Japan Redux

Anyone around my age (46 – ugh!) can still recall one of the dominant themes in every aspect of American life as we were transitioning from adolescents to adults in the early and mid-1980’s. In the news, in entertainment, in pop culture – we heard it everywhere: Japan was taking over the world. From the daily economic reports of Japan’s record exports, Treasury bond holdings and New York City real estate purchases, to Congress’ threats of trade penalties, to popular movies such as “Rising Sun” and bestselling books including “Japan as Number One” – Japan’s world dominance was considered an imminent fait accompli.

Sound familiar? Substitute 2010 for 1985 and China for Japan and it is just a new verse of the same old song. So before we all get too far down the road planning our investment strategies around China and Asia’s new world dominance, perhaps we should ask ourselves: How did that work out for Japan back in the 1980’s? And how did that work out for everyone who invested in the Nikkei in 1985? The answer, of course, is not so good, as Japan’s lost decade now stretches out towards two decades. If China is not careful, they will suffer the same fate.

The details of what happened in Japan, and of how it could happen again in China are complex, but the basics of the problem are relatively simple. After World War II Japan embarked on a managed-economy program to grow from a destitute and devastated wasteland to the world’s second largest economy. Simply put, they exported everything they could to the U.S. and Europe, and then used the proceeds in dollars, pounds, marks, etc. to buy badly needed capital equipment and commodities to further build and fuel their export industries. As they perpetuated and grew this cycle they moved up the value chain to more advanced export goods, generating more foreign currency proceeds to further grow their export industries to move even further up the food chain – a virtuous cycle.

But in the 90’s this virtuous cycle turned vicious. Japan continued to suppress domestic demand and consumption in order to build production capacity well beyond what the world could use. Further excess dollars and euros (earned from exports) that could not be invested in more production capacity were left in bank accounts in the US and Europe, or were used to buy US and European sovereign debt or other assets. Most of the dollars and euros earned from exports had to be either used to buy imports or left abroad, for exchanging those dollars and euros back into yen would have driven the yen way up, destroying Japan’s export competitiveness. But inevitably some of the export wealth did manage to trickle down to Japanese citizens, so to absorb it and suppress demand for goods the government engineered asset price bubbles in real estate and the stock markets.

Eventually these asset price bubbles had to collapse (at one point the land under the royal palace in Tokyo was theoretically worth more than the entire country of Canada). In addition, Japanese exporters had built so much production capacity that they could never find customers for it all overseas (or domestically, where tax and other mechanisms worked to suppress demand). Japanese banks, that had financed the purchase of overpriced assets in Japan and around the world had huge losses and began to fail in massive numbers. Furthermore, since export currency was not converted into yen along the way, Japan now found itself with a significant portion of its wealth, and in effect its money supply, tied up in dollars and euros in foreign bank accounts.

All of the pieces fell into place: Excess production capacity, collapsing asset price bubbles, failing banks, contracting credit, and a constrained money supply formed the perfect deflationary storm. Japan still has not recovered, and their entrenched government shows no signs of making the painful changes needed anytime soon.

Now China is Japan in the early 80’s. Their export industries in technology and complex manufacturing (e.g. cars) have not reached global preeminence, but they are getting there and they have now become the world’s second largest economy. They may soon choose to begin to encourage domestic consumption along with production focused on meeting domestic demand, to import more consumer goods and focus less on exports, and to let the Chinese people innovate and found companies to serve domestic markets, especially in the service sector. But if instead China continues to focus all of its energy and resources on building export capacity while controlling and limiting domestic demand, and continues to use the excess foreign currency proceeds that result from massive trade imbalances to fund the debt of their customers (the U.S. and Europe), then Japan’s fate awaits China as well.

The article linked here (http://www.foreignpolicy.com/articles/2010/09/30/the_japan_syndrome?page=full) explores some aspects of this in greater detail. As the article says, “Japan as Number One now languishes as the 400,000th most popular book on Amazon.com while When China Rules the World is a bestseller.” We’ll see.