Beware the lair of the seiya

Sorry for the delay, real life intervened.

Well, after the bursting of the Japanese commercial real estate bubble  in the late ’80s and early ’90s, the Bank of Japan (after a brief brainfart of raising rates) knocked its interest rates down to effectively zero. Under normal circumstances, this would have led to increased economic activity, since businesses could theoretically borrow money for free.

However, because of the banking crisis going on at the same time, there was actually less lending. Banks held onto their bad loans (toxic assets) and were essentially allowed to continue operating in a technically insolvent state.

So Japan turned to stimulus spending. Their stimulus packages focused on road-building and other infrastructure projects, often in rural areas.  As we know now, these stimulus plans didn’t really work very well, as Japan stayed in stagnation for an extended period. So what went wrong?

First, the ruling Liberal Democratic Party (don’t be fooled by the name, they’re ultraconservative) used these projects to essentially buy votes in the rural prefectures. There are dozens of bridges to nowhere, and pretty much every town has its own local history museum (usually empty).

Second, the stimuli were applied unevenly, and in a stop-and-go fashion. Many projects required followup money from prefectural governments that never came, so the money was never spent. In 1997, the stimulus was reversed — spending was cut and taxes were raised — and that caused another drop in GDP.

Third, the banking problem was never really fixed, either by a bailout or by temporary nationalization (regulatory takeover a la the FDIC). It was dragged out over the years, sort of healed over time through mergers (there are a smaller number of regional banks, and two national megabanks now), and even now many toxic assets are still on the books.

Fourth, and this is a little controversial, the stimulus might have been too small. This is Nobel Prize-winning economist Paul Krugman’s idea, based on Keynesian theory. The idea is to provide a large enough stimulus to shock the system back to life. The Japanese stimuli were on the order of 1.0 to 1.5% of GDP annually (when they weren’t reversing them). Krugman estimates a stimulus of 3-5% would have been signficantly more effective.

So, in the fourth and hopefully final part of this series, I’ll go over the successes and failures of the Japanese policies. Also, where the US in 2009 is similar to Japan in the ’90s, and where we differ. Stay tuned (but don’t hold your breath)!

Slate.com’s Daniel Gross talks about his new book, Dumb Money. Not sure how much I agree with his timeline on how the current financial crisis came to being, but he makes a compelling case.

So, Japan’s Nikkei stock index followed its real estate market up, and peaked at almost 39,000 in December 1989. What happened after that?

The bubble started to burst. By April 1990 the Nikkei fell to 29,585, or about 24%. By June 1995 the index had lost 63% of its value.

The Bank of Japan, the rough equivalent of the Federal Reserve, lowered interest rates from the high of 8% all the way down to effectively zero. Under normal conditions this would stimulate lending and lift an economy out of recession. Instead, Japan continued to slide.

As assets (real estate) declined in price, businesses cut back on expansion, expectations fell, and confidence collapsed. Inventories grew, and producers cut prices (deflation) to get rid of excesses. Economic activity shrank, as deflation set in.

What happened here?

First, Japan’s banks were eyebrow-deep in land development deals that became essentially worthless. Writing off these bad loans would leave the banks technically insolvent; even as they continued operations they had neither the will nor the capability (capital) to lend.

Second, the government feared social upheaval if they let the banks fail, so instead they propped them up with bailouts. This avoided an uprising, but left Japan with a shell of a banking system — often referred to as “zombie banks”.

Third, Japan has historically been a nation of savers, not so much consumers. This aided Japan’s recovery and export-fueled growth during the good times. But deflation and thrift feed on each other.

When you expect an item to be the same price or cheaper next year, you will probably hold off on buying it until you must have it. That’s rational behavior, but it’s also something economists call a deflationary spiral. Because price drops are required to spur spending, prices will drop, which leads to overall lower economic output. Lather, rinse, repeat.

What were Japan’s responses to this crisis? I’ll cover that in the next post.

Most of the comparisons to the current economic crisis are to the Great Depression. Understandable, because everyone around the world has studied about that in school. I think I learned about it in 7th grade, somewhere around then.

Perhaps a more apt comparison would be to Japan’s crisis of the late 80s. But this doesn’t show up in many textbooks, so let’s start with a little history first.

In the early 80s, Japan was the rising star. Led by electronics (e.g. Walkman) and automobile (e.g. Toyota) exports, Japan rose from the rubble of its WW2 occupation and reconstruction. Growing exponentially through the 60s and 70s, Japan became the second-largest economy in the world. It was just a matter of time before she would pass the US and become the dominant economy.

The stock market soared. The Nikkei 225 stock index went from 10,000 in 1984 to a peak of 38,916 in 1989. Confidence was high, and banks would lend money to anyone with a pulse and a plan to develop real estate.

Why not? Real estate prices can only go up… right?

You can probably see where this is leading. I’ll continue this in the next post.

The news, at least the financial news, is almost all bad.

This morning, the announcement was that Q4 GDP fell 6.2% on an annual basis. Expectations were for a 5.4% drop.

It’s been a drumbeat of bad and ugly, without the good.

So where do we find the optimism?

How about the “things can’t get worse now, can they?” To steal a phrase, yes we can. If you think things are bad now, imagine how bad it’d be with the 25-30% unemployment we had during the Great Depression.

Another way to look at it is, if everyone’s bearish, that’s usually a good time to buy. This one does seem to be working today; the Investors Intelligence Bull/Bear Ratio is spiking, which historically has been a buy signal.

I picked up some McDonald’s and GE at these levels. GE strictly for a trade, I don’t trust those guys farther than I can throw them.