Paul Krugman: we’re not Greece in the making, we’re Japan–is this likely?

Paul Krugman, Nobel prize winner in economics and professor at Princeton, gave his view of the coming shape of the US economy yesterday in one of his regular opinion columns in the New York Times.

According to Krugman, the idea that Greece, a country which has maxed out its ability to borrow from the rest of the world, and whose major problems are a gigantic government deficit, non-competitive labor and the threat of devaluation/inflation, is in effect a crystal ball in whose interior we can see the destiny of the US, is very wide of the mark.

Instead, he sees the US of the next ten years as paralleling the “lost decade” of Japan in the 1990s–exhibiting very sluggish economic growth and persistent high unemployment.  In support of this thesis, he cites the high unemployment the US is showing now, as well as the continuance of extremely low interest rates–signaling that deflation, not inflation is the malady we should fear the most.  He also sees recent falls on Wall Street as evidence that the stock market is beginning to factor in the likelihood that his view will prove correct.

Is there any way we can avoid this fate?  Yes.  Fiscal policy in Washington has been unduly restrictive so far.  Congress, too, has bought into the Greek model and is trying to avoiding (non-existent) inflation that it thinks additional spending would induce.  What the economy in reality desperately needs, though, is more fiscal stimulation.  But even if legislation to do so were proposed, it would stand no chance of passing, given the national mood and the posturing of (mis-guided) deficit hawks.

There is some chance that a self-sustaining economic recovery will emerge in the US, despite inadequate fiscal stimulus.  But it’s by no means a sure thing.

I think that Krugman is directionally correct.  His conclusion is grim news for investors seeking to support themselves on interest income from cash or bonds, because it implies that interest rates will stay low for a l-o-n-g time.  But, shock value aside, I think the comparison with Japan is a big stretch.  But even if Japan is an indication of the future for the US, this is not as bad as it sounds for holders of stocks.

maybe it’s nitpicking but the US isn’t Japan

There are lots of points of difference between the US now and Japan back then.  For example,

1.  The median age of the Japanese population is much higher than that of the US.  Japan allows virtually no immigration.  As a result, as the “lost decade” unfolded Japan’s work force began to flatten out in size and then shrink–meaning the country began to depend on solely increasing worker output to produce economic growth.  That’s bad.  Absent productivity gains, the trend will be for GDP to contract!

2.  Japanese companies spent heavily on new plant and equipment during the second half of the Eighties, knowing the demographic story meant they would have to become more capital intensive to make their workers more productive.  Unfortunately, rather than buy more advanced machines or invest in R&D, they seem to have somehow just duplicated what they had already–meaning their costs went up but productivity didn’t.

3.   Japan had (and still has) no effective mechanism for dealing with failing companies.  Change from within is culturally very difficult to achieve.  In addition, government policy actively discourages replacement of even the most ineffective management, as many value investors have learned to their sorrow.  On top of that, for many years banks were pressured to prop up otherwise-bankrupt companies through new lending–thereby eviscerating the profits of better-managed rivals.  Foreign takeover of Japanese firms is virtually impossible.  Prospects for domestic entrepreneurs to do the same are almost equally dim.

The result of policies that preserve a traditional lifestyle at the expense of economic growth mean that in Japan there is little of the “creative destruction” that spawns new businesses.  Loads of economic resources are perpetually tied up doing nothing.

possible commonalities are political

1.  Japan did have a number of big fiscal stimulus packages during the Nineties.  But they were focused mainly on pork barrel public works projects for the rural constituencies of powerful members of the Diet.  These roads and bridges to nowhere did provide temporary jobs for construction workers, but they had virtually no multiplier effect and thus no lasting positive impact on the economy.

One of the goals of prime minister Junichiro Koizumi (2000-2006) was to redirect public works spending toward urban areas to promote productivity in service industries.  But he was only partially successful.  And one of his signature achievements–privatization of the national postal service, which had long been a source of funding for pork–is now in the process of being reversed.

2.  Japanese voters have from time to time elected “reform” slates to the Diet.  But, at least so far as I can see, although the names have changed, the policies haven’t.  PM Koizumi managed to clean up the bad debt problems of the major banks, and a previous Socialist government made the election process more democratic.  Otherwise, though, a case of “same old, same old.”

what about stocks?

For the stock market in Japan, the “lost decade” began with two+ years in which everything went down.  With even such mundane companies as cement plants trading at 100x earnings, this is not surprising.  The market then stabilized, and traded in a wide range for the rest of the decade, ending the next seven+ years basically unchanged.

There were two types of stocks that did particularly well during the decade.  The first were companies with substantial operations outside Japan, many of them global brand names like Canon, Honda, Toyota or Nintendo.  The second were smaller, domestically oriented, niche firms that benefitted from the unresponsiveness of their larger, hide-bound rivals to customer needs.  Some of these rising stars were discount retailers.  Others were service companies, many related to mobile phones and/or the internet.

For a while, foreign investors were intrigued by the extremely low valuations of badly run, but asset-rich, firms.  Gradually, it became clear that Japan had no desire to allow incumbent management to be replaced, whether by new ethnic Japanese executives or by foreigners.  My impression is that there are still a few hard-core activists trying to make social change, but that most have lost interest in this class of companies.

implications for the US?

Even under political and cultural conditions so adverse for investors as Japan has been, it has still been possible to make money in the stock market there.  The situation in the US will without doubt be far more supportive for stocks, even if Mr. Krugman is completely right in his analysis.  After all, the US continues to be a hotbed of internet and other technology innovation.  Washington, for all its faults, is infinitely more business friendly than Tokyo.

The key to outperformance, even in the weak economic environment Krugman envisions, will be the same as it was in the lost decade in Japan:  focus on two areas–the strongest companies domestically, and firms that cater to customers in regions of the world that are growing quickly (in this case, meaning emerging markets generally and the Pacific in particular).

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