There are only two real precedents for the deleveraging cycle that the U.S. economy faces today: 1) The Great Depression & 2) Japan in the 90′s (I am excluding Sweden from this exercise due to their small size – what’s wrong with a Swedish model is always worth a read, however).   I have said that the current deleveraging cycle is actually not all that similar to the Great Depression – primarily because our economy is much more mature and stable, and also because there are certain safeguards in place that help prevent such an event from occurring again (the FDIC is a great example).   The similarities to Japan, however, are quite frightening.   Goldman Sachs recently wrote a piece detailing this point with a few counterarguments.  Just how similar to Japan is the current deleveraging cycle in the United States?   Let’s take a closer look:

Japan’s deflationary slump

The collapse of a massive asset bubble, a banking and credit crisis, zero interest rates and central bank balance sheet expansion, and massive fiscal stimulus: these features of the Great Recession sound eerily like Japan post-1990. The legacy of the Japanese bust was a pernicious deflation, burgeoning government debt, and a seemingly permanent reduction in trend growth casts a long shadow over the current crisis. Will the Fed really be able to make sure it – deflation – doesn’t happen here?

Although a thorough comparison of the Japanese and US crises is beyond the scope of this paper, there are several reasons to believe things could turn out better in the United States:

1. A considerably smaller asset bubble.

Though the US bubble certainly looks large, Japan’s was truly epic three to four times as large by some measures. Exhibit 14 compares equity and home price booms and peak valuations in the two countries. At this stage, it appears that US financial sector losses from the bubble are likely to be proportionately smaller as well.


GS Equity & RE Prices (Exhibit 1)

This is not entirely true.  If you take the short timeframe then yes, Goldman is correct, but if you back these charts out to 10 years then you’ll actually find that the bubbles in both real estate and equity markets were nearly identical.  Goldman is essentially datamining in order to prove their point.  The following chart shows that the 6 city Japan real estate composite is almost EXACTLY the same as the Case Shiller 10 city Composite:


10 Year Japan & U.S. RE Prices (Exhibit 2)

Exhibit 3 below shows nearly the exact same story in equities.  The inflation adjusted prices over the 10 years prior to the peak were nearly identical.   To Goldman’s credit, the PE ratio of the Nikkei was substantially higher at the peak than we experienced here in the U.S., but as regular readers know, PE ratios are about as useless as any pricing ratio.   They are nothing more than an inefficient market price divided by a guess (analyst estimate) – or in the case of a trailing PE – a rear view mirror indicator.  In other words, they are mostly worthless so I will refrain from elaborating.


QE & Equity Prices (Exhibit 3)

Goldman goes on to argue that the policy approach has been far more proactive in the U.S.:

2. A  far more  aggressive and rapid policy response in the  US.

The difference in monetary, fiscal, and regulatory policy in the two countries could not be more striking if we compare the behavior of policymakers following the equity market peak (October 2007 in the United States and December 1989 in Japan): In the first 18 months of the crisis the Fed cut its target rate more than 500 basis points, instituted numerous liquidity facilities, and announced plans to purchase assets worth 9% of GDP. The Bank of Japan took more than a year to begin cutting rates and more than seven years to expand its balance sheet significantly.

On the fiscal side, the US has already enacted a stimulus program worth about 5% of GDP; it was more than two years before more modest and piecemeal stimulus began in Japan.  The US has completed a highly successful bank stress test and recapitalization program for institutions comprising about half of the aggregate balance sheet of the financial system. The Japanese authorities’ first significant injection of funds in the banking system began eight years after asset prices began to deflate (although with a shorter lag after the onset of severe financial market stress).

The following chart shows that the U.S. response was in fact much more swift than the Japanese approach:


BOJ vs. FED Response (Exhibit 4)

The underlying problem was not that rates were too high or that there were no stimulus packages already in place – the real underlying problem was that there was too much debt at the private sector level.  That problem still exists and had already spread throughout the system by the time the Fed began to act.  Nothing was done about it.  All we’ve done is inject the patient with enough Percocet to put an elephant to sleep.  In other words, the patient feels better, but the cancer is still there.  Fiscal policy helps alleviate the problems, but doesn’t necessarily solve it.  Since the cancer had already metastasized by the time the BOJ and Fed began to act, it didn’t matter how quickly they responded.  The Fed would have had to have been much more proactive in order to contain the cancer.  Regardless, Japan is a great example that government stimulus is not going to fix the long-term problem once it is in motion though it can help in the de-leveraging process:


Effects Of Stimulus In Japan (Exhibit 5)

Goldman continues:

3. Potentially better prospects for external adjustment.

Over the decade after the Japanese bubble peaked, the contribution of net exports to real GDP growth was essentially zero, despite a massive deceleration in domestic demand. We see three reasons why US net exports could do better.

  • First, the United States economy is more open: trade (exports plus imports) as a share of US GDP is about 24%, versus around 15% in Japan in the  lost decade.
  • Second, the dollar has appreciated only marginally since the onset of the crisis. The yen rose 7% in the comparable period after Japan’s bubble burst, on its way to a 25% real-trade weighted appreciation after five years.
  • Third, despite what we believe will be a slow US recovery, we expect global real GDP growth over the next couple of years to substantially outpace the early to mid-1990s, although much of the strength is likely to come from emerging market economies such as China rather than key US export destinations.

This is mostly spot-on.  The only thing I would point out is that Japan is a clear example that GDP can expand while the stock market fundamentals can continue to deteriorate.  Reference Exhibit 6 for a visual example of nominal GDP expansion during a deflationary period.  In our consumer based economy it should not shock anyone that a continued debt drag on consumers might hinder future earnings growth.


GDP Japan & Commercial RE Prices (Exhibit 6)

Lastly, Goldman points to the demographic differences:

4. A smaller demographic challenge.
Japanese labor force growth slowed from about 2% per year in the final years of the bubble to a halt in the early 1990s. US labor force growth has also stalled in the recession, but American demographic challenges are less severe. The ratio of the working-age population to non-working age population fell more steeply in the lost decade than it will in the United States over the next decade.

The dependency ratio, however, in Japan and the U.S. is nearly identical.   In 1990 Japan had a dependency ratio of 17%, but that spiked to 25% by 2000.  As of today, the dependency ratio in the U.S. is 18% and is expected to jump to 25% by 2010.

Despite these mostly false counterarguments, Goldman goes on to agree with my primary argument:

Against this, some aspects of the US situation look more challenging. The United States generated significantly larger real economic imbalances during the boom. US consumption reached 70% of GDP and the current account deficit was nearly 5% of GDP at the onset of the crisis; Japan ran current account surpluses throughout. These imbalances probably help explain the deep correction after the bust by most measures, the US has more spare capacity in the economy now than Japan did at any point in the lost decade, and therefore arguably more deflationary risk. The severity of the crisis and its interconnectedness with the rest of the world also means that aftershocks may be more of a risk to US trading partners’ growth prospects than they were to Japan’s trading partners in the 1990s.

In summary, it’s easy to draw several clear distinctions between the US and Japanese post-bubble episodes. But it’s much more difficult to decide which is the more challenging. While US policymakers faced a more manageable asset bubble and dealt with it more aggressively, they preside over an economy with substantially larger fundamental imbalances. And while the United States arguably has better longer-term growth prospects due to productivity and demographics, it may be operating in a less friendly external environment. We are hopeful that the US situation will prove more manageable, and ultimately transitory. However, of the various cross-country historical comparisons to the current US outlook, we believe the Japanese experience provides the closest analogy.

Unfortunately, I am afraid the U.S. situation will not prove to be much more manageable (ironically, because we are not managing it well).  Our deleveraging issues lie with the U.S. consumer despite what the bankers will tell you about their own problems.  The one weak leg of the recovery remains the debt-laden consumer.  The root of the problem is still alive and well and as government stimulus and endless “money printing”  fail to ignite a sustainable recovery there will be a decline in confidence which will ultimately begin to feed on itself.  SocGen’s Albert Edwards describes the phenomenon (for more from Edwards please see here):

One of the key lessons from Japan’s lost decade is that investors’ confidence that the
authorities are in control of events will ultimately drain away. In a balance sheet recession, one should expect frequent downturns as the authorities balk at additional stimulus. Only then will zombie investors, sucked dry of confidence, squeeze the remaining puss from equity market valuations. Only then will the 20 year boil of equity market over-valuation be properly lanced.

While equity investors feed at the trough of greed bond investors are hunkering down for continued bout with deflation.  Despite the Feds all out war on deflation and throttling of the printing press, the bond market isn’t buying it.  3 month t-bill yields remain near all-time lows – another striking similarity with Japan.


3 Month Bills (Exhibit 7)

We continue to ignore our past and the warnings from those who have dealt with similar financial crises.  Keiichiro Kobayashi, Senior Fellow at the Research Institute of Economy, Trade and Industry is the latest economist with an in-depth understanding of Japan, who says the U.S. and U.K. are making all the same mistakes:

Bad debt is the root of the crisis. Fiscal stimulus may help economies for a couple of years but once the “painkilling” effect wears off, US and European economies will plunge back into crisis. The crisis won’t be over until the nonperforming assets are off the balance sheets of US and European banks.

The main issue, as Kobayashi elaborates on, is that the U.S. is ignoring our debt problems rather than confronting them.  We desperately need to encourage this de-leveraging to occur as opposed to implementing policy that incentivizes people to push it off or take on more debt.  This reactive approach to deleveraging is very similar to the ways Japan dealt with their financial crises.  They swept problems under the rug hoping the economy would improve, but it never rebounded substantially.  Low rates and quantitative easing didn’t attack the problem of too much debt. Kobayashi sums it up beautifully:

So long as people hold onto the expectation that recovery could be brought about by fiscal measures, no national consensus can be built to proceed with the painful disposition of nonperforming assets. It is necessary to learn by firsthand experience that fiscal measures are only makeshift. In this context, the enormous fiscal deficit that will be built up in the US in the coming months may be the political cost for consensus building, which would be a replay of what Japan went through in the 1990s.

Up until several years ago, the US and European countries had repeatedly criticized Japan’s policy responses for being too slow. But it might be the case that US and European policy responses are just as slow as those of Japan when it comes to tackling the daunting task of solving nonperforming asset problems. By studying Japan’s experience, foreign policymakers have an excellent example from which they can learn what not to do. Yet, the recent developments show just how difficult it is to learn from the mistakes of others. We, as human beings, are by nature probably unable to take to heart anything having negative implications unless we learn its lesson the hard way through firsthand experience.

I know it’s not easy to take our medicine, but I fear that all we’ve done is create an economic recovery that is entirely dependent on “money printing” and government stimulus.  In other words, it is not sustainable.   For now, I fear that we are simply repeating the mistakes of the past.  This doesn’t necessarily mean that we are destined to suffer two decades of negative stock market performance as Japan has, but investors who are expecting a sustained v-shaped recovery are likely fooling themselves.  These problems run deeper than the bankers and government will have you think.

And what if I am wrong and Ben reflates us back to health, you ask?  Well, it’s likely that all Ben Bernanke has done then is fire up the economy for another round at the boom/bust cycle.

* This piece was later edited to clarify between government debt and private sector debts.  

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. You know there are firms that would pay you hundreds of thousands of dollars to do this sort of analysis right? Awesome job man!

  2. Great piece, clear and well researched. This site goes on my daily reading list from now on.
    Only thing missing was a discussion of the possibility of USD devaluation. This would likely help the US economy adjust faster, but would be very impopular with the international community.

  3. Where did they get the 15% of GDP for Japan’s trade? I was (mistakenly?) under the impression that they were a country of savers and exporters, what is making up the other 85% of that GDP?

  4. Domo Arigato!

    A few questions…

    1. What do the quadrillion dollars of derivatives do to change your ideas? Are these debt, or just debt if things go wrong?

    2. What new problems are there with strategic default and jingle-mail, consumer and business decisions to abrogate existing debt agreements?

    3. How much worse does it get with massive new cap-n-trade taxes, roughly $1,000 a year per household. Lowest 20% of households will see an invisible tax increase of 5% of income, an enormous jump.

    4. Many renewable energy technologies are about to become cheaper than coal, so there is a plausible future of a continued drop in the cost of energy? That said, just as there were many companies for autos and planes, and now only a few, there will be a huge shakeout in green energy, with only a few big survivors.

    5. Japan is, like, really, really old…but they have good medicine cheap. We are getting old, and really expensive medicine?

    Again, thanks for your great essays.

  5. Great analysis TPC, insightful as always. Would like to add one more issue which can make things worse: the USD is the currently the worlds reserve currency and despite the noise, there aren’t many real alternatives to it. This makes devaluing the USD much more painful for the rest of the world (which Japan could do), and this can ultimately severely limit the maneuvers the Fed can take.

  6. TPC, thanks for the excellent post. I would just like to add the following to your post…

    Recession? No, It’s a D-process, and It Will Be Long

    Basically what happens is that after a period of time, economies go through a long-term debt cycle — a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren’t adequate to service the debt. The incomes aren’t adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring.

    We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes — the cash flows that are being produced to service them — or we are going to have to raise incomes by printing a lot of money.

    It isn’t complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.

    What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven’t said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.

    The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.

    However, the reason it hasn’t actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece — banks and investment banks and whatever is left of the financial sector — that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.

    The Federal Reserve is going to have to print money. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression. We are in a position where that will eventually create a problem for currencies and drive assets to gold.

    You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation. So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity. While the dollar is bad, it doesn’t mean necessarily that the bond market is bad.

    The reasons for China to hold dollar-denominated assets no longer exist, for the most part. However, the desire to have a weaker currency is everybody’s desire in terms of stimulus. China recognizes that the exchange-rate peg is not as important as it was before, because the idea was to make its goods competitive in the world. Ultimately, they are going to have to go to a domestic-based economy. But they own too much in the way of dollar-denominated assets to get out, and it isn’t clear exactly where they would go if they did get out. But they don’t have to buy more. They are not going to continue to want to double down.

    From the U.S. point of view, we want a devaluation. A devaluation gets your pricing in line. When there is a deflationary environment, you want your currency to go down. When you have a lot of foreign debt denominated in your currency, you want to create relief by having your currency go down. All major currency devaluations have triggered stock-market rallies throughout the world; one of the best ways to trigger a stock-market rally is to devalue your currency.

    But there is a basic structural problem with China. Its per capita income is less than 10% of ours. We have to get our prices in line, and we are not going to do it by cutting our incomes to a level of Chinese incomes.

    And they are not going to do it by having their per capita incomes coming in line with our per capita incomes. But they have to come closer together. The Chinese currency and assets are too cheap in dollar terms, so a devaluation of the dollar in relation to China’s currency is likely, and will be an important step to our reflation and will make investments in China attractive.

    A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation — and that will last for as far as I can see out, roughly about two years.


  7. Although the J debt theories (Koo + others) are significant, the other problem with 90s Japan is, ask yourself, why invest in the people or companies? Outside of Sony, Canon, Toyota etc. (which had done pretty well), my perception of Japan is of a rigid/slow government, society, labor, consumer and innovative capacity/acceptance. I don’t think the US has that problem (similarily, I always think it’s a miracle that Israel even functions [huge political risk, boughts of 100% inflation, no natural resources, lack of global scale]). There will be big losers in the US, and it is definitely headed for high structural unemployment … due to the Fed postponing the pain for the last 20 years and losing the “gains” made during 85-90s restructuring … but US dynamism will be a big difference … the question is can our politicians inspire us to that. Historically there have been many interesting depression/disaster comebacks: Nazi Germany, post-war Germany and Japan, China and the UK in the 80s, so the glass is also half full. The greatest threat to the US is if unions reassert themselves (with the aid of protectionist policies) … then you will really have Japan … rigid/slow government, society, labor, consumer and innovative capacity/acceptance.

  8. Naa,

    Shoot me an email. I have a present for you.


    You are correct. There are many large structural differences which is why we won’t follow the same exact path as Japan. Also, we’ve been thru a lost decade already….I don’t expect 10 more years of negative stock returns, but I also don’t think we’re going to see above trend growth for the next 5-10 either….

  9. What’s really scary is that America and most of the rest of the world will be facing an age problem with most people retiring and less people going to work to finance them. This will truly be one of the problems of our century. Either the swine flu needs to be particularly lethal to old people or we are in for big problems ahead. And if we have another war or pandemic that kills a lot young people? I don’t even want to think about that.

  10. Dear TPC,

    Once again a very nice piece but one thing jumped out at me.
    As of today, the dependency ratio in the U.S. is 18% and is expected to jump to 25% by 2010.
    Just wondering if that piece is correct?