Japanese parallels

The only country that has experienced true deflation since the 1930s is Japan, and there are a few parallels in the U.S. today to the Japanese situation since 1990. In Japan, the bubble that burst was the stock market; in the U.S., it’s house prices. In Japan, the Nikkei peaked at 38,951 in early January 1990. It fell to its lowest low, 7,604, in May 2003. At around 16,000 today, the Nikkei has regained less than onethird of the lost ground.

In the U.S., house prices bubbled up much like the Nikkei had done, doubling in most places and more than doubling in the hottest markets (California, Nevada, and florida). Now house prices are falling. So far it’s a modest decline of less than 5 percent nation-wide, but with foreclosure rates more than double from a year ago, prices are sure to fall further. Yale Professor Robert Shiller, who invented the phrase “irrational exuberance,” says in some places house prices will drop as much as 50 percent, and a decline of 20 percentplus nationwide is likely. Trillions of dollars in home prices will be lost. Even Greenspan warns of “double-digit” declines.

The key institutional factor in the prolonged recession and deflation that followed the Nikkei crash was the failure of banks. Bank balance sheets were rotten with bad debts. Japanese depositors withdrew funds to put into their mattresses. Banks ran out of safety deposit boxes to hold all the gold bars that shaken and rattled consumers bought. Banks would not lend to just anyone; only the most triple-A of triple A borrowers. The banking sector seized up and in the end, had to be bailed out with injections of government capital. Even today, money supply growth is less than 3 percent and lending growth is anemic at 1-2 percent. During the late 1990s, the Japanese government even tried a helicopter drop — it gave every adult citizen a spending voucher, with an expiration date, worth about $240. Some 40 percent of the vouchers were never spent.

The current U.S. gridlock in the market for collateralized debt obligations, including subprime mortgages, is somewhat parallel to the Japanese banking sector woes in the early 1990s. An important difference is that most financial institutions have good balance sheets, since toxic assets were off-loaded to third parties, many of them outside the U.S. Therefore, untangling good paper from bad paper will not require outright government bailouts of banks.

Again, the U.S. is not Japan. Americans are not savers like the Japanese, but spenders.

In Japan the financial sector problems were structural, while in the West today we like to think they are cyclical — the institutions have solid balance sheets and it’s just a few bad apples here and there that made too-risky loans on too little evidence of credit-worthiness. But as in Japan, it’s going to take a fair amount of time for the sand to be worked out of the gears. All the rate cuts in the world can’t make possibly toxic paper less toxic, or investors — including those investing in pension funds, mutual funds, and hedge funds — more trusting of issuers and their rating agencies.