What Japan Can Teach Us

Government debt as a percentage of GDP

Rank	country	% of GDP
1	Zimbabwe	230.80
2	Japan	208.20
3	Saint Kitts and Nevis	200.00
4	Greece	165.40
5	Lebanon	137.10
6	Iceland	130.10
7	Jamaica	126.50
8	Italy	120.10
9	Singapore	118.20
10	Ireland	107.00
11	Barbados	103.90
12	Portugal	103.30
13	Sudan	100.80
14	Belgium	99.70
15	Egypt	85.70
16	France	85.50
17	Belize	83.60
18	Canada	83.50
19	Hungary	82.60
20	Germany	81.50
21	United Kingdom	79.50
22	Bhutan	78.90
23	Sri Lanka	78.50
24	Dominica	78.00
25	Bahrain	75.30
26	Israel	74.00
27	Austria	72.10
28	Nicaragua	70.50
29	United States	69.40
30	Spain	68.20
31	Malta	68.00
32	Cyprus	66.80
33	Cote d'Ivoire	65.80
34	Morocco	65.00
35	Netherlands	64.40
36	Guyana	62.10
37	Jordan	60.70
38	Mauritius	60.20
39	Pakistan	60.10
40	Albania	59.40
41	Vietnam	57.30
42	El Salvador	57.10
43	Poland	56.70
44	Brazil	54.40
45	Malaysia	53.50
46	Switzerland	52.40
47	Tunisia	51.80
48	India	51.60
49	Uruguay	51.00
50	Philippines	49.40
51	Finland	49.00
52	Kenya	48.50
53	Norway	48.40
54	Denmark	46.50
55	Aruba	46.30
56	Seychelles	46.20
57	Colombia	45.60
58	Slovenia	45.50
59	Montenegro	45.00
60	Latvia	44.80
61	Ukraine	44.80
62	Costa Rica	44.50
63	Bosnia and Herzegovina	44.00
64	Croatia	43.90
65	United Arab Emirates	43.90
66	China	43.50
67	Slovakia	43.40
68	Mozambique	43.00
69	Argentina	42.90
70	Turkey	42.40
71	Ethiopia	42.30
72	Panama	41.70
73	Serbia	41.00
74	Czech Republic	40.70
75	Thailand	40.50
76	Ghana	38.70
77	Romania	38.60
78	Lithuania	37.70
79	Mexico	37.50
80	Yemen	37.20
81	Tanzania	36.90
82	Malawi	36.80
83	Sweden	36.80
84	Bangladesh	36.70
85	Bolivia	36.60
86	Dominican Republic	36.40
87	Venezuela	36.30
88	South Africa	35.60
89	Cuba	34.90
90	Taiwan	34.90
91	Syria	34.40
92	New Zealand	33.70
93	Korea, South	33.30
94	Senegal	33.20
95	Trinidad and Tobago	31.70
96	Australia	30.30
97	Honduras	29.60
98	Moldova	29.30
99	Macedonia	28.20
100	Namibia	27.40
101	Zambia	27.30
102	Uganda	25.00
103	Angola	24.50
104	Indonesia	24.50
105	Guatemala	24.50
106	Papua New Guinea	22.30
107	Ecuador	22.10
108	Peru	21.70
109	Luxembourg	20.40
110	Botswana	20.30
111	Gabon	18.30
112	Nigeria	17.60
113	Bulgaria	17.50
114	Paraguay	17.40
115	Cameroon	16.20
116	Kazakhstan	16.00
117	Iran	11.60
118	Hong Kong	10.10
119	Saudi Arabia	9.40
120	Chile	9.40
121	Qatar	8.90
122	Russia	8.70
123	Uzbekistan	7.70
124	Gibraltar	7.50
125	Kuwait	6.80
126	Algeria	6.60
127	Estonia	5.80
128	Wallis and Futuna	5.60
129	Kosovo	5.60
130	Equatorial Guinea	5.50
131	Libya	4.70
132	Azerbaijan	4.70
133	Oman	3.80
Source: CIA World Factbook (as of 2011)

It is the year 1990. The most dynamic economy in the world is Japan's. The NIKKEI Dow (their major stock market index) is flirting with 40,000. Japan's trade balance is massively positive thanks to Japan's program of keeping the value of the yen low. Public debt to Gross Domestic Product was a very manageable 68% (IMF figures, official government figures have it below 50%). Headlines were proclaiming that Japan, Inc. would own the world.

Didn't quite work out that way. For the year 2011, the NIKKEI Dow remained below 25% of the 1990 top, under 8,600. The trade deficit is negative, while the yen has nearly doubled in value from 133 to the dollar in 1990 to only 77. Japan's debt to GDP ratio is the highest in the industrialized world at 208% -- more than 20% higher than Greece's debt, which has garnered all the current headlines.

What can we learn from Japan's ills that might help us in our current economic malaise? The origins are surprisingly similar. During the 1980's the Bank of Japan had supported the private banks in supplying cheap loans to businesses. These loans meant that Japanese businesses had a price-advantage over their competitors. While Intel was borrowing money at 9% to build plants in the US, Mitsubishi was paying only 2%. Cost differentials were even greater if US companies had to borrow for work-in-progress (to pay for the material they needed to manufacture items). Japanese real estate firms were also acquiring signature properties all over the world. They could afford to pay higher prices because their mortgages were so much cheaper. A small world-wide recession in 1990 ended the party. When rentals and real estate prices dropped, Japanese companies had no margin for error. If they sold, they took massive losses. If they held, they were funding large negative cash flows. When demand dropped because of the recession, Japanese businesses found out that they had over-built and even with cheap loans, they started hemorrhaging money.

The recession of 2007 in the US started because the US government had their agencies, Fannie Mae, Freddie Mac and Ginnie Mae, make massive, cheap loans to sub-standard borrowers. A real estate correction left millions of home-owners in the same position the Japanese real estate companies had been in a generation earlier: continue to fork over money on properties they owed more on than they were worth or sell at a substantial loss. Both governments did the same thing in response to the crisis: They monetized the debts. The government paid the losses of the banking system and absorbed the losses. The alternative was unthinkable. No industrial nation can afford to have its entire banking system collapse. With no one to fund home montages, car loans, credit card debt, etc. the economy would grind to a nearly complete halt. The 1930's depression in the US would be a forgotten footnote in history as compared to the societal destruction that would follow the collapse of the banking system.

Japan in 1990 was hit by a double-whammy while we only had a single-whammy. They lost not only because of the real estate losses but also because of the massive over-building of industrial infrastructure. We were only hit by the real estate bubble. However, they had a huge advantage that the US doesn't have today. In 1990, the rest of the world got healthy in a hurry, providing markets for Japanese industry to sell to. Today, no economy in the world is healthy. Yet, Japan is still mired in a recession that started 21 years ago. How can the world get out of this predicament without spending 20+ years doing so? Politicians around the world are telling people to be patient -- that the economy won't get better over-night. And those politicians are getting turned out of office by those who promise it will get better soon, who as soon as they are voted into power have to tell people to be patient, so they, too, can get turned out of office.

There are two basic schools of thought on how to get out of the quagmire. (1) Cut spending and/or increase taxes to balance the budget and wait for the economy to reach equilibrium. Usually, the discussion revolves around cutting spending as the size of the government in relationship to the size of the economy is at the root of the probelm. Or (2) stimulate the economy so the economy grows. Hopefully, the economy will grow faster than debt, so the debt to GDP ratio will fall. Germany is firmly in the former camp, while most of the rest of the EU is in the latter to some degree or other. In the US, the House of Representatives is in the former, while the Senate and Administration are in the latter (although they do talk a bit about raising taxes). Don't be fooled by rhetoric. Every politician pontificates about the need for both economic growth and economic restraint. But are their pet proposals to cut spending, increase taxes or to spend money? As nearly every psychologist will tell you, "Don't listen to what they say. Watch what they do."

What are the advantages and disadvantages of the two courses of action? The disadvantage of continuing to spend is that if a nation borrows more than it produces (debt to GDP rises above 100%), the government borrowing begins to crowd out private borrowing, so companies become starved for money and growth stagnates, causing the debt ratio to increase still further. At 200%, where Japan is, there isn't much money left for the private economy. That's why their economy is moribund. The advantage of spending is that if you can stimulate the economy, you avoid the pain while growing the economy out of the doldrums. I heard a politician say the other day that the US economy isn't in danger because the debt load today is way below where it was in 1946 at the end of World War II and we didn't cut spending then. We grew our economy so rapidly that the debt from the war, while still with us, was a tiny fraction of the size of the economy and was thus quite manageable. And, that is entirely true, but it is still silly analysis. World War II came on top of the great depression. There was a shortage of housing, cars and nearly all consumer goods from the depression that was exacerbated by the war. When the veterans (many of whom had lived at home before the war) came home, they wanted homes, furnishings, cars, wives, babies and had money to pay for it. We faced a massive shortage of everything the economy suddenly demanded. Can anyone say we have a shortage of real estate, cars or furnishings today? I am not saying that it is impossible to grow ourselves out of this mess. But comparing the situation today to 1946 is plain ignorant -- or it's a politician speaking who doesn't mind knowingly saying ignorant things to improve his reelection chances.

The disadvantage of cutting spending to improve the debt to GDP ratio is that spending cuts have ripple effects in the economy. Every time you cut a dollar in spending, you reduce GDP a bit. Same thing when you increase taxes. Taking money out of the economy reduces GDP. In a fragile economy it is possible that spending cuts or tax increases will reduce the size of the economy by more than the amount of the cut or tax increase -- thus actually making the debt to GDP ratio worse, while also making the lives of the citizens measurably worse. If you can cut non-stimulative programs, however, you can make a lot of progress on debt, without slowing the economy. If there's any strength in the economy at all, you may even grow a small amount while making cuts.

But there is one over-riding reason to favor budget cuts or tax increases over spending: What happens if there is a second economic shock to the economy? The higher the initial debt load, the less wiggle-room there is. With the exception of Germany, Europe wants to spend. Unless this unravels the EU, it is entirely probable that all the main economies will land above 100% debt load. If their gamble pays off and the economy gets better, they will spend a generation trying to cut some spending while trying to grow out from under the load. If a second shock strikes during this period, they will end up in Japan's position, with debt loads above 200% and no way out for more than a generation. In another article, I suggested that Greece should get out of the EU, dump the euro, repudiate much of the debt and start over. Other economies have done this in the past.

But the whole world can't dump their currencies and repudiate their debts. Do that and there's no banking system (who owns all the repudiated debt instruments?). The first world would rapidly become third world. The industrial society as Western Civilization has come to know it, would end. Modern civilizations cannot operate on a barter system. But when no one trusts the currencies and there are no banks, how else do you exchange goods and services? Certainly, the replacement currencies would be used for minor purchases, but not for major. I visited Communist Romania and Soviet Union. No one trusted the government currency. It had been replaced by cigarettes and other consumer items. One Romanian student told me that the communists had deposed King Mihai only to replace him with the Duke of Marlborough and Duchess of Kent (after the favored brands of cigarettes).

Unfortunately, the rhetoric in this hugely important world-wide debate is so basic that most of it would fit on a bumper sticker. Pretty much those favoring cuts are "fat cats," and those favoring expansion are "irresponsible." The world needs a better examination of the issue. But with elections looming nearly everywhere, no one cares much for a careful examination of the issues. No matter which side you are on, there are massive unpleasantries that have to be faced. Utter any of those unpleasantrie and you are certain to lose the election. So, bumper stickers it is.

June 22, 2012

Sources

Yen to dollar, 2011

Yen to dollar, 1990

Historical Japanese debt to GDP data (Click on F-M to download Excel spreadsheet)

CIA Factbook debt to GDP ratio of nations, 2011 (They update the page frequently, so the data you see here may not agree with what you see now, but it was accurate on publication date.)

Historical chart of NIKKEI Dow 1985-2011