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

Beijing's BYO To The Party

Beijing has unveiled a 4 trillion yuan (HK$4.54 trillion / US$582bn) economic stimulus package to help boost domestic demand - in what is seen as a shift to "proactive" fiscal and "moderately easing" monetary policies.

The measures, which run until the end of 2010, were announced after a meeting of the State Council chaired by Premier Wen Jiabao, Xinhua News Agency reported. Some 100 billion yuan (US$12.8bn) is earmarked for this quarter alone.

The spending will focus on 10 areas, including low-cost housing, infrastructure in rural areas, and social welfare, in addition to transport networks - railways, highways and airports - environmental protection and technical innovation.

It also includes capital expenditure to renew city power grids. Some of the spending overlaps longer-term stimulus plans reported earlier - including a 2 trillion yuan railway plan and 5 trillion yuan expenditure on roads, waterways and ports from 2006 to 2020.

BNP Paribas chief economist Chen Xingdong said: "This is the first time China has officially confirmed the shift to easing monetary and fiscal policies. Although it was a 'slow heating up process,' it shows the government's realization of the urgency to bolster economic growth." Economists have been anxiously waiting for a huge stimulus plan ever since gross domestic product growth slowed to 9 percent in the third quarter from 10.4 percent in the first half.

"At the Central Economic Work Conference, to be held later this month, Chinese leaders are expected to announce concrete measures to stimulate the economy ... Beijing's new policy drive of upgrading infrastructure, rural land reforms, and expansion of social welfare is akin to a 'New Deal' with Chinese characteristics," said Jing Ulrich, chairman of China equities at JPMorgan. China's economy grew at the slowest pace in five years in the three months through September as export orders shrank amid the global financial turmoil. Domestic industrial production also fell after Beijing ordered heavily polluting factories to shut down ahead of the Olympic Games in August.

The Cabinet also confirmed that reform of the value-added tax system will cut companies' tax bills by 120 billion yuan. Beijing will also remove credit limits of commercial banks to further encourage lending support to small and medium-sized enterprises. The People's Bank of China has cut interest rates three times since mid- September. People's Bank of China governor Zhou Xiaochuan, meanwhile, said the central bank forecasts the mainland economy to expand between 8 and 9 percent next year.

The success of this plan depends crucially on continued government credibility in the face of rapidly rising deficits as well as on the health and stability of the banking system.If the banking system can withstand a downturn without any significant rise in NPLs and without forced credit contraction, this may be the shot in the arm China and the world needs. This move by China is a very big hint of how worried the government is and how determined they are to address the issue that this plan was approved.

The government can force credit expansion by requiring the banks to lend more.

Certainly they are trying. Last week, after weeks of rumors that loan caps were being relaxed, the PBoC announced that they were junking the credit restrictions they had previously imposed on banks. But loan growth has still been very low.

This is hardly surprising. In such dire economic circumstances with global credit markets and liquidity seizing up, with domestic bankruptcies rising, with inventories and receivables also rising, it takes both brave banks and brave borrowers to accommodate credit expansion. Most good companies seem reluctant to borrow and anyway banks are reluctant to lend.

So what if policy-makers simply announce minimum loan growth targets for every bank? That should certainly cause an expansion in banks’ balance sheets. However, this will create some problems. It might not be effective in net credit creation for the country. If banks don’t want to lend but are forced to, we will see off-balance sheet transactions placed back on balance sheet and a much more rapid decline in loans from informal banks. That means that real credit expansion can still be negative even with minimum loan growth target enforced onto the banking system. Forced lending will also result in a sharp deterioration in quality of borrowers. It is always possible to find borrowers, even in a sharp economic contraction or investment crisis.

US$582bn is not a small sum, even if you spread it out over a few years. There is the multiplier effect or trickle down effects. The rule of thumb is that every one dollar spent is worth between 4-8 dollars in the real economy, velocity of money supply.

The sum announced by China is certainly very big. Is it big enough? The US GDP is about US$14 trillion or 3.5x China's GDP of US$4 trillion. Say US loses 2% of its GDP, to make it up, China would have to grow by a staggering 6.8% - of course, that's assuming the problem is just contained in the US, and that China is the only engine of growth left in the world. The other factor to bear in mind is that Chinese consumer only make up some 35% of China's GDP, much lower than US consumers. Final conclusion - its not a Prozac, but its better than nothing, a lot also depends on whether its for "show and tell" or will the measures be implemented assiduously.

p/s photos: Sammi Cheng