Strategic Investments editor Dan Denning explores Japan’s latest contribution to the story of capitalism: the two-headed monster of Debt and Deflation that has taken the world’s second largest economy to the edge of catastrophe.
Call it the latest strain of the recurring cyclical disease: global financial bust. The entire Japanese financial sector is on the edge of bankruptcy.
In the 1980s we called them a nation of imitators, not innovators. Now, the land of cheap electronics and Godzilla movies is leading the world to the brink of disaster. Most troubling, the whole gruesome affair may be a chilling preview of what debt and deflation could wreak in the United States.
First, let’s take a look at the debt problem. The government says banks have 43 trillion yen ($US320 billion) in non-performing loans on the books. That’s four times the size of Enron.
Private estimates put the figure closer 237 trillion yen (US$1.7 trillion). That’s the equivalent of 20 Enrons… it ain’t a pretty picture.
All that bad debt – and all that unproductive investment – have created an environment where Japanese businesses have very little pricing power. And that brings up the second big "D", deflation.
Deflation runs at a 4% annual pace in Japan. "Deflation has for years been wrecking efforts to revive the flagging economy," the Financial Times reports, "by depressing consumer demand as shoppers wait for prices to fall further, and reducing the incentive for companies to invest in new capacity."
Falling prices. Falling demand. Falling investment. It’s a viscious cycle. Not a virtuous one. And not one that is likely to be reversed with a few shifts in monetary policy.
Japan has had near zero interest rates for years, to no effect. "A 16.4 percent expansion in the monetary base last year has had no noticeable effect on money supply," the FT reports, "nor on bank lending or on prices, which have been falling for three years."
The Nippon government – doing what it does best – has tried to spend it’s way out of the problem. The result? Total government debt in Japan is now 140% of GDP and an astounding 465% of government revenues. That’s the highest rate anywhere in the industrialized world.
What’s more, with high-profile government bail-outs peppering the financial press, the government has encouraged an environment where mal-investment and corruption reign as the business practice of choice.
Case in point, Snow Brand Milk. Snow Brand is a dairy company accused, by the government, of fraudulently obtaining subsidies…courtesy of the government. In a model of foolish consistency, it’s the government who’s bailing out Snow Brand through an alliance of three agricultural cooperatives.
Nestle wanted to make a bid for Snow Brand. But the government intervened and arranged a buyout. By doing so, it perpetuates the existence of an enterprise that should be allowed to fail.
One wonders how, in an era of excess capacity and deflation, prices can rise when the government deems every enterprise "too big to fail"? Free markets work best when failure gets punished so that businesses die out, allowing the more efficient ones to succeed. Free markets work when prices are not artificially suppressed by an excess of government subsidized production.
In less-than-free markets (the U.S. included) government bailouts keep inefficient companies in business and perpetuate excess capacity. And by keeping bad companies afloat, they prevent banks from writing off trillions of yen in unproductive, non-economic, and wasteful loans. But it’s not just bailouts and subsidies that cause problems. It’s also interest rates.
Artificially low interest rates – those designed to "stimulate" economic activity – don’t do anyone any favors. The create cheap credit. And that credit leads to "uneconomic" investment and outright speculation.
In Japan, that speculation was concentrated mostly in the Asian real estate market. In the United States, it’s been concentrated mostly in financial assets. But in both cases, years of speculation has had the same effect: billions of dollars wasted on uneconomic assets, non-performing loans, and excess capacity.
The Japanese are finding out that wasted capital is not good for stock prices. In early February, the Nikkei 225 fell to an 18-year low. And for the first time in 45 years, it closed below the average on the Dow Jones Industrials. "Can’t happen here," you say?
The facts suggest otherwise. America’s debt and deflation problems look very much like Japan’s: lots of wasted capital, lots of excess capacity, and lots of bad debt. The only thing that remains to be seen is if America’s debt orgy will cost it as much as Japan’s has cost the Japanese. And unfortunately, all the factors are in place for us to imitate Japan’s slow motion depression.
Take corporate debt. U.S. corporations have about $4.9 trillion in debt. But in the last few weeks, corporate debt markets have virtually dried up. Spreads between the yield on the 10-year Treasury and corporate bonds are widening. Accounting scandals – and sometimes just boneheaded business decisions – have locked companies like Xerox, Enron, Tyco, and Qwest out of the market for cheap short-term debt used as working capital.
As one corporate giant after another falls, investors are fleeing the commercial paper market for Treasuries.
Investors are showing they have little confidence in businesses that must turn to bank lenders (rather than cash flow) in times of need. And what confidence they have left in corporate America might be further eroded by the fact that both capacity utilization and prices continue to fall.
Capacity utilization in January was down to 74.2%. That’s its lowest level since 1983. It’s fallen seven straight months for a total decline of 2.7% points. That’s certainly no sign that the recession is over or that the economy is recovering. If businesses aren’t using existing capacity – if they’re idling it at higher rates – they don’t see recovery and inflation.
They see deflation.
Core producer prices fell 0.1% in January. From raw materials to finished goods, prices aren’t rising. They’re falling. My friend Greg Weldon at Weldon’s Money Monitor reports that the January reading on the year- year pace of PPI is the lowest since 1950. And while the Fed may be worried about inflation, the broader trend is deflation.
That’s not good news for corporate profits, and by extension, the stock market. Stocks are priced for earnings growth. Not shrinking earnings. At some point, they will have to more accurately reflect corporate reality.
Will that lead to an 18-year low in America as it has in Japan?
Maybe. But even if it’s only a long sideways meandering, investors would see little or no growth from most stocks. We may not have the luxury of a long convalescence.
for The Daily Reckoning
February 20, 2002
P.S. On April 1, the Japanese government will no longer fully guarantee time deposits in Japanese banks. Removing this insurance is causing savers at smaller banks to worry about their banks’ solvency.
Japanese savers are responding by taking their cash while they can get it. And they’re beginning to trade that cash in for something more reliable: gold.
Yoshihiro Matsumoto, who runs the gold retail division at Mitsubishi Materials, says, "Normally, our customers buy 1kg-5kg of gold, but recently, they’re buying huge amounts. And most people want to take their gold home rather than have it in a bank deposit box."
"Customers tell me that even if the price of gold falls," says Yoshiko Mizutani, manager of The Gold Shop, "it’ll never fall to zero. But if their bank goes under, they worry their savings could disappear."
The flight to gold in Japan is just the beginning of what we call "Epic Reversals"..
Daniel K. Denning is the editor of Strategic Investment. Before joining the Daily Reckoning team, Mr. Denning had launched his own investment advisory service focusing on very small innovative companies and had cut his teeth in the competitive world of Internet start-ups, helping to launch a software solutions company.
By some accounts, the Treasury printed up another $3 billion in fiat currency last week. And, says the Mogambo Guru, "the Fed bought outright another $520 million of government debt."
The Mogambo Guru: "The lesson of Argentina is completely lost on Americans. Fractional banking and monumental debt loads work fine in an expanding economy. That is because the amount of money available to the banks to lend is thus multiplied as the reciprocal of the leverage. You have a hundred bucks, and thus are able to lend a thousand bucks or more. Nice leverage.
"The lesson is that the losses from such leverage are exactly multiplied when things go bad. If the bank loses a hundred bucks on the thousand dollar loan, the capital (the original hundred bucks) of the bank is completely wiped out.
"And not just banks. The use of leverage always plays out, and is playing out right in front of your eyes [Enron, Tyco and now IBM], exactly the same in everything."
Meanwhile, the IMF and World Bank are trying to put a debt relief package together for the former Soviet republics of Georgia, Kyrgyzstan, and Moldova, but the Financial Times reports that the three countries – plus Tajikistan and Armenia – have an average ratio of debt to gross domestic product of 73.5%…or nearly half that of Japan’s.
"Who knows," writes Strategic Investment editor Dan Denning, "maybe the U.S. and Japan will get lucky – and the rest of the world will forgive us our debt."
Eric, what happened on Wall Street?
Eric Fry in New York…
– A lot of folks don’t mind eating horse meat…unless they paid for beef. But if you’ve been paying the butcher for beef over the last few years, only to find out that he’s been selling you horse meat, you might be a little upset.
– The first thing you’d do is stop paying beef prices for horse meat…and that’s exactly what investors are doing. They stampeded for the exits again yesterday, amidst persistent rumors of dubious accounting practices within some of America’s premier corporations.
– The spreading suspicions took a toll on IBM shares in particular. Many investors are starting to wonder whether IBM, the filet mignon of tech stocks, might be little more than artfully prepared "hamburger a cheval?" Big Blue’s shares fell another $3.35 yesterday to $99.54, bringing its losses over the last two sessions to nearly 10%.
– The reeling tech stock had plenty of company, as the Dow tumbled 157 points to 9,745. The Nasdaq tanked 3% to 1,750.
– IBM promises more complete disclosure in the future. So why didn’t Big Blue simply provide more complete disclosure in the past? Do you suppose the company’s lavish executive-options program had anything to do with the less-than-complete disclosure?
– In the stock market as a whole, who knows what the marginal difference might be between the S&P 500’s beautified earnings and the real thing. But even marginally lower earnings might be enough to cause severe problems for our richly valued stock market.
– Sometimes, barely perceptible change at the margin can be devastating. Consider, for example, the effect of an arrow shot from William Tell’s bow, were it to fly a marginal inch or so below its target.
– More importantly, there is a world of difference between candor and deception. The "fair value" on exposed deception is probably not 35 times earnings.
– Let’s take a little break from beating up on the U.S. stock market to take some potshots at the Japanese bond market. We’ve been reading for weeks – not to mention for months and for years – that Japan’s economy is sliding into an abyss. And as it has been sliding, so have the yen and the Nikkei 225 stock index.
– But miraculously, the Japanese bond market has remained an isolated pillar of strength…until now. "The country’s government bond market, the world’s largest, has gone dead cold," the New York Times reports. Investors are beginning to shun Japanese government bonds, known as JGBs. As a result, yields have been inching higher.
– Even so, the 10-year bond still yields a paltry 1.5%. This nearly invisible yield has been a financial freak of nature for several years now. How can a country as indebted as Japan be able to borrow money for 10 years at little more than 1%? No one really knows the answer. Some things just are, even if they shouldn’t be.
– Therefore, what is perhaps most astonishing about the recent slide in the JGB market is not that it has caused yields to drift slightly higher to about 1.5%, but that it has NOT caused yields to skyrocket into double digits.
– "In Japan, total government debt is already 140% of GDP and an astounding 465% of government revenues," Dan Denning reminds us. "That’s the highest rate anywhere in the industrialized world."
– Now Moody’s is threatening to downgrade Japan’s yen-denominated debt by as many as two notches. "Since we last downgraded [Japan] in December," Moody’s reports, "the situation has deteriorated and the pace of deterioration, from the point of view of credit worthiness, has accelerated."
– "Deflation is the foremost challenge facing Japanese authorities, exacerbating overall credit risks throughout the economy as debt rises in real terms," Moody’s continues. "Deflation is making a serious government debt problem worse. A policy mix that produces large fiscal deficits is unsustainable in the medium term."
– Meanwhile, the Japanese yen continues its inexorable downtrend, causing a few anxious Japanese citizens to exchange their feeble currency for less feeble gold bullion. This trickle spilling over the Japanese monetary dam has not yet become a flood.
– But just the same, I wouldn’t build a house anywhere near the flood plain.
Back to Addison in the Daily Reckoning HQ…
*** Interesting, isn’t it, that some of today’s most popular investments are stocks selling for 35 times overstated earnings and bonds paying 1.5% annual interest from one of the world’s most indebted governments?
*** "This constant monetization of government debt," writes Richard Daughty, "is a blatant fraud perpetrated by the Fed, and every person in the USA will be a victim when the whole mess falls apart, as it must."
*** And still no one wants gold! What might debt – and it’s evil twin deflation – reap in the U.S. economy? I don’t know…but the Japanese have been experimenting with the recipe for about a decade. More below…