THE JAPANESE PARADIGM
There was a time when Japan’s rising sun appeared to be eclipsing America. Back in the 1980’s, a lot of people thought that Japan Inc. was going to take over the world. The Nikkei, the Japanese stock market, was flying high. Japanese investment capital was pouring into the USA and other places. American businesses were copying Japanese business practices and methods from ‘just in time inventory ordering’ to ‘quality circles’. Many of us had our first taste of sushi. Books such as All Japan: The Catalogue of Everything Japanese, The Japanese Mind and movies such as ‘Shogun’, a made for TV movie based upon James Clavell’s novel were capturing the American psyche. The fictional corporate takeover artist Gordon Gecko in the movie ‘Wall Street’ quoted the ancient warrior Sun Tsu as he lay siege to American businesses and came to symbolize what many thought was the fate of the USA. A variety of factors—the Japanese work ethic, culture, and business practices, high savings rate-- were all cited as the factors for its success. There was something special or unique about Japan: They were different!
Sadly, the once eminent super power has fallen from grace. The 21st century that many predicted would be the Asian century began with the Japanese economy limping out of a recession. Some argue that the nineties have been a depression in Japan. Its finances have been crippled with debt as the Financial Times of London (‘Economy Looms Large over Japanese Poll’, June 23, 2000) noted; ’Central government debt was almost 100% of Gross Domestic Product, but nearly 130 per cent if other public debt is included as well.’ The only record that continues to be broken in Japan today is the number of bankruptcies (1)Notes. A proud country that appeared on the verge of world dominance now finds itself humbled and still reeling from the stock market collapse.
Today the USA is the apple of the world’s eye. The tables appear to have turned. American ingenuity, technological superiority and financial markets are being imitated and cited for our success. ‘[T]here is a widespread belief that the ‘American model’ has won out over all other kinds of capitalism.’(John Gray, ‘Comment: Bursting Bubbles A US downturn would threaten a return to protectionism’ The Guardian, January 26, 1999). American multinationals fattened by the burgeoning stock market spread the gospel of the American model as they spread their tentacles around the globe. We are told we have entered a new era, the Internet has created a new economy and changed the way we do business and the over valued stock market has entered a new paradigm. But has it?
It seems absurd, even unfathomable to compare a technologically driven USA economy and its supportive financial markets, to the Japanese economic and financial Bubble of the 1980’s. But before rejecting such a comparison consider some important aspects of Japan’s post-war history. Much of Japan, from its constitution to business practices, was patterned after those in the United States. We wanted to remake Japan in our own image. The goal of the SCAP (Supreme Commander Asia Pacific) for Japan was ‘economic democratization’. The consequences of transforming Japan notes Theodore Cohen in Remaking Japan: The American Occupation as New Deal (Free Press 1987)(page 2);
‘went far beyond those intended or foreseen. None was more important than the radical shift in the focus of Japan’s economy. The Occupation authorities were under orders to disarm, demilitarize, and democratize Japan, and this they did. But what emerged unexpectedly from that process was the phenomenal development of a mass-production and mass-consumption society.’Perhaps the SCAP did its work too well.
The frightening thing is that comparing the US economy to the Japan Inc. bubble
economy of the 1980’s becomes a cathartic self-analysis. An objective, sober analysis, one not clouded with New Era bull market euphoria, reveals that what many considered a politically dominated and rigged market in Japan is not far too different from how things are run in America today! A national euphoria, an ‘irrational exuberance’ of sorts, gripped both Japan in the 1980’s and has a hold on us today. But ultimately the dominant theme is that a handful of policy makers and special interests put both of their respective countries on a fatal path. Hindsight is 20 20; fortunately Japan’s Bubble economy gives us such an opportunity today. What follows is a more detailed analysis of the specific similarities.
CREATING THE RIGHT ENVIRONMENT
Currency Manipulation, (How the stock market bubbles were created). A policy decision by government bureaucrats to raise the value of their respective currencies sent the stock markets in both Japan and the USA flying. Christopher Wood in The Bubble Economy:Japan’s Extraordinary Speculative Boom of the ‘80’s and the Dramatic Bust of the ‘90’s notes; (page 19)
‘The Bubble Economy has its origins in misguided efforts at international economic diplomacy, efforts on which the major international powers are now increasingly turning their backs as they pursue their own domestic agendas. The key starting point was September 1985’s Plaza Accord, the international agreement to drive down the value of the dollar and so help reduce America’s huge trade deficits with both Japan and Germany.’Wood is not alone in thinking that the Japanese bubble was created by a bunch of bureaucrats who took it upon themselves to manipulate the value of the Japanese yen higher. David Asher, in "What Became of the Japanese Miracle’, Orbis, 3/22/95 reaches the same conclusion.
To thwart the consequences of a stronger yen which, would hurt its exporters, the Bank of Japan (BOJ) primed the liquidity pump. These liquidity injections by the BOJ compounded the problem of investing the proceeds from the country’s huge trade surplus. The mountain of cash got a lot, lot bigger and the stock market became the main beneficiary. Between 1985 and 1990 when then Bank of Japan head Meino raised interest rates the stock market rose from 12,700 to 38,915, over 300 percent, while the price earnings ratio (PE) rose from 35.2 to a record 70.6.
Chart 1 - Nikkei versus yen dollar (dollars per yen)---
Similarly the USA’s financial and economic Bubble took off in the spring of 1995 when the dollar was propped up. The dollar was being propped up because it was in free fall and making new lows against the major currencies of Germany and Japan. There was a growing fear that it was losing its reserve role status that would lead to large-scale dishoarding and undermine its legitimacy. The dollar was falling for a reason; whether it was from the bashing the Clinton administration (2)Notes had been giving it in the prior two years, or whether the toll of the trade imbalance was finally beginning to come home to roost, or whether the period of floating exchange rates (Post Bretton Woods) was finally unraveling is difficult to say; But what is not difficult to assuage is the policy response: save the dollar and jack up its value at any price-Never mind why it is here (its value) or whether it is trying to correct an imbalance. Let’s postpone the pain!
With the dollar collapsing central bankers stepped in and aggressively purchased dollars and USA treasury bonds to reduce the value of other currencies and push up the value of the dollar. By buying dollars the central banks were de facto pumping money into the USA’s economy and financial markets. From the time the currency manipulation began to its most recent peak the S + P 500 stock index has risen from 350 to 1,522, or 435 % and the average price earning ratio (PE) has gone from 16 to over 35 at one point, the highest ever recorded.
Chart 2 of USA-S + P 500 versus dollar/ yen (yen per dollars)-
Foreigners have poured in a record 3.5 trillion dollars (3) Notes plus into the USA since the dollar rescue effort began in 1995. These massive inflows into the USA have lead to a stock market bubble and put the USA economy in a fragile position. "No country can continue to borrow so much from abroad without eventually triggering a depreciation of its currency and a contraction of its economy, ("the Ticking Time Bomb, Why the U. S. International Financial Position Is not Sustainable’, Robert A. Blecker, Economic Policy Institute, July 2000) (4)Notes. In 1972, while with the economic consulting firm Townsend-Greenspan, Alan Greenspan was quoted in The New York Times questioning foreign ownership of dollars and how that that not only jeopardized the USA economy, the dollar and the stock market but raised the specter of the foreign nationalization of USA subsidiaries. (New York Times, DOLLAR PURCHASE OF U. S. UNITS SEEN, Economist Says Foreigners Might Used Holdings to Acquire Subsidiaries, March 12, 1972):
One of Wall Street’s leading economists raised the possibility yesterday that foreign governments might use their holdings of United States dollars to take over foreign subsidiaries of American corporations…
USA Chart 3 of current account-page
USA Chart 4 of foreign inflows-page
Policy makers basically went against the tenets of free markets, which says that markets, not politicians or bureaucrats, determine prices. As Japan found out -- the USA is about to -- no one is bigger than the market. To quote Christopher Wood (Ibid. pg. 20)’the central bankers estimated fatally, as bureaucrats tend to, the animal spirits unleashed with the domestic economy by an abundance of credit. The result was a domestic boom to beat all booms…’ The deceptively easy manipulation of currency values and the subsequent booms in both countries fueled the confidence of policy makers.
Capital Imbalances and the Inability to Recycle them. The challenge faced by both Japan and the USA was what to do with trillions of dollars. Money poured into both countries creating a massive surplus of funds. Japan’s huge trade surplus lead to record inflows of money from foreigners having to pay for the goods they purchased from Japanese exporters. The Bank of Japan fanned the flames with its easy money stance. The USA experienced massive inflows from central bankers and others looking to boost the value of the dollar (5)Notes. To understand why such imbalances are a problem we need to look at the principals underlying the theory of floating exchange rates.
The Float (the period of floating exchange rates) our current monetary regime began in 1973 when President Nixon abandoned the gold standard. The Float removed the determination of exchange rates from government and left it to the market. The market became the arbitrator of foreign exchange rates and a lot more (6)Notes. This change was very important because it allowed government’s to run massive trade and capital imbalances. Prior to this, in a fixed rate regime governments would have had a difficult time running large imbalances because the government’s would have been forced to make hard and painful adjustments or face the possibility of a trade war.
The premise behind floating exchange rates is that the market itself is best able to allocate capital, from those that have it to those that need it. Governments would be able to find financing providing that they pursued prudent policies. Profligate governments would be forced to change and pursue prudent policies or not be funded. The markets would keep governments in check (7)Notes. The market rules!
To quote Michael J. Webber and David L. Rigby in The Golden Age Illusion: rethinking postwar capitalism, (Guilford Press, 1996):
' The demise of Bretton Woods intensified conflict between public institutions and the private market over the control of international finance'(page 28)
But the Float has had a dismal record in its ability to reallocate large financial imbalances. Since the Float began there have been three periods of massive capital imbalances:
‘When the price of oil was first doubled in October 1973 and two months later doubled again, the change was so sudden that it took some time to comprehend. The OPEC countries would earn an extra eighty billion dollars from their oil exports—about ten per cent of the value of all world exports—and they could only spend a few billion of that or more on imports.
(Page 122) 'To many economists and some bankers the flow of these new billions into the banks appeared fraught with dangers…The big multinational banks began lending overseas at a breakneck pace and were able to keep things together though the 1970’s. But when the price oil and other commodities fell in the early eighties it was quite a different matter and problems surfaced. The LDC crisis (8)Notes emerged and put both borrower and lender in jeopardy. It also marked the beginnings of what would become a succession of massive bailouts.
Economists argue over whether money is ‘pushed’ or ‘pulled’ into a country. Money that is pulled into a country does so because its investments are attractive. Money that is pushed into a country does so for a variety of factors extraneous to the host country. In other words, the host country is getting money not because it is a good investment but from factors that have nothing to do with its underlying fundamentals such as flight capital. The Federal Reserve Bank of San Francisco in its July 21, 2000 Economic Letter, ‘What Explains Capital Flows’ by Ramon Moreno, notes the following about the flow of money into emerging countries notes;
'The relative importance of external or domestic factors in driving capital flows has important implications for policy. If capital flows are driven largely by domestic factors, developing countries can attract a steady and predictable flow of foreign capital and minimize cycles by adopting sound macroeconomic and financial policies. However, if capital flows are driven largely by external factors developing countries are vulnerable to unexpected external shocks even if they maintain prudent policies, and they must take measures to insulate themselves.’
To put the American economy in perspective, it does not have a trade or current account problem but a capital account problem. Meaning that money has been pushed into the USA and we have had to adjust; and we have adjusted by running a record trade deficit coincident with a booming stock market. Think of it like what your college age child would do if you sent them a large check each week?
There is historical precedence for foreign flight capital leading to a technological revolution and an economic boom followed by an economic depression. Larry Neal, ‘A Tale of Two Revolutions: International Capital Flows 1789-1819’, Bulletin of Economic Research 43:1. 1991:
'One of the phenomena that accompanied the advance of the French Revolution and its armies throughout the European Continent in the 1790’s was the flight of capital…. These capital movements from the Continent to Britain explain succinctly why the British Industrial Revolution took place during this period despite the large pressures of war expenditures and British government subsidies to Continental allies taking place at the same time. The repatriation of capital to the Continent from England after the peace also helps explain the depression of British industry and incomes from 1815 through the financial crisis of 1825, although the role of British speculators was important too.’
Investment Boom – ‘If you build it, they shall come’(10)Notes. Investment spending spurred the physical as well as spiritual economy of both Japan and the USA during their respective great bull markets. Technological innovation and investment spending helped turn a blind eye to an overvalued stock market and created the delusion that Japan was entering a new era. In the later part of the eighties heavy capital investment, accounted for as much as 2/3's of GDP growth in Japan (11)Notes. The investment boom gave confidence to the perception that the Japanese economy was on a sound footing. It was believed that the investment boom would make Japan Inc. more competitive by increasing productivity, negating the effects of a stronger yen, and tackling the perceived problem of a labor shortage. Similarly, ‘The U.S. economy is enjoying a "golden-age" expansion, characterized by investment led growth and low inflation. This has been extremely bullish for equity prices…The surge in capital spending that occurs during a golden-age recovery often reflects major technological breakthroughs…’, so says John Makin (12)Notes in ‘A Golden Stock Market For A Golden Age ?’, (Bank Credit Analyst, April 1997) The investment boom has increased productivity which has reduced the perceived consequences of tighter labor markets and created the impression that the USA economy was entering a new era. To put the growth in productivity in perspective Paul Krugman in his Reckonings' column, ‘Still A Baby Boom’ (New York Times, August 14, 2000) notes that it began in 1996’…had grown at a snail’s pace for two decades, began to accelerate-and accelerate, and accelerate, with recent numbers so high they take one’s breath away.’ Coinciding with the productivity improvement has been an investment in the Internet economy. The new Internet economy has created a perception that we have a new economy to the exclusion of every country.
The Weight of Money - (syn. Baby Boomer Savings). This was the rationale given for why the Japanese stock market had to go up and could not fall. The weight of money was a reference to the enormous amount money sloshing around in Japan, from its high savings rate to its surplus. The premise was that the only place for all the money to go was the stock market. It was believed to be so powerful that nothing, repeat nothing, could stop it from propelling the Japanese stock market higher Today, USA investors similarly believe that the weight of money will continue to keep the stock market surging ever higher. Our weight of money is based upon the concept of baby boomers savings that will continue to grow in the years ahead and the only receptacle for this money is the stock market.
The weight of money has important implications for investing and valuing the stock market. If one assumes the weight money to be a legitimate variable affecting stock prices it reduces the relative importance of other traditional valuation techniques, such as the price earnings ratio and price to book, which would caution investors in a bubble market. A cottage industry of analysis has developed in America, which analyzes capital flows, money flows and mutual fund sales, since the bubble began. Back in the 1980’s analysts who looked at capital flows as a determinant of financial asset prices were scoffed at.
New economy- Both the Japanese and USA stock market bubbles were predicated on the belief in the creation of a ‘New Economy’, that their respective economies were undergoing a transformation and redirection. Japanese investors believed that a shift was in the works from an export-led to a domestic-led economy with emphasis on real estate and infrastructure development. In the USA there is a belief that the Internet is creating a new way of doing business and a new economy; A new economy predicated on e commerce.
The belief in a ‘new economy’ has important investment implications: Not only does it give confidence and hope to investors and speculators alike that the market is not over valued, more importantly it plays to their greed. The opportunity for profit seems limitless. Anything and everything is possible. Killings were going to be made in the market, visions of robber barons in the gilded age of railroad investments cloud their thinking and the lessons of history faded in the face of their greed.
Concept stocks/ Story stocks. Concept stocks are companies with a dream, a vision if you call it and no earnings. The belief in a new economy created concept stocks in both bubbles. They are the way for investors to participate in and profit from their vision. The value was predicated on the potential of their concept and the hope that they would one-day make money. Essentially you are investing in a story and throwing caution to the wind!
In Japan domestic redevelopment construction companies and developers saw their share prices skyrocket. And when prices got too lofty, the emphasis shifted to real estate companies or to companies with hidden or latent assets. Latent or hidden assets pertained to a company’s real estate holdings, which were recorded on their books below market cost. The new economy helped fuel a real estate bubble, which helped fuel the price of stocks of companies with hidden assets such as Railroad companies. An extreme example of the power attached to the real estate theme was demonstrated in the summer of 1986 when two financially weak shipbuilding companies saw their share prices rocket on the concept that they were going to sink several of their barges in Tokyo bay and build sky scrapers upon them.
It is not difficult to see the parallels in the US today. Simply exchange the words ‘Internet’ for ‘real estate’.
Ambulance Stock, (syn Bailout)- Chris Wood (Ibid. page 118) notes there ‘was a practice to manipulate regularly the market by replacing the losses of certain investors’. Japanese brokers rescued financially injured investors by placing them in ‘ambulance stocks’ whose price would be ‘ramped up’ (boosted) to pay back previous losses. Knowing that they would be rescued from their bad investments added to the air of confidence with which Japanese investors approached investing in the bubble.
Fearing bank failures in the post crash period Japanese officials began propping up the stock market. Every time share prices fell below a certain price the government began a PKO (Price Keeping Operation) (13)Notes. The capital reserves of many Japanese Banks included endangered shares; it was critical that the value (share price) of these holdings not fall below a certain level. If they did, the banks would be threatened with insolvency.
Similarly, the Federal Reserve has undertaken Price Keeping Operations (PKO’s) to bail out big losers. The Fed has bailed out countries, institutions and even speculators all on the premise that they posed some sort of systematic risk and could bring everything down with them. The problem with bailouts however, is that they create a moral hazard and encourage speculation. To quote the Wall Street Journal (‘Decade of Moral Hazard’, Review & Outlook, September 25, 1998);
'[M]oral hazard, the term the financial community uses to describe the distortions introduced by the prospect of not having to pay for your sins, in this case financial ones. The prospect of government bailouts leads to abandonment of credit standards and assessments. As moral hazard grows you get a market so skewed by the expectation of bailouts that vital signs of genuine risk no longer get through. Eventually, the danger turns into one of systemic collapse.’The Journal was talking about the 1998 bailout of Long Term Capital. The 1990’s seem to have been a decade of bailouts and moral hazard.
Bailouts create more than a moral hazard, they play to the other side of man’s ‘animal spirits’, its dark side. ‘ Like Pavlov’s dog large speculators have not only learned to become fearless in their resolve, but they have also developed a ghoulish and perverse view that they can and should benefit from someone else’s misery. The moral hazard has become so great that even the littlest investor has learned the benefits of calamity and others’ misery as they chant, ‘buy the dip’.’ (See ‘It’s Time We Kicked The Rich Off the Dole’, Jubileeinitiative.org).
The ascension of financial professionals. A rising market raises the clout of financial professionals. In Japan, the top college graduates traditionally were placed in bureaucrat jobs at places such as Miti or Mof or to work at the top corporations. But that began changing in the mid 1980’s when the stock market took off and raised the stature and standing of brokerage professionals. Similarly, in the USA we have seen an increased interest in college graduates going to work on the ‘street’. Portfolio managers and even economists in certain instances have taken on celebrity like status.
Sell is a four-letter word. The joke in the eighties was that the Japanese brokers would never give a ‘sell recommendation’. But the USA brokerage community appears to be not much different. Although USA brokers do give sell recommendations, many professional investors complain that the corporate finance (underwritingarms prevent analysts from making candid assessments. Kathleen Keenan writing in Bloomberg Magazine, July 2000, ‘Bad Advice’ found that in 28,000 analyst recommendations on 6,700 companies in North America less that one percent were sell recommendations (per First Call Corp). Failure providing proper assessments about the market adds to the air of confidence with which investors approach it.
Unfortunately, the bull market in the USA has taken a macabre air as Cnet reported (CNETNews.com, July 17, 2000, ‘Analysts getting death threats over reports’) that several analysts who had downgraded popular stocks in recent months had begun to get death threats.
Longest post war economic recovery. The length of the economic recovery in both countries added to the belief that there was no bubble and everything was okay. Many believed that a long economic expansion justified a high stock market valuation. The USA has had its longest post war economic recovery ever.