Could The USA Fall Into The Japan 18 Year Stagflation Trap?

There are now increasing opinions that the US may go the way of Japan - in having a prolonged stagflation. To refresh our memory, Japan's real estate and stock market bubble collapsed quite spectacularly sometime around 1990. The first couple of years saw a lot of wealth being erased from the real estate and stock portfolio. The following 16 odd years, even till today, basically saw Japan registering a period of stagflation or what some may refer to as the L-shaped recovery - i.e. you don't really recover. Japan made many policy mistakes (that the US should and could avoid):
a) it cut policy rates two years after the bust of its asset bubble while the US eased monetary policy aggressively after August 2007
b) it went into quantitative easing reversed ZIRP (zero interest rate policy) too slowly
c) it waited two years after the bursting of its bubbles to do a fiscal stimulus (and reversed it too early with a consumption tax) while the US did one – albeit a failed one – last year and is doing another large one now
d) it created a convoy system of zombie banks and corporate that were restructured too late while the US may become more aggressive in cleaning up the financial system
e) it had structural rigidities – like lifetime employment – that slowed down the adjustment while the US has a more flexible labor markets

If we were to look at the missteps by Japan, we might easily conclude that the US reacted much faster, swifter and the structural and employment adjustments were rapid as well. However, we must also acknowledge that Japan's bubble was in stocks and real estate - as bad as that sound, there were very little leverage or derivatives enlarging the bubble. The current credit implosion is largely driven by a leveraged credit, based on insufficient capital, propeled by new fangled derivatives. Thus in that light, the situation faced by the US was a lot worse than Japan.

Japan was in much better macro and financial shape than the US before and during its stagnation: high household and national savings and low leverage of the household sector, net foreign asset position that allowed it to finance its large fiscal deficit during the stagnation via domestic savings. The US instead has had near zero household savings and massive leverage for years, large current account deficits and is the largest net foreign debtor in the world. Thus any further fiscal stimulus by the US basically is further deficits on an already damaging deficit problem. The problems are in the US are magnified by the high debt levels on the personal level as well, and would eat immediately into consumption patterns. Whereas in Japan they still had truckloads of savings.

Fiscal policy has its limits when you are already the biggest net debtor and net borrower in the world and where you need to borrow this year $2 trillion net ($2.5 trillion gross) to finance your fiscal deficit ... and your currency is still backed by nothing. The US is taking an approach to bank recap and clean-up that looks more like Japan than the successful Swedish outright takeover/nationalization process. While the bad bank idea might work, it will require the US taxpayers to pony up another $2-$3 trillion to fund that bad bank. How many trillions of USD can you print before China and Russia turn around and say "wtf...".

The US and global economy are truly risking a near-depression if the policy reaction is not bold, aggressive, sustainable and credible. For almost every action that the Treasury or the government has proposed, there will be tons of criticisms, and that's beauty and beastly side of a true democracy. This credit crisis is not quite like any we have seen before as it involved an enormous amount of leverage, hence we have no textbook solutions to guide us. Hence, we can be assured that every single policy action, be it the TARP, the reworked and reworked stimulus plan, the bailouts, and now the bad bank idea ... will have a lot of detractors... and probably not many cheering the measures even if they agree (as no one is really sure they will work well).

We also have to remember that there are mainly two main schools of economic thought - though you could probably have tens of shools of economic thought on this - either you are a Keynesian or you are Gasparino (libertarian market purist). The latter being that mainly you think the markets should be allowed to correct itself, and bad companies should be allowed to fail, and shareholders should not be saved... or something to that effect. There are still many more who have opinions along those lines of thought which differ here and there, so you can understand why everyone is an asshole and an expert at the same time.

Back to the Japan trap, its government spending soared (after a couple of years following the correction) as a massive public works program covered the country with cement. Yet Japan also prevented the bust from performing its role of creative destruction. Businesses were reluctant to shed workers and renege on their lifetime employment guarantees. Japanese authorities encouraged banks to supply new credit to weak companies. This served to worsen the bad-debt problems within the banking system, which came to a head in the 1997 financial crisis. Academic research suggests that the increasing dominance of certain industries by so-called "zombie" firms tended to depress job creation and lower productivity. Product prices in zombie industries were low because of excess competition. Low prices and high wages reduced profits and discouraged new investment.

I was working for Nomura, the biggest Japanese securities firm then from 1988-1991, and I can say that Japan did one thing right: government spending increase. They did many things wrong which was what dragged the recession into a stagflation period for over ten years: they did not force bad banks to fail; the worst was allowing banks to not act on bad debts thus keeping technically insolvent businesses alive for years; the life-time employment culture caused many companies not to restructure; not allowing the banks to seek foreign investment to replenish their capital; not allowing foreign ownership of banks and most other companies which would have restructured many of them and given them much needed capital.

Hence to use the Japan experience to somehow link it to the futility of what the US government agencies are doing is flawed, very flawed. The bubble was deflated in stocks and property, stocks crashed because its a relatively open market with foreign participation, property died slowly as there were too many regulations preventing foreign ownership. I basically think that the US moved fast and aggressively, and industries are being restructured quickly, ... I don't like the bad bank idea but it will work best if you don't take the nationalisation route. The US will throw everything at the problems at hand. Its not much point to harp on how much money they will be flooding the system to do that. Yes, the USD is doomed for a long long depreciation. Its the lesser of two evils, throw more money at the problems... as not doing anything will be anarchy.

So, I do think that while the problems are huge, the US will be able to recover much faster and will not fall into the stagflation trap of Japan.

p/s photos: Megan Lai

Wen Jiabao Can Criticise But Putin Should Shut Up!!!

At the current Davos summit, many leaders have whacked the US for its role in bringing the global economy to its knees. Wen Jiabao of China can criticise, but OMG Putin should shut his face. For my life, I cannot understand why Russia was invited into the G8 and not China????? Why does he have the gall to even criticise the US? Its like Thailand advising Malaysia on how to play better politics, or rather, like Malaysia advising Thailand on how to play better politics!

Why Russia should shut up:

a) Despite the huge run up in oil price and hence Russia's reserves, the country did not improve its infrastructure. It allowed Russian gang leaders (or some may call them oligarchs) to lead many big companies, and when things do not go their way, these ballbusters would use the courts, extortion, kidnapping and murders to get their way. Foreign investors who have been in Russia can attest to that.

b) While opening arms to welcome foreign funds, Russia also openly go about nationalising industries whenever they wanted to, or coerce foreign interests to sell back their stakes whenever Russia wants. Now they are angry when foreign funds flee Russia in droves over the past 12 months... wonder why?

c) Business has been firmly reminded that in a country where traditional institutional mechanisms for the implementation of policy are weak, the informal lines of communication should be respected. Its a whole load of bureaucracy and tinged with vested interests everywhere.

d) According to Insead, some recent moves by the Russian central government suggest that foreign companies may face new formal and informal hurdles such as restrictions on investing in certain industries without presidential approval. The current challenging atmosphere creates greater possibilities for those firms that acquire this knowledge to reap greater profits. For example, a company is often served by such simple actions as paying regular visits to government officials, inviting bureaucrats to visit the foreign company, and helping to administer local programs such as work-force retraining or upgrading health care facilities.

e) Compared with the other BRICs, Russia’s market infrastructure is only moderately effective because of the government’s significant participation in and direct ownership of firms. Of Russia’s 80 largest public companies, 71% had a controlling shareholder. Among these controlling stakes, the government held 30%. An additional 21% (of the 80) had one or more blocking shareholder (those with a 25% or greater stake), with the government representing 10% of these. In Russia, the government’s influence is particularly strong at large “strategic companies,” and the combination of a bureaucratic approach to management and continuing pockets of government corruption can hinder the development of more effective corporate governance across a range of industries.

f) The problems with the ruble and Russia's fragile oil base economy seem to be rooted in an erroneous perception of the Russian economy, as the government is echoing the course that was taken following the 1998 default, but the present situation is drastically different. Ten years ago, most prices and salaries were in dollars, and those who were able to keep their jobs had their incomes indexed. Now, everything is mostly in rubles. The consumption growth model has been in place for the last eight years. It has been stalled and it is time to move on to an investment-based economy to improve production. Now they’re still following that model trying to get people to go and spend their savings by allowing further devaluation and inflation; whatever positive effect it has will be only short-term and we’ll still have the same model in place.

Russia, don't go blaming someone else for your problems. Yes, the US credit implosion had some effect but if you had improved your infrastructure, balance sheet, stopped bullying smaller former nations into submission, rein in your gang-like oligarchs, sell more government shares, improve shareholders' rights, treat foreign investors fairly and not in a Sopranos-way, regulate your banks better.... Russia might not be in such a pile of heap.

Russia should not be criticising the US until it has improved their market transparency, accountability, regulatory effectiveness, protection of minority shareholders... its like Iceland criticising the US, shuddup already!!!

Putin is mad because the ruble has totally collapsed, foreign investors have left in droves, and most galling is the fact that Russia used to get above $120 per barrel of oil just a year back. Now he is using the platform to criticise the US and everybody else for heaping troubles onto Russia. Please la Putin, why I don't hear you saying "Gee, oil at $140 is totally out of whack, it is unsustainable, its the US liquidity pushing up commodity prices... you guys beware OK"... If you were smiling when oil was raking in dough above $100... well, take your medicine now. You cannot have it both ways, grow up.

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Various News Media: Wen Jiabao and Vladimir Putin on Wednesday blamed the United States for causing the global economic crisis on a gloomy first day of the Davos forum. Both called for a new attitude by President Barack Obama, while deepening pessimism over the future of the global economy enshrouded the World Economic Forum.

Chinese premier Wen said America's voracious appetite for debt and 'blind pursuit of profit' had led to the worst recession since the Great Depression which has rocked the 2,500 strong political and business elite gathered in the Swiss mountain resort.

Mr Putin said the disappearance of some Wall Street titans over the past six months testified to the errors committed. Mr Wen blamed the crisis on 'inappropriate macroeconomic policies of some economies' and 'prolonged low savings and high consumption,' in a lightly veiled attack on the United States. He blasted the 'excessive expansion of financial institutions in blind pursuit of profit and the lack of self-discipline among financial institutions and ratings agencies' while the 'failure' of regulators had allowed the spread of toxic derivatives.

Mr Wen said the crisis had posed 'severe challenges' for China and that it needed 8.0 per cent growth in 2009 to maintain social stability while the International Monetary Fund predicted 6.7 per cent for this year. The Chinese leader called for faster reform of international financial institutions and for a 'new world order' for the economy.

The Russian prime minister followed him to the podium and said the crisis had been a 'perfect storm'. He also took aim at US banks and the outgoing US administration.' Although the crisis was simply hanging in the air, the majority strove to get their share of the pie, be it one dollar or one billion, and did not want to notice the rising wave.'

Mr Putin insisted that he would not join critics of the United States, but added: 'I just want to remind you that just a year ago, American delegates speaking from this rostrum emphasised the US economy's fundamental stability and its cloudless prospects. Today investment banks, the pride of Wall Street, have virtually ceased to exist. In just 12 months they have posted losses exceeding the profits they made in the last 25 years. This example alone reflects the real situation better than any criticism,' said Mr Putin.

Mr Putin called for a constructive attitude from Mr Obama in international affairs. 'We wish the new team success. I hope they are willing to cooperate constructively,' he said.

US tensions with China have been raised in recent days with new US Treasury Secretary Timothy Geithner saying Mr Obama believes China manipulates its currency to gain an edge in trade. 'In meeting the international financial crisis, it is imperative for the two countries to enhance cooperation, that is my message to the US administration. Three decades of formalised ties between the United States and communist China had shown that 'a peaceful and harmonious relationship will make both sides winners, while a confrontational one will leave both losers,' he added.

p/s photo: Akumsiri Suwansook