Lessons Learned: Comparing The Japanese And U.S. Bubbles
The Japanese Bubble
Japan's stock market officially peaked on December 29, 1989. This marked the height of its equity bull market, while the height of its real estate bubble occurred approximately two years later. Japan's economy also peaked around this time, having grown by leaps and bounds since the early 1980s, only to grind to a standstill for more than a decade after the bursting of its equity and housing bubbles.
With the benefit of hindsight, signs of Japan's stock market bubble were visible when prices and valuations rose well above historic averages. Price-to-earnings ratios of the Nikkei reached nearly 70 times and property prices rose to such extreme heights that 100-year mortgages were created to allow homebuyers the opportunity to afford houses or condominiums at inflated prices. Similar to a P/E ratio for stocks, the ratio of home prices to household incomes reached record levels in Japan at its peak.
The United States witnessed two similar bubbles that were spread over a period of five years, as opposed to the two-year separation between Japan's equity and real estate peaks. Its dotcom bull run ended in March 2000, as theories that a new economic paradigm had been reached thanks to the advent of the internet began to unravel. Excessive P/E multiples at the height of the dot-com bubble led to a flat market for more than a decade. A number of firms reached valuations of more than 100 times earnings during the bubble, and have yet to return to their 2000 stock prices despite earnings growth. (Read more about the dotcom bubble in our Market Crashes Tutorial.)
Easy credit and low interest rates during this period of irrational exuberance sowed the seeds for a growing real estate bubble that is widely believed to have peaked in early 2005 and began unraveling shortly thereafter, accelerating through 2006 and 2007. Excessive mortgage lending and the creation of exotic mortgage backed securities led to a more serious credit crisis. This quickly enveloped countries that lent directly to real estate markets in the United States and also encouraged bubbles in European countries including Ireland, the UK and Spain.
Financial bubbles are well documented throughout history but why investors fail to learn from past mistakes remains somewhat of a mystery. Fortunately for U.S. policy makers, they have had the opportunity to study Japan's responses to its bubbles and learn from many mistakes that were made. For instance, the U.S. government provided rapid and nearly unlimited liquidity at the height of the credit crisis. It did its best to help banks recapitalize and offset bad real estate loans so as to avoid zombie status. Like Japanese officials, the U.S. also increased public borrowing, but it did so at a more significant level to help the private sector clear its debts and refocus on a recovery in its business operations. The Federal Reserve also lowered interest rates to close to zero and kept a loose monetary policy in hopes of avoiding errors that Japan made, such as by increasing taxes too soon and sending the economy back into the doldrums.
Two decades after Japan's bubble, the country still suffered from deflationary expectations and a lack of confidence in any sustainable improvement in economic growth. A high savings rate and risk-averse culture also mean that investors favor bonds over other asset classes, including equities. This has kept interest rates low and the yield curve flat. A lack of growth and inability to earn a decent spread from short-term and long-term rates has kept banks from being able to earn their way out of a financial recession, solidifying a vicious cycle that pushed the economy from one recession to the next.
The U.S. is widely believed to possess a risk-taking culture that is more willing to learn from and move beyond past mistakes. Consumers and businesses in the U.S. are also not afraid to take on debt. Although this was a main cause of the real estate bubble, it could support a recovery by providing capital. In contrast, Japanese consumers do not openly embrace consumer debt, as evidenced by its high savings rate and willingness to accept low interest rates for safety of principal. Japan does have an advantage over many markets due to the strength of its export markets and large multinational firms that operate on a global scale. An export focus was indeed supporting the economy before the current credit crisis sent global growth into negative territory.
Additionally, western economies are believe to be more open to structural changes to maintain productivity, such as rapid job cuts by U.S. firms to maintain productivity and profitability, and sow the seeds for the next upturn in the business cycle. Immigration trends are also much stronger in U.S. while Japan is faced with an aging workforce and lack of immigration to bring in a constant source of young and motivated employees.
The Bottom Line
In 2010, two decades after the bubble, Japan's equity market was trading at approximately 25% of its peak of 38,916 in December 1989. Its industrial production did not reach its 1991 levels until approximately 2005, and it was dealt another setback when global demand weakened during the 2008 credit crisis. This left GDP again back below levels seen in 1992. During the credit crisis, the U.S. worked to avoid Japan's policy mistakes. At the time of this writing, it remains to be seen whether the programs to encourage economic growth and improve banking profitability will prove sufficient in creating the next boom in the business cycle.
The Lost Decade: Lessons From Japan's Real Estate Crisis
From 1991 through 2001, Japan experienced a period of economic stagnation and price deflation known as "Japan's Lost Decade." While the Japanese economy outgrew this period, it did so at a pace that was much slower than other industrialized nations. During this period, the Japanese economy suffered from both a credit crunch and a liquidity trap. In this article we'll define and discuss the meanings of these terms, and draw upon "Japan's Lost Decade" for examples.
Japan's Lost Decade
Japan's economy was the envy of the world in the 1980s - it grew at an average annual rate (as measured by GDP) of 3.89% in the 1980s, compared to 3.07% in the United States (according to the Bureau of Economic Analysis). But Japan's economy ran into troubles in the 1990s. From 1991 to 2003, the Japanese economy, as measured by GDP, grew only 1.14% annually, well below that of other industrialized nations ("The Causes of Japan's Lost Decade" by Charles Yuji Horioka. Japan & The World Economy, June 2006). We'll look at the causes of Japan's slow growth in the following sections, but it's worth mentioning here that the slow growth started in 1989 with the bursting of a couple bubbles.
Japan's equity and real estate bubbles burst starting in the fall of 1989. Equity values plunged 60% from late 1989 to August 1992, while land values dropped throughout the 1990s, falling an incredible 70% by 2001. (To read more about bubbles, see Economic Meltdowns: Let Them Burn Or Stamp Them Out? and Why Housing Market Bubbles Pop.)
The Bank of Japan's Interest Rate Mistakes
It is generally acknowledged that the Bank of Japan (BoJ), Japan's central bank, made several mistakes that may have added to and prolonged the negative effects of the bursting of the equity and real estate bubbles. For example, monetary policy was stop and go; concerned about inflation and asset prices, the Bank of Japan put the brakes on the money supply in the late 1980s, which may have contributed to the bursting of the equity bubble. Then, as equity values fell, the BoJ continued to raise interest rates because it remained concerned with real estate values, which were still appreciating. Higher interest rates contributed to the end of rising land prices, but they also helped the overall economy slide into a downward spiral. In 1991, as equity and land prices fell, the Bank of Japan dramatically reversed course and began to cut interest rates, according to "Japan's Lost Decade: Lessons for the United States in 2008", by John Makin (AEI Online, March 2008). But it was too late, a liquidity trap had already been set, and a credit crunch was setting in.
A Liquidity Trap
A liquidity trap is an economic scenario in which households and investors sit on cash; either in short-term accounts or literally as cash on hand.
They might do this for a few reasons: they have no confidence that they can earn a higher rate of return by investing, they believe deflation is on the horizon (cash will increase in value relative to fixed assets) or deflation already exists. All three reasons are highly correlated, and under such circumstances, household and investor beliefs become reality. In a liquidity trap, low interest rates, as a matter of monetary policy, become ineffective. People and investors simply don't spend or invest. They believe goods and services will be cheaper tomorrow, so they wait to consume, and they believe they can earn a better return by simply sitting on their money than by investing it. The Bank of Japan's discount rate was 0.5% for much of the '90s, but it failed to stimulate the Japanese economy, and deflation persisted. (For more insight, see What does deflation mean to investors?)
To break out of a liquidity trap, households and business have to be willing to spend and invest. One way of getting them to do so is through fiscal policy. Governments can give money directly to consumers through reductions in tax rates, issuances of tax rebates and public spending. Japan tried several fiscal policy measures to break out of its liquidity trap, but it is generally believed that these measures were not well executed - money was wasted on inefficient public works projects and given to failing businesses. Most economists agree that for fiscal stimulus policy to be effective, money must be allocated efficiently. In other words, let the market decided where to spend and invest by placing money directly in the hands of consumers. (For related reading, check out What Is Fiscal Policy?)
Another way to break out of the liquidity trap is to "re-inflate" the economy by increasing the actual supply of money as opposed to targeting nominal interest rates. A central bank can inject money into an economy without regard for an established target interest rate (such as the fed funds rate in the U.S.) through the purchase of government bonds in open-market operations. This is when a central bank purchases a bond, in which case it effectively exchanges it for cash, which increases the money supply. This is known as the monetization of debt. (It should be noted that open-market operations are also used to attain and maintain target interest rates, but when a central bank monetizes the debt, it does so without regard for a target interest rate.) (To learn more, read How do central banks inject money into the economy?)
In 2001, the Bank of Japan began to target the money supply instead of interest rates, which helped to moderate deflation and stimulate economic growth. However, when a central bank injects money into the financial system, banks are left with more money on hand, but also must be willing to lend that money out. This brings us to the next problem Japan faced: a credit crunch.
A credit crunch is an economic scenario in which banks have tightened lending requirements and for the most part, do not lend. They may not lend for several reasons, including: 1) the need to hold onto reserves in order repair their balance sheets after suffering loses, which happened to Japanese banks that had invested heavily in real estate, and 2) there might be a general pullback in risk taking, which has happened in the United States in 2007 and 2008 as financial institutions that initially suffered loses related to subprime mortgage lending pulled back in all types of lending, deleveraged their balance sheets and generally sought to reduce their levels of risk in all areas. (Keep reading about the mortgage meltdown in our Subprime Mortgages special feature.)
Calculated risk-taking and lending is the life-blood of a free market economy. When capital is put to work, jobs are created, spending increases, efficiencies are discovered (productivity increases) and the economy grows. On the other hand, when banks are reluctant to lend, it is difficult for the economy to grow. In the same manner that a liquidity trap leads to deflation, a credit crunch is also conducive to deflation as banks are unwilling to lend and, therefore, consumers and businesses are unable to spend, causing prices to fall.
Solutions to a Credit Crunch
As mentioned, Japan also suffered from a credit crunch in the 1990s and Japanese banks were slow to take losses. Even though public funds were made available to banks to restructure their balance sheets, they failed to do so because of the fear of stigma associated with revealing long-concealed losses and the fear of losing control to foreign investors ("Japan's Lost Decade: Lessons for the United States in 2008", by John Makin, AEI Online, March 2008) To break out of a credit crunch, bank losses must be recognized, the banking system must be transparent, and banks must gain confidence in their ability to assess and manage risk.
Clearly, deflation causes a lot of problems. When asset prices are falling, households and investors hoard cash because cash will be worth more tomorrow than it is today. This creates a liquidity trap. When asset prices fall, the value of collateral backing loans falls, which in turn leads to bank losses. When banks suffer losses, they stop lending, creating a credit crunch. Most of the time, we think of inflation as a very bad economic problem, which it can be, but re-inflating an economy might be precisely what is needed to avoid prolonged periods of slow growth such as what Japan experienced in the 1990s. (To learn more about inflation, see Inflation: What Is Inflation?)
The problem is that re-inflating an economy isn't easy, especially when banks are unwilling to lend. The great American economist, Milton Friedman, suggested that the way to avoid a liquidity trap is by bypassing financial intermediaries and giving money directly to individuals to spend. This is known as "helicopter money", because the theory is that a central bank could literally drop money from a helicopter. This also suggests that regardless of which country you live in, life is all about being in the right place at the right time!
The Myth of Japan’s Failure
By EAMONN FINGLETON
Published: January 6, 2012
DESPITE some small signs of optimism about the United States economy, unemployment is still high, and the country seems stalled.
Time and again, Americans are told to look to Japan as a warning of what the country might become if the right path is not followed, although there is intense disagreement about what that path might be. Here, for instance, is how the CNN analyst David Gergen has described Japan: “It’s now a very demoralized country and it has really been set back.”
But that presentation of Japan is a myth. By many measures, the Japanese economy has done very well during the so-called lost decades, which started with a stock market crash in January 1990. By some of the most important measures, it has done a lot better than the United States.
Japan has succeeded in delivering an increasingly affluent lifestyle to its people despite the financial crash. In the fullness of time, it is likely that this era will be viewed as an outstanding success story.
How can the reality and the image be so different? And can the United States learn from Japan’s experience?
It is true that Japanese housing prices have never returned to the ludicrous highs they briefly touched in the wild final stage of the boom. Neither has the Tokyo stock market.
But the strength of Japan’s economy and its people is evident in many ways. There are a number of facts and figures that don’t quite square with Japan’s image as the laughingstock of the business pages:
• Japan’s average life expectancy at birth grew by 4.2 years — to 83 years from 78.8 years — between 1989 and 2009. This means the Japanese now typically live 4.8 years longer than Americans. The progress, moreover, was achieved in spite of, rather than because of, diet. The Japanese people are eating more Western food than ever. The key driver has been better health care.
• Japan has made remarkable strides in Internet infrastructure. Although as late as the mid-1990s it was ridiculed as lagging, it has now turned the tables. In a recent survey by Akamai Technologies, of the 50 cities in the world with the fastest Internet service, 38 were in Japan, compared to only 3 in the United States.
• Measured from the end of 1989, the yen has risen 87 percent against the U.S. dollar and 94 percent against the British pound. It has even risen against that traditional icon of monetary rectitude, the Swiss franc.
• The unemployment rate is 4.2 percent, about half of that in the United States.
• According to skyscraperpage.com, a Web site that tracks major buildings around the world, 81 high-rise buildings taller than 500 feet have been constructed in Tokyo since the “lost decades” began. That compares with 64 in New York, 48 in Chicago, and 7 in Los Angeles.
• Japan’s current account surplus — the widest measure of its trade — totaled $196 billion in 2010, up more than threefold since 1989. By comparison, America’s current account deficit ballooned to $471 billion from $99 billion in that time. Although in the 1990s the conventional wisdom was that as a result of China’s rise Japan would be a major loser and the United States a major winner, it has not turned out that way. Japan has increased its exports to China more than 14-fold since 1989 and Chinese-Japanese bilateral trade remains in broad balance.
As longtime Japan watchers like Ivan P. Hall and Clyde V. Prestowitz Jr. point out, the fallacy of the “lost decades” story is apparent to American visitors the moment they set foot in the country. Typically starting their journeys at such potent symbols of American infrastructural decay as Kennedy or Dulles airports, they land at Japanese airports that have been extensively expanded and modernized in recent years.
William J. Holstein, a prominent Japan watcher since the early 1980s, recently visited the country for the first time in some years. “There’s a dramatic gap between what one reads in the United States and what one sees on the ground in Japan,” he said. “The Japanese are dressed better than Americans. They have the latest cars, including Porsches, Audis, Mercedes-Benzes and all the finest models. I have never seen so many spoiled pets. And the physical infrastructure of the country keeps improving and evolving.”
Why, then, is Japan seen as a loser? On the official gross domestic product numbers, the United States has ostensibly outperformed Japan for many years. But even taking America’s official numbers at face value, the difference has been far narrower than people realize. Adjusted to a per-capita basis (which is the proper way to do this) and measured since 1989, America’s G.D.P. grew by an average of just 1.4 percent a year. Japan’s figure meanwhile was even more anemic — just 1 percent — implying that it underperformed the United States by 0.4 percent a year.
A look at the underlying accounting, however, suggests that, far from underperforming, Japan may have outperformed. For a start, in a little noticed change, United States statisticians in the 1980s embarked on an increasingly aggressive use of the so-called hedonic method of adjusting for inflation, an approach that in the view of many experts artificially boosts a nation’s apparent growth rate.
On the calculations of John Williams of Shadowstats.com, a Web site that tracks flaws in United States economic data, America’s growth in recent decades has been overstated by as much as 2 percentage points a year. If he is even close to the truth, this factor alone may put the United States behind Japan in per-capita performance.
If the Japanese have really been hurting, the most obvious place this would show would be in slow adoption of expensive new high-tech items. Yet the Japanese are consistently among the world’s earliest adopters. If anything, it is Americans who have been lagging. In cellphones, for instance, Japan leapfrogged the United States in the space of a few years in the late 1990s and it has stayed ahead ever since, with consumers moving exceptionally rapidly to ever more advanced devices.
Much of the story is qualitative rather than quantitative. An example is Japan’s eating-out culture. Tokyo, according to the Michelin Guide, boasts 16 of the world’s top-ranked restaurants, versus a mere 10 for the runner-up, Paris. Similarly Japan as a whole beats France in the Michelin ratings. But how do you express this in G.D.P. terms?
Similar problems arise in measuring improvements in the Japanese health care system. And how does one accurately convey the vast improvement in the general environment in Japan in the last two decades?
Luckily there is a yardstick that finesses many of these problems: electricity output, which is mainly a measure of consumer affluence and industrial activity. In the 1990s, while Japan was being widely portrayed as an outright “basket case,” its rate of increase in per-capita electricity output was twice that of America, and it continued to outperform into the new century.
Part of what is going on here is Western psychology. Anyone who has followed the story long-term cannot help but notice that many Westerners actively seek to belittle Japan. Thus every policy success is automatically discounted. It is a mind-set that is much in evidence even among Tokyo-based Western diplomats and scholars.
Take, for instance, how Western observers have viewed Japan’s demographics. The population is getting older because of a low birthrate, a characteristic Japan shares with many of the world’s richest nations. Yet this is presented not only as a critical problem but as a policy failure. It never seems to occur to Western commentators that the Japanese both individually and collectively have chosen their demographic fate — and have good reasons for doing so.
The story begins in the terrible winter of 1945-6, when, newly bereft of their empire, the Japanese nearly starved to death. With overseas expansion no longer an option, Japanese leaders determined as a top priority to cut the birthrate. Thereafter a culture of small families set in that has continued to the present day.
Japan’s motivation is clear: food security. With only about one-third as much arable land per capita as China, Japan has long been the world’s largest net food importer. While the birth control policy is the primary cause of Japan’s aging demographics, the phenomenon also reflects improved health care and an increase of more than 20 years in life expectancy since 1950.
Psychology aside, a major factor in the West’s comprehension problem is that virtually everyone in Tokyo benefits from the doom and gloom story. For foreign sales representatives, for instance, it has been the perfect get-out-of-jail card when they don’t reach their quotas. For Japanese foundations it is the perfect excuse in politely waving away solicitations from American universities and other needy nonprofits. Ditto for the Ministry of Foreign Affairs in tempering expectations of foreign aid recipients. Even American investment bankers have reasons to emphasize bad news. Most notably they profit from the so-called yen-carry trade, an arcane but powerful investment strategy in which the well informed benefit from periodic bouts of weakness in the Japanese yen.
Economic ideology has also played an unfortunate role. Many economists, particularly right-wing think-tank types, are such staunch advocates of laissez-faire that they reflexively scorn Japan’s very different economic system, with its socialist medicine and ubiquitous government regulation. During the stock market bubble of the late 1980s, this mind-set abated but it came back after the crash.
Japanese trade negotiators noticed an almost magical sweetening in the mood in foreign capitals after the stock market crashed in 1990. Although previously there had been much envy of Japan abroad (and serious talk of protectionist measures), in the new circumstances American and European trade negotiators switched to feeling sorry for the “fallen giant.” Nothing if not fast learners, Japanese trade negotiators have been appealing for sympathy ever since.
The strategy seems to have been particularly effective in Washington. Believing that you shouldn’t kick a man when he is down, chivalrous American officials have largely given up pressing for the opening of Japan’s markets. Yet the great United States trade complaints of the late 1980s — concerning rice, financial services, cars and car components — were never remedied.
The “fallen giant” story has also even been useful to other East Asian nations, particularly in their trade diplomacy with the United States.
A striking instance of how the story has influenced American perceptions appears in “The Next 100 Years,” by the consultant George Friedman. In a chapter headed “China 2020: Paper Tiger,” Mr. Friedman argues that, just as Japan “failed” in the 1990s, China will soon have its comeuppance. Talk of this sort powerfully fosters complacency and confusion in Washington in the face of a United States-China trade relationship that is already arguably the most destructive in world history and certainly the most unbalanced.
Clearly the question of what has really happened to Japan is of first-order geopolitical importance. In a stunning refutation of American conventional wisdom, Japan has not missed a beat in building an ever more sophisticated industrial base. That this is not more obvious is a tribute in part to the fact that Japanese manufacturers have graduated to making so-called producers’ goods. These typically consist of advanced components or materials, or precision production equipment. They may be invisible to the consumer, yet without them the modern world literally would not exist. This sort of manufacturing, which is both highly capital-intensive and highly know-how-intensive, was virtually monopolized by the United States in the 1950s and 1960s and constituted the essence of American economic leadership.
Japan’s achievement is all the more impressive for the fact that its major competitors — Germany, South Korea, Taiwan and, of course, China — have hardly been standing still. The world has gone through a rapid industrial revolution in the last two decades thanks to the “targeting” of manufacturing by many East Asian nations. Yet Japan’s trade surpluses have risen.
Japan should be held up as a model, not an admonition. If a nation can summon the will to pull together, it can turn even the most unpromising circumstances to advantage. Here Japan’s constant upgrading of its infrastructure is surely an inspiration. It is a strategy that often requires cooperation across a wide political front, but such cooperation has not been beyond the American political system in the past. The Hoover Dam, that iconic project of the Depression, required negotiations among seven states but somehow it was built — and it provided jobs for 16,000 people in the process. Nothing is stopping similar progress now — nothing, except political bickering.
Eamonn Fingleton is an author who predicted the Japanese financial crash of the 1990s; he is working on a book about the end of the American dream.
This article has been revised to reflect the following correction:
Correction: January 6, 2012,A previous version of this article included an incorrect figure for the increase in life expectancy in Japan. It changed by 4.2 years, not 3.1.