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Benefits and Pensions MonitorWhy The U.S. Is Not Another Japan By: Drummond Brodeur The recent bursting of the U.S. equity bubble has prompted some commentators to compare it to the collapse of the Japanese equity market (from its peak in December 1989) and draw the conclusion that the U.S. will face an extended period of economic stagnation, just as Japan has for more than a decade. While there are similarities in the patterns of excess and subsequent bursting of the equity market bubbles, there are also crucial differences that underscore our belief that the U.S. is not headed down the same path, but rather a more normal cyclical recovery similar to the early 1980s or 1990s. The similarities between the recent inflating and bursting of the U.S. NASDA -led stock market bubble and that of Japan’s NIKKEI Index in the late 1980s are clearly there. In both Japan and the U.S., industries that expanded considerably during the bubble years continue to face serious problems of excess capacity. Expectations of continued strong economic and corporate earnings growth fuelled stock prices and valuation metrics, which reached unsustainable levels. After the central banks hiked rates, stock prices fell severely (though with a time lag) and sectors that had risen the most fell sharply. As rates later came down, investments in real estate and other physical assets increased. Lastly, in both countries, a variety of scandals surfaced within a year or two of the collapse of the equity market, therebypunctuating the levels of excess reached during the boom times. However, while the similarities cannot be ignored, they are far outweighed by the critical differences between the two economies:
Financial System Stability The bursting of Japan’s speculative bubble in 1990 threatened a systematic collapse of their entire financial system, similar to the U.S. in the 1930s. Although Japan has had more than 10 years to repair the problems, they have not been able to restore the health of their banking system. This is not the case in the U.S. where the banking system remains well-capitalized and solvent. The excesses in Japan were significantly greater than is the case in the U.S. In Japan, corporate debt to GDP reached a high of 220 per cent in 1990 (and remains elevated), whereas it has reached only 95 per cent in the U.S. In other words, Japanese companies borrowed far more money relative to the size of their economy. That excessive level of financial leverage, combined with the ensuing collapse in equity and real estate prices, left a much greater financial burden on Japanese balance sheets, a burden, that largely remains to this day. Japan’s boom was also significantly more dependent on bank financing while the U.S. relied more on capital markets to fund their spending. In Japan, roughly 60 per cent of corporate debt was bank financed compared to less than 40 per cent in U.S. (the balance being mostly in the hands of pension plans, other financial institutions, and private investors) As a result, when the bubble (which was already far greater in Japan) burst, the banking system was the biggest victim as bad loans soared. Due to the diversified debt-holder base in the U.S., the banks have been far less exposed to this ‘bubble burden’ and bad loans remain manageable. Even the underlying sources of these bubble excesses have important differences in economic and financial implications. Japan’s real estate bubble produced no economic benefits in terms of improved productivity while investment in new technologies and telecommunications infrastructure does produce positive economic benefits in terms of enhanced productivity (albeit not as great as the amount of money spent!). From a corporate accounting and collateral perspective, there is no depreciation associated with real estate and, therefore, the excessive valuations can continue to distort balance sheets and mask the problems for many years. In contrast, technology investments tend to be depreciated rapidly, so the accounting problems tend to shrink naturally with time. The implication is that Japan’s banking system was, and remains today, effectively broken. Over a decade later, they have yet to write off many of the bad loans related to the collapse while new non-performing loans continue to increase. As a result, the growth rate of loans in Japan has been falling since 1990 and total loans have actually contracted in the past five years. This lack of credit creation through the banking system has been a primary driver of deflation in Japan. In the U.S., capital market debt is priced in the market and must be marked to market. If impaired, it is written off. Bank loan impairment is based on management judgment and can be subjective, Japan continues to avoid facing the issue and has not recognized nor written off the necessary non-performing loans. As a result, in Japan, unprofitable companies have not been forced out of business and excess capacity continues to plague many industries. In effect, Japan’s banks are creating bad loans! In the U.S., insolvent companies go bust, get restructured, or are sold at market clearing prices. The market determines the true ability of a company to continue as a going concern.
Government Policy Response Throughout history, the U.S. has repeatedly demonstrated that it is much quicker to adjust fiscal and monetary policy to ease rather than exacerbate the problems. In fact, the U.S. Federal Reserve published a discussion paper in June 2002 on ‘PreventingDeflation: Lessons from Japan’s Experience in the 1990s.’ The U.S. government, unlike Japan’s, is not in denial. It understands the issues. It has already cut taxes and rapidly lowered interest rates, both of which can be expected to bolster an economic recovery. In Japan, monetary easing was delayed. The Bank of Japan only began lowering its shortterm rates in July 1991, 18 months after the peak in stock prices. Even then, the policy response was ‘far too little, too late’ as even with declining nominal interest rates, the onset of deflation resulted in real rates remaining high. In contrast, the U.S. was much quicker (eight months) to cut interest rates and has been far more aggressive, thereby pushing real short-term interest rates below zero. Recent actions and comments from the Fed indicate a determination to avoid deflation at all costs and early indications – such as rising gold and commodity prices, increasing freight rates, and accelerating money supply – suggest the Fed is achieving this objective. Economic Flexibility Japan’s economy is inflexible and was unable to easily adjust to the new economic reality while the U.S. market-driven economy is arguably the most flexible and adaptable major economy in the world. Markets for factors of production (labour and capital) are extremely fluid in the U.S. compared to Japan. Companies: Banks: Currencies A further factor that undermined Japan’s economy was the rapid rise of the Yen through the ’80s and early ’90s. The Y/$ rose from Y250 in 1985 to Y120 in early 1989 and kept rising to a peak of Y80 in 1995. So for five years after the peak of the Japanese equity bubble, the Yen continued to strengthen, producing (with a lag) tremendous deflationary and structural pressures on the economy. In contrast, faced with a comparable situation, George Bush quickly abandoned the previous `strong dollar’ policy and the U.S. greenback has already retraced some of its recent (1996-2001) strength. With the U.S. dollar having risen by only 32 per cent at its peak, compared to a 200 per cent rise for the Yen at its peak, the deflationary and competitive impact on the U.S. economy is much smaller than has been the case in Japan. The final fundamental difference between the two is that economic, social, and cultural issue have left the Japanese wrestling with restoring their economy for more than a decade. The U.S., on the other hand, has a system in place which enables it to deal with economic downturns in a matter on months. Drummond Brodeur is vice-president, international equities, at KBSH Capital Management Inc. |
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