"He [Koizumi] said I want to make it very clear to you exactly what I intend to do and he talked about non-performing loans, the devaluation issue and regulatory reform and he placed equal emphasis on all three."

Mr. Bush, of course, meant to say 'deflation(ary)', not 'devaluation' - a slip that was clarified soon afterwards by the White House. However, for a brief moment following Bush's gaffe every forex trader watched the Yen fall and feared the worst...

Is The U.S. Economy Turning Japanese?
The unemployment rate in Japan continues to rise, the country is in its third recession in a decade, banks are carrying anywhere from $300-$500 billion in bad debts, and consumers would rather consume gold bullion and save 30% of their income rather than buy something. By contrast, in the U.S. unemployment has been rising, if you blinked you just may have just missed the first recession in more than a decade, banks do not book bad loans rather they hide them or lie about them (JPM), and consumers spend every penny they earn.

Beyond these simple and slightly embellished comparisons another point is worth mentioning: that being that the economic malaise present in Japan is the result of a full-blown liquidity trap, where as within the U.S. such a trap may or may not be forming. In Japan the trap occurred because monetary manipulations (lower interest rates) did not achieve a systemic response in confidence (spending). By contrast, the United States, at least for the moment, looks to be successfully avoiding such a trap.

With this in mind, and if the U.S. economy is really on the mend, the major difference between Japan and the U.S. has been the ability of the American economy to use a deflationary low interest rate environment as a springboard for economic growth. Moreover, the ability of the U.S. stock markets to ignore slumping earnings (deflation), and the ability of the housing market to remain hot (lower interest rates) comment well on the difference between the two economies.

However, this is not to say that the rebound in confidence in the U.S. sustainable. After all, stock prices, which directly impact confidence, have risen partially because the consumer kept spending for much of 2001 not because the companies that sold consumers products and services made much money. Such is the paradox: corporate margins fall in a deflationary environment buy apparently in the U.S. stock prices and valuations do not.

In sum, the Japanese economy is the weakest developed economy in the world for two reasons: 1) consumers would rather save than spend, and 2) bad loans are not written off or effectively hidden (a temporary solution). As such, the popular mantra that has been regurgitated countless times over the last few years remains in place today:

"U.S. Urges Japan to Clear Bad Loans, Revive Growth" Bloomberg

Question is, what might Japan be saying about the American economy if the tables were turned?

Would it be something like "Japan Urges U.S. to spin bad loans off into debt securities, somehow convince consumers and business to borrow more money, keep the stock market rallying by whatever means possible, and keep growth going for a little bit longer"?

The key phrase is 'a little bit longer'.

It is worth remembering that all of the bad loans currently on the books of Japanese banks began as 'good loans'. With this in mind, if monetary manipulations within the U.S. do not continue to achieve a systemic response in confidence Japan type problems could arise: what happens if deflationary pressures, and new accounting regulations help keep corporate earnings in the doldrums, the stock markets fall, and the lay-offs keep coming? Well, bad loans would continue to mount, confidence would drop, and those optimistic economists/analysts would become a little less jocular on the topic of consumer debt.

As such, the missing ingredient needed for a Japan type bust occurring in the U.S. is a severe drop in asset prices. Without a drop in asset prices it is unlikely that U.S. bank balance sheets will ever mirror those of Japan. Moreover, unless deflation stems to asset prices it appears, however strange, that the U.S. consumer and investor does not mind a recession so long as prices are cheap and the rebound is thought to be on its way.

Deflation, valuations, and consumer debt: are these the 'axis of evil' for the U.S. economy?

New accounting regulations
It should be remembered that the Security and Exchange Commission was not formed in 1933 to help the stock markets rally. Rather, the SEC was formed for the purpose of eradicating fraud, and enforcing accounting standards. This is an important distinction to remember today as investor outrage surrounding Enron, and other corporations prods the SEC to set-up new accounting policies.

'New' accounting rules may be a benefit to the markets longer term. However, it is worth remembering that new rules intended to provide clarity within financial statements would undoubtedly be a stock market negative near term. Think of it this way: how many companies hide good news? How many companies hide assets offshore that would otherwise boast their balance sheet, record stock options as an expense when they don't have to, report pro forma results that included one-time derivatives losses? The answer, of course, is none. Rather, companies that hide bad news and manipulate earnings will be the ones hurt by any new regulations.

Eventually, as companies cannot hide as much, the new rules may 'help'. However, and to reiterate, new accounting rules do not actually 'help' the markets per se. Rather, greater clarity of financial statements can help the investor better understand a company's financial position.

Brady Willett
BWillett@fallstreet.com
www.wallstreetwishlist.com

February 21, 2002