the question

That’s the question of the day for many stock market commentators.  Most are probably aware that Japan boasted the second largest economy in the world in 1989, and at the same time the world’s largest stock market by far.  The prevailing mood in the US back then was that Japan would soon eclipse us as #1, and we’d be left with selling our armed forces as mercenaries to the rest of the world to get foreign exchange (hard to believe, but true).

Yet, the following two decades saw only economic stagnation for Japan, with its economy long ago surpassed by China and its stock market shrunk to less than a quarter of its relative size.

What went wrong with Japan?

Most of those suggesting the US is starting down the same path don’t have a clue.

To my mind, having watched the Japanese economy and stock market for over 25 years, is that those in power in Japan deliberately chose to preserve the status quo–and the traditional semi-samurai way of life that that implied–over the “creative destruction” that would likely have secured a better economic future.  This stands in stark contrast to the behavior of the prior generation, which rebuilt Japan from the ashes of World War II.

There are parallels between Japan then and the US now.  But there’s already been one major difference in approach.  My guess is that Americans will continue to make substantially different choices than Japan did, but, trite as it is to say, it’s too soon to tell.

the parallels

–The most obvious–and possibly the reason for all the talk–is that both countries have extremely low nominal interest rates, which have failed to turbocharge either economy.

More than that, however,

–Japan experienced a substantial bubble in property and financial assets in the late 1980s, caused by reckless bank lending and regulatory neglect.  (In contrast to the American sub-prime housing bubble, which eventually collapsed under its own weight, the Bank of Japan ended that country’s period of speculative excess by raising interest rates).

–Like most nations, Japan believed in the innate superiority of its way of life.  Japan also believed it received special favor from the divine through the mediation of the emperor.

–The legislature was (and still is) dominated by money politics, with legislators’ influence in the Diet based on their ability to raise funds from special interests.

–Neither major political party had a relevant contemporary social agenda.  The Socialists, now the Democratic Party of Japan, opposed the use of nuclear power and drew their emotional appeal from the WWII bombings of Nagasaki and Hiroshima.  Oddly, the party also supported North Korea and pachinko parlors.  The anti-nuclear weapons platform later transmuted into anti-nuclear power.  The Liberal Democratic Party, the dominant force over the past 50 years, favored protection of domestic agriculture and policy support for export-oriented manufacturing–in other words, it maintained positions appropriate for Japan only as the developing country is once had been.

differences, so far

–Japan covered up its banking problems for a decade.  The government pressured (successfully) the banks not to call loans made to bankrupt firms.  In fact, it encouraged them to extend more credit, in the vain hope that time would heal what management incompetence, and sometimes corruption, had created.

The propping up of what became known as “zombie” firms had two very negative consequences:

it continued to degrade the financial strength of Japan’s commercial banks, and

it shifted sales away from healthy firms, weakening them as well.

–Through formal and informal means, the government discouraged mergers and acquisitions that would have brought new management into troubled firms. In particular, a series of new laws made it virtually impossible for a foreign firm to take over a domestic one.

–At the time the bubble popped in late 1989, about 10% of Japan’s workforce was employed in the construction industry.–an unusually high proportion for an advanced economy. Rather than attempting to retrain workers (by the way, a task made more difficult by Japan’s kanji-based written language), the Diet chose to launch a continuing series of infrastructure construction programs to keep these workers employed. Later studies seem to show that these projects had no lasting positive effect on the economy. They appear to have served mostly to line the pockets of politically connected companies, raise the national debt and delay the adjustment of the workforce to the new economic realities.

–Throughout this time, Japanese voters, who are generally highly economically sophisticated, remained surprisingly passive. Although the situation is a bit more complicated than this, voters tolerated LDP mismanagement of the economy for twenty years before voting for change. Unfortunately, the DPJ which replaced the LDP has proved as inept today as its predecessor was when it was briefly in power in the late 1980s.

–The Tokyo government snuffed out a nascent economic rebound twice during the Nineties, once by raising interest rates, once by raising taxes.

what about the US?

Will the US make the same errors as Japan? In a narrow sense, it’s too soon to tell. However,

the US has acknowledged its banking problems from the outset.

We can already see substantial merger and acquisition activity underway.

Certainly, “creative destruction” is regarded in a positive light in the US.

Also, I can’t imagine that American voters would be as tolerant of government ineptitude as Japan has been.

The more relevant question will likely be whether the new politicians voted into office will be any better than those voted out.

Tomorrow: stock market implications.