Will We Have a Lost Decade(s) Like Japan?

Japan vs. U.S.: Compare and Contrast

By Jeff Harding.

Japan has been in decline, or at least stagnation, for 19 years. Their GDP has not grown, unless you consider 0.6% (avg.) robust annual growth. They have experienced a deflationary economy, and now, it’s happening once again.  They now have the highest national debt as a percentage of GDP than any other major economy. It has been argued that the U.S. is catching this Japanese “disease” and that not only will we have continued deflation, but also stagnation.

I went back and read my background material on Japan’s economic history, starting with the Bank of Japan’s money pumping in 1986, and was startled to see the similarities between the policies of Japan to stimulate its economy and what we are now doing. My last major article on this topic, The Japanese Disease, was written in January, 2009, just as our government was ramping up their fiscal stimulus programs, and things have changed quite a bit since then.

It is easy to say that because we have adopted many of the same Keynesian policies that failed in Japan, not only will they fail here, but that the economic results will be identical. As I write this, I am not sure the economic results will not be the same, but I think there are several major differences between Japan and the U.S. that may lead us to somewhat different results.  It depends what the government will do.

Here’s a quick summary of Japan’s experience (excerpted from my January article):

They started with a huge credit expansion. Their discount rate was cut from 4.4% to 2.5% in 1986-1987. The result:

  1. Real estate and equity prices soared.
  2. To counter the speculative boom, the discount rate was raised in 1989-1990 from 2.5% to 6% and their markets crashed.
  3. The Nikkei went from 40,000 in 1989 to 11,000 in 2005. Real estate values plummeted 80%.
  4. GDP grew at only 1.17% from 1992 to 2003.
  5. Unemployment went from 2.1% in 1991 to 4.7% by 2004 (a very high rate in Japan).
  6. Consumption and investment fell dramatically.
  7. Banks were not lending.

What was the response of the government to this crisis?

  1. In order to kick-start the economy, the government went on an infrastructure spending binge and cut taxes.
  2. From 1992 to 1995 they spent ¥65.5 trillion on projects and cut taxes.
  3. In 1998 they cut taxes ¥2 trillion.
  4. In 1998 they spent another ¥40.6 trillion on spending stimulus.
  5. In 1999 they spent another ¥18 trillion in fiscal stimulus.
  6. In 2000 they tried another ¥11 trillion spending package.
  7. They set up a ¥20 trillion fund to lend directly to businesses (the Financial Investment and Loan Program [FILP]).
  8. To try and push money into the system the Bank of Japan and Ministry of Finance bought more than half of existing government bonds from the private market at a cost of ¥2.22 trillion.
  9. Trying monetary policy, they lowered the discount rate from 4.5% in 1991, 3.5% in 1992, 1.75% 1993-1994, to 0.5% 1995-2003.
  10. They set up a $524 billion bailout fund in 1998 to buy stock in failing banks or nationalize them.

It is estimated that the Japanese spent about $1 trillion about (¥135 trillion) to cure their financial problems. But the problems lingered, banks remained weak, lending and investment was severely reduced, unemployment was high, government debt went to more than 150% of GDP [it's now 200%], and the yen devalued. Nothing seemed to work.

Remember some of the hallmarks of the Japanese experience? “Zombie Banks” were banks that the government allowed to keep their doors open although  they were really insolvent. “Zombie Corporations” were the companies whose debt were held by zombie banks, but were allowed to stay in business because the zombie banks didn’t  write off these loans. “Window sitters,” a term applied to workers of zombie companies who showed up for work every day for a paycheck, presumably gazing out the window all day with nothing to do.

The irony of it is that they are trying the same things again in this crisis, with the same results. The Bank of Japan just predicted two years more of deflation,  and unemployment is up to 5.5%. Exports, the mainstay of their economy, are falling off a cliff (11 straight months of decline). It reminds me of a definition of insanity: expecting a different result to occur from the same input, over and over again.

Does the Japanese scenario sound familiar? It should since we are doing most of the same things as they did.

  1. The Fed reduced the Fed Funds rate to 0.25%.
  2. The government has hugely increased the base money supply in an attempt to create inflation.
  3. The government has spent or pledged about $2.7 trillion dollars in direct loans, bailouts, debt purchases, grants, and wasteful spending projects.
  4. The guarantees to Fannie, Freddie, Sallie, and the FHA, plus additional backstop guarantees by the Fed and the Treasury amount to almost $10 trillion.
  5. The Obama Administration expects the national debt is to increase by almost $10 trillion over the next 10 years (a very conservative number considering the new national health care plans). This will get us to a national debt of about 200% of GDP.
  6. Programs like Cash for Clunkers, Cash for Refrigerators, and Cash for Casas are trying  to stimulate consumer spending and increase consumer debt.
  7. Like Japan, mark-to-market accounting requirements for banks have been partially suspended.
  8. The Fed has been directly financing corporations through its commercial paper lending window.
  9. TARP, TALF and the host of other programs were implemented to keep bankrupt institutions afloat.
  10. They have been buying stock in financial and commercial companies.
  11. They have been buying U.S. debt, effectively partially monetizing the deficit.

It is not surprising that these policies have led us to many of the same results as Japan experienced:

  1. Deflation.
  2. Collapsing real estate values.
  3. A shrinking money supply.
  4. Decreased bank lending.
  5. Falling consumer spending.
  6. Falling consumer credit.
  7. Increased federal debt.
  8. Falling GDP.
  9. High unemployment.

One might ask, with all this faith in Keynesian policies, why aren’t they working? Why are we still having these problems? And, why aren’t we doing something different than Japan?

The reason the economy is not responding is that there is too much bad debt sitting on the books of lenders and companies.  Most of it is related to the real estate bubble: home mortgages, commercial real estate loans, consumer debt, and the derivatives and other products that sit on top of it.

Banks are afraid to lend or foreclose on bad debt unless they are forced to because they know they will need to come up with additional Tier 1 capital because their capital base is insufficient. Because credit is tight, home owners are finding it difficult to refinance their loans because of stricter underwriting standards while home values are falling. CRE loans are even more difficult because commercial financing has largely dried up for troubled projects.

And, consumers aren’t borrowing because they are (i) afraid of their economic future, and (ii) the big spenders, the Boomers,  don’t have enough saved up to retire, so savings are going up.

This is why banks aren’t lending.  As a result, money supply is falling. This will continue until the debt situation is resolved, but the government is doing everything it can to frustrate these corrections because they know the cure (tight money) will cause more banks and business to fail. But unless the debt is removed, liquidated, or paid, banks will remain zombies.

If we are following Japan’s remedies, will we experience Japan’s economic results? This depends on a lot of factors, mainly how the government reacts to economic phenomena. But, all things being equal, I think there are several key differences and similarities between the U.S. and Japan that will determine a different outcome.

Let’s examine these differences:

Policy U.S. Japan Outcome
Prevent banks from writing off bad debts either through suspension of mark-to-market accounting rules or by injecting massive amounts of capital into banks to keep them from bankruptcy. Yes Yes This is a “yes, but …” for the U.S. Both countries banks have seen lending collapse because of lack of loan demand and because they are afraid to take risks with capital, knowing that they might need the capital just to survive. This has led to a declining money supply (say, M1 MULT) which has thwarted inflation. Inflation is a monetary phenomenon, not just rising prices. Inflation is a reflection of people’s lack of demand for an increasing supply of dollars. People have less demand for holding the flood of money which results in greater demand for goods, which results in increasing prices. So for the moment as the money supply shrinks, people hold cash (what Keynesians call “hoarding”) as a sensible response to economic uncertainty, creating deflation and falling prices.

I see this overhang of debt as the current big problem in the U.S. because by preventing its liquidation, economic recovery is delayed. But see the next topic.

Prevent banks from going bankrupt. No Yes

This is kind of a “no, but …” for the U.S. This is a major difference between Japan and the U.S. While the Fed and Treasury bailed out of some of the big money center banks in the U.S., the FDIC is letting the majority of banks, those who do much of the real estate lending, consumer financing, and small business lending, fail. Presently 99 banks have been closed down or merged into other banks by the FDIC. While that is a small amount, the other side of the coin is that capital requirements for banks have been tightened and the FDIC is starting to require banks to write some construction loans down (not allowing them to wait until the interest reserve is used up before they have to revalue the loan). This restricts credit and will lead to more failures.

Here’s the most interesting fact: it turns out that only 5 major money center banks held 80% of derivatives that were on the books of 100 U.S. corporations: JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley. Those five banks also account for more than 96% of these companies’ exposure to credit derivatives. It’s about the same for credit default swaps.

So, while propping up these big banks may keep a large amount of debt hanging around the economy, this phenomenon doesn’t carry over to the majority of banks in the U.S. Their problems are mainly commercial real estate, equity lines, and consumer loans.

I don’t mean to play down the size or risk of this debt held by these 5 banks, but I think this represents a significant difference from Japan. It is incorrect to say we are bailing out all banks in the U.S. This toxic debt is a serious drag on these banks and, if the government continues to backstop their losses on them, it will delay recovery and prolong deflation.

But, and this is a big “but”, the U.S. is more likely to flush most of its commercial debt held by the majority of banks. I foresee many more banks being taken over by the FDIC and I believe most of it will be related to CRE debt and consumer debt. This, contrary to current thinking, is a positive for the economy and I hope that the only zombies we’ll see are the big five. If we don’t allow debt to be liquidated, we’ll be more likely to repeat the experience of Japan. As I said, it all depends on the government’s policy response as they see more and more banks fail.

Prevent corporations from going bankrupt. No Yes This issue is more clear cut. Japan did not let companies fail. The banks just sat on their corporate customers’ loans and the government encouraged this. Other than a few major examples, GM and Chrysler, I don’t think that will happen in the U.S. Thus, the specter of zombie companies will not be a problem in the U.S., except for the few that have been bailed out. And this is being reflected in the numbers as bankruptcies, personal and business, are skyrocketing.
Entrepreneurship. Yes No

This is not to say that the Japanese are not enterprising, but they, like many other countries in the world, do not have the level of entrepreneurial drive and financing that exists in the U.S.

According to the SBA about 44% of jobs are found in small businesses, and they have generated 64% of net new jobs over the past 15 years. Roughly 627,200 new businesses were created in 2008 and 595,600 were closed. Now that’s some kind of enthusiasm.

I could not find comparable statistics for Japan. Perhaps some reader could aid me in this. What I did find is a rather stagnant level of business establishments over the past few years.

Let me get to the point: the U.S. economy is more dynamic and resilient than Japan’s economy because of its entrepreneurial drive, and that is a significant advantage for economic recovery. It seems that Americans jump at the chance to be their own boss and are willing to take big risks to do it. Not to mention the economic rewards for success. This creates a dynamic Schumpeterian capitalism that many countries don’t have. Part of the American “genius” if you will.

Our economy is geared to entrepreneurial activity. How many countries have the huge pools of venture (high risk) capital  that we do? How many countries send their capital here for investment in our start-ups?

While venture capital investment was -63% in Q2 2009, there is a huge pool of capital waiting on the sidelines to fund new businesses. It is cyclical like everything else. And, being a believer in the ability of the economy to correct itself, barring government interfering with the process, I know that this will return with a vengeance.

You could argue that new regulations will interfere with business formations, but since that trend is spreading worldwide, that is a relative problem, and we are still the best venue for starting a new business.

Government deficit financing by foreign investors. Yes No

The Japanese government has the ability to finance almost all its deficits internally through its recently privatized post office savings system — basically a large savings bank run by Japan Post. It controls about 25% of household assets in Japan and the government taps into it at will.  Almost 20% of the national debt of Japan was held by Japan Post. Assets in 2007 were about $1.7 trillion. It has been a nice tool for the government to finance its deficit without having to rely on foreign investment or monetize its debt.

As we know, the U.S. relies heavily on foreign investors to finance its deficit. They finance $3,428 trillion of the $11,545 trillion outstanding, or 30% of our debt. While increasing U.S. savings is making somewhat of a dent in this number, foreign investors have significant leverage over the U.S. In additional the Fed has been monetizing some of the debt. This is an invitation to inflate. (See below.)


Where does that lead us? I think these differences will prevent long term deflation in the U.S. Although I believe we will continue to see deflation until more debt is liquidated and banks are allowed to fail. The timing of this is impossible to remotely forecast. But, with the rising problems in commercial real estate, we’ll see increasing bank failures in the next couple of years. This cleansing effect will set the stage for renewed growth. It will also set the stage for renewed inflation. I don’t buy the Fed’s “exit strategy.”

The economy will “recover,” assuming a substantial amount of debt is liquidated as I envision, and businesses will start to pull us out of this de/recession. The ensuing “recovery” will not be supported by real savings (as defined in terms of Austrian economics), but rather by a flood of paper created  and supported  by the Fed. As business demand for credit grows, it will put upward pressure on interest rates because there aren’t enough real savings to support growth.

The Fed will keep pumping new money and credit into the economy to keep interest rates down to thwart a second collapse in the economy (as in 1937). As prices rise, the Fed will be caught between its urge to tighten credit  and pressure from politicians to keep the boom going. Especially if it’s necessary to insure a Democratic re-election.

Add to the mix the fact that increasing deficits and inflation will cause a decline in the dollar and pressure the government to raise interest rates to attract foreign buyers of Treasury paper. Perhaps our sovereign credit rating will be lowered if the government doesn’t raise interest rates.

I think the inflationary process will last for some time because it will benefit debtors, including the federal government, and will allow them to pay down debt with cheap dollars. The perception of a recovering economy will carry the Democrats and President Obama to victory in the 2012 election.

Prices of goods will start to increase at rates not seen since the 1970s. I don’t  believe that we will see hyperinflation for reason that everyone, Keynesian, Monetarist, and Marxist knows how such events arise and won’t let it happen. It will be reminiscent of the 1970s when, contrary to Keynesian theory, we were able to coin that wonderful word, “stagflation”: inflation and economic stagnation occurring at the same time.

The result of any inflation is, ultimately, a declining economy because of the lack of real savings to support real growth. The trigger of its collapse will be the necessary and unavoidable tightening of money and credit by the Fed to control rising prices. Real wages, real production, and real prices will decline.

While I can only guess as to the timing of these events, I believe it will occur during the Obama Administration’s second term.  Obama and his advisers’ initial response to rising prices after the election will be to “temporarily” impose some form of price and wage controls to put a lid on prices before the Fed starts to tighten money and credit. While Obama’s advisers understand the fallacies of price and wage controls, political pressure from the Democrats will lead to the expediency of controls. As politics is substituted for market based pricing, there will be massive distortions in production, which, if left in place too long, will seriously prevent future growth.

It will be a mess.

Please also see Economic Megatrends That Will Drive Our Future.


4 comments to Will We Have a Lost Decade(s) Like Japan?

  • Lloyd G.

    Good post, Jeff.

    In a couple of areas, going into their recession the Japanese were better positioned than the US is now to try policies that are doomed to fail: They are in debt only to themselves — they have not borrowed trillions from other countries, and; Through it all, they still have had a favorable balance of trade.

    In contrast, the US is hemorrhaging wealth to other countries.

    While the Japanese have had a stagnant economy over the past couple of decades, things still sort of functioned — despite the dead weight of all the Keynesian nonsense.

    We’ll be lucky if we’re in the same place 20 years from now that Japan is now. Especially if the dollar loses its reserve currency status in the world.

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