Japan’s Lost Decade & Derailing Future
Written by Contrarian Capitalist
Inspired by Kyle Bass, Hedge Fund Manager of Hayman Capital
This research report is meant to discuss the cause of the Japanese financial crisis, its lost decade in 1990s and the prediction of incoming crisis facing Japan. One cannot talk about a prediction without analyzing the history, therefore this paper integrates the historical analysis and future prediction together to give readers a more coherent and insightful view on Japanese macroeconomic issues.
Japan is a fascinating country in various aspects, such as culture, manners, spirit and its history. After World War II, Japan was one of the fastest countries which recovered from the war. It was almost hard to believe that Japan was defeated in the war when people saw the resilience in Japanese economy. After several decades of growth, the whole world thought Japan was going to take over the world and surpass U.S. pretty soon, which turned out to be untrue after 1990’s crisis. (The symbolic Imperial Palace at the peak of the bubble was worth more than the whole California’s real estate.) Japan fell off the cliff and after two decades, the economy never fully comes back. However, what’s worse is that a debt crisis and massive devaluation are not far away anymore as a lot of factors which kept it going for two decades are deteriorating intrinsically. Let us review the crisis below and let it lead to the main core of this report – incoming crash.
II. The Financial Crisis, Lost Decade and the Cause
The financial crisis and the lost decade
In 1990, Japan had one of the worst financial crises in human history. The wealth lost was equivalent to 2.7 years of GDP of the peak year during crisis, which was more than the damage that the Great Depression did to U.S.. Nikkei 225 after two decades is still down 80% since it tripled its value to almost 40000 points. However, Yen appreciated from 350/dollar to 80/dollar in 40 years, regardless of the financial crisis. Japan’s GDP never contrasted until 1998 due to government’s aggressive fiscal spending.
It was real estate bubble mainly causing the crisis. As we all know, real estate is just a piece of an asset like commodity. It does not grow like a company but its price fluctuates due to supply and demand relationship. Sooner or later, the price would have to drop once the bubble is popped. As the chart shows below, land price soared to an outrageous level, four times the price of 1975 according to the index below, and then it dropped dramatically every year back to almost 1975 level in 2010.
After years of deflation, Japan’s decade was named after “the lost decade”. Deflation really started to hurt the economy since 1998. In order to cure the deflation, Bank of Japan started zero interest rate policy, however real interest rate kept above zero due to deflation. That was when quantitative easing got introduced. This could be well illustrated by MV=PY. If V remains the same, increase of M will increase P*Y. Therefore either demand or price or both have to go up. Even if demand doesn’t go up, certain level of inflation would create some inflation to plunge real rate to negative,  so that people can start borrowing and spending. Yet, it didn’t work too well either.
Argument of causes for deflation
There are various arguments on reasons caused the deflation and the lost decade in Japan. Among those, there are three main and important ones: Keynesian school represented by Ben Bernanke, Austrian school represented by legendary investor Jim Rogers and Balance Sheet Recession proposed by Richard Koo. Although the history wouldn’t change and we would not know had different policies been implemented would improve Japan’s situation dramatically, it’s worthwhile to analyze each to see which makes more sense.
- Keynesian School
Keynesian school represented by Bernanke has long been advocating government intervention and injecting liquidity into financial system during crisis are the correct ways to save an economy. However, Japan followed the theory to lower the interest rate below 1% and inject liquidity by launching quantitative easing. It didn’t work. Keynesians argue that it was because whatever Japan did was too little and too late. Interest rate wasn’t lowered until one year after the crisis and quantitative easing wasn’t launched until 2001. Therefore after 2008, with the lesson from Japan, both Bernanke and Obama implemented policies very fast to keep deflation out of the way and it has so far been successful. However, after five and half years, the recovery is painfully slow as unemployment still remains above 8% excluding a lot of discouraged people. Whether the actions were appropriate and useful remain to be seen, as U.S. fiscal situation deteriorates dramatically post-crisis. This theory overlooks that those bailed out banks would not learn the lessons, because they never did in the history unless they got punished or bankrupt. 2008 crisis was no different. Few got punished or put into jail as they should be. New financial regulations such as Dodd Frank and Volker Rule with 2000 pages are not really improving anything. This is the potential risk of the next recession even if Keynesian theory does work.
- Austrian School
Austrian school, as the oldest economic school advocates no-bailout policies, no government intervention, and completely let the free market work regardless of recession. Jim Rogers has compared with what U.S. did in 2008 to what happened to Japan several times publicly. He considers what U.S. did was similar to Japan, such as bailing out zombie banks, quantitative easing, and zero-interest policy. U.S. is walking on the exact same road with a long-term fake recovery, to an eventual debt crisis like Europe and a dollar crisis due to printing large quantity of money. The appropriate way of coping with crisis is to pop the bubble and let the economy and unethical banks go bust, as this is the necessary cycle of a healthy economy. Short-term deep pain is much better than a long-term pain plus an eventual bust, since there can be no more kick-the-can-down-the-road solution. A good analogy is it’s like you are taking an antibiotic medicine to cure the cancer, which could relieve the pain temporarily but cure is never reachable. The trade-off of this theory is you have to bear through very deep pain for couple years.
- Balance Sheet Recession
The Balance Sheet Recession was brought up by Richard Koo, the chief economist at Nomura Research Institute. Koo claims that monetary policies such as zero-interest policy and quantitative easing are not effective in balance sheet recession, as private sectors are busy with deleveraging and restoring confidence. Supply of money doesn’t meet with demand of money. Only fiscal policies work during that time to keep up the GDP. For example, Japan’s GDP never contracted until 1996 due to large amount of fiscal spending and Japan didn’t have deflation until 1998 when Asian crisis started. The reason why Japan started deflation, according to Koo, was the mistake Japan made to cut budget deficits, as European countries are killing themselves when cutting budget deficits. He emphasized that deflation was the result rather than the cause of balance sheet recession. However, this theory overlooks the fact that deteriorating fiscal situation like Europe could bring the insolvency problem of government. It’s because European countries went out of control of their spending limit that they have to cut those spending now, as the market forces them to.
III. The Worst Fiscal Situation & the Incoming Crisis
Since the crisis in 1990, Japan has been able to kick the problem for two decades. What is a definition of a Ponzi scheme? Japan is a perfect example of Ponzi scheme. In order to keep the scheme (keep piling public debt) going, Japan needs deflation, which leads to low nominal interest rate.
Deflation =>Low interest rate=>Increasing Debt and interest payments=>Either tax more or borrow more to pay interest payments=>Taxing more from a shrinking economy is hard=>The only way out is borrowing more=>Deflation and low interest rate have to exist=> When market stops believing the story, the scheme will be broken. 
Japan’s debt is intrinsically digested. 95% of its debt is owned by Japanese. Therefore people argue that due to low interest rate and ability to borrow money, Japanese government can keep this going virtually as long as it wants. Even if it blows up, Japan can print however much money they want to pay the interest, just as what Federal Reserve did.
However, I counter argue that Japan’s fiscal problem is going to break down due to several reasons:
The contest of printing press
Printing money to pay debt is a fallacy. However, it’s hard to believe former chairman of Federal Reserve Alan Greenspan said exactly the same thing. If it’s true, then the world will be in total disorder. Nobody will ever follow the rules, because it’s just a pure contest of printing presses rather than disciplines. The only reason human beings have been using gold as currency for thousands of years is people can’t print gold as its scarcity. Money is only as good as your belief in it, as Adam Smith put.
Japan’s population peaked in 2005 with more than 120 million people and would start trending down as The Japanese Journal of Population predicted. By the time of 2055, Japan’s population level will return to the level in 1955 after 100 years. According to Japanese Journal of Population, 40% of total population will be 65 years or older, working-age population will count 50%, and child population will count as 40%. As a result, pension funds have been selling their funds to cover the pension redemption for more people retiring. The holding of JGBs from pension funds has decreased 3% in recent years as the chart shows. Social security counts the biggest part of expenditure in both FY2011 and FY2012, implying the government is spending a lot of money to take care of older people.
Fiscal situation deteriorating dramatically:
- Budget and JGB issuance:
The table above shows the budget situation for FY 2011 and FY2012. Under the column of FY2012, it’s obvious that the government bond issues are more than tax revenue collected and what’s worse is that half of the tax revenue will be used to service debt. Japan’s total budget expenditure for FY 2012 is around 90 trillion yen, which is around 1.1 trillion dollars. Around 62% of tax revenue is dedicated to social security. The fiscal situation will only get worse, since the government has to keep borrowing more to pay interest. Banks are the ones who hold the most of JGBs, so if an event like default happens, they are going to suffer the most.  The chart below shows the gap between tax revenue and total expenditures have been widening since 1990’s crisis, as the government increased fiscal spending to fuel the GDP every year and borrowed more to pay back interest payment.
In FY 2012, Japan is planning to issue initial plan of 174 trillion yen worth of bonds, which breaks the record of any previous initial plans. Every year, Japan has to issue over a hundred trillions yen of refunding bonds to fund the redemption of matured debt.
- Interest rate, interest payment and debt service
Interest payment in FY 2012 is about 9.8 trillion yen, 10.9% of total expenditures. Since tax revenue collected counts only 50% of total expenditures, then interest payment counts 20% of tax revenue. Therefore interest payment will match Japan’s tax revenue when interest rate weighted average goes up to 5% from current 1%. Debt service counts 50% of tax revenue will match tax revenue when interest rate weighted average goes up to 2% from 1%.
- Comparison to other countries
Japan has the worst fiscal situation on this planet. It has around 11 trillion dollars public debt, more than 200% debt to GDP and average of $86262 debt per person. In contrast, countries like Australia, Poland, Mexico and Sweden have very small public debt and relatively low debt to GDP. The European countries are not much worse than U.S., indicating the fiscal problem in U.S. is worrisome as well.
Manufacturing slowing down and energy disruption:
- Manufacturing slowing down
Manufacturing has been slowing since the rebound from 2008. Industrial production goes to the level much lower than the pre-crisis level. Most importantly, business confidence fell to negative area.
Small enterprises (non-manufacturing) are particularly worse, falling to -25% in the beginning of 2011. According to METI, the number of manufacturing companies dropped to one third from 1996 to 2006 and the share of manufacturing of whole economy dropped from 35% in 1970s to 18% in 2009. A very big reason of slowing down is coming from the competence of low priced Chinese goods.
- Energy disturbance, trade deficit
Due to the earthquake and tsunami, Japan stopped almost all of its nuclear operators used to supply energy, and replace it with imports of natural gas. The strength of Yen also contributes to the Japan’s first annual deficit, 32 billion dollars, since 1980, which is before 1990’s crisis and this deficit is unlikely to reverse for the next couple years as Japan continues importing natural gas.  This will definitely start hurting the already fragile economy.
IV. Similarities and Differences from Recent Financial Crisis in U.S.
There are a lot of similarities and differences between 2008 crisis in U.S. and 1990 crisis in Japan.
Cause of the crash
Both crashes happened due to real estate bubble and real estate bubble was caused mainly of low interest rate environment. Notice how similar the shape of target interest rate during 1990 crisis and 2008 crisis and how correlated U.S. housing prices and Japan’s were with each other.
Monetary policies and fiscal policies
- Monetary policies:
Although monetary policies were basically the same, timing and speed were very different. Bank of Japan raised interest rate during crisis, and then it started lowering the interest rate in 1991. The interest rate wasn’t lowered to below 1% until 1995. Federal Reserve in contrast started lowering interest in the beginning of crisis and it got lowered to below 1% after couple months. Japan so far has kept its interest rate low for 15 years and Federal Reserve has kept its target rate low for about 5 years and plan for another 2 years. Whether it will take longer to get out of zero-interest rate policy for U.S. still remains to be seen. Bank of Japan didn’t start quantitative easing until 2001, which was fairly ineffective on getting Japan out of deflation, compared to 2009 for U.S.. From the MP, IS, and AD curve perspectives, Fed was shifting the MP curve down right after the crisis, because Bernanke was expecting deflation coming regardless the inflation at that time. IS curve moves down along the curve. AD curve shifts to the right as creating more demand theoretically.
- Fiscal Policies
In terms of fiscal policies, Ministry of Japan and U.S. Treasury were both having stimulus plans after the crisis to make up decreased demand from private sectors. From macroeconomic analysis point of view, Y=C+G+I+NX. If you can make up the C and I with larger G, the economy wouldn’t contrast too much. Those aggressive fiscal policies massively piled the debt owed by the government.
Impacts and effects
- Japanese wealth evaporated in asset collapse was about 2.7 years’ worth of GDP, which is worse than the Great Depression
- U.S. households lost 10 trillion dollars of wealth during 2008 crisis, which is around one year of GDP at that time.
- Japan started the thirteen-year deflationary period since 1998, but U.S. never had deflationary period, as Bernanke learned from Japan’s lesson by pumping massive liquidity very fast. However, whether the speed and quantity were the cause of the deflation in Japan remains debatable, since deflation didn’t start right after 1990, but after Asian crisis started and Japan started to cut budget in 1996 as told from the chart on page 7.
V. Conclusion and Caution:
The crisis is unlikely to come very soon, as Japan is such a large economy and a lot of people still believe in Japanese bond market to work, but it will likely be within the next 3-5 years. European debt crisis and China’s slowdown could accelerate the situation faster than I estimate. Confidence builds slowly but collapses very fast, as we can conclude from stock indexes during crisis. The stock index climbs up on stairs during the bull market but falls over a cliff in the bear market, and that happens to normal human behavior as well. People tend to have false optimism to believe in the government and central bank will act on its duty and they should be fine. It’s this false optimism that fuels the bubble and the pain after crash. That’s why average people are the ones who always can’t make money and lose money in financial markets. When they get there, the smart money already moves to the next place. As media hasn’t shifted its focus on this gigantic hole of Japanese fiscal situation, getting ahead of the crash is still possible. Hopefully, the readers who are reading this research report can turn cautious and prudent on the matter and act correspondingly.
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