Saturday, December 26, 2009

Japan: 20 Years of Lessons for America

On Dec. 29, 1989, the Nikkei 225, Japan's stock market benchmark, closed at an all time high of 38,915.87. On Friday, Dec. 25, 2009 (a trading day in Tokyo), the Nikkei 225 closed at 10,494.71. It's been lower, with a post-1989 low of 7,603.76 in April 2003. That's about an 80% drop, not quite as bad as the Dow Jones Industrial Average's 89% drop during the Great Depression but still pretty awful. An investor who bought the Nikkei 225 at its peak would have a 73% loss today.

Japan's economy was the world's most impressive from 1960 to 1989. In the 1960s, it grew at a rate of about 10% a year, comparable to China today. In the 1970s, it grew at an annual rate of 5%, and in the 1980s, 4% a year. The slowing growth rate reflected the maturation of the Japanese economy, but not decline. In the late 1980s, Japanese investors bought American icons like Rockefeller Center and Columbia Pictures. Many viewed Japan as an unstoppable economic juggernaut.

The 1980s Japanese stock market bubble, and a concurrent real estate bubble, were attributable to the ready availability of cheap capital stemming from Japanese government policies that encouraged saving and low interest rates. The combination of the two led many Japanese to speculate in stocks and real estate. If this sounds familiar, then look at the late 1990s and the 2000s in the United States. There is an eerie resemblance, with the Federal Reserve using monetary policy to ensure a steady supply of cheap capital.

Like all assets bubbles, the Japanese stock and real estate markets popped eventually. The Japanese response also resembled America's response to the 2007-08 financial crisis: all government all the time. Banks were propped up as their accounting standards were relaxed. Losses were swept under the carpet while banks stopped lending. Fiscal discipline evaporated and government deficits ballooned. Government cash handouts to consumers provided temporary stimulus.

But none of it did much lasting good. Japanese economic growth slowed dramatically after 1989, down to the range of 1% to 2% on average. Japanese unemployment levels rose, and remain high. The Japanese social safety net, much of it based on the lifetime employment policies of large companies, frayed. The Japanese consumer, already cautious, became yet more thrifty. Once a mecca for the world's fashion brands, Japan today is singlehandedly causing a depression among European fashion companies. The Japanese economy shrank by 0.7% in 2008 as a result of the world financial crisis and likely has shrunk by more in 2009.

A natural question is whether the U.S. is headed for anything like Japan's 20 years of stagnation. It has suffered a painful stock and real estate market crash, not as proportionately large as Japan's, but nevertheless the worst since the Great Depression. The U.S. government has responded faster than Japan's, but in much the same way--bailouts and grade inflation (in the form of relaxed accounting requirements) for banks, a surfeit of deficit spending, a trillion dollar plus money print by the Fed, and cash given one way or another to consumers. The private sector response has also been similar. Japanese banks didn't make new loans, because of all the bad loans they didn't have to write down. The Japanese government liquidity that was dumped into the economy found its way to investments in Japanese government debt (i.e., the Japanese trusted only their government and wouldn't make private sector investments), and the carry trade, where yen were swapped for higher yielding currencies (like the U.S. dollar) and invested overseas. Today, U.S. banks don't make new loans because they still hold a lot of bad loans and cranky assets. Vast shiploads of the U.S. government's stimulus money is flowing into the carry trade and going overseas, or is being used for commodities and stock speculation. Some of the money loaned by the Fed to U.S. banks is being invested in U.S. Treasuries or is left on deposit at the Federal Reserve Banks. The net effect of these circular transactions is the outright transfer of money by the U.S. government to banks (in the form of interest payments less the minimal costs of banks borrowing from the Fed) for no reason other than that they are member banks.

In short, sloshing a lot of money around is a poor substitute for dealing with economic fundamentals. One begins to suspect that the Fed's and Treasury's secret intention is to stall for time in the hope that the economy somehow recovers. But evidence of recovery is limited, and such that exists indicates a slow recovery. The U.S. stock markets have risen some 60% since March 2009. But the Nikkei 225 also had sharp spikes during its secular decline of the last 20 years. Today's bulls seem to assume that because the market has been on a tear recently, it will always and forever rise. There evidently is no bull market on the learning curve.

The Japanese experience of the last 20 years contains a couple of noteworthy lessons. First, monetary policy doesn't have much impact when the financial system is dysfunctional. Pumping vast amounts of cash into banks and other financial firms has little benefit for the real economy if the cash is siphoned off into commodities and stock speculation, the carry trade, U.S. Treasury securities, or is held in anticipation of having to write off losses banks have been allowed to defer. The velocity of money--or rate at which it turns over--is effectively zero when the cash simply is sent back to the government, as is the case when American banks take federal assistance and invest it in Treasury securities or deposit it with a Federal Reserve Bank. For the velocity of money to be positive (a predicate to effective monetary policy), new loans need to be made. That's been mighty slow to happen.

Second, zero or ultra low interest rate policies won't necessarily spark an economic revival. Indeed, they may be unproductive. When the cost of borrowing is virtually zero, a lot of basically stupid activities begin to make mathematical sense in an ROI (return on investment) analysis. Thus, a lot of the federal stimulus has gone into commodities and currency speculation. Or else it has been used to gamble in stocks when the price-earnings ratio is signalling with a big, bright yellow light (see Asset speculation won't revive the real economy. At the same time, savers--especially retirees who live on interest from their assiduously accumulated CD's--embrace thrift more than ever, reducing consumption when consumption is most needed by the economy. It's one thing to reduce the fed funds rate to lower banks' costs of borrowing in order to motivate them to lend. But when they won't lend because their books are full of rotten-to-the-core assets, reducing interest rates only cuts consumption without increasing lending. The Fed may be pushing things backwards.

Huge government deficits and big money prints can stave off a plunge into depression. They did in Japan, and they have in America. But they won't produce prosperity. That's the lesson that Japan of the last 20 years teaches, and the one that America hopefully learns before suffering 20 years of stagnation itself. Raising interest rates would impose at least the beginnings of investment discipline resulting from an actual cost of capital, which in turn would lead investors to question the wackiness of some of the stuff that's now au courant. Perhaps some funds would even be put to use in the real economy. Even if GDP growth were muted in the short term by increasing interest rates, money invested more intelligently could lay the foundation for long term growth. If Wall Street won't serve the socially valuable purpose of intermediation between savers and economic investment (as opposed to financial speculation), it should be bypassed. Stimulus money could be used for job creation and funding Main Street, as the Obama administration has lately proposed. From massive subsidies for the Erie canal and transcontinental railroad, to mail delivery contracts for nascent airlines, to investment tax credits and job creation measures of every stripe and variety, governments have intervened in the economy for the public welfare. Why stop now? Conservative purists and theorists would object, but their guys, Alan and W, really screwed things up. Why listen to a bunch of failures?

Additionally, immigration standards should be relaxed for highly educated workers from other countries that could bolster America's high tech and other industries. Taking other nations' intellectual capital provides a competitive boost of the first order. Those seeking to come here are ambitious and hardworking. They're exactly the people needed to revive the economy.

There are good reasons for the Fed to pull back from its unprecedented liquidity dump of the last year. But that's not enough. The Fed should impose much more stringent bank capital requirements. It should also make banks book the losses that remain swept under the carpet and greatly improve their risk management controls. Capitalism works only if responsibility and accountability are part of the picture. The government, by intervening, prevented market forces from imposing full responsibility and accountability on Wall Street. The government's subsequent kind and gentle treatment of the reckless few, who caused so much harm to so many, leaves open the possibility of future morasses. Such morasses have been Japan's experience for the last two decades, and they portend America's future unless risk, as well as reward, falls on the high and mighty along with everyone else.

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