[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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