Technical signals from the bond markets and fundamental economic parallels have spooked some commentators about the ‘Japanisation’ of the world. Anthony Harrington asks if we should be bracing ourselves for the inevitable ‘lost decades’
Views on whether Europe and the US are doomed to a protracted spell emulating Japan’s ‘lost decades’ vary sharply among leading fund managers and economists. Some think the parallels are spookily close. For others, particularly those based in Japan, the unique features of Japanese society make the differences so sharp that talk of parallel experiences quickly becomes either meaningless, or downright misleading.
Similarly, viewed from a US perspective, anyone who is the least bit bullish about the prospects for growth in the US market is, almost by definition, going to be pretty dismissive of theories that we’re all going ‘Japanese’. By way of contrast, anyone bearish on the euro-zone’s ability to work its way out of its sovereign debt mess may well be thinking: “Going Japanese? If only! At least they continue to have a stable economy!”
Dan Morris, global strategist at JP Morgan Asset Management, regards the whole attempt to suggest parallels between the Japanese experience and the West’s current predicament as “misplaced”. One oft-cited observation is that the yield of Japanese Government 10-year bonds (JGBs) maps very closely against US Treasury 10-year yields. However, Japan unquestionably had deflation.
“Trying to suggest that you will see deflation in the US in the foreseeable future is ridiculous,” Morris says. He points out that while core inflation in the US fell to just 0.6% after the crash, strip out collapsing house prices and one finds all other prices rising by 1.5% per annum - which contrasts with the Japanese experience. This speaks to another parallel frequently made: that Japan resembles a number of advanced markets - such as the US, Ireland and Spain - which suffered crashes as a result of the bursting of a major property bubbles. However, Morris argues that Japan’s property bubble was orders of magnitude worse than that in the US. Plus Japan’s reaction to the crash was, in his words, “so lethargic that it took 15 years for prices generally to get back to where they were before”.
By contrast, Neil Williams, chief economist at Hermes Asset Management, argues that the ‘Turning Japanese’ parallels are in fact worryingly close. Before taking up his position with Hermes, Williams was head of research at Mizuho in London. He is familiar with the Japanese experience - and he is concerned. “Although, thankfully, we are still some way from replicating what Japan did, we are getting spookily close to where Japan was in the mid-1990s,” he says.
Williams begins his analysis from exactly the point that Morris rejects. He takes the last eight years of US Treasury yields and superimposes them over JGBs during the 1990s (we have done the same with US, UK and German bonds in the chart, right). The match for the crisis years from 2006 to 2011 couldn’t be closer and, as he notes, there is nothing to suggest that the parallel won’t continue.
After six years of their own downturn in 1995, the Japanese government and the Bank of Japan (BoJ) first began to mention deflation as a threat. But that was a very belated recognition and by then deflationary expectations had become so entrenched in the public mind that even zero policy rates couldn’t prise it out. “In the 16 years from 1995, there were only three years when Japan actually managed to have negative interest rates,” Williams notes.
Once consumers start hoarding cash in a flat-to-declining economy, a liquidity trap develops, at which point it doesn’t matter how much the government tries to stimulate the economy by throwing cash at them. “The more cash that comes your way, the more you will hold it in precautionary balances because you fear for the loss of your job and you’re worried about the economy,” Williams reasons. It is hard to argue that these fears are not present right now in a Europe riven by multiple sovereign debt crises and a US still not generating enough jobs to accommodate new entrants, let alone reduce the unemployment rate.
“Japan’s lost decade started with the feeling in policy circles that the markets for both equities and property were completely overvalued and that the bubble needed to be addressed,” says William de Vijlder, CIO at BNP Paribas Investment Partners. “It took years for the politicians to get to grips with the fall out from the crash, and by then a number of structural changes had happened with respect to consumer and corporate expectations.” Japan’s deflation had set in by 1994 but when you look back at inflation forecasts being made by both the BoJ and the IMF, they were all predicting positive inflation that just did not happen, he notes.
Simultaneously, Japan experienced a sustained strengthening of its nominal exchange rate, beginning early in the bubble’s hangover, as households became progressively more risk averse. As a consequence, they pulled out of risky foreign assets, selling dollars to repatriate yen. USD/JPY almost doubled from around 90 in 1990 to 170 by 1995 - a pretty brutal move with no equivalent in the current predicament of advanced markets.
“The appreciation of nominal exchange rates was a considerable deflationary force,” de Vijlder says. “It went along with the declining ratio between bank credit and GDP, falling land and equity prices and a considerably reduced willingness on the part of corporates to invest.”
He also makes the often-raised point that US, European and the UK monetary authorities have had an enormous advantage over the Japanese government: in shaping policy they have been able to learn from the Japanese experience and have reacted far more aggressively. Where the BoJ operated a vacillating, credibility-sapping stop-go policy throughout the period - now tightening, now loosening - the Fed and the Bank of England, and even a reluctant European Central Bank (ECB), have been far more persistently aggressive in implementing ‘innovative’ monetary policies. These have included quantitative easing and ‘loose for longer’ monetary policies, and, in the ECB’s case, purchases of sovereign debt from euro-zone banks. The spectre of Japan’s deflationary spiral appears to be ever-present in Fed Chairman Ben Bernanke’s mind.
However, just to show how complex things really are when you look at the detail, it is perfectly possible to make a really strong counter argument that on this issue too, the West is toying dangerously with the idea of going Japanese.
As Benjamin Segal, lead manager on Neuberger Berman’s international equities team, notes, IMF head Christine Legarde is currently spending a lot of time warning European and UK politicians about the dangers of killing off any vestiges of growth in their economies by going for too much austerity too soon.
“With European austerity measures coming in, and US politicians starting to react to the scale of the US deficit, you are looking at fiscal policy tightening that is going to create unemployment,” agrees de Vijlder. “Whenever you have double digit unemployment, that is highly deflationary for wage costs and that should flow through into prices.”
Add to this a Chinese slowdown and one might expect some heat coming out of commodity prices, leading to lower input costs - and lower prices. “If you have raw material and input costs declining, wages declining and consumers pinched from the asset price decline, it is hard to argue that you do not have deflationary tendencies in developed economies, ” de Vijlder concludes.
Paul Colonna, CIO of fixed income with GE Asset Management, goes further. He is of the opinion that there are serious drivers pushing Europe and the US in the direction of the Japanese experience. He mentions the obvious real-estate run-up, but also sees a very strong parallel in the way the US and Europe are dealing with their banks. Everyone knows that Japan took forever to fix its banks; Colonna points out that it’s hard to argue that either the European or US banking sector has been fixed. Both hold huge amounts of property assets that have not been written down to realistic values, and both have massive exposure to the European sovereign debt crisis - European banks through direct bond purchases and US banks through CDS written against those bonds. “We are still seeing runs on major institutions - Morgan Stanley for one, is still in play,” Colonna says.
The other parallel that he thinks many other commentators ignore is the similarity in political and governance structures. “There is a process in the US political system that is addressing the deficit, and that is a good thing, but the process is not working particularly well, and the uncertainties around this, allied to the uncertainty around whether or not the present administration will be able to inject some fiscal tightening, raises serious question marks,” he says. “This puts us in a very comparable position to the vacillating of the Japanese government.”
For Colonna, the US has not yet demonstrated that there is a strong process in place to support fiscal contraction, while Europe is obviously a fractured system of national regimes that somehow have to forge a common policy. “The upshot is that you are not getting a lot of benefit from clear political direction and a clear path forward, and Japan lacked this as well through the 1990s,” says Colonna. “We have an election in the US in 2012, so it will be mid-2013 before we get any major forward moves, so there is nothing in the immediate future that suggests to me that we are diverging from the Japanese experience.”
Steve Cheetham, senior fund manager with Alliance Bernstein, agrees that the political wobbling in the US and Europe is at least analogous to Japan’s muddling in the lost decades. But he argues that Europe and the US have been more resolute in tackling their bad banks. “Japan had a complete failure to deal with economic issues over a long, long period,” he says. “Here, even with farces such as the Slovakian vote, things are much more open and transparent. The issue from our perspective is that the political process in Europe needs to accept the economic reality and politicians need to show leadership in getting behind the euro.”
John Vail, chief global strategist at Nikko Asset Management, is also sceptical of parallels and rests his case on the vast cultural differences between Japan and the rest of the world. “The people who live in the country and the people who run it are just very different from those in Europe and the US,” he contends. “That has been both a strength and a burden in terms of the way Japan has dealt with its crisis over the last 20 years.” True, Japanese politicians were slow to react, but the people maintained discipline and were very cautious in the way they dealt with their budgets. There was no equivalent of the West’s consumer credit binge.
Then there is Japan’s monster deficit. That too, traps Japan. “If the economy ever got too strong, or inflation marched above 2%, their interest costs would rise sharply,” Vail notes. “That would aggravate the deficit more than growth would help it, and that is the truth of what has been going on in Japan all these years.” This would help explain why the BoJ seems relatively relaxed about mild deflation, and suggests a growing parallel with the US’s own deficit. “The boom years for the US are probably unlikely to return in the foreseeable future - [but] the lower US unemployment gets, the more inflation they are going to get, and that will make debt repayment increasingly difficult for the US.”
For Vail, while there are short-term similarities between the West and Japan, long-term he can’t see zero inflation being on the cards for the West.
Meanwhile the EU certainly, and to a lesser extent the US, are both much more hostages to the ratings agencies than Japan ever was (since Japan’s debts are financed by domestic investors). In addition, Japan’s strong companies and growing Asian wealth and economic activity helped it to export its way out of its recession - if not into growth. The euro-zone periphery certainly is not going to export its way back to health, even if the Germans do.
So is the ‘Turning Japanese’ parallel at all helpful in delineating the path down which the Western economies are walking? Not necessarily: the economic, market, political, social and cultural specificities are such that basing forecasts on the idea is likely to be misleading. Moreover, the true value of considering the parallels lies in the stark warning that Japan’s ‘lost decades’ represent, and the useful policy lessons that can be learned from them: absorbing those lessons might help Japan’s past from becoming the West’s future.