By Michael Pettis
In the past two years a lot of analysts have been warning that the US and/or Europe are about to turn “Japanese”. By this I guess they mean that very high levels of debt are going to set the stage for one or two decades of economic stagnation and zero growth.
I am not sure I agree. I think these kinds of comparisons seriously miss the point about what went wrong in Japan in the 1980s. Except at a very superficial levels Japan’s imbalances before 1990 were very different from the imbalances from which Europe and the US suffer today, and the resolutions in each case are likely to be very different.
But we are nonetheless hearing the comparison more and more often. What some are inelegantly calling “Japanization” is an alluring story, and one that may now be in the process of becoming accepted as self-evidently true simply by dint of repetition. But what does it mean to turn Japanese? An article last week by a BBC business editor describes one version:
When money is flooding into US Treasury bonds and British gilts, it means one of two things: either money tends to become harder to obtain by those in the private sector who take the risks which generate economic growth and wealth; or the climate of pervasive anxiety means that even when money is available to consumers and businesses, they don’t want to spend or invest it.
Both trends are consistent with what has become known as the Japanese disease – the two-decade phenomenon in Japan of incredibly low growth caused initially by a mountain of debt bearing down on banks and property companies, and then by an entrenched and unbreakable propensity to hoard by all important economic players.
Last Saturday the Financial Times described it in a little more detail in an article warning about US and European prospects:
The big question for many investors these days is one that could scarcely have been thought about a few years ago: is the west turning into Japan? The response to that will determine the future direction of western economies as well as of shares and bonds. To date, the tentative answer has been that the developed world is heading Japan’s way as government bonds have far outperformed equities.
“This is looking like a Japan-style scenario. I am more nervous than I have ever been before about it,” says Sushil Wadhwani, founder of the eponymous hedge fund and a former member of the Bank of England’s rate-setting monetary policy committee. The most striking example of the “Japanisation” of countries such as the US, UK and Germany is in their benchmark borrowing costs. If you take 15 years off 10-year Treasury, gilt and Bund yields there is a remarkable similarity with Japan’s performance from 1988 to 1996.
We’ve seen a lot of this kind of comparison. Analysts present charts and graphs that show that US and European stock markets, bond markets, real estate markets, and so on, are retracing paths followed by their Japanese equivalents 20 or so years ago. The graphs are always very unsettling.
The article goes on:
Believers of the west-is-turning-into-Japan argument point to several similarities. In both cases, large debt burdens mean sluggish growth after a stock market crash. Meanwhile, the political response to the troubles is confused and does little to alleviate the pain. “It is blatantly obvious that those comparisons are valid,” says Jeffrey Gundlach, chief executive of US fund manager DoubleLine. “[We have] over-indebtedness and banks with bad assets that they are not writing down because otherwise they would be insolvent. Instead, you try to grind it out on a multi-year horizon.”
Andrew Milligan, head of global strategy at Standard Life Investments in Edinburgh, points to eight characteristics he feels contributed to Japan’s inexorable decline: stock market and property crashes; zombie banks; deflation; zero interest rates; political stalemate; poor demographics; and a high debt-to-GDP ratio. “In a very flippant way you can say the west has all of these components,” he says.
A crisis is a crisis
I am wholly unconvinced by the comparisons with Japan and would go much further than Andrew Milligan (who is also, I think, skeptical). In fact if you look at the characteristics that he and the writer of the article identify as having contributed to Japan’s lost decades, it shouldn’t be surprising that we are seeing many of them in the US and Europe, but not for the reasons you might think.
These characteristics, it turns out, are the same characteristics we have seen dozens of times in the past two centuries. In fact they are the fairly normal set of characteristics during any financial crisis, Japanese-style or not. The one exception in Milligan’s list may be “poor demographics”, but that of course depends on what you mean by “poor”. If all you mean is a rapidly aging and declining population, then this characteristic is something pretty new to the history of financial crises, although for that reason it is not clear that it is a vitally important characteristic, and anyway Japan’s demographics are in no way like those of the US, whose population is growing quite quickly and is barely aging (and even Europe is not aging nearly as quickly and is far more open than Japan – at least for now – to immigration).
On the other hand if the definition of poor demographics is extended to mean a wide variety of demographic conditions that hurt economic growth, there is nothing especially Japanese about Milligan’s list of Japanese symptoms. They are pretty standard for countries undergoing financial crises.
And that’s the point. It may well be true that some current data series in the US and Europe resembles similar data series for Japan twenty years ago, but so what? They resemble data series for a very large number of financial crises throughout history, most of which did not involve anyone’s turning “Japanese”. Financial crises, after all, look a lot like other financial crises. These graphs hardly prove anything except that we are experiencing another financial crisis.
This kind of logic reminds me, to digress a little, about the logic behind one of the reasons the West, or more specifically the US, is supposed to be in terminal imperial decline. The decline of empires, we are told repeatedly, begins with military overreach. Look after all at what happened to Great Britain – the British were overextended militarily at the end of the 19thCentury and the beginning of the 20th Century, and they subsequently went into decline. And since the US is now militarily overextended, it is obvious, we are told, that the US Empire must be in decline.
The problem with this kind of prediction is that it assumes its conclusions. I am not sure what military overextension means beyond having a very high military budget, commitments in a number of difficult places, and a real struggle ahead. By that definition, if one didn’t know the subsequent history, one could have easily argued that Great Britain, or its predecessor, was militarily overextended in the early Elizabethan period, that it was militarily overextended during the Glorious Revolution, that it was militarily overextended prior to the US revolution, that it was militarily overextended during the Napoleonic period, and so on for a number of periods before the end of the 19th century.
But because those earlier periods in British history took place while the country was still rising, they do not count as periods of military overextension. At worst they are seen as periods of temporary military over-exuberance, and since they were only cases of over-exuberance, they did not presage the decline of the British Empire. The only period that counts as “overextension” is the last one – the one that precedes imperial decline.
Predictions work best backwards
But if that’s the case, it is a pretty meaningless predictor. All we can say with any great confidence, then, is that any military overextension that occurs just before the decline of an empire is a good predictor of the decline of that empire. Otherwise it isn’t.
In the same way we can also insist that if a country suffering from the Japanese disease sees its stock and real estate markets collapse like Japan’s did twenty years ago, that country is about to succumb to the Japanese disease. Otherwise it isn’t. All those graphs in other words that, with just the minimum of fudging and re-sizing, overlay current US and European stock prices, real estate prices, debt levels, and interest rates with their Japanese counterparts twenty years ago, are not in themselves very compelling arguments.
But aside from the coincidence on the graphs, is the US (or Europe) really about to suffer ten to twenty years of stagnation? No, at least not for any Japanese reason. The US and Europe clearly have problems, and excess debt is a serious part of that problem, but the underlying causes of their debt crises are fundamentally different from the underlying causes in Japan, and so the resolution will follow a very different path.
As I see it, Japan’s problem was that during the 1980s it was so addicted to investment-led growth and artificially cheap financing that it misallocated capital on a massive scale and failed to include the resulting implicit losses in its GDP calculations. Especially after the Plaza Accord, Japan went on an investment binge that left it with a huge amount of wasted capital. Because of this overinvestment Japan grossly overstated its true GDP during much of the 1980s. Japan’s share of global GDP, after all, nearly doubled in that decade, which is almost too extraordinary to be true, in my opinion.
If it had correctly valued the true economic losses on the various investments, or if it had liberalized interest rates and “de-socialized” credit, and so correctly valued the subsequent rise in non-performing loans, Japan’s reported GDP growth rate in the 1980s would have been much lower. Japan’s true GDP, in other words, was never as high as its reported GDP – and the margin between the two was substantial.
So what happened in the past two decades, when Japan’s share of global GDP declined by over 50% (from 17% in 1991 to 9% last year – another number too extraordinary to be true, in my opinion)? I would argue that in real terms Japan didn’t actually suffer from zero growth. It kept growing, but because it had to write down all of that false GDP during this period, real growth was sharply understated in the official GDP numbers. Of course the fact that Japanese banks and corporations did not even begin to write down the losses for a very long time meant that capital continued to be misallocated, albeit at a slower pace than before.
There is some corroborating evidence for my argument. If you look at real per capita household income and household consumption growth during the period of Japan’s stagnation, you will find that both of them rose fairly rapidly.
Production vs consumption bubbles
This isn’t what typically happens during a US-style financial crisis, when household income suffers. Japanese households on the other hand continued to do better, year after year, after the crisis, the difference being that their wealth increased more slowly than reported GDP before 1990 and increased more quickly than reported GDP after 1990. The problem with Japan – and indeed with every other country I can think of that suffered very long periods of post-boom stagnation – was massive over-investment based on a very distorted investment-driven growth model.
This is not the problem that that the US or Europe is suffering from. They suffer from a typical debt-fueled overconsumption boom, whereas Japan suffered from a typical debt-fueled over-investment boom, and Japan’s period of over-investment was much, much more extreme (centralized investment booms can last much longer and go much further than decentralized consumption booms). This is why I think the Japanese experience tells us almost nothing about what Europe and the US will go through.
On the other hand, it might tell us a lot about what China will go through. In fact we can make a more general point. Command economies (Japan, the USSR, Brazil and many others during their “miracle” periods) tend to have much more rapid investment-driven growth during the good times and much more difficult and longer-lasting adjustments. Capitalist democracies are more prone to consumption-driven booms, which aren’t as extreme and don’t last as long, and their adjustments tend to be brutal but relatively quick.
This is a great generalization, of course, and every specific country departs from the generalization in very specific ways. For example I would argue that a very undervalued currency and low interest rates in the US in the 1920s managed to create in the US more of an overinvestment boom, and the adjustment was especially difficult and brutal. I suspect that we may see Germany’s adjustment will also be a very difficult one, more so than say the US, the UK, and France (although on the other hand I think much of peripheral Europe will have a very difficult time of it because of the combination of limited monetary adjustment mechanisms and excess debt).
But the key point is not the broad generalization. It is that Japan had a massive overinvestment problem that was at the heart of its economic malaise. The Japanese crisis was not “caused” by the collapse in the stock or real estate markets any more than the Great Depression was caused by the 1929 stock market crash. They were simply symptoms of overinvestment, which is what caused the crash, the surge in debt, and the subsequent economic stagnation.
This is not the problem from which the US and Europe have suffered in the past decade. There is no reason, I would argue, to assume that their adjustments should at all be similar.
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P.S. For those wondering about the meaning of my title, “Big in Japan” is of course a song by the great Tom Waits. Perhaps you thought I was referring to the Alphaville song by the same name, or even think that as long as I am name-checking musicians I should have used the Vapors’ song“Turning Japanese’? No way. Listen to the Tom Waits piece if you don’t know him and you’ll see why.
This is an abbreviated version of the newsletter that went out last week. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.