Are we all Japanese now?

Andrew Milligan examines whether Western countries are facing the same fate as Japan following the 1989-1990 crash.

At times of stress investors tend to ask more questions. Recently, they have evolved from “Are we in recession?” through “How long will the slowdown last?” towards “Are we entering a lost decade?”.

Comparisons are increasingly being made with the well known and long lasting difficulties facing Japan. For years academics and commentators argued that its problems were unique and could not be replicated in the West.

Today, when UK government bond yields are the lowest since the reign of Queen Victoria, and public statements from eminent economists show their concern, the issue needs careful consideration.

Lessons from history

We must begin with a little history. Japan’s initial difficulties started with the stock market crash of 1989-90, when prices almost halved.

Other expensive assets fell too: Japanese land prices slumped over 60% between 1991 and 2006. For years before, capital had been mis-priced and mis-allocated, the famous time when small areas of land in central Tokyo were supposedly worth more than all the state of California.

The authorities made many mistakes, in particular allowing banks to nurse their losses, keeping companies afloat, rather than biting the bullet and facing up to the situation. ‘Zombie banks’ led to insufficient lending from the financial system to propel the economy amidst a sizeable degree of excess capacity.

The end result was the first time when consumer prices fell on a sustained basis in any of the major economies.

Lost decades

Of course events have moved on. Eventually, but only in the early 2000s, the Bank of Japan finally forced the banks to own up to their problems. Various attempts at QE managed to stabilise the price level. By then though the economy was poorly placed to deal with the next set of shocks.

In the 2008-09 global recession, Japan’s industrial production fell some 40%. It recovered but was hit hard by 2011’s natural disasters. As a result, nominal GDP in Japan has returned to the levels last seen about 1991; in effect Japan has lost not one but two decades.

At first sight, many aspects of that unfortunate experience ring true for Western economies. On closer examination though there is better news – few countries suffer from all of them. It is important to dig deep into the detail, answering some specific questions. Has there been a major loss of wealth? Is there a property overhang? Are there zombie banks? Is deflation appearing? is the population declining; Is public sector debt manageable? Can governments reform?

Making comparisons

Let us start with the banks. It possible to argue that some zombie banks in Europe are being kept artificially alive. However, UK and US banks appear to have bitten the bullet, realised their losses and re-capitalised. Why is bank lending low then? This reflects another aspect of the Japanese experience though, debt levels can become too high.

Again the detail matters: households have taken on board too much debt, and the property markets are in a poor way in, say, the US, the UK and Spain but not elsewhere such as Germany or other parts of Europe which never had a housing boom or bust.

The patchwork comparison is also seen when looking at the demographic issues. Japan is suffering from an ageing population, one that has started to fall modestly in absolute numbers.

There are Western economies that face similar problems – Italy for example – however, migration has been an important trend in the US and UK in recent years and on current projections their populations are expected to expand for some decades to come.

Is deflation present? Not in most OECD countries, indeed the reverse seems to be the case. Inflation is at or above target in many countries, especially Europe where the ECB has been raising rates and also the UK where the MPC has had to write a series of apologetic letters to the government.

How did the Bank of Japan respond to deflation? By zero interest rate policies (ZIRP). When the MPC and the Fed took rates towards zero some years ago, it was meant to be an temporary emergency measure.

Instead it has more of the appearance of a permanent situation, especially after the last FOMC meeting decided no interest rate increases before 2013. Hence, Western yield curves are becoming distorted and borrowers are increasingly making decisions on the basis of regulation and coercion rather than voluntary profit or loss decisions.

Politics mattered: Japan did not benefit from the most far sighted of governments during the 1990s and 2000s. Only the Koizumi administration was generally seen as a success; otherwise, crony capitalism was seen in many aspects of the wasteful response by the authorities – concreting over more river beds, bridges to nowhere.

A series of fiscal programmes plus slow economic growth combined to push Japan’s debt to GDP ratio to its current 200% level, exceeding even Greece and Italy. On that basis, the 60%-80% levels commonly burdening the OECD economies are acceptable.

However, the dangers remain clear. Academic analysis has shown that once debt to GDP ratios pass about 90%-100% then it becomes much more difficult for an economy to grow due to the distortions to its capital structure. Italy only grew about 1% a year in the decade before the 2008-09 crash. A self fulfilling cycle can appear, hence the concerns about the unfunded liabilities in the US and the willingness or not of Congress to address the fiscal debate before it is too late.

Major differences

At face value North America and Europe face many of problems which caused Japan so much difficulty. Underneath the surface though, there are important differences, between countries and with Japan.

Amongst the major economies, Italy does look at risk, but so far the UK, US and Germany only show a few of the same characteristics. This places the onus on central bankers and politicians though to ensure that these countries are not sucked into the deflation whirlpool in coming months and years as deleveraging pressures remain profound.