Lessons that Will Be Ignored

One argument put forth by those who deny that the bursting credit bubble will lead to hard times is the fact that authorities have the lessons of the past to go on. Unfortunately, that knowledge didn't seem to do much good when the Japanese were faced with a similar deflationary unraveling during the 1990s.

While it is always possible that this time will, you know, be different, I believe there are always going to be certain influences that get in the way of finding solutions that truly are the least painful. The list includes any number of human behavioral foibles, including an aversion to recognizing losses quickly and in full, as well as the realities of democratic politics.

That is one reason why I am less than optimistic that those in charge here will heed the warning of Bloomberg commentator William Pesek, writing in "Japan Ghosts of Bubbles Past Haunt U.S. in 2008," to "begin taking the lessons of Japan more seriously."

In early 2001, economist Stephen Roach raised a warning flag that enraged many peers: The U.S. risks repeating Japan's mistakes of the 1990s.

It was during the darkest days of the Nasdaq crash that Roach, then Morgan Stanley's chief economist, began worrying Japan's malaise could be repeated in the No. 1 economy. The concern was less about the loss of wealth than policy makers papering over economic cracks with easy money.

Roach called it the "bubble fix," a policy then-Federal Reserve Chairman Alan Greenspan is now at great pains to justify. Ben Bernanke hasn't deviated from that strategy since succeeding Greenspan in February 2006.

At its core is a Bank of Japan-like belief that low short- term rates and liquidity are the cure for sliding stocks, plunging real estate prices and lost investor confidence. As 2008 begins, U.S. policy makers need to look long and hard at whether they're repeating Japan's mistakes.

"The only lesson the U.S. has learned from Japan is how to clean up the post-bubble mess," says Roach, now chairman of Morgan Stanley in Asia. "America has failed to learn the much more important lesson -- how to avoid dangerously destabilizing bubbles in the first place. The Greenspan/Bernanke ideology still places disproportionate emphasis on the former while ignoring the latter at great peril."

The argument against the U.S. suffering a Japan-like lost decade lay in the economy's structure. The U.S. banking system is sounder than Japan's was in the 1990s, while the Fed is thought to be more independent than the Bank of Japan.

U.S. Versus Japan

U.S. accounting rules are thought to make it harder for banks to hide losses. The lack of cross-holdings of equities that wreaked havoc on Japanese balance sheets also is worth mentioning. And with oil prices near $100 per barrel, U.S. stagflation seems more likely than deflation.

Yet it's becoming clearer that the problems facing the U.S. are now about banking structure -- just as they were with Japan.

The most obvious similarity with Japan is bad loans. The potential scale of U.S. bad loans is spooking investors and raising prickly questions about the transparency of the U.S. financial system. Yale University Economist Robert Shiller recently told the London-based Times that U.S. housing losses may triple in the next five years, with the country possibly heading for a prolonged, Japan-style slump.

For years, regulators and investors sold an appealing tale: The U.S. has become so sophisticated and efficient at managing risk that a financial meltdown is unthinkable.

Opacity

That was a myth, of course. The aggressive and profitable repackaging of credit risks in recent years made global markets more volatile, not less. In the 1980s, executives and investors put their faith in Japan's system of companies and banks bailing out each other in times of trouble. That banks were maddeningly opaque didn't seem a problem so long as Japan Inc. stayed on track.

During the 1990s, then-German Bundesbank President Hans Tietmeyer's skepticism about financial engineering annoyed many investors. Many may wish they'd heeded his call for banks, securities firms and companies trading and using complex investment instruments to provide a clear picture of the scope and nature of such activities and their impact on earnings in financial statements.

Faith is now being lost in the U.S. system. Look no further than Blackstone Group LP's recent experience. On Jan. 1, PHH Corp., the New Jersey-based mortgage and auto-leasing company, scrapped a $1.8 billion sale to General Electric Co. and Blackstone after the buyout firm said banks reneged on an agreement to lend the money.

Reluctance to Lend

"Banks facing further writedowns are reluctant to lend, so the extra liquidity from the central banks isn't greasing the wheels of commerce as intended," says Simon Grose-Hodge, an investment strategist at LGT Group in Singapore. "When the likes of Blackstone are getting turned down, you've got a problem."

In Japan, the failure of cornerstone institutions such as Yamaichi Securities Co. in 1997 brought down the veneer of invincibility. These days, a similar dynamic may be found in Wall Street titans turning hat-in-hand to foreign governments.

The need for capital recently drove Citigroup Inc. to sell a $7.5 billion stake to the Abu Dhabi Investment Authority, Morgan Stanley to accept a $5 billion investment from China Investment Corp. and Merrill Lynch & Co. to accept $5 billion from Singapore's state-owned Temasek Holdings Pte.

U.S. Risks

So, really, what are the odds of the U.S. sliding into a Japan-like funk? While not great, there are at least two reasons why the risk can't be dismissed: Denial and easy money.

There's still considerable denial about the magnitude of the U.S.'s problems. The subprime-loan crisis led to a broader contagion in credit markets that's spreading around the globe, much like Asia's meltdown in the 1990s. Denial will only let these problems grow bigger.

Also, all low rates and capital injections from central banks offer markets is breathing room. They treat symptoms of the problem, not the underlying disease. Japan's interest rates have been at or near zero for a decade and it still has deflation. Japan's economy has yet to return to normal.

If the U.S. is to avoid that trap, it needs to begin taking the lessons of Japan more seriously.

Comments

[Deborah]

Learn from them and do what?

[Donald Luskin]

"Now the Fed and the rest of the world's central banks are making policy easier, in response to the global credit crisis that they themselves enabled. We're experiencing the benefits of that, in the form of resiliency in the economy and the markets. But I continue to worry that over time, once the housing contraction and the credit crisis have passed, the Fed will have to tighten significantly to curb the inflation risks set in motion by its ongoing easy posture.

"But that's a problem that's over the horizon at this point. For now, take an objective look at the markets and the economy, and you'll see they look pretty good. Compare that to what the bears are saying at the top of their lungs anytime they can get in front of a TV camera. It doesn't match up.

"What are you going to believe: the bears or your own two eyes?

Donald Luskin, Smart Money Magazine, December 28, 2007

[Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com]

[farang]

If there was a way for America to avoid that trap (Japan's plight with stagflation and low or no interest savings accounts), I would assume the Japanese are intelligent enough to have figured it out over the last 18 years or so. Hard to compare situations and results for me, because even with no interest, the Japanese save like crazy, while Americans save not. at. all.

I say it is unavoidable, and now let's see the US mass's tolerance for economic pain.

They've damn sure earned it through willful neglect.

And unlike Japan, or other Asian countries for that matter, we don't all feel a sense of shared beliefs, struggles and kinship for our fellow Americans. Plus, our government is too busy invading and occupying other countries, to ever conceive of domestic spending programs to improve the US infrastructure like Japan did. We are falling into debt held by foreigners, and into technological and manufacturing oblivion.

What, pray tell, is the economic White Knight that will lead America out of this mess?

I have no idea.

[Highlander]

Donny Luskin.
The problem is one of solvency, not liquidity.
You speak as if it were liquidity.
The Fed can create liquidity, but can't cure insolvency
Reverse engineered fractional lending is destroying asset bases when losses happen.
Banks pull in their horns. Libor and euribor go higher. Everything stalls, circulation stops. Opaque balance sheets. Opaque asset bases.
ECB open market operations are actually removing cash from the stage, and that's good for inflation.
SWF investments are good baleouts.
Politically acceptability may limit though.

[highlander]

Fannie and Freddie asset base is just about fried.
Ron Paul tried to get taxpayer liability for Fannie and Freddie removed, a few months ago.
Everyone ignored, or laughed.
Fools.
Watch out for a massive socialization of debt.
SWFs got screwed the first time round (citi). They'll wait for better deals next time.
Maybe the 5% limit on foreign ownership that restricted citi will vanish from the rule book.
Fiscal stimulant from Dubya? - budget deficit is less than 2% of GDP, so there is room, but will it be enough? Can it be enough? The Dems are bound to howl "helping the rich", and then propose similar.
ALL the stimulus from equity withdrawal is now gone, - how many points on the GDP do you figure that created.
Jobs report has financial services creating jobs for the last full year, via "births and deaths". Expect a massive revision shortly, as that just has to be bullshit.
The productivity adjustment on the GDP is just pure fiction, and the CPI is even worse.
It's real world, man in the street, inflation that affects discretionary spending power, not some massaged figure constructed to avoid the truth. And in an economy dependent on the consumer, discretionary spending power is king. Grain futures are through the roof, so is oil ($200/b futures by the year end).
A 2 year slow motion train wreck. At least.
How much Sharia will SWFs import?
Gordon Brown is on record as being determined to make London the Sharia Banking Global Capital.

[Lady From Middle America]

"The U.S. risks repeating Japan's mistakes of the 1990s."

Hardly an original thought, but a select few in Japan seem to have benefited quite nicely from their "mistakes". Let's just hope this isn't the "lesson" the U.S. learns from the Japanese.

Although the Japanese still save more than the Americans, Japan's Ministry of Finance has a few thoughts on their country's continuous decline in their rates of savings.
http://www.mof.go.jp/jouhou/soken/kenkyu/ron164.pdf