is roughly the size of California. However, 75% of its land is not really fit for human habitation.

The Return of Japan

(Source: Wikipedia)

As this map shows, Japan is very mountainous. Only 13% of these islands are arable. The population of Japan is concentrated on the coasts, especially in the natural bays and harbors shown in green on the above map. In addition to lacking arable land, Japan has few natural resources.

Although this wasn’t a major issue prior to industrialization, it became an important factor when the country’s economy developed. The mountainous nature of Japan makes centralization difficult. Japan has no interconnected river systems. In the country’s history, there have been long periods where regional warlords (shoguns) held power and either a centralized government didn’t exist or it was very weak.

Finally, the other major feature of Japan’s geography that shapes its behavior is its isolation. The nearest point between Kyushu, the third largest island of Japan, and the southern tip of the Korean Peninsula is 114 miles compared to 91 miles from Key West, Florida to Cuba. The distance from England to France is only 23 miles. China is 480 miles away from Japan. No nation has successfully invaded and conquered Japan. In the 13th century, the Mongols tried to invade with a massive fleet which was hit by a typhoon, subsequently dubbed the “kamikaze,” or “divine wind.” A major reason that President Truman opted to drop two atomic bombs on Japan was due to concerns that an invasion of Japan would be extraordinarily costly. For the most part, this separation has created a tendency toward introversion

This isn’t to say that Japan does not, at times, seek contact with the broader world.

However, due to Japan’s geography, it generally can pick and choose when it wants to engage the world. Thus, throughout its history, it has vacillated between engagement and withdrawal.

Periods of introversion usually occurred when Japan was trying to establish centralized power. During these eras, the country focused on internal matters. In some cases, these periods of introspection followed phases of extroversion where people became worried about excessive foreign influences. For example, after the Portuguese came in the 16th century, extroversion was dominant and Christianity spread rapidly. This led to a sharp reaction of introversion against the religion about 100 years later that led to a bloody persecution of Christians.

During introversion periods, Japan tends to fall behind the rest of the world technologically. The history of human societies shows that economies of insular peoples tend to suffer from slow growth as a steady stream of new ideas is hard to generate from a relatively smaller and indigenous population. After periods of introversion, Japan usually opens up to the world and furiously tries to make up for lost time.

Japan can engage the world during its extroversion periods because it is so isolated. Engagement does not mean that it is risking invasion or incursion. Instead, it can pick and choose what it wants from the world.

In 1853, when U.S. Commodore Matthew Perry steamed into Edo (Tokyo) Bay and demanded Japan open itself to trade, the country faced the possibility that it would be colonized or it would need to modernize to confront the threat from the West. The Meiji Restoration of 1868, which ended the Tokugawa shogun and a period of introversion, restored the emperor and brought centralization and modernization to Japan. Most historians hold that the Meiji Restoration marked the beginning of modern Japan.

In the modern era, Japan has four geopolitical goals:

  • Maintain central authority and unity of the home islands.
  • Gain sovereignty over nearby seas.
  • Secure strategic approaches to the home islands to secure supply chains.
  • Acquire necessary resources and labor by expanding economic or military power.

The fourth goal was especially necessary due to Japan’s lack of natural resources.

Japan’s Policy of Expansion and WWII

From the 1860s into WWII, Japan aggressively expanded its military and began to attack its neighbors. In 1874, it captured Okinawa. Twenty years later, it took control of Korea, wresting control from China. In 1905, Japan routed Russia in a war, a move that shocked the West. This conflict prevented Russia from capturing

Manchuria’s mineral wealth; in addition, Japan annexed the southern portion of the Sakhalin Islands. In the 1930s, Japan expanded into Manchuria to secure natural resources and labor. The continued conflict in China and worries about further Japanese expansion led President Roosevelt to threaten an oil embargo on Japan if it didn’t abandon its territorial acquisitions. By the early 1940s, the U.S. was supplying Japan with nearly 80% of its oil. Roosevelt’s ultimatum put Japan in a very difficult position. Either Japan had to abandon its fourth geopolitical goal or use its military to acquire oil reserves that rested in Indonesia, which were controlled by the Dutch and the British. Attacking these colonies would probably prompt a war with the U.S. at some point. Thus, Japan made the momentous decision to launch a surprise attack on the U.S. Naval station at Pearl Harbor. Although the attack was a tactical success, it turned out to be a strategic disaster. World War II ended badly for Japan. Although the U.S. did not invade the country, it did force Japan into an unconditional surrender by a nuclear attack and established an occupation government for a few years.

America’s Solution to the Japan Problem

As we discussed in the aforementioned WGR on Germany, after WWII, the U.S. directly addressed the German problem for Europe by demilitarizing the country. Germany is centrally located and difficult to defend militarily; at the same time, the lack of natural boundaries helped make the country an economic powerhouse. Essentially, the U.S. took over Germany’s foreign policy, eliminating the need for the country to build a large military (at least until now).

Japan’s situation was different. Japan is similar to Great Britain; it is an island nation that, as we noted above, can decide when it wants to become externally focused or not. At the same time, it is virtually impossible to invade and difficult to contain in its expansionary periods. As with Germany, the U.S. eliminated the threat to Japan’s neighbors by forcing Japan to adopt a pacifist constitution that would not let the country engage in offensive warfare.

Although Japan has “bent” this constitution to allow it to build a formidable military, the country has generally avoided any serious military actions since WWII.

By “outsourcing” its foreign policy and defense to the U.S., Japan could focus on economic recovery and development. This situation proved to be quite favorable for Japan; from the devastation of WWII, Japan built itself into one of the top economies in the world. For most of the Cold War, the U.S. allowed Japan to use export promotion polices in its recovery, which included a weak currency. The U.S. did press back against this currency policy in the late 1980s, which was partially responsible for the last three decades of economic stagnation. Japan, thus far, has not been able to transition from an export-driven economy to a consumption-driven economy.

The American Policy Shift

Since the Cold War ended, U.S. foreign policy has been adrift, swaying from aggressive Wilsonian intervention to hints of withdrawal. The current policy appears to be evolving to one of offshore rebalancing. Such a policy means the superpower refrains from being directly involved in the world beyond keeping the sea lanes secure and keeping rival regional powers “balanced” (hence the name). As we noted in a previous report (see WGR, 1/27/2014,  The  TTIP and the TPP), the administration is negotiating trade deals that would effectively establish the global trading regime going forward according to U.S. dictates. The “pivot” to Asia and negotiations with Iran could be considered steps in establishing this new policy regime.

However, there are concerns the president cannot deliver on these trade deals. The day after his State of the Union address where Obama asked for “fast track” authority (critical legislation for trade agreements), Senate Majority Leader Harry Reid (D-NV) indicated that this legislation would not be on the agenda this year. Adding to Japan’s concern is the seemingly disjointed policy toward Asia. When China recently announced an Air Defense Identification Zone (ADIZ) in an area that includes islands claimed by both China and Japan, the U.S. initially reacted strongly by flying B-52s into the zone without warning China. However, soon after, the administration recommended that commercial airlines notify China when their aircraft entered this newly declared zone. The recommendation that U.S. airlines comply with China’s ADIZ was seen by Japan as a sign of weakness.

Japan’s current Prime Minister, Shinzo Abe, is considered a right-wing politician that has consistently called on Japan to throw off the WWII constitution and take a more active military role in the region. If the U.S. is moving to offshore rebalancing, a balancing power for China will be necessary; Japan, at least for the next decade or two, is the mostly likely candidate for this role. From America’s perspective, Japan using its military in a more active role relieves some of the burden the U.S. has shouldered since WWII. However, for Japan’s neighbors, this is an unwelcome development; despite the passage of nearly seven decades, Japan’s behavior during WWII is still a contentious issue.

Ramifications

Every winter, Davos, Switzerland hosts the World Economic Forum, which brings leaders from government, business, the media and academia to discuss various topics. A number of news reports from that event, which were conducted under Chatham House Rule,1 suggested that a number of participants are quite worried that Japan and China may be nearing a “hot war.” There are a number of reasons for rising tensions. China fears Japan is an active participant in a U.S.-led effort to contain China. China has little influence over Japan; most other nations in the region house a Chinese diaspora that leads to some degree of sympathy for China’s rise. No such group exists in Japan. Given the anti-Japan feelings in China, the CPC can use opposition to Japan as a rallying cry. In Japan, polls suggest that Japanese citizens do not have a high regard for the Chinese government either. Thus, using China as a foil is a helpful strategy.

Japan’s return is due to the apparent U.S. policy to reduce its global hegemony. This decision, though defensible, increases the risk of regional conflict. In a recent report (see WGR, 1/13/2014,  The Great Man or  the Great Wave), we examined one of the great historical debates, namely whether history is shaped by great movements (waves) or great people. In general, we lean toward the “Great Wave” side of the argument which suggests that America’s steady withdrawal from the world is really part of a broader trend. American society saw the need to make sacrifices as the superpower in the face of the Communist threat, but now that Communism is no longer relevant, Americans are simply less inclined to continue those commitments. If this is the next wave, it probably doesn’t matter who occupies the White House in 2016.

If U.S. policy creates a power vacuum in the Far East, it is reasonable to expect that Japan and China will compete to fill the void. It is also reasonable to see why China would oppose Japan’s efforts to end its official pacifist policy and fear its resurgence.

For investors, it is important to note that significant changes in the global environment are underway. These changes can also affect how markets relate to each other, how currencies react, etc. Former patterns may no longer hold. Although it is too early to tell exactly how these changes will affect markets, we feel confident that relationships and correlations will likely adjust and, as they do, investors will need to adapt.

Bill O’Grady

February 24, 2014

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

Confluence Investment Management LLC

Confluence Investment Management LLC is an independent, SEC Registered Investment Advisor located in St. Louis, Missouri. The firm provides professional portfolio management and advisory services to institutional and individual clients. Confluence’s investment philosophy is based upon independent, fundamental research that integrates the firm’s evaluation of market cycles, macroeconomics and geopolitical analysis with a value-driven, fundamental company-specific approach. The firm’s portfolio management philosophy begins by assessing risk, and follows through by positioning client portfolios to achieve stated income and growth objectives. The Confluence team is comprised of experienced investment professionals who are dedicated to an exceptional level of client service and communication