Merely 30 years ago, Prime Minister Yasuhiro Nakasone announced his desire to transform Japan into an "unsinkable aircraft carrier." Three decades later, Japan cannot plug the holes of that carrier fast enough to keep it from sinking. Is there a lesson the US can take from Japan?
Bull Run to the Brink
1986 marked the onset of the asset price bubble in Japan. The Bank of Japan (BoJ) sought to keep the yen from rising to support its export driven economy through expansionary monetary policy. Between 1986 and 1987, the BoJ cut the discount rate from 5.00% to 2.50%. Plunging interest rates encouraged borrowing and capital investments over traditional savings. With easy credit and arcane property tax laws that kept taxes disconnected from valuations, real estate and asset prices entered a phase of hyper-inflation. The bull run, however, was short-lived and ended predictably. As the valuations soared well above what income levels could support, and new household formations declined sharply due to decades of falling birth rates--demand suddenly vanished and speculations came to an end. The aftermath was ugly; as homeowners surrendered their homes to the banks, banks became stuck with non-performing assets on their books and liquidity dried up.
Sound familiar? In the US, the Great Recession was largely the result of a similar housing burst. The parallels are striking. Stable growth during the Clinton presidency banished the budget deficit, creating a glut of cash that depressed the interest rates and forced investors to seek higher return alternatives. Financiers bundled low quality mortgage with high quality ones, issuing CDOs of dubious quality to unsuspecting investors. Rating agencies were unable to adequately rate such complex securities. Regulators underestimated the risk associated with such products. With easy money rolling in, banks suspended rigorous checks, doling out mortgages to those who had little ability to pay. When the real economy slowed, banks began foreclosing on their homes, further depressing the housing market. And like Japan, underwater mortgages led to more foreclosures. CDOs became toxic overnight. The banks got stuck with non-performing assets as the liquidity dried up. They stopped lending to each other and the economy nearly grinded to a halt. The only missing ingredient from the Japanese version of this movie is the declining population.
For both countries the burst was preceded by financial deregulation. Larry Summers, the treasury secretary during the Clinton administration, was a strong proponent of self-regulation of banks. The bureaucratic hurdles for any meaningful legislation were also immense, preventing critical policies from being ratified. There was no system in place to stem the degree of speculation and no system to contain the damages. Thus, what followed was a series of ad hoc steps by the central bank in absence of any political consensus.
Post-Bubble Economy
In both nations, the banking liquidity crisis followed the crash in the housing market. In Japan, this led to the creation of zombie banks that were full of bad debt. Suffering from a lack of funds, banks could not lend money to businesses. The Japanese government stepped in to recapitalize the banks by borrowing from the BoJ. In the absence of inflation, the BoJ lowered interest rates to near zero levels. Governmental lending to deleverage financial corporations ended with full governmental control and nationalization of four of the largest banks in Japan.
That is exactly what our Fed began doing around eight years ago. In the aftermath of the Great Recession, the US government bailed out AIG and Bear Stearns. Further, under the Trouble Asset Relief Program (TARP), the US Treasury bailed out Fannie Mae, Freddie Mac, GM, and Chrysler. As the politics around the bailout became toxic, the Fed took over the process with quantitative easing, buying non-performing loans to recapitalize the banks.
"The Lost Era"?
With large debts on its books, outside investors are reluctant to buy Japanese government bonds. However, the government has no other choice than to borrow more money to stimulate its economy and support the social security system in Japan. The government issues bonds in the open market which are purchased by the BoJ. The BoJ finances such purchases simply by printing money.
Further, in Japan, the combination of a deflating economy and a declining population means that Japan's own physical security is under threat. With escalating tensions over the Senkaku islands in the South China Sea, it is difficult to see how Japan can defend itself.
Expansionary monetary policy through the creation of money in Japan has run into another problem now: negative interest rate for depositors. At this point, it is far more profitable for Japanese citizens to put their money under a mattress than a bank. Storing money in the mattress leads to Keynes' "paradox of thrift"--the attempt to increase individual savings, freezes up the flow of money and lowers total savings. A lower total savings rate is indicative of a stagnating economy. On the other hand, keeping money in the bank at a negative interest rate also reduces the amount of money people save. With negative interest rates, if there is any anticipation that things will be cheaper tomorrow than today, people will have no incentive to purchase goods today, also reducing the flow of money. Quantitative easing must continue to avert deflation; any austerity at this point will be far more disastrous, yet with aging population and falling birth rates, Japan is caught up in a trap that it cannot break out of.
Currently in the US, 10,000 baby boomers are easing into retirement each day, while only 10,800 babies are being born. At this rate, in less than 30 years, US will reach a point where there is one retiree for every worker--not different from Japan. To support the current system of social security, if the US exercises fiscal policy, the budget deficit can only be disastrous. If the US exercises monetary policy in combination with budget deficit, perhaps we will face the same fate as Japan.
Exceptional America
Despite the seemingly matching trajectories of these two disparate economies, there are several determinants that set the US apart from Japan.
The first difference is cultural: how the government and the citizenry responds to a crisis. Evidently, at the beginning of the economic slump, Japan denied any kind of economic decline. The US on the other hand, recognized the signs of a declining economy and began efforts to contain economic spillover. Additionally, in terms of assessing risky behavior among citizens, Japanese citizens are more risk-averse than US citizens. For this reason, despite over twenty years of quantitative easing, Japanese citizens still prefer to put their money in the bank over the capital market. US citizens are less risk-averse and more willing to put their money back in the capital market after signs of economic recovery.
The second difference is in levels of unemployment. In terms of unemployment, Japan does not have a problem. With declining population and workers' ability, the level of unemployment in Japan is quite low. The US labor force by contrast, lags the Japanese workforce in quality and levels of employment. Given the current priorities, the US is unlikely to further invest in its workforce. Thus, unemployment levels are not likely to fall further.
The US also differs from Japan in immigration and foreign investments. The US has benefitted from immigration and foreign investment and continues to be a magnet in both. In recent years, with falling birth rates in Mexico and an improving economy, the immigration from Mexico has declined drastically. Unless the reduced immigration from Mexico is offset by immigrants from other countries, preferably skilled immigrants, the US may not escape the trap that Japan has fallen into.
Veritas non Sequitur
The United States enjoys two unique advantages: its language that makes it a destination of choice of skilled immigrants from all over the world and its openness of culture. Given a choice, a would-be immigrant from China, Russia, India, Brazil or South Africa would much rather come to the US for a lower language barrier and also, for a lower barrier to integration than any other country.
If the U.S. economy appears to be resurgent now, it is only due to quantitative easing - the program initiated by the Federal Reserve to purchase toxic debt from financial institutions which injects liquidity into banking directly. The value of assets on the Federal Reserve Balance Sheet now stands at more than $4 trillion. Quantitative easing, however reaches a point of diminishing return when the supply of liquidity exceeds commercial demand. Japan is at that point, where Bank of Japan is not able to stimulate demand by increasing supply of liquidity. Thus, the U.S. must remember that this resurgence may only be temporary, and find better ways to stimulate demand. America should focus on plugging the holes in its economy by opening its doors to immigrants wider. Without growth in demand, the prospect of Japanese style perpetual stagnation is staring at us directly.
Reproduced from Cornell Business Review