News of the finance

This article appeared on iBC;

I’ve become moderately obsessed with the “Lost Decade” in Japan. I am a firm believer that there truly is nothing new under the sun and if one examines history correctly one can find pointers and perhaps a true north if one works particularly hard at it.

August 19, 2005 Moneyweek Japan’s New Dawn:

Several times in the last decade and a half, this is exactly what has happened. Investors have got very excited as a global cyclical upswing has driven the market up 40% to 50% in the space of a year. But then, as in 1997-1998 and 2001, the cycle turned, taking the Nikkei down with it. The upswing has never yet turned out to be self-sustaining and there has been no end to the debilitating run of deflation in goods and land prices

From the Wikipedia Entry on Japanese asset price bubble:

The easily obtainable credit that had helped create and engorge the real estate bubble continued to be a problem for several years to come, and as late as 1997, banks were still making loans that had a low guarantee of being repaid. Correcting the credit problem became even more difficult as the government began to subsidize failing banks and businesses, creating many “zombie businesses”.

and finally, more clues to what I was looking for in this Financial Times article from February of 2007 (while it talks about China the history lesson is the road map):

The definitive history of Japan’s dismal decade has yet to be written. But almost all knowledgable observers would agree that significant elements included the bursting of the stock market and land bubbles, the resulting problems in the financial system, the collapse of aggregate demand as banks stopped extending credit

or here:

In retrospect, Japanese officials made several important policy errors. In order to avoid further yen appreciation after the 1987 Louvre agreement, they followed easy monetary and financial policies that gave rise to huge asset price bubbles and expansions in credit that set the stage for the subsequent downturn.

What’s Different

Well, there’s a whole wack of things different between the US and the Japanese markets of their respective time periods. While there are great similarities the differences boil down to two things that I’d like to point out:

The Japanese culture of the time was less individual oriented and more geared towards making sure that the country, the corporation, or the family prospered at the expense of the individual. The North American model could be almost a perfect inverse of that priority structure. At the time of the bank failures, the “zombie businesses” there were not the same levels of individual debt that is carried now by the American consumer.

The Japanese economy at the time was an exporter. The main problem that the central bank had, which took a full decade to solve, was to get the individual consumer to spend domestically. Again, the American situation is a stark contrast as the US seems to export little and certainly, if left to it’s own devices, would have a long rough row to hoe if it were to forced to look inwardly to stimulate growth.

The comparison is valid and has been made by a number of people. Both stockmarket busts were led by banks and real estate.

The Japanese market, almost 20yrs later is still in the doldrums, is this what is in store for the American market? I think not, due to some very important differences. The crucial difference is contained within the accounting standards utilised.

Japanese banks record assets at "Historical purchase value" thus, the assets are not marked-to-market and written down if they become impaired. Obviously in the real estate bust, poor real estate loans were impaired, but never written down. The result being that the capital of the bank and it's ability to lend were impaired, while concurrently scaring off sources of new capital as they did not know the true extent of the damage.

In the US, banks are forced to mark-to-market, thus faulty loans are written down aggressively, so aggressively that many lending institutions are boderline insolvent if not outright bankrupt. That so many within the financial system are insolvent has led to a government bailout to protect the financial system from total collapse. This has happened numerous times, each time, it has been successful.

The huge advantage is by writing down impaired loans and reserving against future losses is that should the banks overestimate the losses, via a total writedown, any surprises must be to the upside.

Prior to the 1935 post depression, banks had never lent against real estate, it being deemed too illiquid. Business was exclusively in self-liquidating loans. This business is still viable, and will most likely be the source of banking profits again, whether legislation forces it upon them or not.

That the banks are now probably through the worst of their writedowns, that the Fed has taken upon itself to fund any bank in serious trouble, the financials will cease to be a drag on the index.

That is not to say that the economy is not without problems, just that banks and bank earnings will start to surprise to the upside, rather than being a source of continued woe.

Japanese banks by contrast, not only did not write down their losses, thus depriving themselves of gaining meaningful new capital, they further compounded their error by continued lending to already failed loans, digging themselves ever deeper into insolvency.

The destruction currently being endured by American banks is creative in that it sows the seeds for the next expansion.

It is interesting in that the American consumer is also engaged in writing down his debt, via walking away from underwater mortgage contracts. Personal bankruptcy, as corporate bankruptcy, has become a viable and acceptable business decision. Thus again we have a creative destruction underway, paving the way for future prosperity.

Obviously this will not resolve overnight, however, the seeds of the next expansion are being sowed while all eyes are still focused on the doomsday scenario.

The key will be on productivity going into the future. High productivity will allow America to earn it's way out of the hole that it has dug for itself.

Comments are closed.