America is repeating Japan’s follies

“So you are back finally,” she said, opening the door and giving me a tight hug.
“Yeah, I am.” I replied.

“Hope the sickness is all gone by now?”

“Yeah. At least that’s what the doc says.”

“Hmmm. You know, more than missing you, I missed the discussions we used to have,” she said rather matter-of-factly.

“Oh. I did not know parts of me were competing against each other. Nevertheless, let me fulfill your wish,” I said, making myself comfortable on the sofa.

“My wish?”

“Yeah. Your wish for a good discussion. What do you understand when I say United States is the new Japan?”

“Oh like black is the new pink? Or pot-belly is the new six pack?” she mocked.

“I’ll ignore that. What I meant is that the US is getting into the position that Japan got into the 1990s and has stayed there ever since. This means that all the talk about the upcoming economic recovery is plain bunkum.”

“When will you stop making these big statements? First explain what happened in Japan,” she interjected rather emphatically.

“I was coming to that. Japan as you would know was in a bad shape at the end of the Second World War. But from the early 1950s to the early 1970s the country did really well, becoming the largest exporter of steel and automobiles in the world, from being a primarily agricultural nation.

The prosperity continued into the 80s with high corporate profits and low unemployment. This meant higher incomes and higher savings for people. These higher savings had to be invested somewhere. This led to a boom in the stock market as well as the real estate market. What also helped was the fact that bank loans were easily available.

As Paul Krugman, the Nobel Prize winning economist, writes in The Return of Depression Economics and the Crisis of 2008, ‘At the beginning of the 1990s the market capitalisation of Japan — the total value of all the stocks of all the nation’s companies — was larger than that of the United States, which had twice Japan’s population and more than twice its gross domestic product.

Land, never cheap in crowded Japan, had become incredibly expensive: according to a widely cited factoid, the land underneath the square mile of Tokyo’s Imperial Palace was worth more than the entire state of California.’”

“Wow. Some bubble they had out there.”

“Yeah they did. But like all bubbles, it eventually burst. The country’s central bank, the Bank of Japan, became excessively worried about the bubble and started raising interest rates in 1990. Initially this did not have any impact, but gradually, stock prices as well as land prices did start to fall, and a few years down the line, they were down 60% from their peak levels.

This, of course, did not help the Japanese economy, as people cut on their spending and the economy entered into a depression. Now, almost two decades later, the stock market is still down around 75% from its peak levels,” I explained.

“This sounds suspiciously similar to what happened in much of the Western world over the last few years, except for the fact that stock markets across the Western world have soared” she remarked.

“Yup it does.”

“But the Japanese government must have done something to help revive the economy.”

“Oh yeah, it did do a lot of things. It first started to cut interest rates and brought them down all the way to zero percent in the hope that people might start to borrow and buy things again, which in turn would mean higher corporate profits and hence, a growing economy. But it did not help. This move created other problems, something which I will come to a little later.

Then the bank started what economists like to call ‘pump priming’. It borrowed to build roads and bridges in the hope of generating jobs, which would generate more income for people. This income, hopefully, would be spent on buying goods and services and help to revive the economy. This move did not help much either. As time went along, the government decided to borrow even more to build these bridges and roads to nowhere, but it did not help.

What is happening in the US and much of the western world right now is more or less similar to what has happened in Japan, since the bubble burst. And even after all these years, the Japanese economy hasn’t managed to get back to growing like it used to.”

“But why weren’t the Japanese then and the Americans now spending money?”

“Oh for the simple fact that they had lost a lot of money during the bubble. Something that plagues the US as well, where a total of $13 trillion has been lost since the bubble burst in late 2007. So people aren’t going to start spending money anytime soon. Also, people in the US had borrowed big time to speculate in the real estate market. And all that debt has to be gradually repaid and they are doing just that. They repaid debt worth $21 billion in July.

Now, that is four times what economists had forecast. Where does this money to repay debt come from? Through savings. And when you are saving, you can’t be spending money. It is as simple as that. Other than this, with the unemployment rate about to touch 10%, people are getting ‘job security oriented’. This essentially means that with so many people around them being fired, people are saving money to take care of themselves, in case they are fired next.

The third main factor is the phenomenon of expected inflation. If people feel inflation is on its way, then they go out there and spend money, and hence it discourages people to save. And right now, with prices going down, no one is expecting inflation anytime soon. Now, as I have often pointed out in the past, around 70% of the US GDP comes from consumer spending. And that doesn’t look like picking up anytime soon. What this means is that all this talk about an economic turnaround of the US is at best, claptrap.”

“Hmmm. You were also talking about problems due to low interest rates?”

“Yeah. Even with interest rates in Japan being almost zero percent, the Japanese consumer was not ready to borrow. But international speculators were ready to borrow at these low rates and invest the money across the world, in search of better returns. This became to be known as the yen carry trade, where speculators borrowed money in yen and invested them wherever they thought they could earn better returns.

Like a lot of money that ultimately led to the US dotcom bubble at the turn of the century was raised through the yen carry trade route. So, low interest rates in Japan, essentially led to a boom world over and ultimately, also fuelled bubbles in other parts of the world.”

“Interesting. But what is the link with the current crisis?” she interrupted.

“Oh. I thought you would have it all figured out now. The Federal Reserve, the central bank of the US, has also acted in a way similar to the Bank of Japan and cut interest rates to almost zero percent. But American citizens are not borrowing.

Nevertheless, big speculators are borrowing these dollars and looking to invest it across the world, wherever they feel they can generate returns. This phenomenon is now being called the dollar carry trade, akin to the yen carry trade. And it is this easy money that has led to stock market and commodity prices all across the world shooting up.”

“Oh the dollar carry trade. Yup I remember first reading about it in DNA Money on August 7, 2009. So you mean, like the yen carry trade, the dollar carry trade will be responsible for bubbles across the world?”

“Yeah. That is the long and the short of it.”

“So doesn’t that mean investors and speculators should be exiting their positions before the bubbles burst?”

“Well who knows when the bubbles will burst? And, as George Soros, the biggest speculator of them all once wrote ‘Nothing is quite as profitable as investing in an early stage bubble.’”
 

References:
The Return of Depression Economics and the Crisis of 2008, Paul Krugman, Penguin Books, 2008  Stabilizing an Unstable Economy, Hyman P Minsky, McGraw-Hill, 2008 The New Paradigm for Financial Markets, George Soros,
PublicAffairs, 2008 Mom and Pop Can’t Catch a Break, Bill Bonner,