The mindset will not change; a depressionary relapse may be coming
When former Morgan Stanley chief Asian economist Andy Xie comments on the United States, he focuses on a bailout nation keen on perpetuating a bubble economy predicated on malinvestment and overconsumption. In this he sees parallels with Japan and its long malaise.
Japan has experienced two decades of economic stagnation since the collapse of the infamous bubble it suffered in the 1980s. The most popular explanations are that Tokyo wasn’t aggressive enough in stimulating the economy after the bubble burst, or that it withdrew its stimulus too early – or both. This line of thinking is popular among elite economists in the US, where it is rarely challenged. But few Japanese analysts buy it…
The argument to "stimulate until prosperity returns" is popular because it doesn’t hurt anyone in the short term. When a central bank prints money, its nasty consequence — inflation — takes time to show up. When a government spends borrowed money, repayment is in the future. Nobody feels the pain now. Indeed, when debt is sufficiently long-dated, nobody alive need feel the pain. So analysts who advocate stimulus are popular with politicians because it sounds like a free lunch. Japan’s tale is just a nice story that seems to support the argument…
Japan has run up the national debt equal to 200% of GDP — the greatest Keynesian stimulus program in history — all in the name of stimulating the economy back to health. It has failed miserably. Japan’s nominal GDP is about the same as when the stimulus began. Those who advocated the policy blame Japan’s failure on either the stimulus being too small or not being sustained for long enough – that is, the dosage, not the medicine itself, was at fault.
The bankruptcy of Japan Airlines is a sobering reminder of what is still wrong with Japan. It stayed with unprofitable routes for years without its creditors or shareholders being able to do anything about it. And by making credit cheap and easy, the stimulus prolonged the airline’s business model — actually, an anti-business model — for a long time. Zombie companies that have first claims to resources have trapped the Japanese economy in stagnation for decades. The lack of shareholder rights has given the moribund companies the luxury of being able to disregard capital efficiency. The government stimulus has prolonged this inept business practice.
What ails Japan is a lack of reforms, not stimulus. The prolonged and massive bailout has only allowed a bad situation to continue. As governments around the world look at their own problems, this is the lesson they should draw from Japan – not the wrong one that insists Japan should have spent more.
Exactly right. Stimulus is no panacea for excess capacity and malinvestment. The problem in Japan is that it propped up zombie companies and asset prices in a quest to prevent a Great Depression-like deflationary bust. This has discouraged capital investment in the business sector because zombie competitors reduce returns on investment. And it has trapped some in debt-laden assets.
I was thinking about this in the U.S. context. What would happen to a neighborhood where house prices declined just enough that it created financial distress for the house debtors but not enough that they were foreclosed on or walked away?
The answer I came up with is low property maintenance. I liken it to what happened at RJR Nabisco post-leveraged buyout. The company was so indebted that it focused on debt reduction to the expense of capital investment and maintenance. This ended up hurting their brand and reducing profitability.
The same is true for neighborhoods in distress where houses just aren’t maintained and fall into disrepair. You see similar patterns with elderly people living on fixed incomes. So this is my guide of what to expect.
Then I asked myself what would happen with price discovery – a more rapid fall in asset prices to their previous long-term trend level – in that same neighborhood. The answer is default, foreclosure and bankruptcy – effectively reducing debt levels. The question then becomes whether those houses would remain empty and abandoned and fall into disrepair because of excess capacity or whether they would eventually be bought because of the now lower price.
On the whole, I think we need price discovery. This would stress the system and reveal many banks to be insolvent. However, if done with enough fiscal force to prevent a deflationary spiral, we could actually get through the period quicker and with a lower increase in public sector debt.
As for Xie’s views on the U.S., optimistically, he entitles his latest piece “A Change of Mindset,” as if to say the bailout mentality has come to an end:
We are hearing the first major departure from the mainstream consensus; US President Barack Obama has just announced a proposal to limit proprietary trading on Wall Street. This is his first major step to address the root cause of the crisis.
The crisis happened because financial professionals had incentives to bet other people’s money in a game they could not lose. With so many getting in on the act, the liquidity they threw into the trades made them effective, turning bankers into heroes, but only for a while.
The crisis showed that their behavior was indeed rational: while the losses to shareholders and taxpayers surpassed all the accounting profits that Wall Street reported during the bubble, those who made the trades are still rich, because they paid themselves bonuses in cash, not derivatives.
Obama has not been well-advised. His so-called accomplishment — stabilizing the financial system — comes from throwing trillions of taxpayers’ dollars at financial firms. He has behaved like a Wall Street trader: spending other people’s money with no thought of consequences. Anyone can do that. Hopefully Obama has fundamentally changed his approach.
Reform, not stimulus, is the solution. Only by limiting financial speculation can the foundations be laid for a healthy recovery, and to prevent another crisis.
I am glad he is hopeful that Obama sees the folly in more bailouts and malinvestment. Perhaps he is on to something. However, I do not expect the mindset to change whatsoever. Bank profits are back at record levels and the worst of the panic is now over. You don’t get a change in mindset in that environment. More likely, you get a victory lap.
I expect the following to occur:
- Public pressure to withdraw monetary and fiscal stimulus will work and stimulus will be reduced quicker than many anticipate – beginning sometime in early 2010. The Fed has already said it will stop buying mortgages in March and the Obama Administration is now focused on deficit reduction as evidenced by the paltry jobs bill just passed.
- The fiscally weak state and local governments will therefore receive little aid from the federal government. This will result in budget cuts, tax increases, and layoffs by the end of Q2 2010.
- At the same time, the inventory cycle’s impact on GDP growth will attenuate. By the second half of 2010, inventories will not add considerably to GDP.
- Meanwhile, the reduction of Fed support for the mortgage market will reveal weaknesses there. Mortgage rates may increase, decreasing housing demand.
- Employment will be weak in this environment, leading to another spate of defaults and foreclosures.
- The foreclosures and weak housing demand will pressure house prices and weaken lender balance sheets, especially because of second-lien exposure. This will in turn reduce credit growth.
I expect the weakness in GDP from this scenario to be evident sometime in the second half of 2010. The only thing in this sequence of events which is supportive of asset prices, credit and GDP growth is that the government will still be manipulating mortgages even after the Federal Reserve stops buying MBS paper. Fannie and Freddie are the only game in town in securitized mortgages, buying the vast majority of paper.
As they are now government entities with an unlimited backstop from the U.S. Treasury for losses, the nationalization of America’s mortgage problem I had foreseen can begin. I understand Fannie and Freddie have been shifting their excess funds from the term Fed Funds markets to Treasury Bills. This may be because of a regulatory mandate to achieve more liquidity and may help explain why the Fed Funds rate is creeping up to the upper bound of the Fed’s policy range. Whether this liquidity policy is in anticipation of the need to use Fannie and Freddie’s balance sheet is unknown. In any event, if Fannie and Freddie are used to forestall weakness in the mortgage market, they will eventually suffer huge losses.
Will this be enough to prevent a double dip? I think not, but you can bet the Obama Administration will try.