Japan as object lesson: does culture make a difference?
We explored in a recent paper the idea that Japan’s dire experience in the 1990s is a warning of the fate in store for over-borrowed western economies. The idea has continued to gain ground in the US and in the UK (for instance in a series of FT letters). These comments tend to focus on policy errors supposedly made by Japan that western governments and central banks are less likely to make. In this brief item I question whether these were really errors or a reflection of Japan’s culture. Depending on how long it now takes for the gung-ho anglo-saxon economies to restore sound financing, and what price they pay in long-run inflation, this cultural difference does not invalidate comparisons. Indeed, history may even judge Japan’s conservative financial culture to have served it in better stead over the long term.
The significance of prolonged bear markets Our research paper focused on stock market returns, adjusted for inflation, as the measure of the impact of a period of economic stress associated with households, companies and banks all trying to increase their liquidity and balance sheet strength. What we observed is that Japan’s peak to trough decline in real terms was very similar to that experienced by the UK in the 1970s. But whereas the UK’s worst bear market lasted just two years, Japan’s lasted for as much as 14 years. This was also longer than the period of falling real stock prices in the US Depression and the period of ‘Eurosclerosis’ in Continental Europe in the late 1970s.
Prolonged bear markets are rare but occur more frequently than many investors realise. We suggested the duration of a bear market makes a big difference to investors, compared with its ultimate degree, crushing opportunism and reinforcing risk aversion.
From the narrow but very useful perspective of modeling long-term real returns for equity markets, it is clear that prolonged bear markets need to be assigned some probability of arising if the true risks of holding equities (and particularly drawing down from equities) are to be communicated to investors.
What people think happened in Japan The economic interpretation of Japan’s prolonged bear market from 1990 to 2003 has three typical strands. First, monetary policy was too restrictive and impeded the effects of fiscal expansion. Second, banks were too slow recognising their losses as the market prices of their collateral weakened and they continued to support weak borrowers. Third, structural reforms that could have helped the economy recover were frustrated by political conservatism.
The three strands together supposedly led to an inappropriate bias to austerity. How we listen to these arguments is of course conditioned by the fact that it was less risk-averse western governments that counselled Japan, at the time, to be ‘more like us’.
These all reflect to some extent the innate financial conservatism of the Japanese. Faced with the loss of secure, life-time employment, households’ instinctive priority was to increase liquid savings balances. Faced then with persistent weakness in personal incomes, mostly widely spread rather than focused on the unemployed, the Japanese chose not to use their prudently high savings to cushion the impact of weak incomes and spend more. Monetary policy tried to counter this conservatism by keeping interest rates very low but with moderate deflation persisting for much of the ensuing recession, real rates were inevitably higher.
This demand-based interpretation seems more productive than focusing on the possible conflict between an austere bias in the Bank of Japan and fiscal expansion by the Government, particularly since the public spending growth was not directly linked to households anyway.
When conservatism is rational The idea that households’ preferences for balance sheet management are rational and should not be ‘managed’ by fiscal policy was voiced in a recent letter to the FT by Willem Thorbecke of the Research Institute of Economy, Trade and Industry in Tokyo, referring to US consumers.
“High spending was rational for individuals during the bubble. The problem is it is unsustainable… High saving is now rational for individuals after housing prices have collapsed, and will help to rebalance the global economy. The problem with using fiscal policy to stimulate consumer spending is that it risks keeping the world economy on the same unstable trajectory that it has followed over recent years. The US economy is very resilient, and we should let it respond on its own to any dislocations caused by a much-needed increase in saving.”
In response, Roger Sandilands, Professor of Economics at the University of Strathclyde, thought it ironic this advice should come out of Japan:
“The Japanese response to the collapse of asset prices in 1990-91 was a big increase in the propensity to save as households tried to rebuild their wealth. The ministry of finance increased fiscal deficits massively but financed them through the issue of bonds which households eagerly absorbed. This crowded out any fiscal stimulus. For meanwhile the conservative Bank of Japan, barely on speaking terms with the ministry of finance, refused to monetise the fiscal deficits. The result? More than a decade of deflation and stagnation.”
Banking differences I would be more easily persuaded by the case for policy errors, instead of rational balance sheet preferences, if it were clear that the Japanese banking system had shaped these preferences and that this could have been avoided by bank management, with or without the help of government.
Japanese banks differ from Americans in a number of important respects. In their approach to close relationships with client firms, consolidated by share ownership, Japanese banks have more in common with the European banque d’affaires model. To the extent that falling share prices therefore weakened bank balance sheet capital ratios, this was unfortunate but it did have an advantage in maintaining access to credit for many Japanese firms, not just weak ones. Indeed, the financial performance of Japan’s corporate sector throughout the recession was actually quite impressive. In America’s more pluralist financial markets, relying more on securitised capital markets than banks (let alone relationship banking), it is by no means obvious that banking and credit-market dislocation in an American recession will produce better outcomes for firms.
It is also argued that public money could have been used to recapitalise the Japanese banking system at an early stage of the recession. But because the prices of Japanese collateral, both property and share prices, did not fall quickly, this is to apply hindsight about the ultimate degree of market losses rather than the way in which those losses actually emerged.
The suddenness and gravity of the liquidity crisis within the anglo-saxon banking system (largely due to its engagement in securitisation) is far more menacing than the problems Japanese banks faced, which were specific rather than systemic.
Conclusion It is clear that Japan’s sector financial balances never got as much out of hand as they have in the US (and arguably the UK too) and the bursting bubbles of commercial property and equities did not impact Japanese households as much as the US housing bubble affects US households. America’s challenge is on paper far greater. It remains to be seen whether Japan’s innate conservatism or the anglo-saxon economies’ new conservativism, born of the necessity to rebuild exceptionally depressed savings and reduce borrowings, will have the greater long-run effect.