The parallels are many and they are disturbing. Japan's
problems started with a sharp decline in Japanese stocks in 1989.
As other asset values, especially real estate, followed suit and
headed south, banks were saddled with mounting bad debt. The
initial impact was on smaller regional banks and cooperatives, but
it soon impacted the entire banking system. GDP growth turned
negative on a year-on-year basis in 1993. The Bank of Japan (BOJ)
responded by cutting rates from a high of six percent in 1991 to
0.50 percent in 1995. They assured the world that banks would be
bailed out by each other, started purchasing Japanese Government
Bonds (JGBs) in 1995 and in 2001 announced the start of
quantitative easing; they increased the money supply and reduced
long-term interest rates. Fiscal policy was highly expansionary as
well; government debt went from zero prior to 1989 to just below
200 percent of GDP last year, fueled by large public works projects
and tax cuts.
And what was the net outcome of Japan's massive fiscal and monetary
stimulus? The Nikkei is over 75 percent off its 1989 highs, land
prices are down over 80 percent, but GDP grew on an annual basis
every year since 1989. Tax revenues are still below 1989 levels,
but government spending has shown a steady increase, hence the
large fiscal deficit. Money supply growth has remained positive, as
private sector credit contraction has been more than offset by
expanded government borrowing. Finally, the JPY: The trade-weighted
JPY fell sharply after the BOJ stepped up its JGB purchases in 1995
and weakened again for six years after the start of quantitative
easing in 2001. Both periods of JPY weakness ended with events that
caused carry trades to be unwound - the Russian debt crisis in 1998
and the U.S. credit crisis more recently. Despite the recent
strengthening of the JPY, it remains significantly below its trade
weighted peak in 1995.
Analysts have tried to reassure us that we are not headed for a
Japanese-style prolonged slump. After all, the Fed acted far sooner
and more aggressively and banks have actually written down bad
assets, unlike in Japan where banks and the BOJ failed to clean up
the banking system fast enough. It is also claimed that one of the
drags on Japan was the lack of domestic consumer demand, while we
have a larger consumption base with consumers who are apt to spend
more.
I believe we are worse off than Japan was in the early 1990s.
Structurally, their economy was in better shape - no government
debt, a large trade surplus, large foreign currency reserves and,
most importantly, a vibrant global economy that provided a market
for Japan's exports, partially offsetting the domestic slowdown.
Since both the government and the consumer had healthy balance
sheets, they were able to take on debt (or save less in the case of
most consumers), whereas we are already reeling under huge fiscal
and consumer debt. Our trade deficit and our indebtedness to
overseas investors raise serious doubts about our ability to
continue to borrow foreign money to finance ourselves. Japan's
credit spreads remained low through their financial crisis. As a
result, the government was able to focus on buying JGBs alone,
whereas with us the greater need is asset classes such as
mortgages, agencies and corporate debt. The Japanese crisis
impacted banks for the most part; ours extends to all sorts of
non-bank financial institutions. Finally, property prices ran up
faster in the U.S. than they did in Japan and our mortgage industry
is more complex and leveraged, which arguably creates a bigger
bubble and more downside risk.
Lessons Learned
There are lessons from the Japanese experience despite somewhat
different circumstances: act early and aggressively (which both the
Fed and Treasury have done), enact structural reforms and get toxic
assets off the books of the financial institutions (both still a
work in progress). In my opinion, Japan's example also points to
the need for large fiscal stimulus, through both tax cuts and
spending. Many conservatives will disagree with the latter, but
when private balance sheets are contracting, government spending is
the only offset to falling consumption and investment demand. If
that sounds Keynesian, it is.
The Japanese experience also leads to some conclusions and
predictions, none of them particularly rosy. Even if everyone does
everything right, the economic recovery will be very shallow and
slow to unfold and in the interim, continued negative GDP growth
and deflation are real possibilities. As a result, the Fed is
likely to be on hold for a long time (possibly over a year, in my
opinion) and long-term yields could fall even further. We will face
the apparent contradiction of deflation concerns in the near term
and inflation concerns in the longer term, but it is deflation that
will win out in 2009. Finally, asset values will probably take
years to recover and even longer to make new highs.
The conclusion for the dollar is similar (less than rosy) - with
rates remaining close to zero, it will increasingly become a
funding currency for carry trades. In addition, poor growth
prospects, high deficits, reduced overseas demand and concerns
about long-term inflation eroding currency value will pressure the
currency. The new administration will find a weaker dollar useful
in boosting exports and creating inflationary (or reducing
deflationary) pressure. I have revised my forecasts in favor of a
weaker dollar after the latest Fed move and recent economic
data.
| 3 Months | 1 Year |
| EUR | 1.40 | 1.50 |
| GBP | 1.55 | 1.75 |
| JPY | 85 | 95 |
| CAD | 1.25 | 1.18 |
| AUD | .72 | .80 |
| CNY | 6.90 | 6.65 |
| INR | 51 | 47 |