Rebel Traders - Stock Market and Economic Analysis

Andy Xie, whose insights we have often referenced in our chronicles is back with an analysis of the failure of Keynesian economics in Japan on Caijing.

As previously mentioned in two posts, Andy Xie firmly believes in a second dip taking place somewhere next year in Anglo-Saxon economies.

Before delving more ahead, that specific distinction warrants by itself more attention, as to the foundations of the US or British economies. It is true that they have been based on sand in the form of dangerous credit expansion and a housing market bubble. Something similar to what is happening in China, with the addition of a huge bailout that was partially rerouted towards the stock markets and commodity assets. You can read the full article here.

For Xie, exports were one of the major motors of the Japanese economy (not unlike China).

Anyone who doesn’t believe in the harm of a financial bubble but does believe in Keynesian stimulus magic should visit Japan. A likely dip for the Anglo-Saxon economies next year will underscore these truths. The same goes for anyone who thinks China’s latest real estate bubble, asset borrowing and shadow banking system are worthwhile substitutes for real economic growth.

The world including China can learn a lot by looking at what’s happened to Japan, and what’s in store for DPJ. Since Japan’s stock market bubble burst in 1989 and the land market popped in 1992, the LDP government has run up debt equal to nearly 200 percent GDP in hopes of reviving the economy. And its economy has stagnated.

The burst of the global credit bubble in 2008 brought down Japan’s export machine. That was its only hope. Now, of all OECD economies, Japan’s looks most like a depression. Its nominal GDP declined 8 percent in the first quarter 2009 from the year before. Although its economy rebounded a bit in the second quarter, nominal GDP for 2009 is still expected to decline substantially and will likely be lower than in 1993.

Despite the difference in the return on assets between Japan and the US, it might almost instinctively be understood that Japan was mostly basing itself on “real” economy, whereas the US corporations were using financial engineering to achieve the higher return.

U.S. return on asset (ROA) was twice as high as that in Japan. But, in hindsight, higher ROA in the United States was mostly a bubble phenomenon. Much of U.S. corporate profitability was due to financial engineering. In one aspect, the export performance of Japan’s corporate sector has done very well — much better than its U.S. counterpart. Japan’s exports doubled in yen terms between 1993 and 2008, and the sector’s share of GDP nearly doubled to 16 percent from 9 percent, even though the yen remained strong during the period. The performance of Japan’s export sector shows its inefficiencies elsewhere were largely due to shortcomings in the system.

Where it starts getting very interesting, it is in the policies pursued to stimulate recovery in Japan from the 1980′s onwards, after the country fell prey to a burst real estate bubble: rates at zero and… abolition of mark to market! Sounds familiar?

The consequences of running high deficits and trying to maintain the bubbles has been of maintaining a very high cost of living, thus putting a pressure towards limiting the birth rate and ultimately compounding Japanese economic issues.

This strategy was flawed in three aspects. First, even as the corporate sector earns profits to pay down debt, the government’s debt is rising. At best, it is shifting corporate debt to government debt. In reality, government debt has been rising faster than private sector debt has been falling.

Second, economic efficiencies don’t increase in such equilibrium. Existing resources in the zombie sector are essentially unproductive. Bankruptcies improve efficiency by shifting resources from failing to succeeding companies. When rules are changed to stop bankruptcies, efficiency is sacrificed. Worse, incremental resources are sucked up to pay fiscal deficits used to prop up zombie industries. Japan is thus trapped in equilibrium of low productivity.

Third, a long period of stagnation could worsen irreversible social change. A falling birth rate, for example, is one consequence that is wreaking havoc on the Japanese economy. Japan’s post-bubble policy was to let property prices decline gradually. Hence, living costs also declined gradually. On the other hand, the economy stopped growing, which caused income expectations to quickly adjust downward. The combination of high property prices and low income growth rapidly pushed down Japan’s birth rate. As a consequence, Japan’s population is declining two decades after the bubble. The rising burden of caring for the old will lower Japan’s ability to pay for anything else.

Legacy of the failed policies of stimuluses: Japan’s corporate indebteness is of about 180 % of GDP even if the households are “only” leveraged at 69 % of the GDP. Of course, the Government’s debt is one of the highest in the world at 194 % of the GDP (still some way to go for the US before becoming nipponized).

For Andy Xie, the Japanese experience prefigures what will happen to the US next year:

As the global economy is again showing signs of growth in the third quarter, most governments are celebrating the effectiveness of their policies. Yet Japan’s experience forces us to pause: Its economy experienced many such growth bounces over the past two decades, but was unable to sustain any of them. The problem was Japan only used stimulus, not restructuring, to cope with the bursting of its bubble. After the demise of any big bubble, serious structural problems that hamper economic growth remain. Stimulus can only provide short-term support that makes structural reform possible. When policymakers celebrate the short-term impact of stimulus and forget structural reforms, economies slump again. I think the Anglo-Saxon economies will dip again next year.

He sees the only solution in restructuring at the same time as stimulating. Bankruptcy, from that point of view is an essential tool as it refocuses resources on more efficient companies, rather than on the failing companies.

Andy Xie concludes by exploring some avenues and necessary restructuring for China, but in my view, many of his comments could be transposed to the US:

A bubble rises when there is excess money supply. Is the current, excessive monetary growth due to demand or supply? We can argue that point forever. When the former chairman of the U.S. Federal Reserve, Alan Greenspan, said a central bank couldn’t stop a bubble, he meant money demand would rise regardless of interest rates. I disagree. If a central bank targets monetary growth in line with nominal GDP growth, a big bubble can’t happen. Aside from central bank failure, then, the most important microeconomic element in a bubble is the shadow banking system.

Regulators limit what banks can do by imposing capital requirements. The international standard is 8 percent of total assets, but banks can use accounting tricks to minimize their requirements. But a big accounting loophole can lead to disaster. For example, the loose restrictions on off-balance holdings were major factors in the global credit bubble. Most regulators are now tightening accounting rules for capital requirements.

Shadow banking is a less noticed but more important factor in creating bubbles. Most analysts compare it to the hedge fund industry, which provided leverage for financial speculators with little capital. The shadow banking system is much more because industrial firms engaging in financial activities are more important. Entities such as GE Capital and GMAC provided massive leverage to asset markets with little capital. A shadow banking system is essential to a big bubble.

China’s corporate sector increasingly looks like a shadow banking system. It raises funds from banks, through commercial bills or the corporate bond market, and then channels the funds into the land market. The resulting land inflation underwrites corporate profitability and improves their creditworthiness in the short term.