I write frequently about my theory that we are, in fact, “Turning Japanese”. I thought over the next few nights, I would give you a brief history lesson on what actually happened in Japan and let you connect the dots as to what is happening now in Europe and elsewhere. Really the whole globe has taken on Gentle Ben’s philosophy that it is better to bail out than to fail and while many economists claim that this economic theory started in the US as a response to the 2008 debt crisis, it in fact was started by the Japanese in 1990.
During the 1980’s Japan was the model economy and many throughout the world copied their efficiency theories such as “just in time inventory” as well as their technique for leveraging their economy. Japan enjoyed strong economic growth on the 1980’s and with it huge abnormalities within their economy. A massive wave of speculation within the Japanese economy and stock markets was fueled by low interest rates. Japanese companies, banks and securities companies were all caught up in this speculation as land values, stock prices as well as company valuations skyrocketed due to exceptionally low interest rates. Both real estate and stock prices tripled in less than 6 years during the 1980’s. Credit was both easily available and extremely cheap and acted as rocket fuel spread on a fire of speculation. Massive borrowing took place and the proceeds from this massive leveraging was used to invest in domestic and foreign stocks as well as land.
Many believe that the close relationship between banks and corporations combined with a the implicit guarantee of a taxpayer bail-out of bank deposits created a huge moral hazard problem that led to an assumption of “crony capitalism” and therefore reduced lending standards. Anyone could get a sweetheart loan that was connected to either the right corporation or bank. “Japan’s banks were lending more with less regard to the quality of the borrower than anyone else at any time”.
By 1991, stock and real estate values crashed by as much as 60%.
In late 1989, the Japanese Finance Ministry, their version of the FED recognized that this bubble was becoming unsustainable as well as dangerous and they decided to end it by raising interest rates. After a few increases, the bubble popped and the Nikkei stock market crashed in late 1989 and the rout carried into 1990. During this time, most assets were highly correlated and as stocks crashed, so did real estate prices. This led to a debt crisis. A big amount of the debt that has been newly created over the past 3 years turned bad and defaults escalated. This led to a crisis in the banking sector as loan losses skyrocketed, reserve requirements were far below minimums and the government made a decision to bailout the banks a keep them afloat.
Michael Schuman of Time Magazine, who’s articles on Japan are a primary source of this brief history wrote that “banks kept injecting new funds into unprofitable zombie firms. A zombie firm is defined as a company that needs constant bailouts in order to operate. They are simply companies left on life support with loans, unable to function but kept alive. The reason behind keeping these companies and banks alive was a familiar one in a phrase originated in Japan, these firms were “too big to fail.”
The key here was NOT that they were too big to fail, but after all of these companies received massive amounts of bail-out loans, they were so debt-ridden that their only function was to stay alive and survive on further bail-outs. As they became more bloated by debt and the austerity demands put on them because of this debt, they only lived to survive on more bail-outs. Like a junkie or alcoholic gone past the point of no return, these companies were beyond life, they just existed and did nothing more. Every penny of profit was sucked up by interest payments on the ever increasing debt. Economists labeled this phenomenon as “losers paradise.”
To try and help these zombie firms, the Finance Ministry made a decision to keep interest rates at the lowest level possible. A Zero Interest Rate Policy or ZIRP was implemented to keep rates low. With all of this new debt outstanding, any rise in interest rates would be a disaster, one that Japan could not afford, especially with the crash of the stock market still fresh in people’s minds. So ZIRP was put into effect.
Eventually, many of these zombie banks could not survive and a massive wave of consolidation within this industry took place and the result was that Japan was left with only four major national banks. And because of this consolidation, the economic situation deteriorated rapidly as many Japanese companies were now overwhelmed by massive debts which affected their ability for capital investment. Not many people wanted to put their money in an entity where the debt burden was so extreme that mathematically, there was no good end solution. And more importantly, because there were only 4 banks to choose from, credit became very difficult to obtain not only because not many firms or people qualified due to their already huge amount of debt on their balance sheets, but because these national banks were in a terrible state themselves and could not afford to lend due to the enormous risk profiles of the lendees. These banks wanted to shrink and try and become smaller and they decided that cutting off most lending was a good way to start to do that.
The official interest rate fell to 0.1% and for a while moved north and south of 0.0%.
Many borrows turned to “Sarakin”, a Japanese word for loan shark. The black market for loans exploded along with the interest rates charged on these loans.
During the 1990’s Japan experienced what is now known as the “lost decade” where economic expansion basically came to a total halt during this time. Unemployment ran high, but never at crisis levels. As some observed, it was “stubbornly high but didn’t set off and alarms…sort of like a long term low grade fever”. You know you’re sick but can still operate around work and home.
The average Japanese during this period was affected but not to a substantial degree. Most Japanese are frugal people, they have always been savers. They don’t believe in credit or buying things without a cash transaction. Therefore, this crisis produced a minimal effect on the general population due to this frugalness and reliance on cash and not credit.
One of the major responses to this crisis was Japanese policymakers implementing a series of economic stimulus programs as well as the bank bailouts. A 2.4% budget surplus in 1991 soon turned into a 4.3% deficit 5 years later and a 10% 7 years later. The debt to GDP ratio hit 100% 7 years after the crash. ( By the way, the US debt to GDP ratio hit 99% last week, only 3 years after the crash.).
In 1998, a massive $500 billion bank rescue plan was launched to encourage bank lending and borrowing. There was also a large consumer spending stimulus introduced in 1998 and while these helped for a short time, by the turn of the century, the economy lapsed back into recession as people elected to save and pay down debt instead of spending. Remember, credit cards are not popular in Japan and limited excess cash means limited spending.
EUROPE TODAY
Compare this to what is happening in Europe today. Europe is racked with massive debt as far as the eye can see and they continue to pour more debt on the fire and are actually in a serious stage of leveraging that debt up even higher. They are lowering interest rates to try and ease the burden on banks and corporations and therefore, we may NOT HAVE EVEN BEGUN TO SEE THIS CRISIS UNFOLD as in Japan, the real crisis started when the Finance Ministry jacked up rates.
Banks are in terrible shape and with this new EFSF recap agreement, they will be in even worse shape as they announced this weekend that their response to having to find new capital on their own by 2012, WILL BE TO SHRINK THEIR SIZE AND NOT INCREASE IT WITH NEW CAPITAL. THEREFORE MANY BANKS ANNOUNCED THAT WILL END ALL LENDING IMEDIATELY UNTIL FURTHER NOTICE. Like Japanese banks in the 1990’s European banks will stop lending, loans will become scarce and loan sharks…i.e. China and Russia…will become a dominant player on the scene. The inroads that the Chinese as well as the Russians can make by becoming the loan sharks of Europe could be a game changer. Eastern Europe as well as Greece, Spain and Italy may be under the thumb of “Godfather” China and “Loan Shark “ Russia.
The debt to GDP level of most European nations is already over 100% while estimated GDP growth is below 1%. As the cost of servicing loans increases drastically not because rates are going higher, but because the sheer amount of the loans is getting bigger, and the amount of GDP grows smaller, the math just doesn’t work and therefore, just like Japan, these European countries will become “zombie nations”. They will exist just as long as the bail-out loans continue to be made. The austerity measures imposed on them will take the very spirit out of the nation and the citizens will feel like slaves to the system.
After World War I, Germany felt this same way as war reparations sucked the country dry economically and the defeat of the army and the absolute depression within the country, the lost souls and the lost dreams destroyed the very fabric of German society. That was until a guy named Hitler came around.
Don’t think that this can’t happen again. Just look at the Middle East to see how fast things like leaders can be swept out of power once the mood swings one way in a very quick fashion.
There are many comparisons between Japan and Europe and too many to ignore. Japan’s lost years are still going on. This is not over in Japan and may not be for another 10 years. The stock market is still down over 75% from its 1989 high. Interest rates are still well below 1% and have been for over 20 years. Deflation is still in force and real estate prices have never recovered anywhere near 1990 highs.
A debt crisis is far different than an ordinary recession. As far as Europe goes, this crisis has another 20 plus years to run as we haven’t even seen deleveraging at all. As a matter of fact, we may not even be in the first inning over there, still in batting practice as leverage continues to ramp up and debt continues to build.
Contrary to what most experts say, in my view, this scenario is not even close to generating the seeds of a new long term bull market and has all of the seeds of a long term bear market continuing.
We will have rallies and they will be powerful. During Japan’s run to down 75% on the Nikkei, they experience at least 5 rallies of 70% up moves or better. So while you can remain long term bearish, you can’ miss these rallies. I think we had the first from 2009 to 2011 and both coincided with QE. In Japan, as these new QE and stimulus measures were announced, stocks rallied most during these periods. I’m sure that when QE3 is announced here in a short time, the stock market may rally so more.
So while it is good to keep your head here and not get overly bullish during rally days, it is just as important not to get over bearish and look for rally opportunities especially after large declines.
