RateWatch #358 – What Happened in Japan Isn't Likely to Happen Here
May 24, 2003 by Dick Lepre
What's Happening. Why Are Rates So Low?
Treasury yields and mortgage rates have been driven to low levels not seen in 50 years. Why?
Only one thing really causes Treasury yields to fall. That is rising Treasury prices. Treasury prices rise for the same reason that prices in any market rise - more buying than selling.
So the question really is: why are so many folks buying Treasuries? There are a number of reasons:
1) Our old friend the StoMaster indicated that we started a bull cycle in August 2002. So the first reason is seasonal.
2) In the fixed income market there is still some reticence to buy corporate debt (bonds). Treasuries are safest, Mortgage Backed Securities are fine but have been subject to early payoff in the declining yield environment.
3) The present administration has formulated a policy that a declining dollar would serve well
to stimulate the economy by making imports more expensive and exports cheaper. This is intended to stimulate GDP. If consumption is constant and imports fall, then GDP must increase.
4) Fearing #3 the Bank of Japan has undertaken to support the dollar v. the Yen as a method
of insuring that Hondas don't cost too many dollars. They did this by creating Yen, buying
dollars on Forex markets and using those dollars to buy U.S. Treasuries.
This produces the rather strange effect that Japan is supporting our currency while we are
trying to let it fall.
Speaking of Japan, there has been a lot written lately about deflation. We have been subjected to a mass media, anthrax-story bombardment regarding deflation. A couple of weeks ago I wrote a brief piece briefly addressing deflation and concluding that, basically, it was not going to happen here. Since this important I would like to expand on the previous thought.
What Happened in Japan Isn't Likely to Happen Here
Economists have long (since the Great Depression) been worried about deflation as a precursor to depression or prolonged recession.
Until recently, this has been, largely, theoretical. Then starting in 1991 something bad and prolonged happened in Japan. In the '70's and '80's it seemed as if Japan could do no wrong. Businessmen and economists here asked "why can't we be more like Japan." Japan was painted as a nation of hard workers while Americans were slackers.
Japan - What the Heck Happened?
In order to ascertain if what happened in Japan can happen here it is best to first get an idea of what happened in Japan.
The most noticeable thing that happened to Japan is that it suffered back-to-back collapses of
equity and real estate bubbles. Not mere bear markets but true bubble bursts. The only recent
thing comparable here is the dot-com collapse, or - on a broader base - the NASDAQ collapse.
Japan's problems began in 1990 when the Bank of Japan, concerned about the equity bubble,
decided to slow the growth in the money supply. The Nikkei index dropped first from close to
40,000 to around 24,000 during 1991 and then dropped further to about 16,000 in 1992. An
accompanying fast fall in interest rates was construed as a supply of "easy money." In fact,
it merely reflected a decline in investment spending and a decreased expectation of inflation.
(That last point should be noted because, in this regard, we are on track with Japan.)
Japan had started easing money (increasing the money supply at a higher rate) in 1994 but the next year hacked back growth in money supply. From 1994 to 1995 the Nikkei lost another 25% of its value. At that time personal spending started contracting while the Yen was still rising. Japan was stuck in an economic Bermuda Triangle. The three sides of the triangle were: a declining equity market, contracting personal spending and a currency that is strong on Forex markets. This is the "perfect storm" that deflation is made of. Why spend money if stuff is going to be cheaper
tomorrow? Deflation is like a big sale that is starting next week. Why go to the mall this week if everything will be cheaper next week? Why spend Yen if they will buy more dollars
next week? Why buy equities if they will be cheaper next month?
Japan's Problems Are Almost By Design
Given the publicity about corporate governance in the U.S. it is amazing to see what passes for
corporate governance in Japan. Japanese companies have long favored employees over shareholders. Something like two-thirds of all Japanese companies hold their annual meeting on the same day. This makes it just a tad difficult for shareholders to speak out. Independent Boards of Directors rarely exist. The banking system served to, in effect, encourage personal savings and pass this along - in the form of loans - to business, many in bad shape. Foreclosing on loans was rare.
In the United States the primary forms of financing business are equity financing (as in IPO's) and corporate bonds sold on an open market.
Japan's failures are, in a sense the result of rigid nationalistic pride. In the U.S. banks are much more ruthless and are successful because "they are only in it for the money". In the U.S., digging up "dirt" is a national obsession. It is hard to hide misdeeds for too long.
In a sense, the same basis that Japan used to grow its economy - the close relationship between government, the banking sector and corporations - is what has let to its present funk. In the U.S. everyone is constantly dissing everyone else. The government, corporation and the media are engaged in a perpetual struggle to get the public to not trust the other parties. On a good day this
is called checks and balances. While these competing forces might, in fact, hold business back they serve to keep it from screwing up too badly.
The Japanese Real Estate Bubble
A few years ago I wrote a newsletter that said that I declared the tech bubble near explosion when the market capitalization of Palm exceeded General Motors. I did not want to hear anything about how wonderful the Palm Pilot was (and I had one at the time) I knew without any analysis that the company that made this (which was a mere spin-off of another company) was not worth anywhere near what GM was. (BTW, Palm is now worth under 1% of where it peaked.)
There was a time when a string of land in Tokyo was theoretically worth more than all of Canada. The value of the city of Tokyo exceeded the value of all the land in the U.S. Something was amiss.
This real estate "event" was truly a bubble because it was based on a fallacy of greed. The Japanese had become successful because of genuine hard work and real business savvy. They understood and, in a sense, reinvented a new generation of productivity. That success was real and also something that we Americans have done well to copy. Japanese who saw what Sony had done sought economic fortune buy buying real estate, causing the value of that real estate to increase and then tapping into this phantom equity to borrow more money to buy more real estate to push the other real estate to a higher value to borrow more money etc. That is what made it a bubble and it did what bubbles always do - it burst.
Real estate bubbles in the U.S. do exist but they are local and their correction may be a source of consternation to a few cities and a few banks they are not going to have any significant impact on the U.S. banking system.
The Last Straw?
The last straw in the realization of Japan's cycle of deflation may have come with the
Asian Currency Crisis of 1997-1998.
So... Is This Happening Here?
I don't think so. While equities have taken a beating with the Dow declining 3 consecutive years for the first time the overall stock market has not been a bursting bubble. And nothing approaching the Tokyo real estate bubble is remotely possible here simply because there has not been an absurd bubble. Sure, commercial real estate suffers massive setbacks because of declining rents (San Francisco being a good example) but banks are aware of this and nothing
approaching the S&L crisis is likely to happen here any time soon.
Absent a dual collapse of equities and real estate values a Japan-like event in not likely in the foreseeable future.
The "Liquidity Trap"
Continuing this line, next week, I would like to examine the idea that declining interest rates will create a "liquidity trap" or, more precisely, an inelasticity of supply and demand for money which will stagnate the economy by leaving the Fed unable to stimulate the economy.
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