Category Archives: Japanese development

Comparative Advantage: an early pro-trade argument

April 6, 2010 By in comparative advantage, economics, Japanese development Tags: , , , , , 1 Comment

Absolute advantage and comparative advantage

The common-sense notion of when trade between countries should occur is this:

if I make something you want more cheaply than you can, you should buy it from me rather than make it yourself; and if you make something more cheaply than I can, again it makes sense to trade.  This is called absolute advantage.

David Ricardo is credited with advancing our understanding of when trade makes sense in his 1817 book, On the Principles of Political Economy and Taxation, which promotes the idea of comparative advantage.

Comparative advantage, in its simplest sense, says that even if you’re a high-cost producer of everything, you’ll very probably be better off if you concentrate on making for export the stuff you’re least bad at, and trading it.  This is a counter-intuitive result.

a (bare-bones) example

Let’s say there are two countries, A and B, and that they make two products, wine and cheese.  Each country has 30,000 units of resources.

Country A needs 100 units to make wine and 300 to make cheese.  Country B needs 200 units to make wine and 400 to make cheese.

At one extreme, country A can make 300 wine and 0 cheese; at the other it can make 100 cheese and 0 wine.  Assuming no benefits/losses from scale differences, it can substitute wine for cheese at the rate of two to one.  Put another way, production possibilities are described by the line, wine = 300 -3(cheese).

Country A can make 150 wine instead of 300 and put the resources into cheese-making–yielding cheese output of 50.  It can choose any point along the line for actual production, but will always have the tradeoff of gaining 2 wine by making 1 cheese fewer, and gaining 1 cheese at the expense of 3 wine fewer.

Similarly, Country B can devote all its resources to winemaking and have output of 150, or all its efforts to cheesemaking, with output of 75.  Or it can make anything in the middle, with a tradeoff of 2 to one.  Its production possibilities are described by the line, wine = 200 – 2 (cheese).

Where does this get us?

The important thing to notice is the wine/cheese tradeoff in each country.  In country A, the cost of 1 extra cheese is 3 wine.  In country B, the cost of 1 extra cheese is 2 wine.

So, both sides would be better off if Country A would trade its wine for Country B’s cheese at a ratio of 2.5 to one.

Ricardo’s insight was that all that’s needed for profitable trade between countries is a differing internal tradeoff, or opportunity cost, or comparative advantage in the production of tradable goods between the two nations.

Lots of caveats in this simple world:  Factors of production must be completely mobile between industries in a given country, but not mobile at all between countries.  Employment should be full.  The market must set prices.

specialization

More than just some trade, assume the two countries began to specialize their production according to where their comparative advantage lay–wine for Country A and cheese for Country B.  Let’s go crazy and assume that Country A produces only wine and Country B produces only cheese and they trade with each other for the other product.

Country A makes 300 wine.  Country B makes 75 cheese.  A trades 100 wine for 40 cheese.

Country A now has 200 wine and 40 cheese.  B has 100 wine and 35 cheese.

Could either country have achieved this outcome by itself?  No!

To make 200 wine, A would need 20,000 in resources; to make 40 cheese it would require 12,000.  The total exceeds available resources by 2000, which is Country A’s gain from trade.

To make 100 wine, B would need 20,000 resources; for 35 cheese, it would need 14,000.  Again, this is more than the total available internally.

Neither country has the production capability to achieve this outcome without trade.

Therefore, one would conclude, open yourself to trade and specialize in the things you do best, even if your best is not as good as someone else’s efforts in the same area.  Trade will lift your living standards anyway.

What’s wrong with this picture–if anything?

1.  There are the “usual” kind of observations that point out the simplifications made in trying to illustrate the point.  For example, employment isn’t always full, so relative prices may change if one country has a glut of labor.  Great vintners may make poor cheese makers, and vice versa.   Production equipment may not shift frictionlessly from one industry to another.  Climate may be conducive to some products but not others.  These are not necessarily such a big deal.

2.  Mobility of the factors of production is a much bigger issue today than two centuries ago.  Yes, every country has identified strategic industries–typical cases would be telecommunication or transport–where local ownership is mandated by law.  But otherwise, most nations actively woo foreigners to set up shop locally, especially in areas where they think technology transfer is possible.  Global-oriented firms who believe they have a technological or business-practice advantage also seek to make maximum use of their edge by expanding abroad.  The internet makes this much easier.

3.  The world is changing a lot faster today that it has been in the past.  Putting a lot of your eggs in a single basket requires an enormous level of confidence in a country’s ability to find specializations that won’t quickly become obsolete.

4.  Developing nations consider the short-term rewards of specialization at what they do best at the moment as a trap that will make it much more difficult to advance technologically.  Some might say the entire idea of comparative advantage is a ploy by colonial powers among industrialized nations to keep their technological edge and effectively force developing nations to remain colonies.

They can point to instances of “lucky” countries like Argentina or, until relatively recently, Australia, which have enormous natural resource endowments but have been economically weak  because they’ve focused on farming or mining and have never developed higher value-added industrial or scientific skills.

Is the idea still useful?

Developing nations have gone on to adopt the currency-peg, technology transfer model perfected by Japan after WWII for dealing with developed countries whose markets they are targeting.  So the Ricardo model has been resoundingly rejected there.

On the other hand, two countries at roughly the same level of development still use the idea in their dealings with one another.  But even in this relatively safe arena, emerging countries like China are beginning to raise questions its viability.





A thought on Toyota’s current troubles

March 16, 2010 By in Autos, Industry Analysis, Japanese development, Stock ideas Tags: , , , Leave a comment

When I began to study the Japanese economy and stock market twenty-five years ago, a brokerage friend of around my age described his generation as having one foot in the samurai era and one foot in the modern world.  His father had bequeathed to him forty cypress trees to use to build a traditional home.  He thought the equivalent gift for his children would be an American college education, which he thought would give them over their Japan-educated peers.

True, that was a long time ago.  And, yes, twenty-and thirty-somethings reject large parts of the traditional Japanese culture.  But, on the other hand, there’s even a kind of nostalgia today in Japan for what might have been, had the black ships of Commodore Perry not arrived in Uraga harbor in 1853, triggering the demise of the Tokugawa shogunate and the restoration of imperial rule as part of a rush to incorporate advanced Western technology into the domestic economy.  In addition, managers in their fifties and sixties still do have a partial anchor in the traditional culture.

There are two important consequences of this cultural tie:

1.  much traditional Japanese discourse serves to communicate that the speaker understands his place in the social order.  Unlike the US, where the lightly regarded social butterfly can secretly be Zorro or Batman, in Japan the senior manager is exactly what his position proclaims him to be–older, wiser, more powerful, a sound decision maker.  The senior does not expect his views will be contradicted by a lower-level employee.  The junior will have a lot of psychological difficulty in conveying such dissonant information;  the senior will have trouble making it sink in that the junior might be right.

This inflexibility is not only an ailment of the pre-WWII zaibatsu conglomerates, like Mitsubishi or Mitsui.  High-level Sony executives, it seems to me, destroyed their first-class video game software business sometime between the PS1 and PS2 generations because the mostly North American game developers weren’t deferential enough.  Sounds crazy, but the two sides were too culturally different.

2.  “Stamp your feet loudly and walk through a wall of iron,” is a famous tenet from a samurai training manual.  It means that a warrior with a pure heart and the right martial spirit can overcome any obstacle, no matter that the laws of physics may say otherwise.  (Another way of putting it might be that any action, no matter how apparently foolish, is a better choice than no action at all.)  tradition invites the manager to think that he can will a part that doesn’t quite come up to specifications to perform as well as if it did.

I’ve seen numerous Japanese firms over the years that I regard as having competent, hard-working, honest managements put out flawed products.  #2 is the best explanation I can come up with for why.  Of course, it doesn’t hurt if information only flows easily in one direction, either.

Of course, Japan is not alone in having management foibles.  For example, where but in the US would a spiritual descendent of P T Barnum be able to Powerpoint his way to become CEO of a huge industrial conglomerate or a major commercial or investment bank, without having much idea of how the operations actually work?  Here such a person might put a cap on his career by becoming Secretary of the Treasury, as well.

Investment implication: Yes, there is one.  In Japan, go for counterculture companies, run by younger people–women, if possible.

The Lehman Report, “Repo 105,” and “tobashi”

March 14, 2010 By in Accounting, Cash position, Current Market Thoughts, Industry Analysis, Investment firms, Japanese development, tobashi Tags: , , , , , , , Leave a comment

The Valukas report

A court-appointed examiner, Anton Valukas, released his nine-volume, 2200 page report on the bankruptcy of Lehman Brothers last Thursday, after more than a year of investigation.

I haven’t read the report and I don’t intend to, since I’m pretty sure it won’t be chock full of useful investment information.  There’s one aspect of the newspaper accounts of Valukas’s work that jumps out to me, though–the now-becoming-infamous “repo 105″ transactions.  It isn’t just that Lehman actively distorted its financial statements so that Wall Street would not understand the true extent of its borrowings.  It’s that all the distortions emanated from London.

Why do US transactions in London?

From the beginning of the financial crisis it has struck me as odd that very many of the “toxic” asset transactions done by the big commercial and investment banks were executed in London–even though they involved US assets, US-based sellers and US-based buyers!

nothing by accident

It’s my experience that nothing big companies do happens by accident.  There’s always a reason, even if you can’t immediately see what it is.  In the toxic asset case, I thought the two logical possibilities were that:

–there was an economic reason–a tax advantage, perhaps, or lower execution costs–to doing the transactions in the UK, or

–there was legal one–firms were trying to protect themselves from civil or criminal action.  In other words, they were doing things that London’s “regulation lite” philosophy might lead it to turn a blind eye to, but which would be clearly illegal in the US.

The Lehman Report seems to tip the balance in favor of the second explanation.

What “Repo 105” was

The name has already caught reporters’ fancy.  In its simplest form, toward the end of each quarterly reporting period Lehman would agree with commercial banks:

(1) to exchange large baskets of the company’s assets for cash, and

(2) to repurchase the assets at a higher price a few days later, after the end of the quarter.

Lehman would use the proceeds of these “repurchase agreements” to reduce the debt outstanding on its balance sheet at quarter’s end.  Repos are very common, plain-vanilla transactions in finance.  A money market fund, for example, might buy a short-term note from, say, IBM for 99 that both sides agree will be cashed in a month from now for 100.  So the fact of repos or even that they made debt “vanish” for a few days is not where the problem lies.

But Lehman also decided that in its SEC filings and other official reporting to shareholders, it would suppress the information about its repurchase obligations.  By only showing one side of the trade, it made itself seem to have less debt than it actually had.  In its last year of existence, Lehman was hiding close to $50 billion in borrowings.

Illegal in the US, ok in the UK

Lehman maintained that if it was fancy enough in structuring the transactions, it would get away with not disclosing the repurchase obligations.  Ernst & Young, Lehman’s auditors, had no quarrel with this.  But Lehman couldn’t find a single US law firm willing to say that doing so was legal.  Put another way, every law firm it approached told Lehman what it was proposing to do was against the law.

How did Lehman respond?

It found a British law firm willing to say that not revealing the repurchases would be legal in the UK–and then did all the transactions in London!

As Lehman got into deeper and deeper trouble, the amounts repoed got larger.  During 2008 the repos approached $50 billion, enough to “lower” Lehman’s financial leverage (its borrowings divided by net worth) by over 10%.  That’s an enormous difference.

Madoff redux

Even though the amounts were mammoth and that reducing leverage was one of his key aims, Lehman’s chairman, Richard Fuld, reportedly denies any knowledge of the scheme.  And in a reprise of the Bernie Madoff scandal, a very persistent whistleblower was apparently ignored by regulators, and Lehman’s top management and board of directors alike.

It will be interesting to see if the Valukas report is an effective counter to the intensive, and so far successful, lobbying efforts of the banks to maintain the status quo, avoid prosecution of their managements, and stymie regulatory reform.

We’ve seen this once before–“tobashi”

During the second half of the Eighties, when the Japanese stock market was booming, investment bankers persuaded many domestic companies to raise capital by issuing bonds with warrants attached.

The companies didn’t really need the money, but the bankers’ sales pitch was persuasive:  give the money to us, they said, to invest for you in the Japanese stock market.  As the Nikkei rises, we’ll make lots of money for you.  And you’ll pay the bonds back with the funds you’ll get when the warrant holders exercise their rights to buy new shares of your stock at much higher prices than today’s.  You win two ways.

Events didn’t work out as planned, though.  For one thing, most of the warrants expired worthless, leaving the issuing companies stuck with repaying bondholders.

Just as bad, the Japanese investment banks lived up to their reputations as notoriously bad investors by losing in the stock market virtually all the money entrusted to them in the corporate stock accounts.  That’s when they came up with the idea of “tobashi,” or “hot potato,” as a way of disguising from company shareholders the fact of their horrible investment performance.

Let’s say the original amount invested, and the carrying value of the portfolio, was 100, but the money left was only 10.  (Hard as it is to imagine, I think this would have been a typical situation.)  The investment banks would find a third party willing to “buy” the portfolio at a price of 100 just before balance sheet date and sell it back to the original holder for the same amount a couple of days later.  Thereby, the losses would never be discovered.  This activity was a very closely guarded secret.

What eventually happened?  One reporting period, a company decided that selling a portfolio worth 10 for 100 was a great deal.  So it refused to accept back the “hot potato” it had tossed to the other firm.  The whole fraudulent scheme quickly became public.

Maybe this is where Lehman got the idea.  After all, it was around in Japan at the time.

A new finance minister for Japan

January 13, 2010 By in economics, Japanese development Tags: , , , , , Leave a comment

The Democratic party took office in Japan last year as the result of an overwhelming rejection of the ruling Liberal Democratic party by Japanese voters.

The Democrats’ platform was a hodge-podge of different policies, to me anyway, with the one connecting element in the pledge that the government would be run for the Japanese people, rather than for special interests–namely, the government bureaucracy, export-oriented manufacturing companies, and multi-generational political “machines” spawned by the long rule of the LDP.

One of the pleasant surprises of Prime Minister Yukio Hatoyama’s cabinet has been the presence of seventy seven-year old Hirohisa Fujii as finance minister.

Mr. Fujii made early waves by announcing that the new government intended to let the yen settle where the currency markets led it.  In other words, it did not intend to adhere to adhere to the LDP policy of intervention to help smooth the profits of exporters.  Mr. Fujii also earned praise from domestic economists for his efforts to craft a government budget that tried to set limits to new bond issuance.  But his efforts appear to have earned him the enmity of long-time political fixer and one-time leading light of the LDP, Ichiro Ozawa, who is now the secretary general of the Democratic Party.

In late December, right after the budget had been set, Mr. Fujii checked into the hospital, suffering from high blood-pressure and fatigue.  Reports differ on whether Mr. Fujii is actually ill, or (more likely, in my view) whether this was a conventional signal of his disagreement with party policies.

Mr. Fujii tendered his resignation a few days ago and has been replaced–not by his assistant and fellow budget hawk, Yoshihiko Noda–but by one of the founders of the Democratic Party, Naoto Kan, who has little financial expertise.

Almost immediately, Mr. Kan announced that the government was considering intervening in the currency markets to weaken the yen in order to enhance the results of exporters.

What’s wrong with that?

It sounds like a return to the failed policies of the past twenty years and the cycle of self-reinforcing economic weakness that has gripped Japan over that period.  The steps:  discourage companies from becoming profitable on their own, so that they become dependent on government assistance and produce little economic growth.  Avoid outright deflation by public works construction projects.  But no growth and the threat of deflation keep nominal interest rates near zero, so the government is not overwhelmed by sharply rising interest expense and can continue to issue new debt.  Citizens continue to buy government bonds, since there aren’t other viable investment opportunities.

Great for political fixers, great for the establishment, bad for citizens who believed the Democrats’ campaign promises.

Mr. Hatoyama has rebuked Mr. Kan publicly, but so far Mr. Kan appears unrepentant.  Stay tuned.

Without structural change, I think Japan will remain a marginal stock market.  There will be very focused small-cap investment opportunities, but it seems to me these stocks will be swimming against the tide.  Given that they will stand out so starkly from the overall bleak economic background, such stocks may end up trading at much higher multiples than they would elsewhere.  The ideal strategy for them, then, would likely be to raise capital in Japan and invest it elsewhere–sort of a non-hedge fund carry trade.

Japan today–the selfish generation

January 12, 2010 By in economics, Japanese development Tags: , , , , , Leave a comment

I’ve been watching the Japanese economy and stock market since the mid-Eighties.  (I’ve written my take on the post-WWII reindustrialization of Japan in an earlier post.)

I want to write about the recent switch in finance ministers by the recently elected Democratic Party and, in a wider sense, lessons for the US from the Japan of today.  As the first step in doing this, though, in this post I want to give a thumbnail sketch of how I think the Japan of today–which is just completing its second consecutive “Lost Decade”–came to be.

Recapping my earlier post

It seems to me that the first, and most essential, step in any successful economic leap forward by an emerging country is an implicit or explicit political pact:

–the current generation agrees to create a favorable environment for both technology transfer from abroad and the development of local industry–all with an eye toward building export-oriented manufacturing.  This means long working hours, low wages, deferring consumption and a loss of current national wealth through an undervalued currency.

People do this so their children and grandchildren will have a better life.  Post-WWII Japan is the standard example of the success of this strategy.  The sacrifice of workers of the Forties-Seventies has created the immense wealth of today’s Japan.

My view of the Japanese “bubble economy” (1986-1989)

During the “bubble economy” of the second half of the Eighties, Japan took two steps that proved to be horribly misguided:

1.  The banks raised tons of cash in the Tokyo stock market to satisfy international capital adequacy requirements.   But the banks were never designed to be anything more than conduits for national saving to support industrial conglomerates.  They ended up making highly speculative real estate and other loans, and basically lost all the money.

2.  Manufacturing companies, perhaps anticipating the aging of the workforce, made large capital investments in productivity-enhancing machinery.  Unfortunately, a lot of it was wasted.  It was not spent on genuinely new products or processes, but instead just increased the amount of Eighties-era equipment on hand, making the firms more vulnerable to competition from Korea, Taiwan and China–or to innovation from Silicon Valley or elsewhere.

Popping the bubble

In late 1989, Mr. Yashshi Mieno became governor the Bank of Japan.  He quickly raised interest rates in order to pop the speculative economic bubble.  This action stopped the speculative fever.  In short order, it also laid bare problems 1 and 2 for all to see.

Government reaction

What was the reaction of government and industry?–not to fix the problems but to cover them up!!

Banks were encouraged to continue to lend more money to prop up what became known as “zombie” companies, chronically loss-making and insolvent firms.  Legal and administrative roadblocks were thrown up to prevent competent outside managers from–domestic or foreign–from stepping in to take control of foundering enterprises and restructuring them.

This destructive behavior regarding the banks continued until Prime Minister Koizumi appointed Heizo Takenaka to address the problem in 2002.  Although limited change of control of industrial firms has been allowed from time to time, the government policy of denial of the problem continues to today.

Rather than deal with the causes of flagging economic performance, Japanese government policy under the Liberal Democratic Party (LDP) has consisted mostly in enacting successive debt-funded public works stimulus packages.  Much of the “stimulus” has been distributed along political lines rather than economic, however, resulting in lots of “bridges to nowhere” in the rural constituencies of powerful politicians–which are of little help in an increasingly urbanized Japanese society.  The net result of this policy has been a mammoth increase in Japan’s government debt.

Three tries to reject politics-as-usual

There have been three attempts by Japanese voters to remove the entrenched legislative apparatus from office.

The first, in the early Nineties, resulted in the Socialist Party taking power.  The Socialists managed to get election rules changed to limit the LDP’s ability to gerrymander election districts, but soon descended into partisan squabbling and were swept out of power.

The second was the election of LDP reformer Junichiro Koizumi in 2001.  Koizumi was able to fix the banking problem and start the process of removing the Japanese Postal System, long a source of pork-barrel finance, from the control of the legislature.  But the LDP resisted further reforms and Koizumi withdrew from office.

The third is ongoing, with the resounding defeat of the LDP in last year’s election its replacement in power by the Democratic Party (an offshoot of the old Socialists).

Why “selfish”?

Not only has the current generation in Japan enjoyed the economic prosperity created as a gift by the sacrifices of its parents, but it has financed its own consumption by running up a huge unpaid tab which it is leaving for its children to repay.  Japanese government debt, which was about 60% of GDP in 1990, has steadily risen to the point where it is now fast closing in on 200% of GDP.  If we ignore Zimbabwe, this number puts Japan in a league of its own in terms of debt.

Japanese government borrowing is almost totally funded by domestic buyers.   That’s bad if you’re a Japanese citizen being saddled with this obligation.  That’s “good” only in the sense that there would doubtless have been a financial crisis long ago if the country needed foreign buyers.