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Why we (probably) won't repeat Japan's infamous "lost decade."
Edward Teach, CFO Magazine
March 1, 2009
The news about the economy hasn't been good for some time, but in early February it got worse. The Labor Department reported that the United States had shed 598,000 jobs in January, the worst monthly loss in 35 years, for a total of 3.6 million jobs lost since the recession began in December 2007. The unemployment rate climbed to 7.6 percent, a level last reached 16 years ago. Meanwhile, the S&P 500 stock index remained 45 percent below its October 2007 peak, and millions of Americans dreaded checking their 401(k) balances. Housing prices, which lay at the root of the crisis, were down 25 percent from the 2006 peak of the S&P/Case-Shiller index and expected to fall further.
The economy, in short, is deteriorating at an alarming pace. In its annual budget and economic outlook, the Congressional Budget Office said the recession "will probably be the longest and the deepest since World War II," lasting "well into 2009." As of March the recession is 15 months old; by comparison, the longest postwar downturns, beginning in November 1973 and July 1981, lasted 16 months apiece.
On Capitol Hill, Democrats and Republicans wrangled over the provisions of an $800 billion stimulus bill, prompting an exasperated President Obama to scold Congress for the "inexcusable and irresponsible" delay. Treasury Secretary Timothy Geithner unveiled a new plan to bail out the nation's troubled banks, into which the government has so far poured hundreds of billions of dollars, with little visible effect — except that the banks are still in business.
To a growing number of observers, the current recession is beginning to look like something much worse than 1973 or 1981. It shares key hallmarks of the recent Great Stagnation in Japan — the "lost decade" of the 1990s, an economic slump and financial crisis that actually lasted longer than 10 years. The U.S. economy, many fear, may be on the verge of its own lost decade.
The basic outline of Japan's lost decade is familiar. Japan's "bubble economy" of the 1980s saw an astronomical run-up in the values of stocks and property. Famously, the land under the Imperial Palace in Tokyo was said to be worth more than the entire state of California. When the Bank of Japan raised the discount rate from 2.5 percent to 6 percent in 1990, first stocks and then real estate values plummeted. Suddenly saddled with bad loans they were loath to write off, banks curtailed lending to healthy companies, yet refused to pull the plug on insolvent "zombie" companies. Growth fell, and the Bank of Japan steadily lowered the discount rate to 0.5 percent in 1995, holding it there for the rest of the decade. Still, deflation set in.
The consensus is that quick, aggressive action by Japanese authorities would have abbreviated the crisis. Instead, they reacted first by denying that there was a problem, then by trying to bail out banks in a piecemeal fashion, and finally by starting a full-blown bank-recapitalization effort. By the end of the 1990s, many banks were thought to be insolvent.
Fiscal stimulus consisted largely of a massive public-works program, which spent hundreds of billions on buildings and infrastructure. But only when the global economy began to boom in 2003 did Japan's rev up again. By then the Nikkei 225 stock average was down more than 75 percent from its 1989 peak.
Japan's annual growth for the 1990s averaged a pitiful 1 percent, compared with 4 percent for the 1980s. From 1992 to 1998, the output gap (a measure of economic slack) was about 68 percent of gross domestic product, or ¥340 trillion. By some estimates, Japan has spent more than 20 percent of GDP to fix the financial system. (By comparison, the $700 billion Troubled Asset Relief Program [TARP] represents about 5 percent of U.S. GDP.) Today Japan's public debt is 180 percent of GDP, by far the highest ratio among industrialized nations.
It's not hard to see the parallels between Japan then and the United States now, in the wake of our own multi-trillion-dollar housing bubble. The current recession is not the old-fashioned kind that can be cured with cheap money. As in the case of Japan, the balance sheets of U.S. banks are clogged with questionable assets — namely, toxic mortgage-related securities. Banks are hoarding TARP capital instead of lending it (see "The Big Freeze"). Although the Federal Reserve has lowered the federal funds rate to near zero, credit is still frozen.
Meanwhile, amid a stunning drop in consumer spending, a federal bailout is moving forward fairly quickly. Despite criticism from the right that it's wasteful and from economists that it's not large enough, the roughly $800 billion program will include substantial spending on "shovel ready" infrastructure projects, just as Japan's did.
It Probably Won't Happen Here
Why will a banking bailout and a gigantic stimulus program work more powerfully here than in Japan? A number of reasons are offered in a 2008 working paper by James Wilcox, professor at the University of California at Berkeley's Haas School of Business and former chief economist at the Office of the Comptroller of the Currency. Although the paper was written long before last fall's deep freeze in the credit markets, Wilcox continues to stand behind most of his main arguments. They include:
• The government and the Federal Reserve have countered the crisis far more swiftly and aggressively than Japan's authorities did, with interest-rate cuts, tax rebates, TARP funding, and fiscal stimulus. "They have responded with size and speed," Wilcox tells CFO. Fed chairman and former academic Ben Bernanke is a student of the lost decade as well as the Great Depression in the United States, he points out. "The U.S. clearly has the advantage of having watched what happened in Japan," says Wilcox. "The specter of Japan has been hanging over people for a while."
• Real estate is a smaller share of total assets in the United States than in Japan. The decline in Japanese real estate values between 1991 and 2006 amounted to 225 percent of annual GDP. By comparison, a decline in U.S. real estate values from 2007 levels to the lowest level during the past few decades would amount to "only" 75 percent of GDP.
• Equity values as a percentage of GDP have fallen less in the United States than in Japan.
• U.S. banks have been quicker to write down their problem assets than Japan's were. In the 1990s, "many analysts were skeptical, to say the least, about the reported data from Japanese banks," writes Wilcox. Even today, he adds, "considerable suspicion remains that Japanese banks have large volumes of as-yet unreported losses lurking in their loan portfolios."
• U.S. corporations have lots of liquidity and relatively little debt. In Japan, corporations, not consumers, had to rebuild their balance sheets during the lost decade.
• The United States has faster population growth, which in the longer term means more demand for housing.
Increasing layoffs are worrisome, acknowledges Wilcox, though unemployment rates aren't as high yet as in the 1981 recession, which featured months of 10 percent unemployment. Still, "one of the great virtues of the U.S. economy is its enormous flexibility," he says — especially compared with Japan's rigid labor market of the 1990s. "It helps to be able to bend so that you don't break. We're taking some pretty tough body blows."
A Lost Half-Decade?
Wilcox and others remain confident that the United States will avoid a lost decade, if not a severe recession. Simon Johnson, a professor of entrepreneurship at MIT's Sloan School of Management and co-founder of The Baseline Scenario, a popular Website devoted to the financial crisis, predicts that the United States will endure at worst "a lost five years." On the other hand, Johnson believes a lost decade for the world economy, already in recession, is "quite possible," as he advised the Senate Budget Committee in January. "The world is headed into a severe slump, with…no clear turnaround in sight," he testified. The likeliest outcome is an L-shaped recovery, he said, "in which there is a steep fall and then a struggle to recover."
"I do think the U.S. will do relatively better," Johnson tells CFO. "I think the U.S. is pretty good at getting through the denial phase." In this regard, "partisan bickering [over the stimulus package] is a healthy thing," he says, because it reflects a willingness to openly grapple with the problem. While ultimately there may be some wasteful spending by the government, "the risks of inaction are greater."
Nouriel Roubini, a professor of economics at New York University who was one of the first to warn about the financial crisis, recently said that even if everything goes right — the banking cleanup, the fiscal stimulus, monetary easing — the U.S. economy is still in for a stiff, U-shaped recession. But if everything doesn't go right, the recession could change to a longer, L-shaped stagnation rivaling Japan's lost decade. "Even a U-shaped recession is ugly," said Roubini.
The big question is when consumers will feel like spending again. After several years when personal savings fell close to or below zero as a percentage of disposable income, people are keeping their wallets closed. The savings rate rose to 2.9 percent in the fourth quarter of 2008, compared with 0.4 percent a year earlier. November saw the biggest-ever decline in credit-card borrowing. Household debt is sky-high, housing and pension values are down, and wages are stagnant. Suddenly a decade doesn't seem like such a long time.
Edward Teach is articles editor of CFO.
Proceed with Caution
Those who say the U.S. economy will not suffer its own lost decade typically stress two reasons: one, U.S. authorities have learned from Japan's mistakes and will not repeat them; two, the United States will act far more quickly and aggressively to end the recession. Both reasons may indeed be correct, but some experts advise caution.
"[O]ne would be wise not to push too far the conceit that we are smarter than our predecessors," warn economists Carmen Reinhart and Kenneth Rogoff in a January working paper on the aftermath of financial crises. "A few years back many people would have said that improvements in financial engineering had done much to tame the business cycle and limit the risk of contagion."
In a December working paper on the U.S. bank-recapitalization effort, Takeo Hoshi and Anil Kashyap note that the government's "try-everything approach, without careful regard for implications, also bears an eerie resemblance to Japan's decade-long response to its financial crisis." The success of the recapitalization plan, they say, will lie in paying close attention to the details.
Acting too quickly and aggressively may pose its own risks. Stanford University economist John Taylor argues in a January working paper that three government actions — the 2007 term auction facility, the 2008 tax rebate, and the lowering of the federal funds rate between 2007 and 2008 from 5.25 percent to 2 percent — actually prolonged the financial crisis, "either because they did not address the problem [which Taylor identifies as counterparty risk, not liquidity] or because they had unintended consequences."
Why did the financial crisis intensify in the fall of 2008? Conventional wisdom says the bankruptcy of Lehman Brothers is the answer. But Taylor's own "event study" suggests that what truly spooked the credit markets was uncertainty over the initial undetailed (recall that it ran a mere two-and-a-half pages), $700 billion TARP, drawn up over a weekend and presented by Henry Paulsen to the Senate Banking Committee on September 23. Haste, it seems, still makes waste. — E.T.