The motivating factor?  this article in Politico:

President Barack Obama plans to announce in next year’s State of the Union address that he wants to focus extensively on cutting the federal deficit in 2010 – and will downplay other new domestic spending beyond jobs programs, according to top aides involved in the planning.

The president’s plan, which the officials said was under discussion before this month’s Democratic election setbacks, represents both a practical and a political calculation by this White House.

The article, while couched in the language of fiscal responsibility and political tactics, is really an ode to the likelihood of spending cuts, tax increases or both. I see tax increases and I will tell you why later. Either way, these measures will choke off aggregate demand, making a double dip a much more likely scenario.

Below is the associated video from Politico, talking about the political calculus.

Get ready for 1937 redux – it’s coming. I warned against this before Obama even took office. But, no one in the White House is listening.

From an article here on 20 November 2008:

Recently, deficit hawks have been pushing a nefarious line of argument that I need to debunk right here and right now. The line goes as follows: we need to spend government monies now to get the economy back on its feet. In a couple of years, we can signal all clear and then raise taxes on the middle class in order to reduce the deficit again, much as we did in 1993.

While I agree that deficits will need to be eliminated, this line of thinking risks a repeat of 1937-38 in the U.S. and 1997 in Japan and must be refuted…

Just as in the two previous periods of asset deflation, we are dealing with massive amounts of debt and leverage combined with severe declines in standards of living for average citizens. In both previous cases, government thought we were out of the woods and raised taxes in order to return to fiscal prudence. On both occasions, the result was a severe recession and stock market meltdown.

Can we really balloon the deficit to $1 trillion and expect business as usual in 4 to 5 years given the precedents and given the low savings and high debt? This doesn’t make sense to me. Read my post “Charts of the day: U.S. macro disequilibria” to see greater detail on some of the headwinds we face.

I would normally consider myself a deficit hawk as well. However, this is not the early 1990s. The recession will be much deeper, the possibility of systemic risk much greater. And the imbalances are much larger.

Maybe the presence of so many Clinton Administration officials is skewing this Administration’s understanding of the magnitude of the problem facing us. I don’t know. But, the White House seems to think this IS the early 1990s and we are reliving a repeat of the Clinton days. It is clearly not.

I have a lot of sympathy for the Austrian school view, although I have grave misgivings due to the likelihood of geopolitical tension and civil unrest. John Mauldin simplifies the view in a recent post:

Here I refer to the Austrian school of economic theory, based on the work of Ludwig von Mises and Friedrich Hayek, et al. There are those in the Austrian camp who argue the need to do away with the Fed, return to the gold standard, allow the banks that are now deemed too big to fail to go ahead and fail, along with any businesses that are also mismanaged (such as GM and Chrysler), and leave the high ground to new and more properly run.

In their model, government spending is slashed to the bone, as are (in most cases) taxes. The advantage is that, in theory, you get all your pain at once and then can begin to recover from what would be a very bad and deep recession. The bad news is that you risk getting 30% unemployment and another depression that could take a very long time to climb out of.

Now, let me say that I have GREATLY simplified their argument. If you want to learn more you can go to www.mises.org. It is an excellent web site for all things Austrian. While I am not Austrian, I have spent a lot of time reading the literature and have certain sympathies for this view.

That being said, this also has almost no chance of being implemented. In Congress, only my friend Ron Paul is its advocate. Most Austrian followers are Libertarian by nature, and that is just not a political reality for the coming decade.

And Mauldin is right. Barack Obama is not focusing on deficits in order to “get all your pain at once." This is not a Libertarian solution. The President is trying to reduce the deficit to please deficit hawks, all while perpetuating the bailout culture we have become addicted to.  This is the Japanese solution and it will not work.

Witness recent comments from Arnold Kling, who is an Austrian school economist at George Mason:

In my view, the current Administration is pro-business and anti-market–the worst possible combination. By pro-business, I mean that it likes businesses that survive on the basis of subsidies and regulatory advantages.

Now, what I fail to understand is how the Administration believes it can cut the deficit and add stimulus. James Pethoukoukis, who writes in Reuters says we are likely to see more stimulus initiatives:

How much money are we talking about? Alec Phillips of Goldman Sachs calls $250 billion over three years a “conservative” estimate. And what might be in the bill? Look for more highway spending, more aid to state and local governments and some sort of business hiring tax credit.

The only way to both add stimulus and reduce the deficit is to increase taxes – on whom is the only question. Obviously, adding stimulus while increasing taxes sounds a lot like ‘tax and spend’ and opens the door to all manner of attacks from the right. This is a huge tactical error that will be both politically damaging and unlikely to actually stimulate the economy. I see this as a potentially catastrophic outcome for Democrats. It is all too predictable although Obama is rushing ahead with this even earlier than I suspected he would.

Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.

I understand the why of this i.e. the need to provide cover for moderate democrats in 2010. But the “tax and spend” onus during a period of weakness will have people talking about shifts to the left and Jimmy Carter’s presidency – both of which are poison to moderate Democrats.

If the Administration really wants to provide cover for Moderates, a payroll tax cut or a tax break for any firm that hires X % more employees will be more targeted to the jobs problem and will avoid both the more taxes and the more spending labels.

Donald Tsang is right; America is doing exactly what Japan did last time – not just on monetary policy but on fiscal policy too. It didn’t work for Japan and it won’t work for the United States either.

Sources

After spending binge, White House says it will focus on deficits – Politico

Obama eyes domestic spending freeze – AP

Related posts:

• Barack Obama: “if we keep on adding to the debt… that could actually lead to a double-dip”
• Beware of deficit hawks
• The Great Depression II meme
• Japan does not demonstrate the failure of stimulus
• A brief philosophical argument about the role of government, stimulus and recession

Hong Kong’s leader Donald Tsang has come out with a scathing criticism of U.S. monetary policy, comparing it to Japan’s which he believes contributed to 1997’s Asian crisis. This is the most direct and strident criticism of the U.S. Federal reserve’s monetary policy from a major international politician yet.

Bloomberg reports:

The Federal Reserve’s policy of keeping interest rates near zero is fueling a wave of speculative capital that may cause the next global crisis, Hong Kong’s leader said.

“I’m scared and leaders should look out,” said Donald Tsang, chief executive of the city, said in Singapore today. “America is doing exactly what Japan did last time,” he said, adding that Japan’s zero interest rate policy contributed to the 1997 Asian financial crisis and U.S. mortgage meltdown…

“We have a U.S. dollar carry trade at the moment,” Tsang, 65, said in a speech where leaders of the Asia Pacific Economic Cooperation forum are gathering for a weekend summit. The carry trade is where investors borrow cheaply in one currency and use the funds to invest in other currencies.

“Where is the money going — it’s where the problem’s going to be: Asia,” Tsang said. “You can see asset prices going up, not only in Korea, in Taiwan, in Singapore and in Hong Kong, going up to levels that are incompatible or inconsistent with the economic fundamentals.”

Tsang’s criticisms are sure to draw attention as it comes during the APEC summit in Singapore, which is a cross-Pacific economic and political group now being used to show Asian-U.S. cooperation and harmony. Tsang has an especially painful memory of the Asian Crisis as he was Hong Kong’s financial secretary at the time and was forced with the central bank to spend $15 billion to defend Hong Kong’s currency peg as speculative capital fled Asian markets en masse. Depression ensued across wide swathes of Asia, leaving a psychological scar that reverberates today.

As for the comparisons of America to Japan, I find them very well placed.  Yesterday I posted an article in which Marshall Auerback and Fox’s Brian Sullivan discussed parallels between the two. Nouriel Roubini fears that a U.S. dollar carry trade is building which is being used to help inflate assets outside of the U.S. in a global financial bubble.

This is certainly what the Japanese had done in the 1990s. Last August, before the Lehman collapse and panic I wrote that Japan was an enabler of the tech bubble of the late nineties:

the Bank of Japan did not realize the limitations of monetary policy. It could provide easy money, but it could not control where that money ended up. So, ultimately it ended up in the carry trade and helped supply the fuel for the tech bubble.

Was the BOJ responsible for the Tech Bubble? That’s a question that cannot be answered. But, what is true is that the Japanese government and monetary authorities were very instrumental both in the late 1990s and earlier this decade in providing free money to global investors via the carry trade.

Tsang is saying that Japan’s easy money policy also infected Asian markets, helping to inflate an unsustainable bubble which led to collapse and depression. In a macabre repeat of economic history, he sees the same re-occurring now as the U.S. tries desperately to ward off deflation.

Source

Fed May Cause Next Crisis, Hong Kong’s Tsang Suggests – Bloomberg

Related posts:

• Japan’s easy money policy was the trigger for the tech wreck
• Is the U.S. dollar carry trade replacing the one in Japanese yen?
• Depression in Japan
• Asia is de-coupling
• Big Mac Index: Europe overvalued, Asia undervalued

In the video below, Marshall Auerback gives a even-handed analysis of the parallels between the US and Japan on Fox Business with Brian Sullivan.

Demographic trends, GDP trends and deleveraging trends are all similar. But, Marshall goes further by pointing to the misallocation of fiscal resources, the emergence of crony capitalism and the likelihood of zombie banking which he saw in Japan and is seeing now in the U.S.

Another similarity is low interest rates. One issue Marshall didn’t take on when asked about low interest rates by Brian is how this policy not only reduces the cost of capital, but also decreases investment returns, encouraging the carry trade and excessive risk.

When looking at how we are avoiding the mistakes of Japan, I didn’t find the arguments as convincing because it’s early days yet. But, there is hope.

The segment runs just over 5 minutes.

Related posts:

• Japan’s easy money policy was the trigger for the tech wreck
• Chart of the day: Aussie – Yen cross
• Hong Kong: “America is doing exactly what Japan did last time”
• Is the U.S. dollar carry trade replacing the one in Japanese yen?
• The carry trade unwinds and it’s not pretty

Andy Xie thinks the Fed is on an inflationary path.  Last month, he wrote an article in Caijing which says that ‘stagflation lite’ is the Federal Reserve’s preferred outcome. What’s interesting is his recent article about the need for China and Japan to join forces under an ASEAN umbrella, rejecting the APEC umbrella shared with the U.S.

In last month’s article, Xie said:

The bottom line is that, regardless what central banks say and do, the world will be awash in a lot more money after the crisis than before — money that will lead to inflation. Even though all central banks talk about being tough on inflation now, they are unlikely to act tough. After a debt bubble bursts, there are two effective options for deleveraging: bankruptcy or inflation. Government actions over the past year show they cannot accept the first option. The second is likely.

Hyperinflation was used in Germany in the 1920s and Russia in late 1990s to wipe slates clean. The technique was essentially mass default by debtors. But robbing savers en masse has serious political consequences. Existing governments, at least, will fall. Most governments would rather find another way out. Mild stagflation is probably the best one can hope for after a debt bubble. A benefit is that stagflation can spread the pain over many years. A downside is that the pain lingers.

If a central bank can keep real interest rates at zero, and real growth rates at 2.5 percent, leverage could be decreased 22 percent in a decade. If real interest rates can be kept at minus 1 percent, leverage could drop 30 percent in a decade. The cost is probably a 5 percent inflation rate. It works, but slowly.

If stagflation is the goal, why might central banks such as the Fed talk tough about inflation now? The purpose is to persuade bondholders to accept low bond yields. The Fed is effectively influencing mortgage interest rates by buying Fannie Mae bonds. This is the most important aspect of the Fed’s stimulus policy. It effectively limits Treasury yields, too. The Fed would be in no position to buy if all Treasury holders decide to sell, and high Treasury yields would push down the property market once again.

I certainly agree with him. You don’t have to be in the hyperinflation camp like Marc Faber to think the Fed takes Ken Rogoff’s suggestions about 6% inflation seriously. In a May post, I said:

Basically, the Fed wants to inflate our way out of this depression – that’s the dirty little secret.  There is really no other policy choice because the mountain of debt in the United States is immense.  And I think Bernanke, Geithner and Summers have proven they are willing to do anything to reflate this economy and avoid debt deflation dynamics.

And when I say anything, I mean create asset bubbles that are being given intellectual cover by the likes of Frederic Mishkin. This is a policy of economic weakness.

So what should the Asians do?  China is desperate to employ its tens of millions of countryside transplants cruising its cities in search of urban employment. That’s a major reason it keeps its exchange rate fixed to a plummeting dollar, making not just Americans but Europeans irate?  Japan has been in a modern day depression for twenty years. Its sovereign debt-to GDP is now over 200%, risking a downgrade.

Xie says the two should join forces – in part as a rejection of the U.S., which he basically calls a fading power (although the paragraph above points to serious weaknesses in China and Japan as well).

Here is an excerpt of Xie’s article:

Yet the fundamental case for Japan to increase integration with the rest of Asia and away from the United States grows stronger every day. Despite high per capita income, Japan remains an export-oriented economy, having missed an opportunity to develop a consumption-led economy in the 1980s and ’90s. In the foolish belief that rising property prices would spread wealth beyond the industrial heartland in the Tokyo-Osaka corridor, the government of former Prime Minister Kakuei Tanaka pursued a high-price land policy, discouraging the middle class from pursuing a consumer lifestyle as they saved for property purchases…

The point is that Japan has a strong and genuine case that favors more integration with East Asia. The United States is unlikely to recover soon and with enough strength to feed Japan’s export machine again. There is no more room for fiscal stimulus. Devaluing the yen to gain market share is not an option as long as Washington pursues a weak dollar policy. Without a new source of trade, Japan’s economy is doomed. Closer integration with East Asia is the only way out…

Five years ago, I wrote an op-ed piece for the Financial Times entitled China and Japan: Natural Partners. At the time, a prevailing sentiment was that China and Japan were antithetical: Both were still manufacturing export-led economies and could only gain at the other’s expense. I saw complementary demographics and capital: Japan had a declining labor force and China needed to employ tens of millions of youths migrating to cities from the countryside. China needed capital and Japan had surplus capital. And their trade relations indeed tightened, as Japan had increased the Chinese share of its overall trade to 17.4 percent in 2008 from 10.4 percent in ‘04.

Today, the situation has changed. China has a capital surplus rather than a shortage. Demographic complementarity is still good and could last another decade. As China shifts its development model from resource intensive to environmentally friendly, a new complementarity is emerging. Japan has already made the transition, and its technologies that supported the transition need a new market such as China’s. So even without a new trade agreement, bilateral trade will continue growing.

An FTA between China and Japan would significantly accelerate their trade, resulting in an efficiency gain of more than US$ 1 trillion. Japan’s aging population lends urgency to increasing the investment returns. On the other hand, as China prepares to make a numerical commitment to limiting greenhouse gas emissions at the upcoming Copenhagen summit on global warming, heavy investment and rapid restructuring are needed for its economy. Japanese technology could come in quite handy.

An FTA involving Japan and China would be a serious threat to American economic power. You can imagine that policy makers in Washington are opposed to this idea.  Let’s watch to see what kind of rhetoric comes out of Barack Obama’s China trip to see if this issue is discussed.

Xie’s article in its entirety is at the link below.

Source

Andy Xie: Why China and Japan Need an East Asia Bloc – Caijing

Related posts:

• Stephen Roach: Downturn in Asia less severe, but recovery later
• China: reflation play spells trouble for rest of the world
• Chart of the day: Aussie – Yen cross
• The Dollar
• China warns that the west’s quantitative easing is inflationary

The following is a re-print of the latest monthly newsletter from Niels Jensen of Absolute Return Partners, published with the express permission of the author. Visit www.arpllp.com to learn more about Absolute Return Partners. You can reach the firm by email at info@arpllp.com.

This post on taxes and budget deficits should remind one of three recent posts here which take varying views of the fiscal position in Japan. See "Marshall Auerback’s "Japan does not demonstrate the failure of stimulus" and “The new Japan, domestic consumption, and the neo-liberal thought machine “ and my “Japan: stimulus without reform leads to a policy cul de sac.”

While I am personally no fan of supply-side economics or Arthur Laffer (actually, in full disclosure, I have to admit to being generally anti-Reagan/Thatcher as well – in large part due to a lax regulatory environment on both counts and some heinous racial politics in Reagan’s case), I do favour lower taxes as a way to stimulate the economy (through a payroll tax cut, for example).

“The only thing worse than rescuing the system would have been not to do so.”   – Martin Wolf

Welcome to the third letter in our four letter series about major trends defining the future of the world we live in. I kicked off back in September with a piece on energy supplies and last month I took a closer look at the demographic outlook. This month my focus will be on government and why our leaders need to think outside the box to solve the crisis we find ourselves in. I have found this topic particularly difficult to handle – probably because I am somewhat outside of my comfort zone. I sincerely hope you enjoy it anyway.

Let me introduce the main characters: First, the banks which are veering out of control (again!). Next, our central bankers and regulators who are doing a better job than broadly perceived; however, they lack the political support to tackle a financial system which thrives on excesses. And, just to complete the picture, we are up against a political system which is institutionally corrupt and politicians who are hopelessly narrow-minded and unable to look beyond the next election.

Less means more

Since the early 1980s, we (or at least those of us living in an Anglo-Saxon country) have lived in a world where less has carried the meaning of more. Reagan and Thatcher both genuinely believed in small government. Fundamentally, they shared the view that people respond to economic incentives, but it was not only about tax. The public sectors in both countries were slimmed down and much red tape removed. Even the City of London underwent drastic transformation – the so-called Big Bang. The economy reacted favourably in both countries and stock markets began a journey which lasted more than two decades and delivered the most powerful bull market of all times.

But, as we all know now, it ended in tears. Like children in a candy shop, we couldn’t control ourselves. Greed took over and whatever control mechanisms there were in place failed miserably when we needed them the most. It is therefore perfectly understandable that both regulators and politicians want more control. I just wish that our elected leaders would put their self-interest to the side for once and do what is right for the country. Unfortunately, that is about as likely as the sun not rising tomorrow morning.

Too big to fail or…?

Central to the discussion is the role of our banks. Are some banks really too big to fail or are they just too politically connected to fail? Following last year’s near Armageddon, most banks desperately need fresh capital and our monetary authorities – with plenty of encouragement from our Government – have created an environment which has handed banks a license to print money. In a budget constrained world, such a policy was always considered a more palatable way to re-finance the banking sector than the alternative – pumping more hard earned tax payer money into the banking system. So far so good.

Unfortunately, little seems to have been learned from the excesses of recent years. As we have seen time and again, easy money leads to carelessness, paving the way for future bubbles, and why should it be any different this time? A system where profits are privatised and losses socialised is destined to fail. It is the old moral hazard argument all over again and it encourages extreme risk taking. It is nevertheless the system which is being practised all over the world at the moment. And if politicians believe they can solve the problem by capping bonuses, they are less intelligent than even I thought.

In a recent article in the Financial Times, Willem Buiter made some interesting observations on this subject:

Will things be different during the next boom/bubble?  The next credit and asset market boom will generate massive profits and generous tax revenues.  The same phalanx of lobbyists will again descend on regulators, legislators and members of the executive branch of government.  New and exciting financial instruments – superprime lifegages perhaps – will be demonstrated by highly paid hirelings from academia to have unprecedented potential for diversifying, sharing and extinguishing risk.  It will be different from every other boom in the past.  It will be a truly sustainable euphoria – a high for humanity.  And the regulators/supervisors will be convinced, seduced, intimidated or co-opted.

Bank of England Governor Mervyn King recognises the problem:

It is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble.

As a possible solution, King has proposed a re-introduction of the rules which used to be in place, prohibiting retail and investment banking activities under the same roof. For speaking his mind, he was publicly reprimanded by the Prime Minister, who deemed such a policy response “simplistic and out-of-date”. Perhaps I should mention that banks are amongst the largest contributors to the political parties in this country. So much for integrity.

It is time to move on

A friend of mine attended an investment conference recently, where one of the speakers was the CEO of a world famous investment bank. When the talk turned to bonuses, the CEO stated flatly that “it is time to move on” (no prizes for guessing which bank). Perhaps it is time to move on, but not in the direction he wants to go. When US tax payers were forced to cough up $185 billion last year to save AIG which in turn saved an entire industry bar Lehman Brothers, the man on the street would be forgiven for expecting a touch more humility and sensitivity from those running our banks.

I am not for one second arguing that bonuses should be regulated. It is simply the wrong way to address the problem. But society is faced with a much broader problem when bankers carry on living in their ivory towers whilst the canyon between them and the rest of society grows bigger and bigger. “Take risks and you will be amply rewarded; fail and the tax payer will bail you out” is about the only lesson they seem to have learned from the past two years. The solution? Force banks to take less risk. It is absurd that many of our banks are still levered 30, 40 and some even 50 times. With less risk, their profits in good times will be much lower (and their losses in bad times correspondingly smaller), and the reduced profits will automatically drive down bonuses.

Here in the UK, two banks (Royal Bank of Scotland and Lloyds Banking Group) are being forced to break up their businesses. If you are too big to fail, you are too big to exist, seems to be the philosophy. However, the government deserves little or no credit for that decision. It is in fact the EU Commission which is forcing the government to take this draconian step. Who said nothing good comes out of Brussels? It is a much more constructive move than the pathetic focus on bonuses, but it doesn’t address the basic problem – banks must reduce their gearing.

The Laffer curve

Regulating banks more effectively is only half the story, though. As already alluded to, governments all over the world are faced with rising debt, threatening to bankrupt many countries. Several political leaders have already stated publicly that taxes will have to rise, but is that really the appropriate policy response to a dire fiscal outlook? Let’s turn our attention to the so-called Laffer curve. The Laffer curve simply states that there is always a revenue optimal tax rate. The Laffer curve does not provide any evidence as to what that tax rate actually is. As illustrated in chart 1 below, not surprisingly, when the tax rate is zero, the tax revenue is also zero; likewise when the tax rate is 100%. Somewhere in between, the optimal tax rate is to be found. The obvious implication of this relationship is that, over and above a certain point, the tax revenue falls once the tax rate is increased.

Behind the relationship between the tax rate and tax revenues lies the simple notion that a change in the tax rate has an arithmetic as well as an economic effect on tax revenues. The arithmetic effect of a tax hike is always positive whilst the economic effect is always negative due to the effect it has on output, employment, consumption, etc. In other words, the two effects always move in opposite directions.

  Chart 1:  The Laffer Curve

Source:

http://www.heritage.org/research/taxes/bg1765.cfm

It was this basic idea which drove President Reagan to lower tax rates in 1981, yet he was by no means the first US president to do so. In the early 1920s Presidents Harding (1921-23) and Coolidge (1923-29) had reduced the top rate from a whopping 77% to 25% and, in the early 1960s, President Kennedy had also introduced massive tax cuts. The top rate had peaked at 94% (!) by the end of World War II and he brought it down to 70% (see chart 2).

Chart 2:  US Marginal Tax Rates

Source: http://www.heritage.org/research/taxes/bg1765.cfm

Compelling evidence

So how did these tax cuts actually affect tax revenues and overall economic growth? The evidence is quite compelling (see table 1 below). During the four years prior to 1925 (the year in which the 1920s tax cuts were fully implemented, US tax revenues declined by 9.2% per year. In the following four years, tax revenues rose 0.1% per annum. The Kennedy experience was equally convincing. In the four years prior to the 1965 tax cuts, tax revenues rose by 2.6% per annum. In the following four years, revenues rose by 9.0% per year. Finally, in the Reagan years, tax revenues declined by an annual rate of 2.6% during the four years leading up to 1983, whilst revenues grew by 3.5% annually during the subsequent four year period.

Table 1:  US Tax Revenues around Major Income Tax Cuts

Source:  http://www.heritage.org/research/taxes/bg1765.cfm.

All numbers are inflation-adjusted.

Furthermore, in all three instances, economic growth accelerated following the tax cuts. For example, between 1978 and 1982, US GDP growth averaged 0.9% per year in real terms. Between 1983 and 1986, the economy grew by 4.8% in real terms, so the case in favour of tax cuts appears to be pretty compelling.

Other factors to be considered

It is not always one-way traffic, though. In his first term as President Clinton actually increased taxes in 1993 and what followed? One of the biggest economic booms of all times. Other factors impact tax revenues as well. In the case of Clinton, he presided over an economy which benefited immensely from globalisation and an IT boom, the likes of which had never been seen before.

Here in Europe, total tax revenue as a % of GDP is, on average, much higher than it is in the United States (chart 3). Whilst European growth rates have, admittedly, been modestly below US growth rates in recent years, there is no evidence to suggest that the higher tax rates have done significant damage to European growth. If that were the case, Denmark and Sweden should suffer the lowest growth rates amongst developed nations. In fact, the two Scandinavian countries have enjoyed comparatively high economic growth in recent years.

Also, corporate earnings have been as strong here in Europe as is the case in the US, and European stock markets have actually vastly outperformed the US market in recent years. So it is hard to drive the argument that lower taxes always lead to higher economic growth and stronger stock market performance. However, it is noteworthy that, in the United States, 3 major income tax cut programmes have been implemented in the last 100 years. In each and every case, tax revenues have grown, GDP growth has accelerated and there has been significant job creation. Can you ask for any more than that?

The canary in the coal mine?

One thing is sure, though. Given the rapidly rising public debt all over the OECD area, economic growth must be secured at any price. Anything else will be devastating longer term. Japan stands out as the black sheep with public debt-to-GDP reaching 218% this year. Japan has tried many things to drag itself out of the quicksand but to no avail.

Chart 3:  Total Tax Revenues as % of GDP (2006)

Source: OECD

Its stimulus programme has been very Keynesian with a multiple of public spending projects over the past couple of decades, most of which have been a terrible waste. Now, 20 years later, Japan is falling into the precise trap our economic adviser Woody Brock is warning so vehemently about. GDP growth is slow or non-existent. Debt continues to grow rapidly and sticky deflation makes an already difficult situation almost impossible to deal with.

So far, Japan has just about gotten away with it because they have had easy and cheap access to credit. But what will happen if (when) that changes? It is no longer inconceivable that Japan will default on its sovereign debt at some point over the next decade. Ambrose Evans-Pritchard has written an excellent piece in the Daily Telegraph recently about Japan’s predicament, which you can read here.

Woody Brock did a study earlier this year where he pointed out the danger of allowing public debt to grow much faster than GDP for an extended period of time. As is evident from chart 4, should the United States (or any other nation for that matter) fall into that trap, the implications could be very dire indeed. Think Zimbabwe. Therefore, given the large escalation of public debt, policy makers should aggressively pursue a pro-growth policy. Anything else could have fatal consequences.

Chart 4:  US Federal Debt Outlook

Source: www.sedinc.com

Cut income taxes! 

Empirical evidence suggests that recessions destroy tax revenues; tax cuts don’t. And increased tax revenues are precisely what we need to solve our fiscal crisis. It is therefore tempting to argue that now is the time for a reduction in income tax rates. Unfortunately, and true to form, our politicians will most likely do exactly the opposite. And the Swiss will be laughing all the way to the bank as more and more disenchanted people in this country flee Britain and Gordon Brown’s strait jacket to start a new life in Switzerland.

Niels C. Jensen

© 2002-2009 Absolute Return Partners LLP. All rights reserved.

This material has been prepared by Absolute Return Partners LLP ("ARP"). ARP is authorised and regulated by the Financial Services Authority. It is provided for information purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. The information provided is not intended to provide a sufficient basis on which to make an investment decision. Information and opinions presented in this material have been obtained or derived from sources believed by ARP to be reliable, but ARP makes no representation as to their accuracy or completeness. ARP accepts no liability for any loss arising from the use of this material. The results referred to in this document are not a guide to the future performance of ARP. The value of investments can go down as well as up and the implementation of the approach described does not guarantee positive performance.  Any reference to potential asset allocation and potential returns do not represent and should not be interpreted as projections.

See other posts I have published referencing or presenting Niels’ analysis.

• The emerging markets crisis – Nov 2008
• Do BRICs (and Germans) Eat PIGS? – Feb 2009
• Europe on the ropes – Mar 2009
• The Fake Recovery - Apr 2009
• Green Shoots or Smoking Weed? – May 2009
• Make Sure You Get This One Right – Jul 2009
• The Hamster on the Wheel – Sep 2009
• A Country for Old Men and a Bit of Samba – Oct 2009

Related posts:

• Japan does not demonstrate the failure of stimulus
• Obama takes middle road on stimulus and taxes that leads nowhere
• Are US corporations feeding at the trough of low taxes?
• Japan: stimulus without reform leads to a policy cul de sac
• A note on Japan’s experiment with quantitative easing

Several notable economists prognosticated on what Japan should do to get out of their malaise in the 1990s but none of them understood the problem or the options available to the sovereign government. They all gave poor advice. The way Japan recovered after that decade of poor economic outcomes was through fiscal policy. Monetary policy had little to do with it, as Richard Koo has demonstrated in his recent book on the country.

Let’s eliminate a few misconceptions.  Japanese households do not fund the deficit.  A government default is not possible (unless Japan chooses to do it, which I suppose they could do as they are pretty clueless).We learned that interest rates do not sky-rocket and inflation does not accelerate when deficits and debt issuance are on-going and huge – quite the opposite. If the BOJ should want to increase the money supply, devotees of the money multiplier model (including numerous Nobel Prize winners) would have the BOJ purchase securities. When the BOJ buys securities reserves are added to the system. However, the money multiplier model fails to recognize that the added reserves in excess of required reserves drive the funds rate to zero, since reserve requirements do not change until the following accounting period. That forces the central bank to sell securities, i.e., drain the excess reserves just added, to maintain the funds rate above zero. If, on the other hand, the BOJ wants to decrease money supply, taking reserves out of the system when there are no excess reserves places some banks at risk of not meeting their reserve requirements. The BOJ has no choice but to add reserves back into the banking system, to keep the funds rate from going, theoretically, to infinity.

In either case, the money supply remains unchanged by the BOJ’s action. The multiplier is properly thought of as simply the ratio of the money supply to the monetary base (m = M/MB). Changes in the money supply cause changes in the monetary base, not vice versa. The money multiplier is more accurately thought of as a divisor (MB = M/m).

Their export model is dead, the Chinese are eating their lunch, so the Japanese have to switch to a domestic consumption based model.  How do you do that without spurring lots of unemployment in the absence of government spending?

It is clear to me that the neo-liberal period in Japan has devastated the security of the middle class which accounted for more than 80 per cent of the population. A person could rely on retaining full-time employment on good wages for life as long as they completed secondary school. The 1991 recession which followed the real estate collapse and poor investments by the financial sector led to the “lost decade”. The Japanese government under the neo-liberal helm of Prime Minister Koizumi started deregulating things that had previously been integral to providing this security, including cutting back government spending. See Koo’s book. His evidence is very compelling here.

Around 30 per cent of Japanese workers are employed in low-paid, casual jobs that offer no security. While Japan enjoyed stable growth this was not a problem. But the numbers of temporary workers has risen as the revered life-time employment system that generate prosperity in the Post-World War II period for the vast majority of workers has been steadily dismantled under neo-liberal urging.

I can do no better than to relay discussions I had on this point with Professor Bill Mitchell of the University of Newcastle in Australia.  Bill eloquently summarises the neo-liberal insanity which is destroying this country:

The neo-liberals are running rampant now and predicting a maelstrom. This dominance of neo-liberal thinking will be a major constraint on the new government and it is already showing a compliance to the views.

The family-first policy proposals are a sop to the intergenerational debate.

The decision to shift spending priority to welfare away from national infrastructure provision is an example. The new Prime Minister has already said he will raise taxes to “pay for” the new spending initiatives. He has also promised to cut spending on major infrastructure.

The private investment jackals who have been indulging in wasteful, inefficient yet highly profitable private equity projects in the West are poised to capitalise on this shift in Japanese sentiment. They see Yen-signs before their eyes and are on the move already.

One commentator in today’s Australian says Australia investors are “primed and ready, as Japan rebounds from the global downturn with more resilience and speed than expected …”

The upshot according to the Australian commentary (consistent for a News Limited journalist) is that there will be:

… a focus on public-private partnership projects – a new concept for Japan. They are now essential as government debt soars past double the country’s annual economic output, with public infrastructure spending totalling $7.5 trillion since 1991. And the latest central government stimulus package crowded out bond-raising opportunities for regional governments.

Infrastructure is emerging as a new “asset-class” in Japanese financial markets. We never learn!

If they really understood the fiat monetary system they could continue to provide public infrastructure and extend better safety net protection for the poor. The large deficits that the Japanese government runs is symptomatic of the huge saving desire of the domestic population. Not even the traditionally strong net export performance can offset the high saving ratio.

The saving ratio will also decline as more safety net provisions are extended to the population, who at present feel as though they have to provide for their own retirements. The introduction of a national superannuation scheme would also help.

In that sense, the deficit would fall anyway as consumption increased.

Related posts:

• Japan’s easy money policy was the trigger for the tech wreck
• Is Japan next on the road to quantitative easing?
• Japan does not demonstrate the failure of stimulus
• Japan: stimulus without reform leads to a policy cul de sac
• The Japanese Problem is now ours

When I read Ed’s recent piece “Japan: stimulus without reform leads to a policy cul de sac,” I couldn’t help but think he is wrong about Japan.

Supporting aggregate demand

The problem is taxes. In Japan, taxes are too high relative to the desire for spending and savings. Policy makers need to stop taking so many yen away from working people, so that they are able to buy all of the output which they can produce at full employment levels.  

The Japanese should have gone for domestic demand-led growth instead of export-led growth. When export growth reversed, the economy went into depression. Even Richard Koo, who has often spoken of a balance sheet recession and has the right approach on Japan, never imagined that such a thing would happen.  But it’s easy enough to resolve; simply support domestic incomes with the right tax cuts to sustain domestic demand at desired levels to sustain output and employment.

One can always sustain domestic demand by altering the fiscal balance.  In truth, it is as simple as debiting and crediting accounts on the Bank of Japan’s master yen account spread sheet.

Again, a fiscal adjustment can restore domestic demand immediately.

Savings in Japan

The savings rate in Japan is down as a consequence of falling net exports and what was until recently a falling budget deficit. The deficit trend is now reversing in a very ugly way- falling revenues and increased transfer payments.  True, private sector savings have fallen which means that Japanese policy makers have run out room for error.  I would contend that the vast scale of private savings allowed them to continue to screw up for so long by, for example:

• hiking the VAT in 1996
• introducing ‘fiscal consolidation’ in 2001 (and finally relenting in 2003 when the economy finally started to grow again, until this latest fiasco). 

Issuing one’s own fiat currency debt

But, the notion that the country is in a ‘debt trap dynamic’ as Ambrose Evans-Pritchard suggests is ludicrous.  Debt is serviced by data entries by the BOJ- debits and credits to securities accounts and transactions accounts at the BOJ. The BOJ can spend/credit accounts at will.  It’s just data entry.  Spending is not constrained by revenues (this is fiat currency, not a gold standard). In a worst case, ‘over-spending’ causes inflation. But, that happens to be what they are trying to accomplish. Getting some inflation would be considered a success.  Moreover, it can easily be reversed by tightening fiscal policy if it comes to that.

It’s really that simple.

Related posts:

• Japan: stimulus without reform leads to a policy cul de sac
• Do the personal income data demonstrate unbalanced reflation?
• Unrealized gains in wealth
• South Korea going gangbusters in contrast to UK
• Depression in Japan

This article by Peter Tasker, a well-regarded financial analyst in Asia, comes via the Financial Times (hat tip Marshall). He sees an enormous bubble forming in China – and parallels to Japan circa 1987:

Emerging markets, it seems, have had a good crisis. In contrast to the debt-ridden G7 economies, they have quickly resumed their growth trajectory. No surprise, then, that US emerging market mutual funds are experiencing record inflows. The stellar performance of the Brics markets – Brazil, Russia, Indian and China – is due to continue into the distant future.

Such is the narrative now forming among investors. To anyone who has lived through the rise and fall of the Japanese bubble economy, it should set off alarm bells.

Remember that it was in the years following the 1987 "Black Monday" crash that Japanese assets went from being expensive to absurdly overvalued and the Nikkei’s dizzy rise to 39,000 forced the bears to throw in the towel…

But what you saw was decidedly not what you got. The crisis, far from leaving Japan unscathed, exacerbated its structural problems and laid the groundwork for a far greater disaster…

Interest rates have been far too low for far too long. If the natural interest rate is, as the Swedish economist Knut Wicksell posited, around the level of nominal GDP growth, then China’s interest rates should have been close to 10 per cent for most of this decade. Alan Greenspan, former chief of the US Federal Reserve, has been criticised for holding interest rates too low and setting off a housing and credit bubble in the US. But if US monetary policy was wrong for the US, it was even more wrong for the high-growth countries that "imported" it. The result could only be a massive misallocation of capital…

At the 2008 peak, the price-to-book ratio of the Shanghai stock exchange was over seven times, well above the five times achieved by Japanese stocks in 1989. After the turbulence of the past 18 months, the ratio has fallen to 3.3 times, still the world’s second highest after India, and residential real estate trades at multiples of income that make the US housing boom look tame…

What is scary is that the current frothiness of emerging markets, centred on China, may be only a taste of what is to come.

There is a lot more in the original article. Link below.

Source

China rushes towards a Japan-style bubble – Financial Times

Related posts:

• China: reflation play spells trouble for rest of the world
• Subprime housing bubble timeline
• Marc Faber: China’s numbers are fake
• Hong Kong: “America is doing exactly what Japan did last time”
• Huge property bubble in China

If one wants to see what happens when you use stimulus to help keep zombie companies alive and to resist reform efforts, look no further than Japan. 

For twenty years now, Japan has been dealing with the consequences of a burst asset bubble in shares and property. And for twenty years, the body politic has been unwilling to make the necessary reforms which would eliminate zombie companies while still helping to repair balance sheets in the private sector. Instead, the Japanese have piled government deficit upon deficit like Sisyphus trying to get consumers to reflate the economy. It has not worked.

Simon Johnson, former chief economist of the International Monetary Fund (IMF), told the US Congress last week that the debt path was out of control and raised "a real risk that Japan could end up in a major default".

The IMF expects Japan’s gross public debt to reach 218pc of gross domestic product (GDP) this year, 227pc next year, and 246pc by 2014. This has been manageable so far only because Japanese savers have been willing – or coerced – into lending for almost nothing. The yield on 10-year government bonds has been around 1.30pc this year, though they jumped to 1.42pc last week.

"Can these benign conditions be expected to continue in the face of even-larger increases in public debt? Going forward, the markets capacity to absorb debt is likely to diminish as population ageing reduces saving," said the IMF.

The savings rate has crashed from 15pc in 1990 to near 2pc today, half America’s rate. Japan’s $1.5 trillion state pension fund (the world’s biggest) has become a net seller of government bonds this year, as it must to meet pay-out obligations. The demographic crunch has hit. The workforce been contracting since 2005.

Japan Post Bank is balking at further additions to its $1.7 trillion holdings of state debt. The pillars of the government debt market are crumbling. Little wonder that the Ministry of Finance has begun advertising bonds in Tokyo taxis, featuring Koyuki from The Last Samurai. If Japan’s bond rates rise to global levels of 3pc to 4pc, interest costs will shatter state finances.

What this illustrates is that stimulus cannot be seen as a cure-all in an economy which lacks in domestic demand or in which debt burdens are high. I see this as a cautionary tale for The Europeans and Americans looking at stimulus as some magic bullet which will make structural problems disappear.

I increasingly ask myself whether any advanced democracy has the foresight to implement a targeted monetary stimulus campaign without knee-capping efforts to induce more private sector savings – fiscal stimulus is a whole different affair. Right now, the savings rate in Japan is even lower than in the United States, a direct result of easy money.

In my view, fiscal or monetary stimulus are bridges to a sustainable economic future built on the back of deleveraging, a purge of malinvestments and industry consolidation. Right now, the stimulus in Japan is looking more like a bridge to nowhere.

It is Japan we should be worrying about, not America – Ambrose Evans-Pritchard, Telegraph

Related posts:

• Japan does not demonstrate the failure of stimulus
• Pushing on a string and similar notions on monetary policy ineffectiveness
• The new Japan, domestic consumption, and the neo-liberal thought machine
• Don Kohn says Fed policy has kept rates down 100 basis points
• Japan’s easy money policy was the trigger for the tech wreck

Nouriel Roubini seems to think so. In remarks quoted via Bloomberg, he called the enormous increase in asset prices “the mother of all carry trades.”

Investors worldwide are borrowing dollars to buy assets including equities and commodities, fueling “huge” bubbles that may spark another financial crisis, said New York University professor Nouriel Roubini.

“We have the mother of all carry trades,” Roubini, who predicted the banking crisis that spurred more than $1.6 trillion of asset writedowns and credit losses at financial companies worldwide since 2007, said via satellite to a conference in Cape Town, South Africa. “Everybody’s playing the same game and this game is becoming dangerous.”

If you recall, this is the same trade the world’s punters were putting on via the Japanese yen when the Japanese were pumping out huge amounts of liquidity earlier in this decade.  The yen’s real effective exchange rate only hit post Plaza Accord trade-weighted lows in 2007 when the carry trade was all the rage and just when all hell was breaking loose in subprime.

Reuters said then:

The yen’s real trade-weighted value slipped in October as the Federal Reserve’s interest rate cuts gave a boost to global stock markets and prompted investors to sell the Japanese currency in carry trades.

Bank of Japan data on Friday showed its index of the yen’s real effective exchange rate fell 1.9 percent in October to 96.7 JPYEEXR=J.

The retreat in the BOJ’s REER index took it closer to a 22-year low of 92.8 hit in both June and July, when the currency was sliding as carry trades flourished.

That was the weakest since the September 1985 Plaza Accord in which the five biggest industrialised countries agreed to depreciate the dollar against the German mark and the yen via intervention, aiming to correct the giant U.S. trade deficit at the time.

For the year the yen’s real value has lost 3.6 percent despite periodic bouts of strength as the credit market crunch this year and worries about the U.S. economy prompted market players to unwind risky carry trades.

The yen has suffered in the past few years from carry trades in which investors use the low-yielding Japanese currency as a cheap source of funds to buy higher-yielding currencies or rising assets, such as stocks or commodities.

My view has been that the Japanese yen carry trade was a major contributor to asset bubbles globally as the Bank of Japan’s excess liquidity found its way to other asset markets via the carry trade.  Last August, in my post “Japan’s easy money policy was the trigger for the tech wreck” I also pointed to the yen carry trade as a major factor in the Internet bubble. And I certainly see it as a major factor in this decade’s housing bubbles.

Now the U.S. dollar is the carry trade currency of choice, with zero percent interest rates funding asset purchases globally. This play is certainly pumping up all manner of asset prices. But as with the yen carry trade before it, I do not see this ending well.

Roubini takes a similar tack:

The risk is that we are planting the seeds of the next financial crisis,” said Roubini, chairman of New York-based research and advisory service Roubini Global Economics. “This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals.

Source

Roubini Says Carry Trades Fueling ‘Huge’ Asset Bubble – Bloomberg

Related posts:

• China slams U.S. for inflating global asset prices via carry trade
• U.S. Bailout: the mother of all carry trades?
• Hong Kong: “America is doing exactly what Japan did last time”
• Japan’s easy money policy was the trigger for the tech wreck
• Chart of the day: Aussie – Yen cross

Nouriel Roubini is the most prominent economist to warn that a double-dip recession would be a distinct possibility if economic policy-makers return to policy normalization too quickly.  Now, Stephen Roach, head of Morgan Stanley Asia, is making similar arguments. 

Roach was on Bloomberg Radio’s show Bloomberg Surveillance with Tom Keene and Ken Pruitt yesterday, where he had a wide-ranging discussion about the global economy, China, Japan, government stimulus, and a host of other issues.

Some memorable quotes:

• China: “Late last year the Chinese economy came to a full stop and the government embarked on a massive investment and bank lending stimulus that I think is worrisome and not sustainable.”
• Japan: “The key premise I think that needs to occur in Japan as well as the rest of Asia is the need to really put a lot of emphasis on internal private consumption.”
• The Fed: “I am really critical of the idea that we can blame America’s problems on the so-called surplus savings glut primarily from China.”
• The U.S.: It looks like the worst of the downturn is behind us.”
• Banks: “The financial crisis itself is far from over. A lot of financial institutions will continue to find their earnings and their lending capacity impaired.”

The downside risks and double-dip that Roach points to for the U.S. and global economy should not be taken as a ‘base-case’ scenario but rather a possible outcome to avoid through the appropriate economic policy response.  I should note that the same risks were present on a lesser scale after the Technology & Telecom bubble-induced recession in 2001, and Roach warned of these risks at the time. We avoided a double dip in part because of loose monetary policy, which created the housing bubble.

He has a lot more to say. The audio is below and runs about 12 and 1/2 minutes. Enjoy.

Related posts:

• Stephen Roach sees a W-shaped recovery for China
• Stephen Roach: Downturn in Asia less severe, but recovery later
• Stephen Roach is still bearish, no recovery until 2010
• Quote of the day: Stephen Roach
• A conversation with Stephen Roach on Charlie Rose

Toyota, now the world’s largest automaker, has said it would halt production at a plant in Aichi prefecture in Japan, reducing total output by a massive 220,000 cars.  This should be seen as a recognition of the over-capacity tat exists in the auto sector despite other recent upbeat news.

Toyota raised its parent-only production target for 2009 by 150,000 units to 5.95 million on Aug. 20 in response to various government stimulus programs and a reduction in inventory. The last press release from Aug. 21 on Toyota’s US website touts Toyota’s addition of capacity at its site in Huntsville to produce an additional 216,000 vehicles, with production scheduled for 2011.  From these two announcements, one would assume that production is slated to ramp up.

Yet, we now understand that the company is looking to actually reduce overall capacity in order to return to profitability.  In fact, some experts believe Toyota’s capacity cuts could eventually reduce capacity by 700,000 cars or 7% of annual production.  Reuters is talking about a cut of 1 million units of capacity or 10% of annual production.

The problem is that Toyota, which produced 8.2 million vehicles in 2008, has a capacity of about 10 million units worldwide.  And when your 2009 target is for 5.95 million vehicles that necessarily means you have a huge amount of excess capacity.

To my mind, these announcements speak to the vast difference between the meaningful uptick in demand today, the much larger demand of just a few years ago, and the capacity built for even more demand that was expected. 

Yes, the economy is picking up globally, but while 5.95 million units is more than 5.8 million, it is nowhere close to 10 million.

Related posts:

• Third quarter auto production to be significant boost to U.S. GDP
• Industrial production implodes
• Auto sales plunge in September
• Sweden: competitive auto bailouts begin with Saab and Volvo
• Chart of the day: Industrial Production

This post is from Niels Jensen of Absolute Return Partners.  I have featured his monthly newsletter a number of times on Credit Writedowns (here’s the link to the last one, hilarious title).  Jensen is very good.

Visit www.arpllp.com to learn more about Absolute Return Partners and to sign up to receive their free monthly newsletter by e-mail.  You can reach them by email at info@arpllp.com.

In this particular article, he makes a well-argued case for deflation over inflation as the likely long-term outcome.  I express some of the finer points differently, but come to similar conclusions. The scenario I see is a low-growth muddle through (see the section labelled “Scylla and Charybdis” in my post, “Central banks will face a Scylla and Charybdis flation challenge for years”).  Also, note that he is not talking about a sustained recovery at all, while I expect a fake recovery in 3-9 months.

The central question here is: “But what actually happens when credit is destroyed at a faster rate than our central banks can print money?”

Here is the post.  Enjoy.

The Absolute Return Letter, July 2009

“You can’t beat deflation in a credit-based system.”-Robert Prechter

The great debate

As investors we are faced with the consequences of our decisions every single day; however, as my old mentor at Goldman Sachs frequently reminded me, in your life time, you won’t have to get more than a handful of key decisions correct – everything else is just noise. One of those defining moments came about in August 1979 when inflation was out of control and global stock markets were being punished. Paul Volcker was handed the keys to the executive office at the Fed. The rest is history.

Now, fast forward to July 2009 and we (and that includes you, dear reader!) are faced with another one of those ‘make or break’ decisions which will effectively determine returns over the next many years. The question is a very simple one:

Are we facing a deflationary spiral[1] or will the monetary and fiscal stimulus ultimately create (hyper) inflation?

Unfortunately, the answer is less straightforward. There is no question that, in a cash based economy, printing money (or ‘quantitative easing’ as it is named these days) is inflationary. But what actually happens when credit is destroyed at a faster rate than our central banks can print money?

A Story within the Story

Following the collapse of the biggest credit bubble in history, there has been no shortage of finger pointing and the hedge fund industry, which has always had an uncanny ability to be at the wrong place at the wrong time, has yet again been at the centre of attention. And politicians, keen to divert attention away from themselves as the true culprits of the crisis through years of regulatory neglect, have been quick at picking up the baton. Admittedly, the hedge fund industry is guilty of many stupid things over the years, but blaming it for the credit crisis is beyond pathetic and the suggestion that increased regulation of the hedge fund industry is going to prevent future crises is outrageously naïve.

If you prohibit private investors from investing in hedge funds which on average use 1.5-2 times leverage but permit the same investors to invest in banks which use 25 times leverage and which are for all intents and purposes bankrupt, then you either don’t understand the world of finance or you don’t want to understand. Shame on those who fall for cheap tactics.

Let’s begin by setting the macro-economic frame for the discussion. I have been quite bearish for a while, suspecting that the growing optimism which has characterised the last few months would eventually fade again as reality began to sink in that this is no ordinary recession and that ‘less bad’ doesn’t necessarily translate into a quick recovery. I still believe there is a good chance of enjoying one, maybe two, positive quarters later this year or early next; however, a crisis of this magnitude doesn’t suddenly fade into obscurity, just because the economy no longer shrinks at an annual rate of 6-8%.

The return of the boom & bust

Going forward, not only will economic growth disappoint, but the economic cycles will become more volatile again (see chart 1) with several boom/bust cycles packed into the next couple of decades. This is a natural consequence of the Anglo-Saxon consumer-driven growth model having been bankrupted. Growing consumer spending over the past 30 years led to rapidly expanding service and financial sectors both of which will now contract for years to come as overcapacity forces players to downsize.

Chart 1: US GDP Growth Volatility

Source: Reserve Bank of Dallas

This will again lead to higher corporate earnings volatility which will almost certainly drive P/E ratios lower, making conditions even trickier for equity investors. At the bottom of every major bear market in the last 200 years, P/E ratios have been below 10. As you can see from chart 2 overleaf, few countries are there yet. The next decade is therefore not likely to be a ‘buy and hold’ market for equity investors. The combination of low economic growth and pressure on valuations will create severe headwinds. The most likely way to make money in equities will be through more active trading.

Japan all over again?

So now, two years into this crisis, where do we stand and where do we go from here? History offers limited guidance, as we have never experienced the bursting of a bubble of this magnitude before. The closest thing is the collapse of the Japanese credit bubble around 1990. As the Japanese have since learned, recovering from a deflated credit bubble is a long and very painful affair.

Governments and central banks on both sides of the Atlantic are pursuing a strategy of buying time, hoping that a recovery in economic conditions will allow our banking industry to re-build its capital base. The Japanese pursued a similar strategy back in the early 1990s. It failed miserably and set the country back many years in its recovery effort. Ironically, the Japanese approach was almost universally condemned as hopelessly inadequate. It is funny how you always know better how to fix other people’s problems than your own. A little bit like raising children, I suppose.

Chart 2: P/E Ratios in Various Countries

Another lesson learned from Japan is that once you get caught up in a deflationary spiral, it is exceedingly hard to escape from its grip. The Japanese authorities have used every trick in the book to reflate the economy over the past two decades. The results have been poor to say the least: Interest rates near zero (failed), quantitative easing (failed), public spending (failed), numerous attempts to drive down the value of the yen (failed); the list is long and makes for painful reading.

The liquidity trap

We are effectively caught in a liquidity trap. The Bank of England, the European Central Bank and the Federal Reserve have all flooded their banking system with enormous amounts of liquidity in recent months but what has happened? Instead of providing liquidity to private and corporate borrowers as the central banks would like to see, banks have taken the opportunity to repair their balance sheets. For quantitative easing to be inflationary it requires that the liquidity provided to the market by the central bank is put to work, i.e. lenders must lend and borrowers must borrow. If one or the other is not playing along, then inflation will not happen.

This is illustrated in chart 3 which measures the growth in the US monetary base less the growth in M2. As you can see, the broader measure of money supply (M2) cannot keep up with the growth in the liquidity provided by the Fed. In Europe the situation is broadly similar.

There is another way of assessing the inflationary risk. If one compares the total amount of credit destruction so far (about $14 trillion in the US alone) to the amount spent by the Treasury and the Fed on monetization and fiscal stimulus ($2 trillion), it is obvious that there is still a sizeable gap between the capital lost and the new capital provided[2].

The output gap

If we instead move our attention to the real economy, a similar picture emerges. One of the best leading indicators of inflation is the so-called output gap, which measures how much actual GDP is running below potential GDP (assuming full capacity utilisation). It is highly unlikely for inflation to accelerate during a period where the output gap is as high as it currently is (see chart 4). Theoretically, if you believe in a V-shaped recession, the output gap can be reduced significantly over a relatively short period of time, but that is not our central forecast for the next few years.

Chart 4: Output Gap & Capacity Utilization

The deflationary spiral

I can already hear some of you asking the perfectly valid question: How can you possibly suggest that deflation will prevail when commodity prices are likely to rise further as a result of seemingly endless demand from emerging economies? Won’t rising energy prices ensure a healthy dose of inflation, effectively protecting us from the evils of the deflationary spiral (see chart 6)?

Good question – counterintuitive answer:

Contrary to common belief, rising commodity prices can in fact be deflationary so long as demand for such commodities is relatively inelastic, which is usually the case for basic necessities such as heating oil, petrol, food, etc. The logic is the following: As commodity prices rise, money earmarked for other items goes towards meeting the higher commodity price and consumers are essentially forced to re-allocate their spending budget. This causes falling demand for discretionary items and can in extreme cases lead to deflation. We only have to go back to 2008 for the latest example of a commodity price induced deflationary cycle.

A price increase on a price inelastic commodity is effectively a tax hike. The only difference is that, in the case of the 2008 spike in energy prices, the money didn’t go towards plugging holes in the public finances but was instead spent on English football clubs (well, not all of it, but I am sure you get the point) which have become the latest ‘must have’ amongst the super-rich in the Middle East.

For all those reasons, I am becoming increasingly convinced that the ultimate outcome of this crisis will turn out to be deflation – not inflation. Inflation may eventually become a problem, but that is something to worry about several years from now. The Japanese have pursued an aggressive monetary and fiscal policy for almost 20 years now, and they are still nowhere.

Interest rates on the rise

So why are interest rates creeping up at the long end? Part of it is due to the sheer supply of government debt scheduled for the next few years which spooks many investors (including us). And the fact that the rising supply is accompanied by deteriorating credit quality is a factor as well. But countries such as Australia and Canada, which only suffer modest fiscal deficits, have experienced rising rates as well, so it cannot be the only explanation.

Maybe the answer is to be found in the safe haven argument. When much of the world was staring into the abyss back in Q4 last year, government bonds were considered one of the few safe assets around and that drove down yields. Now, with the appetite for risk on the increase again, money is flowing out of government bonds and into riskier assets.

Perhaps there are more inflationists out there than I thought. Several high profile investors have been quite vocal recently about the inevitability of inflation. Such statements made in public by some of the industry’s leading lights remind me of one of the oldest tricks in the book which I was introduced to many moons ago when I was still young and wet behind the ears. ‘Get long and get loud’ it is called; it is widely practised and only marginally immoral. Nevertheless, when famous investors make such statements, it affects markets.

Make sure you get it right

The point I really want to make is that the inflation v. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come. If I am wrong and inflation spikes, you want to load your portfolio with index linked government bonds (also known as TIPS for our American readers), gold and other commodities, commodity related stocks as well as property.

If deflation prevails, all you have to do is to look towards Japan and see what has done well over the past 20 years. Not much! You cannot even assume that bonds will do well. Recessions are bullish for long dated government bonds but a collapse of the entire credit system is not. The reason is simple – with the bursting of the credit bubble comes drastic monetary and fiscal action. Central banks print money and governments spend money as if there is no tomorrow, and all bets are off. Equities will do relatively poorly as will property prices. But equities will not go down in a straight line. The market will offer plenty of trading opportunities which must be taken advantage of, if you want to secure a decent return.

All in all, deflation is ugly and not conducive to attractive investment returns. It is also not what governments want and need right now. With a mountain of debt hitting the streets of Europe and America over the next few years, as the cost of fixing the credit and banking crisis is financed, one can make a strong case for rising inflation actually being the favoured outcome if you look at it from the government’s point of view. The problem, as the Japanese can attest to, is that deflation is excruciatingly difficult to get rid of, once it has become entrenched. I am in no doubt which of the two evils I would prefer, but we may not have the luxury of choosing our own destiny.

Focus on volatility trades

So where does all that leave us? Our good friend and business partner, John Mauldin, has just put the finishing touches to a new accredited letter which will be published in the next day or two. In his letter, John makes the point that markets are likely to remain volatile for quite a while yet. On a personal note I will add that if my worst fears are proven correct and we have to fight a bout of deflation, the authorities will have no choice but to try and provoke price increases through aggressive policy measures. Otherwise entire countries could be bankrupted as they suffocate in their own debt. Whether it will work is a different story.

Such a struggle for supremacy between deflationary and inflationary forces will only add to the volatility predicted by John and give rise to an investment environment which is very unlike the one we have seen during the past 20-30 years. You need strategies in your portfolio which thrive on volatility, and they are certainly not the same strategies as those held by most investors today.

We are currently preparing the launch of a new single manager fund which is designed to thrive on volatility. It is also operating in markets as far detached from the world of equities as you can imagine, so the correlation to equities will almost certainly be low. If you are based in Europe, Africa or Asia and want to learn more about this new product or if you wish to receive John’s letter[3] when it is published, just drop us a note and you will hear from us. In the meantime, join me and wish for a bit if inflation. It is clearly the lesser of two evils.

Niels C. Jensen

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[1] See chart 5 for a definition.

[2] http://seekingalpha.com/article/145904-hyperinflation-trade-looking-crowded

[3] If you have already signed up as an Accredited Investor on John Mauldin’s website, you will receive his new letter automatically.

Related posts:

• Roubini: How to avoid the horrors of ‘stag-deflation’
• Inflation or deflation?
• Liquidity trap of a different sort
• Germany gets deflation
• Kasriel: ‘greater risk for the global economy…is inflation’

In the lead-up to next week’s G8 summit, the Chinese have been making yet more noises about setting up a new monetary system without the dollar as its anchor and leading reserve currency.  The Chinese, who have maintained a export orientation which has made them the largest holder of U.S. government bonds, are concerned that they are holding depreciating assets. As the U.S. economic and fiscal position deteriorates, the likelihood for a disorderly decline in the U.S. dollar increases.  So, China wants a change.

The Japanese, who also have the same export orientation, making them the second largest holder of U.S. treasury assets, have come America’s defense.

Major countries should support the dollar as the key international currency, although emerging nations may discuss a new global reserve currency on the sidelines of the G8 summit next week, a Japanese official said on Friday.

China has asked for debate on a new global reserve currency when leaders from the Group of Eight (G8) meet with the G5 emerging economies next week in Italy, G8 sources told Reuters. News of the Chinese request pushed the dollar down to a three-week low on Wednesday.

But Japan thinks it would be difficult for another currency to replace the dollar as the world’s global reserve currency and it is against any move that would unnecessarily weaken the status of the dollar, said Yoichi Suzuki, director-general of it is against any move that would unnecessarily weaken the status of the dollar, said Yoichi Suzuki, director-general of the Japanese foreign ministry’s economic affairs bureau and one of the country’s main coordinators for the G8 summit.

"Japan’s stance is that major countries should support the dollar," Suzuki told Reuters in an interview.

"It won’t benefit any country to talk about ideas of a new global key currency, which would weaken the dollar," he added.

And Suzuki is right.  Yes, I believe the dollar is a weak currency over the long-term due to structural imbalances.  But, there is no currency to replace it as a reserve currency right now.  The Euro is a new and artificial construct. It is facing its first real test as signs of tension are rising in the Eurozone due to the global downturn.  The economies supporting the Yen, the Pound Sterling, and the Swiss Franc are all too small. And the Renminbi is not fully convertible.  George Soros has said “the dollar is a very weak currency except all the others.”

So, it makes no sense to talk the dollar down here and now and risk a disorderly fall.  It certainly is not in China’s best interest as all their U.S. dollar assets will lose value.  But, the Chinese have been talking down the dollar as a reserve currency for months now – and their tone seems ever more shrill on this topic.  Perhaps the Chinese see their dollar holdings as a sunk cost.  Perhaps the Chinese have moved on and are ready to decouple from an over-indebted America, which cannot continue to run massive deficits now that crisis has hit.

Next week, we will get hints because G-8 members will have every opportunity to make this an issue at the upcoming summit.

Source

Major nations should back dollar as key currency: Japan – Reuters

Related posts:

• Is China avoiding using US dollars?
• Mea culpa on the need for a new currency
• China slams U.S. for inflating global asset prices via carry trade
• More thoughts on the switch from dollars as reserve currency
• China to diversify out of U.S. dollars

Will Hutton has a pretty good interview with Paul Krugman in the Guardian newspaper.  The exchange is quite long, so it gives you a fairly broad understanding of Krugman’s view on the global economy and specific country economies.  What I found especially interesting was Krugman’s admission that we are essentially flying blind.

The Federal Reserve has hit the zero bound just as Japan had done nearly a decade earlier.  At this point, traditional monetary policy has no effect – we are pushing on a string.  What comes next, nobody knows and Krugman has said as much.

The thing about Japan, as with all of these cases, is how much people claim to know what happened, without having any evidence. What we do know is that recessions normally end everywhere because the monetary authority cuts interest rates a lot, and that gets things moving. And what we know in Japan was that eventually they cut their interest rates to zero and that wasn’t enough. And, so far, although we made the cuts faster than they did and cut them all the way to zero, it isn’t enough. We’ve hit that lower bound the same as they did. Now, everything after that is more or less speculation.

Read the rest here.

Related posts:

• Liquidity trap of a different sort
• BoE makes a dramatic 1 1/2 point cut
• Norway makes three
• Paul Krugman on the global economy
• Japan’s easy money policy was the trigger for the tech wreck

It is not just the Chinese making noises about the reliability of the United States as a debtor.  Now, Japanese politicians are doing it too.  In fact, the Democratic Party of Japan (which is not in power) have said they would not buy U.S. bonds if elected.  An excerpt from a BBC story covering these comments reads as follows:

Japan’s opposition party says it would refuse to buy American government bonds denominated in US dollars, if elected.

The chief finance spokesman of the Democratic Party of Japan, Masaharu Nakagawa, told the BBC he was worried about the future value of the dollar.

Japan has been a major buyer of US government bonds, helping the US finance its Federal budget deficits.

But, he added, it would continue to buy bonds only if they were denominated in yen – the so-called samurai bonds.

“If it’s [in] yen, it’s going to be all right,” Mr Nakagawa said in an interview with the BBC World Service.

“We propose that we would buy [the US bonds], but it’s yen, not dollar.”

However observers say that, while the move would be a remarkable policy shift, it was unlikely that Mr Nakagawa’s party will win the forthcoming election, due before mid-September, despite the unpopularity of the ruling Liberal party.

While the Democratic Party is unlikely to gain sway over the electorate in Japan, their comments do reflect a growing unease with the United States’ deficit spending.  With dissatisfied noises coming from America’s two largest creditors, the Obama Administration’s policy options for continued reflation appear more limited.  In essence, America can inflate and deficit spend at its own risk.  Unfortunately, there are not very many other policy options available.

Related posts:

• China issues bonds to “promote the RMB in neighbouring countries”
• Rosenberg: The U.S. dollar could be next
• Japanese defend dollar’s status while China tears it down
• Parallels between US and Japanese economies
• Massive debt issuance in the U.S. and elsewhere

The following is the currency outlook released today by the Brown Brothers Harriman Currency Strategy team:

Swine flu and concerns about US banks may be hitting the headlines but, the European banking sector remains a threat for the euro zone. Indeed, ECB President Trichet, speaking in NY yesterday, highlighted the fact that the European banking sector is significantly important in the euro area compared to the US although Trichet noted signs that liquidity was moving away from the ECB balance sheet to the money markets was an indication of improving confidence. The President held back from making any strong hints about policy, merely stating that any non-standard measures would be announced at the next meeting May 7. He attempted to address the criticism that the ECB’s refi rate is higher than the Fed rate by pointing out the importance of the 0.25% deposit rate in Europe, and the rough parity of euro and dollar money market rates. The President also defended the ECB’s stance on policy indicating the ECB had been the first to introduce non-traditional policy measures. The ECB’s balance sheet did expand in late 2008 although overall assets have slipped by more than 10% since their January highs. While the Fed’s balance sheet also slipped as some programs such as the commercial paper program began to take affect, the Federal Reserve have continued to adopt additional policy measures including the purchase of US Treasuries and expanded its MBS program to address other financial concerns. The ECB President and some ECB members including Weber and Hurley appear to be continuing with a cautious approach to policy. That’s in contrast to other ECB members such as Austrian Council member Ewald Nowotny whose dovish comments yesterday coincided with the euro’s tumble by over a big figure to around $1.30 yesterday. Nowotny said the central bank ‘stands ready to use unconventional measures of quantitative easing to assure European firms and consumers access to credit at appropriate conditions.’

The Japanese yen is the top performer against the major currencies today; the US dollar has now given up 38.2% of this year’s gains against the yen (JPY95.98) while the euro cross has now lost half its gains (124.76). That isn’t a reflection of the Japanese economy. While there have been some signs that the decline in exports may be easing, today’s retail sales point to ongoing weakness in the consumer sector. Retail sales fell for a seventh month in March. Sales were down 3.9% from a year ago compared with February’s 5.7% slump. Though better than the 4.7% drop expected, this is still a sharp decline, and just one month’s data. Meanwhile, the April business confidence index showed a slightly better monthly outcome, up to 30.8 from 30.4, though not as much as expected. Note that the BoJ is holding its regular meeting on Thursday: rates will most likely stay on hold (at 0.1%) and the central bank already on a program of quantitative easing.

The Mexican peso has lost further ground overnight amidst concern about the escalation of the swine flu scare. The World Health Organization said the flu outbreak is no longer containable, upgrading its global pandemic alert level to four from three. The current outbreak of flu in Mexico is a cause for concern for both the people of Mexico and the economy, but is also raising concerns about the possible effects on economies worldwide. Level five signals a pandemic is imminent while level six signals it is under way. However, it remains too early to make any material changes to our Mexico forecasts just yet, but the situation bears close watching. There was further news that could increase risk concerns for investors with the Wall Street Journal reporting that US regulators have told Bank of America and Citigroup that they need to raise more capital based on the stress tests. The two banks are expected to respond, denying the assessment, according to the report.

Related posts:

• U.S. Dollar: Cliff Diving Again
• The dollar is rising against floating currencies
• U.S. Dollar: Cliff Diving
• Japanese defend dollar’s status while China tears it down
• Chart of the day: Japanese Yen

This is another post I originally ran on Naked Capitalism last month. As you know, I have turned more positive about the potential for a cyclical economic recovery. However, I am unchanged regarding much of the sentiment expressed in this post – that any upturn must be considered with suspicion because the underlying fundamentals of the U.S. and global economies remain poor (See my post on macro disequilibria to see why).

My personal view at this time is that we will get a rebound of uneven quality, the prospect of which will be supportive of financial markets. However, it is far from clear how robust this upturn could be or how long it could last. I see an L- or W-shaped outcome as likely (i.e. prolonged weakness or a double dip recession).

I am not convinced we are in a new bull market either. More likely, we have seen a strong bear market rally (but, like the ones experienced in Japan and the U.S. post-2002, it can go on for much longer than anyone could predict). Remeber, bull markets arise from a confluence of P/E ratios going from low to high, high secular earmings growth potential, and high seclar GDP growth potential. We have not reached a low that is comparable to previous lowsin 1942 or 1982 in this regard.

Now, here is the original post with some edits.

As I see it, the Geithner Plan is inadequate because it assumes illiquidity where insolvency is the problem. The long and short of it, from my perspective, is that this plan will not get at the heart of the issue, leverage, debt and unsustainable levels of credit growth. (Dan Roberts of the Guardian has an interesting take on this, suggesting the US is following the UK lead here).

Nevertheless, I want to suggest that the liquidity thrown at the U.S. economy by this and other stimulus plans is so great that it may induce a cyclical upturn. Heresy? Hardly, as I mentioned in my previous post, this is what essentially transpired in Japan in the 1990s. So, let’s look at Japan for a second.

Last July, I wrote a post, “Japan circa 1996 – forgotten already?” to remind readers of what took place in Japan in the 1990s. The Yamaichi Securities episode of 1996, as told by the International Herald Tribune, was the event I highlighted:

In a reminder of the scale of the bad debts still weighing on Japan’s financial system, Yamaichi Securities Co. on Wednesday became the second of the “Big Four” Japanese brokerage houses this week to unveil a billion-dollar bailout for a subsidiary struggling with irrecoverable real-estate loans.

Ryuji Shirai, vice president of Yamaichi, said the brokerage would spend 150 billion yen ($1.31 billion) to help its nonbank subsidiary, Yamaichi Finance. The bailout forced Yamaichi to revise its earnings forecast for the year to March 1997 to a consolidated net loss of 108 billion yen from a previously predicted net profit of 18 billion yen.

Yamaichi’s move followed an announcement by rival Nikko Securities Co. on Tuesday that it would spend 147.5 billion yen to help three affiliated units write off their bad debts. Nikko also cut its earnings forecast for the year, from a net profit of 24 billion yen to a net loss of 95 billion yen.

Yamaichi and Nikko’s bailouts and forecasts for big losses followed similar moves earlier this year by Japan’s two other major brokerages and came as little surprise.

But they again illustrated the difficulties that even Japan’s biggest financial institutions are having dealing with an estimated $400 billion in mainly unrecoverable real estate loans and underlined that it would take years for Japan’s financial system to recover from its real-estate lending binge in the late 1980s.

Over the past couple of months, Nomura Securities Co. has announced a 371 billion-yen bailout for a troubled financial unit while Daiwa Securities Co. has spent 120 billion yen. Nomura now expects to post an annual loss of 332 billion yen, while Daiwa said its loss would depend on the sale of securities.

The bailout of Yamaichi Finance was designed to maintain Yamaichi’s reputation and to “reinforce its competitiveness through early write-offs of the affiliate’s bad property-related loans,” the company said.

The daily Nihon Keizai Shimbun said Yamaichi Finance, which mainly lends to real estate firms, plans to write off all its bad loans in three years. Yamaichi Finance, which has 140 billion yen of bad loans and assets of 360 billion yen, will receive 100 billion yen from Yamaichi Securities and borrow 50 billion yen at low interest rates, the newspaper said.

Following Yamaichi’s announcement, the ratings agency Moody’s Investors Service Inc. said it was upholding its Baa-3 rating on Yamaichi’s senior debt and its Prime-3 rating on short-term debt, affecting $2.2 billion in debt securities.

“Although the full amount of the cash support will be recognized as an extraordinary loss, the actual impact on Yamaichi Securities will be reduced by the anticipated gain on the sale of securities and other assets and by profits arising from normal operations throughout the year,” Moody’s said.

Moody’s said its ratings had already “incorporated the expectations of substantial losses related to its affiliate” and noted that the size of the bailout was “within the anticipated range.”

“The firm’s capital adequacy, though weakened by its real-estate exposures, remains adequate, given the company’s liquid balance sheet and extensive domestic franchise,” the agency said.

On Tuesday, Nikko said it would give 82.1 billion yen to its affiliate Kyodo Mortgage Acceptance, 47.7 billion yen to Nikko Credit Services and 17.7 billion yen to Nikko Real Estate. Although Nikko plans to provide the money to the three nonbank affiliates during the 1997 financial year, the company said it would report a one-time loss of 147.5 billion yen for its financial year in 1996.

If you recall, Yamaichi was not the only Japanese brokerage to lose its independence. Three of the big four Japanese brokerages, Yamaichi, Nikko, and Daiwa were merged out of independence as the lost decade continued. Only Nomura remains independent from the halcyon days of the 1980s Bubble Economy. Certainly, this might be a bad omen for Morgan Stanley and Goldman Sachs, but more importantly, it should remind us of a couple of things:

1. Even if economic and monetary policy have poor longer-term consequences, it does not mean that policy won’t gain traction in the short-term. I see the potential for a cyclical upturn due to the massive stimulus campaign (See Paul Kasriel’s take at the linked pdf). Ask Alan Greenspan regarding his 2001-2003 easy money campaign. This is what happened in Japan before Yamaiichi’s demise in 1996 – and again before Daiwa and Nikko were merged out of independence.
2. Even if economic and monetary policy have stimulative short-term consequences, it does not mean that the structural problems have disappeared. They are merely lurking underneath, waiting for the next downturn to re-assert themselves. Again, the Japanese scenario is a cautionary tale on this score.
3. Asset prices will respond to an upturn, but that does not mean we are about to embark on a new bull market. Japan is the right precedent here again. After the upturn inthe mid-1990s, property prices continued to collapse in Japan, sucking many more individuals into the deflationary spiral.

I do hope we can avoid the worst-case scenario here. However, I am concerned that the Obama Administraton and the Federal Reserve are literally papering over the problem with half-measures. America is turning Japanese.

Whether they recognize this fact or understand the consequences their actions is unknown.

Brief Footnotes
Daiwa never did go bust and Nikko actually was merged into Salomon Smith Barney to prevent its demise. Parts of it are now on the auction block again. Therefore, Yamaichi was really the only one of Japan’s Big 4 to die. Cassandra of “Cassandra Does Tokyo” informed me as follows:

“Neither Daiwa, or Nikko went bankrupt to the best of my recollection – and I traded continuously large diversified books of stocks from 1991 to 2008, and was deeply anal about data integrity, survivorship bias and the likes, and deeply concerned with tail risk so I reckon I would have known had one of these listings drilled a hole in a long portfolio or scored-me a ten-bagger on a short torpedo. I certainly remember Yamaichi’s flame-out since specs (and Tiger Mgmt) started massively shorting each and every Yamaichi security holding on the suspicion and the news – both real and imagined, and this DID hurt and was VERY painful (at least until the end of the fiscal year.

Yamaichi was Fuji’s big-4 brokerage affiliate – both members of the Fuyo keiretsu, (including Fuji Bank, Yasuda Trust, Yasuda F&M, Taisei, Sapporo Brew, Canon, Nissan, Tokyo Tatemono, Marubeni amongst others too numerous to mention). Fuyo was closest to Sumitomo of the competitive keiretsus, and these groups had overlap. Fuji was the JP MOrgan of Japan, but was weakened the most of the major banks thanks to real estate.

Daiwa was the Sumitomo-group big-4 broker, so it was natural that Sumitomo would agglomerate it’s second-tier affiliated brokers and then affix them to its own securities sub and JV with Daiwa in a resignation that they just couldn’t compete. Nikko, as well, didn’t go bankrupt, eventually choosing a foreign partner in 1999 or so that merged Salomon/Citi ops giving the Americans a large stake, and an exit from marginal business, and giving the Japanese access (so they thought) to US distrbution clients and expertise to compete with Nomura. Of course it never happened, but that is just culture plain and simple. Americans took advantage of market punishment to acquire all of it (I think in 2007), though they are probably regretting it.

Even Daiwa Bank (now Resona) was never bankrupt. Rising like a Phoenix from many recaps.”

Nikko was essentially ‘rescued’ by Citi and merged into Salomon Smith Barney. As I recall, everyone outside of Japan (in New York and London) was fired on the deal as several friends lost their jobs. The news story is below:

Salomon Smith Barney, the securities arm of Citigroup Inc., and Japan’s No. 3 brokerage firm, Nikko Securities, said yesterday that their investment banking venture would open on Monday after a month’s delay because of procedural problems. The venture, Nikko Salomon Smith Barney Ltd., will be capitalized at 106 billion yen, or $883 million, and will have a staff of about 1,100. Separately, Standard & Poor’s lowered Nikko Securities’ counterparty rating yesterday to ”BBB-,” one notch above ”junk” status. A counterparty rating reflects a company’s ability to honor its senior obligations for swaps, forwards, options and other financial contracts.

Daiwa did merge investment banking with Sumitomo but the securities group was never merged out of trouble.

Japanese securities firms have struggled ever since the bubble economy burst nearly a decade ago. Now, deregulation has made things worse, opening the firms to intense competition from foreign concerns with expertise in products and services they know little about.

Outsiders have already made big gains in Tokyo Stock Exchange trading and pension-fund management. Merrill Lynch has taken over Yamaichi Securities, and Salomon Smith Barney is in a joint venture with Nikko Securities.

Only Nomura Securities, the brawny leader of Japan’s securities firms, has a chance to survive as an independent, many analysts suggest.

So in July, when Daiwa, Japan’s No. 2 brokerage firm, announced an alliance with Sumitomo Bank, it was greeted with something verging on disappointment.

Sumitomo, Japan’s No. 2 bank after the Bank of Tokyo-Mitsubishi, is the core of the keiretsu, or business group, that includes Daiwa, and the alliance was largely seen as just another case of circling the wagons.

Moody’s Investors Service, which had already put four Daiwa subsidiaries on notice for a possible downgrade, said the announcement did little to dispel its concerns.

-NY Times, 1998

Sources
Brokerage Is Last of Japan’s ‘Big 4′ to Recast Debt : Yamaichi Bites the Bailout Bullet – IHT
US follows UK – on the wrong road – Guardian

Related article
Geithner plan ’short-sighted’ – The Age

Related posts:

• Japan circa 1996 – forgotten already?
• Bernstein: America is turning Japanese
• The Japanese Problem is now ours
• Japan’s easy money policy was the trigger for the tech wreck
• Unscathed Japanese banks on the prowl

Yesterday, I posted an item on Naked Capitalism about the bankruptcy of Yamaichi Securities in 1996 as testament to lingering weakness in a country’s financial sector if sick financial institutions are not dealt with swiftly. In essence, the entire Japanese banking sector remained weak for years despite multiple cyclical upturns after the Bubble Economy burst.

So, let’s fast forward to 2003 and take a look at Sumitomo Mitsui, Japan’s third largest bank. This is a full 13 years after the bubble burst in December 1989.

The story is from the NY Times. I have bolded the important bits.

The Goldman, Sachs Group will set up an investment fund to buy as much as 1 trillion yen ($9.1 billion) in nonperforming loans from the Sumitomo Mitsui Banking Corporation, the latest effort by a foreign firm to help a Japanese bank strengthen its balance sheet.

Goldman Sachs, which has longstanding ties with the Sumitomo banking group, says it hopes to make a profit by rehabilitating the borrowers and repackaging the loans into potentially lucrative investments, like asset-backed securities. Goldman Sachs has been buying golf courses and other Japanese properties with steady cash flow and is considered one of the best foreign firms at reviving distressed assets.

Other foreign investment banks, most notably Merrill Lynch and Deutsche Bank, have bought troubled assets from Japanese banks. Some have also helped banks raise capital so they can more easily write off their sour loans. In January, Goldman Sachs agreed to buy 150.3 billion yen ($1.4 billion) of preferred shares from the Sumitomo Mitsui Financial Group.

Sumitomo Mitsui, like other large banking groups in Japan, is under pressure to meet the government’s stiffer requirements for financial health. Regulators want banks to more than halve their nonperforming loans as a percentage of their total lending to 4 percent by March 2005. Sumitomo Mitsui says it hopes to meet the goal early by selling many loans at once.

The Japan Endeavor Fund, as it is tentatively named, will be 58 percent owned by Goldman Sachs and will begin buying loans from Sumitomo Mitsui early next year. The Daiwa Securities SMBC Company and Sumitomo Mitsui will also invest in the fund. The venture will buy loans to medium-sized companies that have had trouble making interest payments and require ‘’special monitoring,” jargon for watching borrowers in danger of default.

At the same time, the Sumitomo Mitsui Financial Group will set up a separate venture that will send turnaround experts to the businesses that have had their loans sold to the investment fund. This is intended to strengthen potentially profitable businesses so that they can generate steady sales and repay their loans.

”We have always just sold our nonperforming loans,” said Yoshifumi Nishikawa, president of the Sumitomo Mitsui Financial Group. ‘‘By setting up this revitalization company, we will not only accelerate bad loan write-offs, but also increase our chances for turning a profit.”

The new venture, called the SMFG Corporate Recovery Servicer, may also dispel widespread fears among Japanese executives that a foreign buyer like Goldman Sachs will foreclose on delinquent borrowers.

Investors were encouraged by the establishment of the two companies, partly because Goldman Sachs — a healthy, outside investor — is shouldering some risk for disposing of the nonperforming loans. The Sumitomo Mitsui Financial Group’s shares rose as much as 4.4 percent on Tuesday.

Since Goldman’s investment fund will only start buying loans in early 2004, Sumitomo Mitsui’s balance sheet will probably not be affected much this fiscal year, which ends in March. Sumitomo Mitsui hopes to sell 1 trillion yen in loans within one year, Mr. Nishikawa said.

Sumitomo Mitsui expects to earn 150 billion yen ($1.4 billion) in fiscal 2003, a reversal of the bank’s 465 billion yen loss ($4.2 billion) last year.

As in other cases where bad loans are sold, the key to each company’s profitability is how the loans are valued. The buyer typically wants to pay less for riskier assets, while the seller wants to recoup as much as possible from the sale.

”The question is what’s the haircut,” said Hironari Nozaki, a banking analyst at HSBC Securities, referring to the discount the buyer receives. ”The sale is a big help to Sumitomo Mitsui because it saves time. But if the price is too favorable to Goldman Sachs, it could limit Sumitomo Mitsui’s net income.”

According to Mr. Nozaki’s estimates, selling 1 trillion yen in non-performing loans would reduce Sumitomo Mitsui’s bad loan ratio to 6.6 percent. Additional measures by Sumitomo Mitsui to write off loans could push that number closer to 4 percent, he said.

Goldman Sachs, meanwhile, must devise a strategy for profiting from the loans. Foreclosing on loans, especially to large companies, is difficult because of the bad publicity it generates and because of outside pressure from politicians, regulators and others. But loans can be packaged into bundles and resold as securities, or restructured individually to produce a higher return.

It may also take time to identify the loans with the best chance of turning a profit.

But a Goldman Sachs executive said the investment bank had been reviewing Sumitomo Mitsui’s loan portfolio for several months, , so it had begun identifying loans with potential.

”This is no walk in the park,” the executive said, ”but we’ve been doing our homework.”

Source
Goldman to Buy $9.1 Billion in Sumitomo Loans – NY Times

Related posts:

• Unscathed Japanese banks on the prowl
• Bloomberg: $500 billion in writedowns by firm
• Lessons from Japan’s Bank Crisis
• Goldman partners get margin calls
• Goldman and Morgan Stanley are now banks

I do believe the U.S. policy response to this financial crisis is very much like the Japanese response to their crisis in the 1990s. I have a post up at “naked capitalism” making this point. I would add, however, that America is in a worse position due to its lack of exports and manufacturing and it huge current account deficit and low savings.

Richard Bernstein, who is leaving Bank of America for greener pastures has also made the connection to Japan, but based on different data.

A critical assumption behind the latest plan being proposed is that there is no market for bank assets. This is clearly untrue,” the US-based Mr Bernstein told clients in a note.

“There is a market, but the bid/ask spreads are exceptionally wide. Distressed sellers (that is, banks) do not like the bids they are receiving for their tarnished assets. In addition, these distressed sellers do not want to sell good assets (who would?).”

Rather than forcing bad banks to sell assets at distressed prices or seizing the assets (as was done in the 1989/91 cycle), Mr Bernstein said the latest plan tried to put the government in the middle of the yawning gap of the bid/ask spread.

“Private investors can effectively pay a reduced price because of generous government financing, yet banks can receive fictitious inflated prices for their assets – everyone should be happy,” he said.

“The problem, however, is that the plan sacrifices the longer-term health of the economy and the financial system for a short-term fix for the banks. Excess lending capacity will remain, lending will accordingly be curtailed, and bank profitability pressured.”

Mr Bernstein argues that the current attempts at reviving the US economy appear to be a version of the Japanese policy during the 1980s and 1990s as that country battled to snap its slump. These policies mostly centered on keeping the excess capacity alive and hope the economy can grow into it.

“Financial history solidly suggests that such policies will not work,” Mr Bernstein said.

Source
Geithner plan ’short-sighted’ – The Age

Related posts:

• Bernstein: America “practically invites another catastrophe”
• Bernstein: What kind of recovery are we going to get?
• The Japanese Problem is now ours
• Richard Bernstein: Once a huge market bear, now a bull
• Turning Japanese and understanding the consequence of policy half-measures

As I mentioned in my post, “TALF: A bailout if one reads the fine print” the TALF is not a program ONLY for U.S. institutions. It is a vehicle for re-starting the U.S. asset-backed securities credit markets. In fact, the first recipient of TALF money may be Nissan Motors, a Japanese company (Hat tip Marc):

via email:

After focusing on the big banks and AIG, official attention has broadened in recent weeks to include help for home owners, consumers and small businesses. The Fed’s Term Asset-Backed Securities Loan Facility (TALF) is aimed re-opening access to credit by consumers and small businesses by re-opening the market for the securization of such credit. The Federal Reserve is committed to buying up to $1 trillion worth of such ABS.

After much tweaking of the rules to ensure a successful launch, the program is ready. Ironically, Nissan, the Japanese auto maker, may be the first participant. It security will likely be priced tomorrow, the deadline for investors to apply to the Fed for loans to buy the debt. Reports indicate Nissan is preparing a package of $1.3 bln in auto loans that may the first to qualify under the TALF program. The largest AAA portion of Nissan’s securities matures in a little less than 2 years and indicative prices suggest 185-200 bp premium to the benchmark.

Here in Q1 09, about $2.3 bln of auto-backed debt has been issued. This is less than a third of the amount issued in Q1 08 and illustrates the drying up of the market. It also highlights the significance of the Nissan deal–increasing the auto ABS brought to market by 50%.

The Fed had initially hoped to start TALF in Feb. Procedural and legal issues have been behind the delay. However, the size of the program has been lifted from $200 bln initially proposed.

Bloomberg says substantially the same thing.

The Obama administration is counting on the TALF plan to help end the credit crunch and recession, thawing the market for asset-backed securities so lenders can make new loans to consumers. The program, first announced in November, was hampered by delays as investors, dealers and issuers worked on details.

“A number of people were concerned that some glitches might not have been ironed out this week” in time to meet the first deadline for investors to apply for the Fed loans, said Malcolm Dorris, a senior partner in the securitization group at law firm Dechert LLP in New York. “Getting a deal done in March is good for the program. We are still in the wait-and-see stage.”

Investors have shunned debt backed by consumer loans as unemployment has climbed in the worst financial crisis since the Great Depression. Sales of the bonds plunged 40 percent last year to $106 billion, according to data compiled by Bloomberg, choking off funding to lenders. About $2.3 billion of debt backed by auto loans has been sold this year, compared with more than $9.6 billion in the same period of 2008, according to data from JPMorgan Chase & Co…

The first phase of the TALF will finance the purchase of as much as $200 billion of AAA rated securities containing loans for autos, education, credit cards and small businesses. Officials eventually plan to include other assets, including commercial mortgage-backed securities.

The Fed originally planned to start the TALF in February, then delayed the debut to ensure “all our legal and procedural steps had been taken,” Bernanke said in congressional testimony Feb. 25. On March 3, the Fed and Treasury said applications for the first deals would be due in two weeks, with loans disbursed on March 25.

The largest AAA portion of the Nissan sale maturing in 1.98 years may price to yield between about 185 basis points and 200 basis points more than benchmark interest rates, the person said. JPMorgan and Bank of America Corp. are underwriting the bonds.

This is the big test. If credit markets are not freed up by these moves, we must hope there is a Plan B.

Sources
Fed’s TALF Consumer Lending Program Starts With Nissan Debt – Bloomberg.com
Nissan to Sell $1.3 Billion of Auto Debt Through TALF – Bloomberg.com

Related posts:

• Kasriel says that Fed could get stuffed under TALF
• A few words from a reader on TALF mechanics
• TALF: A bailout if one reads the fine print
• TALF: ‘the great liquidation’ begins for hedge funds and shadow banks
• TALF details suggest Obama doesn’t get it

Overnight, the Japanese government released figures for Q4 2008 GDP that pointed to a depression-like fall in the Japanese economy.  GDP contracted 3.3% from Q3, or 12.7% using the U.S. convention of annualizing those numbers.  This is the largest such quarterly contraction in Japan since 1974.  While a very poor number was expected, this number was even worse than forecast.

Ken Worsley of the Japan Economy & News website has a good summary of the situation:

While PR fallout has yet to land concerning Finance Minister Shoichi Nakagawa’s seemingly drunken appearance at the G7 meetings in Rome this past weekend, data released today by the Cabinet Office shows Japan’s GDP as having fallen 3.3% in the October quarter, annualized at a 12.7% decline. This is the largest fall since since an annualized 13.1% decline in the January-March quarter of 1974.

For comparison, while Japan’s October-December GDP declined 3.3% against the third quarter, the US saw a 1% fall while the EU experienced a 1.5% contraction.

Where were the declines seen? Here’s a breakdown of performance by major categories, compared against the third quarter:

Domestic Demand: -0.3%

Private Demand: -0.6%

• Private Consumption: -0.4%
• Household Consumption: -0.4%
• Household Consumption (excluding rent): -0.6%
• Private residential investment: +5.7%
• Private non-residential investment: -5.3%

Pubic Demand: +0.6%

• Government consumption: +1.2%
• Public investment: -0.6%

Capital Spending: -2.9%

Exports of goods and services: -13.9%
Imports of goods and services: +2.9%

The largest drag on GDP figures is clearly in the export category, which fell at an annualized 45.0% in the fourth quarter. Is there any end in sight for this? With bankruptcy figures still climbing and machinery orders still falling, the head of research at the Bank of Japan, told reporters last week that there is a possibility that the first quarter of 2009 might see worse numbers than what was reported today.

Japan’s GDP number is important for a number of reasons.  First, despite massive stimulus – economic and fiscal, Japan has never fully rebounded from the  stock and property market crashes that began nearly two decades ago.  While one cannot rule out demgraphic shifts as a major reason for the economy’s continued sluggishness, the Japanese experience reinforces the notion that stimulus is inadequate without a robust  financial sector policy response.

In addition, just as in the U.S. Q4 numbers, there was a significant inventory build in the figures which artificially goosed the final figure.  The GDP number would have been even worse were it not for the inventory build.  Given the massive layoff announcements in Japan and elsewhere, it is evident that companies are looking to reduce inventories drastically in Q1 2009, that is going to depress GDP figures.  I expect a serious downside surprise in Japan and the United States at a minimum.  Such a nasty surprise could have an important psychological impact for markets and consumers.

Further, the Japanese figures demonstrate the huge falloff in global trade as exports collapsed in Japan.  Similarly large falloffs have been witnessed across Asia including in Taiwan, Singapore, and South Korea.  Therefore, the figures in Japan bolster the notion that China’s economy is suffering mightily due to its export orientation.  This would also suggest that Sovereign Wealth Funds domiciled in China and elsewhere in Asia will have much less appetite for overseas investments, which could be a meaningful loss of investment demand should Western markets come under pressure.

As they plot their future investment strategies, SWFs are trying to gauge how deep the recession will be, how long it will last and what shape a recovery will take.

Some funds are facing pressure to invest more at home instead of abroad. The French government announced in November that it would establish a 20 billion euro SWF not just to help local companies cope with the effects of the credit freeze but also to prevent the takeover of strategic French firms by “foreign predators.”

Other SWFs in Asia and the Middle East, burned by investing early in the current crisis, are wary of going back into the market until they are more confident an upturn is in sight and the financial system has stabilized.

Lou Jiwei, chairman of the $200 billion China Investment Corp., said in December that “we don’t have the courage to invest in financial institutions anymore, because we don’t know what problems we’ll have.” Like the Singapore SWFs and some Gulf Arab funds, CIC invested early in the crisis in Western financial services companies and has lost billions of dollars on paper.

Analysts say China’s other SWF, the $312 billion SAFE Investment Company, is also sitting on book losses on some of its foreign investments, although they appear to be smaller than those of CIC.

Before buying abroad on a significant scale again, SWFs will have to make an assessment about the future strength of the global economy, and where its most vibrant growth centers and sectors will be. This recession is the worst since World War II, and possibly since the Great Depression in the 1930s. Unlike previous downturns, it has hit all major markets, both developed and developing. Demand for exports is down everywhere.

 
Finally, recent news from Japan overnight suggests that the economy is still headed down. One should see this as a harbinger of global economic trends.

Japan’s government may cut its economic assessment for a fifth month, Nikkei English News said, without citing anyone.

The Cabinet Office report, to be released on Feb. 19, is likely to downgrade it description of the economy from “worsening rapidly,” the Nikkei said.

The report may also cut its assessments for employment and personal consumption, the news wire said.

In sum, I see the Japanese numbers as big news. It has meaning far beyond the Japanese economy. This was a downbeat number which suggests that the global economy is indeed getting worse.

Sources
Japan’s GDP contracts 3.3% in fourth quarter, 12.7% annualized – Japan Economy & News Blog
Former saviors racking up losses – Japan Times
Japan to Cut Economic Assessment for Fifth Month, Nikkei Says – Bloomberg.com

Related posts:

• Depression in Japan
• Japan: stimulus without reform leads to a policy cul de sac
• Is Japan next on the road to quantitative easing?
• China is now on the same bubble path as Japan post-1987 crash
• Japan’s easy money policy was the trigger for the tech wreck

The statistics coming out of Japan have been truly awful of late.  In my last post, you saw a small video connecting reduced spending in the U.S. to Japan.  However, I need to be more explicit about how things are unraveling in Japan.  The industrial production number that was released this past Friday was a wake-up call that Depression has arrived, at least in Japan.   Industrial production fell a stunning 9.6%, the most since statistics began in 1953.  This is a figure that translates into a GDP of 10% — and this in the world’s second largest economy.

Frank Veneroso’s latest piece “The Yen is madness” sums it up quite well (hat tip Scott):

December industrial production came in down 9.6%, worse than the METI forecast. It is now down almost 21% year over year. METI forecasts a further 4.7% decline in February. The inventory to production ratio soared again. Maybe METI will be correct. If it is Japan industrial production will have fallen 28% (non annualized) in four months. It will have fallen by a third in about a year. Nothing in the history of major nations compares. A 28% decline in four months would be more than half of the entire decline in U.S. industrial production over the 3 years and nine months of the U.S. Great Depression. It would be a greater decline in four months than in any 12 month period in the Great Depression in the U.S. We are literally looking at the unimaginable.

This is a wake-up call to everyone, especially China bulls because everywhere in Asia, a similar story can be told. The Economist puts this into context.

It seems so unfair. Most Asian economies have been models of prudence. While American and European households were borrowing up to the hilt, Asian ones were tucking away their savings. While rich-country banks were piling into ever-riskier assets, Asian banks kept their holdings of such assets small. And while America and Britain were sucking up the world’s savings, Asian governments piled up vast stocks of foreign reserves.

Yet many of Asia’s tiger economies seem to have been hit harder than their spendthrift Western counterparts. In the fourth quarter of 2008, GDP probably fell by an average annualised rate of around 15% in Hong Kong, Singapore, South Korea and Taiwan; their exports slumped more than 50% at an annualised rate. Share prices in emerging Asia have plunged by almost as much as during the Asian financial crisis a decade ago. That crisis was caused by Asia’s excessive dependence on foreign capital. This time the tigers have been tripped up by their excessive dependence on exports.

Asia’s emerging economies have long been the world’s most dynamic, with GDP growing at an annual rate of 7.5% over the past decade, two and a half times as fast as the rest of the world. Only last summer, many of these countries were being warned by foreigners that they were growing too fast and needed to raise interest rates to prevent a surge in inflation. Now, many seem to be in free fall and the news is likely to get grimmer.

In the fourth quarter of 2008, real GDP fell by an annualised rate of 21% in South Korea and 17% in Singapore, leaving output in both countries 3-4% lower than a year earlier. Singapore’s government has admitted the economy may contract by as much as 5% this year, its deepest recession since independence in 1965. In comparison, China’s growth of 6.8% in the year to the fourth quarter sounds robust, but seasonally adjusted estimates suggest output stagnated during the last three months.

Asia’s richer giant, Japan, has yet to report its GDP figures, but exports fell by 35% in the 12 months to December. In the same period, Taiwan’s dropped by 42% and industrial production was down by a stunning 32%, worse than the biggest annual fall in America during the Depression.

Asia’s export-driven economies had benefited more than any other region from America’s consumer boom, so its manufacturers were bound to be hit hard by the sudden downward lurch. Asian exports are volatile anyway (see chart 1). And though the 13% fall in the region’s exports in the 12 months to December was slightly smaller than in 1998 or 2001, those dismal records seem certain to be beaten soon.

The plunge in exports has been exacerbated by the global credit crunch, which made it harder to get trade finance. Destocking on a huge scale has further slashed output. Trade within Asia has dropped by even more than the region’s sales to America or Europe. Exports to China from the rest of Asia were 27% lower in December than a year earlier, partly reflecting weaker demand for components for assembly into goods for re-export.

Shocking as the export figures are, they are not entirely to blame for Asia’s woes. A closer look at the numbers reveals that in most countries imports have fallen by even more than exports, and that weaker domestic demand explains a larger part of the slump.

In China, for example, weaker domestic spending—mainly the result of a collapse in housing construction—accounted for more than half of the country’s slowdown in 2008. In South Korea, net exports actually made a positive contribution to GDP growth in the fourth quarter, while consumer spending and fixed investment fell at annualised rates of 18% and 31% respectively. South Korea is an exception to the rule of Asian prudence. Its households’ debt amounts to 150% of disposable income, even higher than in America. The banking system, which borrowed heavily abroad to finance a surge in domestic lending has also been badly hit by the global credit crunch, making it harder for firms to finance investment.

Domestic spending has collapsed elsewhere. Over the past 12 months, retail sales have fallen by 11% in Taiwan, 6% in Singapore and 3% in Hong Kong. As big financial centres, the two city-states have been battered by the global storm. Both have high levels of share ownership, so tumbling stockmarkets and property prices are depressing consumption. In Hong Kong average house prices have already fallen by almost 20% since the summer and Goldman Sachs, an investment bank, forecasts another 30% drop by the middle of 2010.

Do I need to go on here? All of Asia is in a recession more severe than the Asian Crisis in 1997-98.

So, what does all of this mean?

First and foremost, one should look at Japan. Here’s a country that has gone through massive monetary and fiscal stimulus for a decade, ballooning their government debt level to 200% of GDP. And, yet, they are seeing a collapse worse than the Great Depression. Japan has a massive domestic savings to absorb government debt. However, one cannot just continue printing money without consequence.

Question: will stimulus save us or is Japan just a bad example? The conventional wisdom is that Japan waited too long to provide stimulus and they also propped up their financial sector in ways that the West will not. Carl Weinberg of High Frequency Economics certainly takes that line in the video I from the last post. But is that really true? I see Japan as a worrying example of how ineffective stimulus can be. As I have said before, stimulus is no panacea. We are still going to suffer greatly nevertheless. Fixing the banking system and liquidating overcapacity are more important even than stimulus.

Then comes the question of what Asia’s collapse portends for North America and Europe. After all, exports from Asia are collapsing largely because demand in North America and Europe is collapsing. The Economist demonstrates in their article that Asia was too dependent on exports as a model for growth. However, I can’t help but think the interconnectedness of the global financial system will bring all of this back to the West in terms of reduced appetite for financial assets as Asians reduce their exposure.

My own view is that the West too often views Japan as a separate case and fails to appreciate the parallels there with what is occurring in the West — the asset bubble, the aging population, the monetary stimulus, the fiscal stimulus, the broken banking system.   Japan is in Depression.  However, Japan is not that different. What is happening there could just as easily happen here.

Sources
Record 9.6% fall in output sparks fear for Japan’s future – Times Online
Troubled tigers – Economist

Related posts:

• Japan does not demonstrate the failure of stimulus
• Is Japan next on the road to quantitative easing?
• Trade flows in flux: is this re-balancing?
• ISM Manufacturing Index: Deep recession territory
• Japan: stimulus without reform leads to a policy cul de sac

News in Japan has been particularly grim. Industrial production has plummeted, exports are in free fall and banks are simply not lending as excess reserves pile up. As a result, Japanese share prices threaten to revisit lows that bring the country back to 1981 prices. Japan is in Depression. The question is what to do about it. Rates are already near zero. The answer that I believe will be found by Japanese policy makers is what is known in economic policy circles as quantitative easing, a hifalutin way of saying printing money.

One can see the implications of all this in a recent missive from the well-regarded Japan Economic Pulse where they say the BoJ will go unorthodox like the Fed has done and start funding companies directly instead of waiting for banks to supply the liquidity. That means buying up commercial paper and corporate bonds. Moreover, Japan Economic Pulse suggests that the government may want to buy shares in the market to prop up prices — and to eliminate writedowns by financial institutions which own those shares. (Japan’s fiscal year end is March and banks want to present a good face to the market when it comes time to show their numbers).

Now, I should add that the Federal Reserve and the Bank of England are both turning to the printing presses – although the Fed says it is focusing on the asset side of its balance sheet. And the ECB is now expected to follow suite – dragged kicking and screaming to this policy choice.

What are the likely implications? Here is my list:

1. The Japanese Yen, which I saw going to 85 to the U.s. Dollar, may end up being a lot weaker than anticipated.
2. We are seeing the makings of a competitive currency devaluation here.  China is also a major player in this, being the Alpha producer of choice in Asia.  I warned that I see the potential for unilateral protectionist actions if these types of activities continued.
3. Underlying inflationary pressures are building worldwide.  If you look at M2 in the U.S., it is exploding.  The only reason we are not seeing inflation in the U.S.  right now is deleveraging in the financial sector.  The same is true in the U.K. and the Eurozone to differing degrees.
4. This is a very bullish scenario for gold and commodities when reflation takes hold.  As I have mentioned in the past, I expect deflation followed by high inflation when the economy turns.
5. This is NOT a bullish scenario for government bonds.  This is the major reason you won’t see me advocating buying treasuries here despite my belief they will go higher.  Ultimately, treasuries are a bubble that will burst and there is a lot of downside risk in that trade given the factors enumerated above.

Those are my views here.  Feel free to add your two cents.

Related articles
Tokyo shares end 2008 42% lower – BBC News
Toyota closes domestic factories for 11 days – Guardian
Japan: New auto sales plunge 23.3% in December, 6.5% for 2008 – Japan Economy News & Blog
China cuts rates for fifth time as Japan suffers record exports drop – Independent.ie
Mitsubishi UFJ to Book 288 Billion Yen Loss on Stocks – Bloomberg.com

Related posts:

• A note on Japan’s experiment with quantitative easing
• China to diversify out of U.S. dollars
• Sweden: negative interest rates and quantitative easing
• Japan does not demonstrate the failure of stimulus
• Quantitative easing: printing money like mad to ward off deflation

Federal Reserve Chairman Ben Bernanke gave a speech at the London School of Economics today in which he outlined the measures the Federal Reserve was prepared to take in order to deal with the financial crisis.  Of particular note, Bernanke indicated that the U.S. central bank would keep interest rates low and that it would buy mortgage-backed assets in order to increase its direct control over the interest rates borrowers actually see.

Bernanke also clarified his position on quantitative easing (QE), explaining that the Fed is more concerned about the asset side of the balance sheet than the BOJ (Bank of Japan) was when Japan engaged in quantitative easing.  One could take this to mean that the Fed is engaging in both qualitative easing as well as quantitative easing. The Fed means to supply liquidity to the financial system and to buy poorer quality assets (i.e. Mortgage-Backed Securities instead of Treasury bonds), whereas the BOJ was merely supplying liquidity.  Bernanke was careful to note that the Fed was taking a ‘haircut’ and receiving enhancements in its experiment with QE so as to prevent any impairment in the Fed’s balance sheet.  However, I did not find this part of Bernanke’s talk particularly convincing.

Another interesting tidbit from the speech was Bernanke’s defense of Fannie Mae and Freddie Mac and their business conduct during the housing bubble.  Bernanke does not feel their actions were reckless, nor does he believed they contributed negatively to the situation.

On the whole, Bernanke was refreshingly clear regarding both his intentions and his reasoning. Below are three videos of Bernanke’s speech on CNBC.

Related posts:

• Plosser: The Fed must stop qualitative easing
• Don’t underestimate the power of printing money
• Pushing on a string and similar notions on monetary policy ineffectiveness
• Connecting Fed cuts with credit writedowns and quantitative easing
• Mea Culpa: The Fed is not going to buy treasuries