The coming Japanese militarism

Michael Pollak mpollak at panix.com
Mon May 10 02:23:38 PDT 1999


[Okay, I'm over quota, but I promise to be under during the workweek. This last piece from the Stratfor archives follows hard upon their analysis of Indonesia, and it's the place where they diverge the farthest from the common wisdom. The reason I bring it up is that it's based on a very eclectic view of Japan's current economic problems, but one they manage to make sound almost plausible. I would be very interested to see what our resident mavens have to say, especially since you guys were hashing out Japan's situation only a few days ago.]

8 March 1999

The Nikkei Rally and the New Asian Reality

Summary

The 5 percent rally in the Nikkei on Friday has as much to do with

government strategy to increase the market prior to the end of the

fiscal year as it does with economic reality. The underlying economic

reality in Japan is still extraordinary weak, reminding us of the

United States in the 1970s. Keynesian pump-priming will, we feel, make

the situation worse, not better, as it did in the early years of the

Carter Administration. The problem then, as it is in Japan today, is

capital formation, not demand. One of the strategies used for capital

formation by Reagan, in addition to tax cuts for the wealthy, was

increased defense spending. We observe that both major U.S. economic

recoveries this century involved massive increases in defense

spending. Japan's geopolitical and economic condition both argue for

massive increases in defense spending. However, Japan's political

system will not support this. When there is such a divergence between

political sentiment and geopolitical and economic necessity, the

natural result is a massive political crisis. That seems to us

inevitable.

Analysis

The sudden and spectacular surge in the Nikkei leaves us with two

questions: what does it mean and does it matter? The nature of the

first question is obvious. Is the Nikkei surge signaling that the

worst is over for Japan and that it is joining South Korea and some of

the rest of Asia on the path to final recovery? The second question,

does it matter, is more complex and subtle. Does the future of Asia

still depend almost exclusively on economics or have we entered a new

period in which non-economic news is as important, or even more

important, as economic news. In other words, quite apart from the

economic cycle, did October, 1997 mark the end of the era of economics

that dominated Asian life since the death of Mao?

Let's begin with the simpler and perhaps less important question: the

Nikkei rallied by over 5 percent on Friday; does this mean the end of

Japan's recession? Certainly, even within a long-term down turn, there

are opportunities for rallies, not only in the markets but in the

economy as well. This may well turn out to be such an upturn in a

general downtrend, but even that is not clear.

There were several reasons for the market rally. The first, and

perhaps most important, is that we are now in March. March 31 marks

the end of the fiscal year. The government has a vested interest in

increasing the value of stock portfolios. Doing this increases bank

valuations at the all-important end of the year audit, while also

increasing loan collateral for troubled loans. In short, an end of the

year rally has disproportionate value compared to rallies at other

times of the year.

The government took some steps during the first week to trigger such a

rally. First, short-term interest rates were cut again, this time

allowing banks to borrow at about zero interest rates. The government

also addressed the unemployment problem that now stands at over 4

percent and is, in fact, substantially larger when hidden unemployment

is taken into account. The Japanese government announced a good

old-fashioned Keynesian job creation program, which when coupled with

the interest rate cut, managed to weaken the yen substantially. That

made Japanese exports cheaper and, therefore, kicked off a massive

stock market rally. With luck, the rally might last until the end of

March, thereby stabilizing weak balance sheets throughout Japan. It

might even increase economic activity somewhat.

But Japan's problem is not that its short-term interest rates are too

high. The difference between free money and practically free money is

trivial. The real problem is a long-term capital shortage in Japan,

reflected in relatively high long-term interest rates. Indeed, the

real fact of the matter is that the true interest rate in Japan is

even higher, since money at all rates is carefully rationed to favored

customers, and some are unable to borrow at any price. On an

international scale, the true price of interest in Japan, particularly

in secondary and tertiary companies, is as high as junk bonds

anywhere. The rate cut has no effect on the fact that most companies

can't access money except as needed to stabilize the system as a

whole.

The endemic capital shortage is caused by over-employment not

unemployment. To be more precise, Japanese businesses still employ far

too many people relative to production and profits. What Japan needs

is a massive dose of austerity that forces companies to lay off people

who are then hired by newly created, entrepreneurial organizations.

Japan needs a short-term cut in consumption designed to force capital

formation. The paradox of Japan's high savings rate is that it is used

to manage cash flow rather than create capital. Cutting unemployment

is politically sensible but the exact opposite of what needs to be

done.

This is reflected in the relative effect of prices on Japanese

international competitiveness. The expectation that lower prices will

increase Japanese exports has some merit, but only some. During the

early 1990s, Japanese products competed not only on price but also on

quality. They were seen as, and actually were, superior to U.S. and

European products, since they were the products of newer, more

innovative and efficient factories. But the United States, in

particular, has re-capitalized its economy dramatically and its

factories are more than a match for Japanese factories in terms of

innovation and quality. With the booming American economy, the paradox

is that lower prices will not have the dramatic effect that a cheaper

yen was able to produce in the past.

The Keynesian solution assumes that there is an underutilized but

highly efficient industrial plant waiting to be used. Each increased

unit of production increases net profits on an ascending curve, until

production begins to push toward capacity. However, if the industrial

plant is aging and even obsolete, increasing production has the

opposite effect, squandering resources with a much shallower yield

curve and much earlier declines in production on the plant utilization

curve. This is precisely what happened in the 1970s in the United

States when the Carter Administration applied Keynesian pump-priming

techniques to an aging industrial plant during a time of capital

shortage. Increased demand actually accelerated capital scarcity

through the over-utilization of inefficient plants. It increased

interest rates and inflation simultaneously.

The virtue of supply side economics, for all of its vices, was that it

focused on the central issue: increasing capital formation. Tax cuts

targeted at the wealthy were intended to generate increased investment

capital. The willingness of the Reagan Administration and the Federal

Reserve to implement tax rate cuts while keeping interest rates high

was designed to hold down the utilization of the industrial plant

while simultaneously generating capital for modernization. That, along

with falling commodity prices, did the trick.

Japan is following the early Carter Administration strategy (which was

abandoned in the later part of Carter's term, but too late to save his

administration). There will be a short- term bounce in Japan's

economy. But the core problem is to increase capital formation, to

modernize Japan's industrial plant, and to dramatically shift the

equation. One of the powerful tools used by Reagan was dramatically

increased defense spending. Defense spending, unlike other consumer

spending, enhances capital formation by stimulating technological

innovation in dramatic and exaggerated ways.

This brings us to the second question. Apart from Japan's mini-boom,

this was a week in which the deployment of North Korean missiles,

Chinese espionage against the United States, and an unhappy visit by

Secretary Albright to China seemed to dwarf the business and economic

news of the region. As we have said many times before, without really

being believed, it seems, we are in an era similar to that which

preceded Mao's death, in which politico-military affairs are becoming

at least as important as business affairs. Most observers are not yet

used to this shift, and see politico-military affairs as really

diverting from the main story-the main story being economic.

This points us in an interesting direction. Most truly successful

long-term recoveries this century in the United States have been

linked with massive increases in defense spending. The depression was

ended by World War II. The stagflation of the 1970s was partly solved

by Reagan's massive increase in defense spending. Japan is in a very

similar position to the United States in the 1970s. They are also

facing an increasingly dangerous North Korea, a China that is turning

hostile and a very uncertain Russia. Increases in defense spending

make both political and economic sense.

We believe that this is a direction that Japan will have to move for

both political and economic reasons. But it is a direction that will

require massive political re-alignment. Japan's geopolitical

requirements and economic recovery strategy both require massive

armament. Japan's internal political structure can't yet support the

shift. When there is such a divergence between geopolitical and

economic necessity and political reality, the inevitable outcome is a

massive political crisis. Until that crisis takes place and Japan

redefines itself, we feel that all rallies will be temporary.

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