Although many would find the notion of similarities between the US and Japan's economies laughable at the present time, the two do have a great deal in common, as Alan Greenspan is only too aware
When I was in Tokyo at the end of January and the annual rumours about impending financial crisis were doing the rounds, a little joke was circulating at the expense of the Japanese ' Q: What's the difference between Japan and Argentina? A: Two years.
Of course, the crisis was once again postponed and we look forward to next year's ' same time, same place.
In this light, it is perhaps a little surprising to consider that the Japanese equity market is among this year's best performers. In fact, at the time of writing, it is the best performing major market.
Sadly, this accolade comes by virtue of the weakness of others ' dollar returns on Topix are around 4% year-to-date, compared to -20% on the S&P 500 or -32% on Nasdaq, so there is limited scope for pride on the part of the usually benighted Japanese.
The implication that the US will suffer a Japan-style deflationary decade of lacklustre economic and equity market performance after the bursting of its own bubble is regarded as risible by some. Are the markets telling us that the parallels are too numerous to dismiss the suggestion out of hand?
Let us first of all be clear about the issue. Have years of over-investment, made possible by unrealistic growth expectations and a consequent equity market bubble, resulted in a US economy so over-burdened with debt and so lacking in confidence that in the absence of extremely lax monetary and inflation policy, growth will remain below potential for many years?
The issue has, in fact, been taxing the brains of many market strategists and economists. The US Federal Reserve is sufficiently concerned about a potential deflationary spiral to have commissioned a report on Japan's experience during the 90s and the lessons it holds for others so far as the conduct of monetary policy is concerned.
Central bankers tend to stick together, so we should not be too surprised to learn that the Fed is sympathetic to the plight of its counterparts at the Bank of Japan (BoJ). Nonetheless, their conclusion is interesting and instructive. Japan's monetary policy was far too tight at critical periods, when the decline into the deflationary spiral could have been avoided.
However, the paper suggests that the BoJ's policy was entirely consistent with the data that was available at the time, and only with the benefit of hindsight can it be seen to have been erroneous. The idea that we can be fooled by economic data is scarcely news, but it does mean that the chances of policy error are high.
What are the similarities between the American and Japanese experiences? In Japan, during the four years from 1987 to 1990, annual GDP growth exceeded 5%, while private sector capital expenditure exceeded 12%. Banks were lending freely on the basis of real estate collateral of ever increasing value.
From late 1985 to its peak at 39,000 at the end of 1989, the Nikkei 225 tripled and so did urban land prices. Tokyo was the world's biggest equity market and the market value of the Imperial Palace Gardens exceeded that of the State of California. Confidence abounded in Japan, in marked contrast to sentiment on the other side of the Pacific.
The bubble was pricked at the beginning of 1990 by a series of interest-rate hikes and tax increases intended to take the steam out of the real estate market, which finally peaked around the end of the year. The Nikkei declined 63% to a level just above 14,000 in August 1992, knocking nearly ¥400 trillion (at about 80% of GDP) off the value of stocks compared to the peak. Real estate prices have so far declined by an average of 40%, or around ¥900 trillion.
The BoJ began an aggressive series of interest rate cuts, from 6% in July 1991 to 1.75% in September 1993 but the economy dipped into recession in 1992 and has been kept afloat since by a combination of government spending and export demand.
Interestingly, though, it was not until the mid-90's that economists generally began to revise their growth and inflation expectations for the economy to the sort of levels with which we have become familiar.
What are the similarities with the recent Nasdaq bubble? From early 1995 to its peak in March 2000, the index rose sevenfold, driven by the growth story in IT stocks and a belief in the new economy. The bubble burst owing to a combination of rate hikes and a revision in the view of the growth prospects of many stocks, bringing into question their associated valuations.
The Fed then began to cut rates aggressively from January 2001, bringing them down from 6% to 1.75% by the end of the year during which the Nasdaq declined from 2500 to 2000, a 60% decline from the March 2000 peak. Most of the IT stocks that found capital so easy to come by during the bubble have either fallen by the wayside or are struggling with the burdens of overcapacity and weak cashflow.
Over a similar period, the S&P 500 tripled to a peak above 1500 in early 2000 and has declined about 40% in the two years since. Since the peak however, consumer spending and the real estate market have remained buoyant, just as they did in Japan for a time. It all sounds very familiar. So what are the differences that the optimists cling to?
First of all, it may be stretching a point to suggest that there is a real-estate bubble in the US. Of course, there are hot spots in major urban areas where real estate price hikes are running way ahead of rental increases, but nationwide real estate inflation has been much more moderate. For example, house prices have increased by only 4% per annum over the last decade. It does not sound like a bubble ' at least not yet.
What about debt levels? Cashflow is tight and total debt stands at 95% of GDP. However, these levels were not abnormal in the 90s and compare favourably with the situation in Japan where at the peak of the bubble, corporate borrowing exceeded 200% of GDP. The key element of Japan's speculative bubble has been missing: the desire to invest in real estate. Whereas at one time it seemed every Japanese company had a real estate subsidiary, there has been relatively little of that sort of excess in the US.
In the Japanese bubble, finance was famously provided on the basis of real estate collateral alone, without regard to cashflow. This was easy when the value of such assets was increasing at 10% or 20% each year and there seemed no prospect of a decline, but the resulting damage to the banks' balance sheets is still being dealt with.
The greater dependence upon capital markets and more aggressive attitude of American banks has meant that, on the whole, the recognition of loan write-offs is taking place more quickly, aided by the dispersion of risk throughout the financial system.
Admittedly, this has meant that bad loans are popping up in rather unexpected places, but the lack of concentration of risk should mean that the financial system as a whole is better able to weather the storm. Compare this situation to that of Japan where poor disclosure and the willingness of banks to continue to lend to moribund companies meant that the first major bubble-related bankruptcy did not occur until 1997.
It is probably true to say that only since the financial crisis of 1998 have the banks been making any real attempt to deal with the problems.
However, the main advantage that the US ought to have is the salutary lesson provided by the Japanese experience. The key recommendation of the Fed's discussion paper is that monetary and fiscal policy should be kept ultra-loose if there is even the possibility of deflation. The Fed has certainly reacted much more quickly to conditions than did the BoJ, which took fully 18 months to start cutting rates after the Nikkei collapsed.
There are a couple of flies in the ointment however. The Fed's report was written at a time when most agreed that the economy was experiencing a normal cyclical recovery and the report was seen by some as justifying the relatively easy stance that the Fed was adopting at the time. At the time of writing, the Fed's stance is unchanged but the downside economic risks appear to have deteriorated significantly.
Will Greenspan have the nerve to cut rates much further from current very low levels, or will he adopt the BoJ's approach of seeing every glimmer of economic light as justifying the current position? We may find that the Fed is destined to repeat the mistakes of its Japanese counterpart despite its superior knowledge, resulting in several years of sub-par growth.
Seen in this light, the relative attractions of Japan's world-class companies are perhaps more obvious. Perhaps we will all need to develop the skills needed to operate in a low growth, deflationary environment. Much may yet depend on Greenspan.
Japan's position as best performing investment market comes by virtue of weakness of others.
Japan's monetary policy was far too tight at critical periods, when the decline into the deflationary spiral could have been avoided.
Is the Fed set to repeat the mistakes of its Japanese counterpart, resulting in several years of sub-par growth?
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