Japan 1990 - Unites States of America 2006 The past as a window on the future

March 11, 2006
Japan in retrospect
As 2006 takes shape, there is in some quarters concern that all is not as well with the US as what seemingly an overwhelming majority of observers of its economy believe. In an attempt to discover what really lies ahead for the US, this essay looks at the situation in Japan as it was in 1989/90, when Japan's economy was the envy of the rest of the world.

What has happened in Japan since then is well-known. The question to be examined here is whether the US, also perceived to be at a pinnacle of success, will maintain its success story better than what the Japanese could achieve.

The essay, in five installments, to be released about 2-3 days apart, looks at what Japan was like in 1989/90, at what brought about the severe changes that have been observed since; it then extrapolates this insight to examine conditions in the US in 2006. And to speculate about the future.

Introduction
Over a period of three decades, from the 1960's to the 1980's, Japan was the envy of the rest of the world. It blazed a trail of economic success for other developing countries, such as South Korea and what became known as the SE Asian Tigers. Japan performed exquisitely in terms of all parameters used by economists. Growth in GDP remained near double digits over this whole period; their consistently large trade surplus helped to keep interest rates low and was bringing in wealth upon wealth; inflation spiked following the 1973 oil crisis, but was brought under control by historically high interest rates, enabling low rates to return so that the economy extended its growth. The stock market boomed; by 1989 the Nikkei had increased 10-fold over its value in 1970. The Yen was strong, boosted by the strong economy and the healthy trade balance. In 1972, when currencies were set to float following Nixon's unilateral abrogation of Bretton Woods, it traded at ¥357 against the US dollar; by the end of the 80's the Yen was at ¥123 to the dollar, a 65% gain in value for the Yen, (and then it firmed to just ¥80 a mere 5 years later - with the dollar down by more than 77% against the Japanese currency!).

Japanese innovation and productivity in industry were being copied all over the world, to the extent that foreign cultures made this practice possible; as it happened, success for the transplantation of some Japanese business solutions to the western world was quite rare. By 1990, Japan owned nearly 10% of all of the US, by value, and analysts were creating scenarios in which by year 2000 Japan owned 50% of the property in the country with the largest economy of all.

Then, on the last trading day of 1989, the Nikkei 225 index in Tokyo reached its all time high of 38 957 points, before closing the day, the week and the year at the high of 38 916 points. Since then, it could not remotely approach that record. A year later the index had lost nearly 40%, on its way to 'achieving' a low of 7608 points in April 2005 - a loss in value to investors of over 80% from the high.

Even so, the Nikkei fared marginally better in its collapse than the Dow Jones Industrial index managed in the aftermath of the 1929 debacle. The Dow Jones had an initial value of 40.94 in 1896; in 1929 it reached a high of 381.217, only to plummet to a close of 41.22 in July, 1932; only a fraction above its opening value 48 years earlier and all of 89.2% down from the high 3 years earlier.

Following the collapse of the Tokyo stock market during the early 90's - which also saw the pricking of their property bubble - Japan entered a 16 year period of near constant recession and deflation. This debilitating state of the economy is still not fully resolved, even though the situation recently showed some signs of improvement. It is still too early to confirm whether Japan will grow its economy out of their 16 year slump; its precarious financial system conceals massive bad debts as a consequence of the collapse of the property market. However, Japanese ingenuity and some escape routes in legislation have enabled the banks to successfully brushed the bad debts under the carpet, as discussed in "A Japanese Tale Parts 1 & 2", where by all accounts these still reside to gather dust. One could speculate that, even though well-concealed, this load of bad debt could resurface in reaction to an external shock to make the financial system very vulnerable.

While Japan's economy and growing wealth were the envy of the rest of the world, no analyst protective of his reputation dared disregard consensus to suggest that the euphoria about Japan could not last. Potential problems, such as extreme valuations on the stock exchange, were rationalised away; such as by saying Japanese investors cared little for dividends, that their only interest was in increasing capital gains, which meant that the high valuations had become irrelevant. (This again became a familiar theme during the 1990's hi-tech bubble, with similar lack of lasting power!) Yet, despite all the earlier optimism, starting in 1990 the Japanese equity and property bubbles deflated steeply to ring in an extended period of stagnation.

As we enter 2006, the US in a number of respects reflects the situation Japan had worked itself into, 16 years ago. Optimism of a new golden era is widespread, despite portents of doom from a small minority who typically anchor their pessimism in a rampant increase in the amount of debt owed by all sectors of the US - by households, corporates and the government; debt that is owed both internally in the US and externally to foreign lenders.

This essay attempts to consider these factors in relation to what had happened in Japan after 1990 as a means to cast some light on the future of the US. Conditions in Japan, at the beginning of 1990, are compared to the current situation in the US, in order to provide grounds for speculation about what lies ahead for the US. Given the many similarities, allowances yet have to be made for significant differences between the two countries - economic and also cultural - which implies the US will not follow the exact same path Japan had done over the past decade and a half.

Please observe that while some statistics and graphs are essential, the idea is not to dazzle with lots of tables and graphs; this essay is intended to provide an overview for a general readership of what has happened in Japan and what might happen in the US, rather than for more academically inclined readers.

Japan in the making, to 1989: The Japanese
For outsiders looking into Japan, the Japanese people are perceived as being 'different'. Their isolation from the rest of the world during much of their history, the geography of their islands and their demographics, meant they developed an own, unique set of cultural characteristics, different even from their nearby neighbours on the Asian mainland. A long history of internal warfare coupled to the dominant role of the samurai caste, made them a warlike people, even though only a small fraction of the population had samurai warrior status; the rest, mostly peasants and merchants, from early youth learnt to be obedient and subservient to avoid the consequences of perhaps inadvertently offending someone of the warrior caste or, worse, a noble lord. Their wrath in response to perceived disrespect was immediate and terrible.

Pervasive discipline, self and externally imposed, over time, transmuted into strong type-casting, almost stereotypes, that affected everything from speech patterns to dress codes. Each demographic layer in their society was molded into predetermined, fixed patterns of dress, customs, how one behaved generally, even where one could live, from which there was little chance of escape to different circumstances. Conditions of daily living in over-crowded towns and cities, in flimsy housing structures, placed a premium on showing respect for another's right to privacy and demanded that people conform to the norm in terms of their behaviour - a significant attribute of which was to avoid giving offence or becoming a nuisance to others.

Further, sheer pressure on peasants and merchants to survive during frequent periods of upheaval and hardship - man made, such as being recruited into an army for the frequent warfare over 800 years of civil strife or finding themselves living in the way of an army on the march, or, else, due to various natural disasters to which these tiny high-population islands are prone - taught them to remain aware of risk, to be prepared for eventualities through hard work and productivity. Thrift and care in the management of assets were of high priority in the household, where the women traditionally controlled family finances.

In this way, a strong culture of conformity developed over many centuries, while a risk averse philosophy in the management of household finances was passed from mother to daughter and came to permeate all of society.

Individually, these are not all unique qualities, but their combination in one people and the degree to which all of society adheres to these principles are not matched elsewhere.

Japan post WWII - The rising sun
Following the ignominy of the disastrous defeat in the Second World War, the Japanese started to rebuild their economy with typical will to work. Their industry and dedication paid off and well before the end of the century the Japanese economy had moved into the second spot behind the United States, that it still maintains despite what had happened since the collapse of their markets that started in 1990.

By the late 1980's, Japan was on top of the world. The stock market was at a breathtaking high; the Japanese economy, driven during preceding decades by an absolute explosion in both innovative business methods and productivity, was the envy of the rest of the world. No wonder Japanese business practices were being copied all over the developed world in an attempt to emulate what Japan had achieved since the devastating defeat at the end of the Second World War.

The property market had been screaming skyward since the late 1950's, so that by 1990 the land value of Greater Tokyo exceeded the total land value of the US by 20%. Japan was in fact by then the owner of about 10% of the US, by value - a minor investment in property, compared to the land value of Japan. No one knows what may have been the situation by the end of the century if the wheels in Japan did not come off in 1990/91. Any attempt to project the trends to the end of the century is likely to result in a scenario that would seem totally implausible today, in the light of what really happened.

The sun at midday
The story of the run-up to this state of affairs in Japan, with the focus on the real estate bubble that had formed, is told in the author's first internet essay, published at Gold-Eagle early in 1999.

"A Japanese Tale" recounts the inflation of the property bubble and what was done to deal with the mass of bad debts after it was pricked. A key consequence of the deflating stock market and property bubbles was that financial institutions sat with a heavy load of bad debt at the same time as their capital base was eroded by the reduced value of their stock market investments. Historical facts and some conclusions of the original essay that are relevant to this review, include:

  • The Nikkei stock index lost 24% during the first 4 months of 1990, dipping to a loss of 50% after 9 months - during which time the property bubble was also pricked
  • When property prices halved during the first 12-18 months after the peak, companies as well as individuals who had mortgages close to the original value of their property - which meant a good fraction of all households and a large proportion of businesses, with the latter using the mortgages to fund working capital - simply stopped paying monthly installments, knowing full well that the mortgage holders would not, in fact could not, re-posses all the delinquent properties
  • It was reported at the time that, since the rules said a mortgage that was delinquent by 6 months had to have the whole amount of the mortgage assigned to bad debt, banks were under pressure to protect their capital base, else they would not meet the capital requirements to continue operation. One solution was to offer delinquent mortgagees who were 5 months behind an interest free loan, repayable after the full mortgage had been paid up, provided the loan was used to pay the installments that were due. When both parties knew full well the mortgage would never be repaid, there was no risk in accepting the offer; however, doing so achieved two objectives - the property was not at risk of foreclosure and bad loans did not erode the bank's capital.
  • Using rough estimates for the amounts involved, the conclusion in 'A Japanese Tale' was that institutions faced a potential $2.5 trillion in bad debt. [When an early draft of this analysis was in 1993 leaked in the office of the author's employer, a prominent stock broking firm, the banking analyst considered the conclusion ridiculous since the official estimate for bad debt in the banking sector at that time was less than $100 billion. This almost cost the author his job and would have done so if the analysis had become public! Yet that apparently outrageous estimate was vindicated when the NY Times (July 30, 1998, by David E Sanger - worth reading still) reported at least $1 trillion of estimated actual bad debt.]
  • At that time, the author naively thought once this vast amount of bad debt in a major economy became visible and had to be dealt with, it would inevitably lead to major ramifications; perhaps even a near collapse of the global financial system. Of course, this did not happen, perhaps for two reasons. The ingenious Japanese were successful in their use of various means to conceal the true extent of the black hole in the banks' books and secondly, nobody who knew the full extent of the potential crisis wanted to give wide publicity to these facts and perhaps be known as the person who triggered a global financial melt-down
  • Another solution to conceal the true extent of bad debt, was a stratagem that could be employed over and over by a small group of banks. A report at the time explained how a such a group would collude to get rid of bad debt by floating off a company in which each of them parked some of their bad debt, yet each bank was to own too small a share in the new company for the rule to consolidate its financial statements with those of the owner banks to come into effect. Doings so moved bad debt off the books of all participating banks into limbo. It was reported that around the turn of the century one major Japanese bank listed an interest in more than 2400 such synthetic companies housing nothing but bad debt!
  • By 1980 the Tokyo stock market had been in a long term bull trend. The final and also steepest phase started at the time when Wall Street finally turned bull - in mid 1982. By then the Nikkei had already almost tripled since the early 1970's, while the Dow had spent 16 years unsuccessfully trying to break above 1000 points. By the end of 1989, the Nikkei had improved by another 450%, which easily eclipsed the 240% gain achieved by the Dow Jones over this period. As the Nikkei stormed to its peak, PE ratios for the larger part of the market climbed to 80 and higher. The generally accepted explanation why this could be sustained, was that Japan had become a new economy and could not be evaluated by outdated measures. Japanese investors, so it was said, did not care about miniscule dividends, because they were only interested in capital growth. [This may sound familiar to people who had experienced the heydays of the Nasdaq on its way to above 5000 points in the late 90's!]

Low darkening clouds over the landscape
For Japan, the good times came to an end with a bang when both the equity and property markets collapsed in 1990. The Japanese people reacted as they have always done during tough and uncertain times; households fortified themselves financially against risk from all quarters by becoming even more thrifty and risk averse. Purchases were limited to little more than what was essential and to save as much as possible became of overriding importance. This reduction in consumer spending triggered a deflationary recession that was to last on and off for 15 years; the worse conditions became, the greater became the incentive for the Japanese to save and thus prepare for more inclement economic weather.

Yet, for the vast majority of Japanese households the financial threat posed by recession was not imminent nor significant. Total household savings during those years were about $12 trillion, or about $100 000 for every man, woman and child. This provided a useful buffer for financial survival of the household during the worsening economic climate.

Tradition is very important in Japan. Despite widespread (and growing) presence of some elements of western (US) culture, predominantly among the young, many Japanese still adhere to cultural guidelines and mores that stretch back hundreds of years. In times of adversity, tradition becomes even more important, since, among other things, it offers time tested rules of how to deal with risk and uncertainty. However, the Japanese also have their valued way of dealing with failure and 'loss of honour'. In the aftermath of the economic collapse of the 1990's, many businessmen suffered a 'loss of honour' that in their Bushido tradition could only be expiated by the commission of seppuku, also known as hara-kiri - that is, ritual suicide.

By the mid-1990's it was estimated that as many as 33 000 Japanese had committed ritual suicide in response to failure of their businesses as a consequence of the collapse of the markets and its effect on the economy. This statistic is included here to give readers an idea of how much Japan even today still values its traditions. [As an aside, one wonders how many Enrons and Worldcoms there would have been if the US - and elsewhere in the west - had a similar tradition of honour for dealing with failure in one's responsibilities to employees and share holders!]

Summary
The main points we can learn from this review about the situation in Japan in 1989, at the cusp of its period of rise, to be followed by decline, include:

  • A long history of excellent economic growth that induced a widespread belief among most Japanese that the good times would not come to an end, only get better
  • A sustained bull market in equities, with very high PE ratios, which were discounted by market analysts on grounds of a widespread investor preference for capital gains, not for earnings or dividends
  • A booming economy, partially fueled by debt; in Japan, with large household savings and successful businesses, this was almost exclusively mortgage based since property values were astronomically high, rates were low and 100% mortgages easy to obtain in the climate of ever rising property prices
  • Low - although not yet super-low - interest rates that made Japanese businesses and households confident there are no dark clouds on the economic horizon
  • A strong currency and positive trade balance that kept the economy pre-eminent in relative global terms, even after the collapse in local markets; these factors cushioned the economy against the negative effects of the implosion that began in 1990
  • Widespread belief in national moral and economic superiority, nurtured by sustained world class growth and no lasting economic setback to rupture that belief, at least not until the bubbles deflated and the Japanese retreated into traditional risk averse mode
  • A strict and rigid social class structure developed over centuries around a tradition of strong self-discipline and being highly self-reliant at household level; with a history of coping with all kinds of adversity with equanimity and the use of own resources, rather than relying on the authorities for relief and assistance

In the third part of this essay we examine how Japan was affected by the situation as it developed post 1990, but first we take a look at comparative conditions in the US today.

One cubic foot of gold weighs more than half a ton (1,306 pounds).

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