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)
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.