Even the most unreconstructed bull will tell you that what they see happening in Japan scares them, and it’s not just because of the unspeakable, horrific loss of human life and the destruction from the massive earthquake and tsunami, costs for which the Insurance Information Institute now estimates may likely rank as “the worst in the history of the world.”
Specifically, while Wall Street executives say Japan will ultimately survive, privately they worry its recovery efforts could be slowed due to the overly lenient, easy credit policies it has embarked upon over the last two decades, which have made Japan now the most indebted nation on the planet.
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Specifically, they worry that Japan has committed financial hara-kiri by blowing out its government debt, now at $11 trillion creating a debt to GDP ratio of 200%, resulting in further credit rating downgrades that have made its borrowing costs rise.
Ironically, it was U.S. Federal Reserve chairman Ben Bernanke who advised Japanese central bankers on exactly how they could further blow out their government's balance sheets in order to arrest a deflationary spiral triggered by a real estate and stock market crash caused by bursting asset bubbles Japan blew between 1986 and 1991. The Bank of Japan had aggravated those bubbles by conducting monetary easing in the late '80s.
Japan desperately needs capital for its recovery efforts, to revive its energy, finance and automotive sectors. Will the increasingly tired capital markets again step up to the plate for its most frequent visitor?
All this worry leads to the most serious question many are asking about Japan: Are we witnessing another, more intractable, deeper leg down in one of the world's great economies, one that could keep it flat on its back for decades?
Japan Already Falling Behind
Officials at the credit rating agencies indicate Japan can pull itself out of this current horrific crisis, just as it has done in the past.
But already, China has surpassed Japan in the ranking of the world’s largest economies. The U.S. is number one, China is second, Japan is third.
And the credit rating agencies have already taken notice of Japan’s struggles. Japan was downgraded in 1998 when its debt to GDP ratio hit 115%; just this past January, the credit rating agencies downgraded Japan again because it lacked a coherent strategy to tackle its debt. The ratings agencies are now threatening further downgrades to Japan’s beleaguered insurance industry.
All this has further fueled speculation as to the economic shocks the U.S. faces as it travels down the same debt road as Japan. The ratings agencies have been increasingly threatening the U.S. with the loss of its Triple-A rating which it has held since 1917.
More Than 70 Nations Pledge Support
Japan is now going through its 2011 budget to find funds to deal with the crisis, at the same time it is struggling -- like the US -- with an outsized fiscal 2012 budget heavily reliant on more government spending.
To date, more than 70 nations have pledged financial support to Japan, including Russia and China, two of Japan’s historic arch enemies. Japan is also scrambling for assets to sell off for cash, including oil out of its strategic reserves, which rank second behind the United States’ Strategic Petroleum Reserves.
Japan will need all the help it can get, because it is decades deep in a debt crisis that could be blown out further, as its economy has been doing the metaphorical equivalent of trying to bicycle through quicksand ever since its stock and real estate markets crashed in the late ‘80s, early ‘90s. Japan is now in its second decade of lost growth, what market experts call its “zombie” decades.
Ten Stimulus Bills in Eight Years
Specifically, Japan answered a 1990 recession by passing 10 stimulus spending bills over eight years, but its economic growth remains flat.
Quite a comedown for a country that, by the end of 1989, accounted for more than half of the world’s stock market capitalization. At that time, Japan was so feared by the U.S., that the government grew publicly concerned over Japan’s U.S. asset purchases, including the Mitsubishi Estate Co.’s $2 billion stake in Rockefeller Center. At that time, even the grounds of the Japanese Imperial Palace alone were reportedly worth more than the entire state of California.
Fed Chief Bernanke Instructed Japan on Easing
Since the late ‘80s, Japan has been going full throttle, stoking its liquidity furnaces to battle deflation via more government spending and easy monetary policies.
Ironically, it was Federal Reserve Chairman Ben Bernanke who advised the central bank in Japan, the Bank of Japan, to drop its interest rates in order to keep borrowing costs cheap, and to buy government bonds to reflate assets and arrest its deflationary spiral downward.
Earlier this decade, Bernanke previewed the Federal Reserve’s own, current easy monetary policies in the U.S. in a speech where he instructed Japanese central bankers to artificially hold its domestic interest rates at the zero bound level.
Unfortunately, the Japanese government embarked on even more borrowing, because such leverage was cheap. The speed and breadth of Japan’s borrowing may have never hit such dramatically high proportions had the free market set domestic interest rate levels.
What Bernanke Told Japan to Do
In his speech, “Deflation: Making Sure "It" Doesn't Happen Here,” before the National Economists Club in Washington, D.C. on November 21, 2002, Bernanke urged Japan to keep interest rates low so as to reflate assets—a little inflation will do you good was the message. And Bernanke advocated novel ideas such as the central bank buying government bonds, with the quid pro quo that fiscal policy makers would use the money subsequently raised to finance tax cuts to boost consumer demand (never really happens that way, does it?)
In this speech, Bernanke also made his famous “helicopter drop of money” quote, where he said that central bankers can’t do economic rescues alone, and that tax cuts are helpful, specifically, “a money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.
All of those moves, Bernanke indicated, would keep rates low and take the pressure off of Japanese debtors reeling from high real interest rates, and also help break deflationary expectations.
U.S.-Japan Analogies Not Picture Perfect
Still, beyond the debt picture, any attempts at drawing analogies between the U.S. and Japan won’t be pitch perfect. Japan has more older citizens, its banking sector has been less-profitable and it protected many industries from international competition, introducing rigidities.
Also, Japan is a big exporter, while the U.S. is a big net importer. About 90% of Japan’s debt is owned by its own savers, where as the U.S. is a big debtor to the rest of the earth. Also, Japan has a high savings rate, meaning it can fund its deficits internally.
And to this day Japan is still fighting a years-long battle with deflation, while the U.S. is battling disinflation in extremis.
Raising Cash by Selling U.S. Bonds
But for now, Wall Street traders see a new “known unknown,” and that is the effect on US Treasury yields from the massive amount of capital Japan will need to rebuild. About 90% of Japan’s bonds are owned by its domestic savers, many of whom may need to cash out in this time of crisis, especially as the population ages and savings rates are trending down. Japan is the third largest buyer of U.S. Treasurys, more than $882 billion worth, putting it behind the Federal Reserve and China. The U.S. central bank currently holds $1.2 trillion in Treasuries and is expected to own $1.6 trillion by the end of June when its second round of quantitative easing comes to an end.
But U.S. Treasury officials don't believe Japan will start selling Treasurys. Instead, it may simply stop buying. Japan’s thinly capitalized banks also may need to dump both Japanese and U.S. bonds, as will insurers, to raise cash.
When a country is in crisis, foreign assets tend to be liquidated first when there is an urgent demand for capital. For example, in the weeks after the Kobe quake in 1995, Japanese insurance companies sold off US Treasury bonds, their most liquid holdings so as to meet mounting claims by their Japanese clients.