IS THE U.S. ECONOMY TURNING JAPANESE ? / THE WALL STREET JOURNAL OP EDITORIAL ( HIGHLY RECOMMENDED READING )

The Wall Street Journal

OPINION

OCTOBER 28, 2009

Is the U.S. Economy Turning Japanese?

By CHRISTOPHER WOOD

Happy days are here again in world stock markets. This week's profit-taking notwithstanding, the Dow Jones Industrial Average is flirting with 10000 and the S&P 500 is up 60% from its March low. Still, if risk-seeking behavior has returned to financial markets, much of it is funded by borrowing increasingly cheap U.S. dollars. There is also very little evidence, if any, that consumption and employment are really recovering in America.

With the U.S. government stepping in to keep markets from clearing, today's U.S. economy in many ways resembles the post-bubble Japanese economy of the 1990s. Ultra-loose monetary policy and low demand for credit, combined with high unemployment and consumer deleveraging, could lead to a prolonged slump.

Consumption, which still accounts for 71% of total nominal GDP in America, is still weak, and there remains little reason to expect it to pick up in a healthy fashion. Aside from the well-known and related issues of high household debt and negative equity in houses, the latest U.S. employment data have highlighted the still dismal state of the job market. Average weekly earnings of production workers rose by only 0.7% year on year in September as the average number of weekly hours worked fell to a record low of 33 hours. This marks the lowest annualized weekly earnings growth since the data series began in 1964.

Meanwhile, there's an unhealthy reliance on government for growth in America's increasingly command-driven economy. This is clear from the severe slump in car sales post "cash for clunkers." U.S. auto sales declined by 35% month on month in September to an annualized 9.2 million. It's also clear from the enormous role now played by government in the residential mortgage market. Government-guaranteed mortgages accounted for 98% of total mortgage-backed security issuance in the third quarter.

The reality of an increasingly command-driven economy in America means that government policy is likely to become the key determinant of where investors should place their money. For example, the near-term prospects for the housing market in the U.S. will be strongly influenced by whether the federal government extends its first-time home-buyer tax credit when it expires in November. Like cash for clunkers with autos, the risk is that such a program is simply buying demand from the future.

The other risk is the same as subprime mortgages—encouraging people to buy houses who may be better off renting. This is suggested from the growing delinquency rates on Federal Housing Administration (FHA) approved loans since the FHA has taken over from Fannie Mae and Freddie Mac as the prime way of increasing U.S. taxpayer exposure to future residential mortgage defaults. The default rate on FHA-insured mortgages was already running at 8.1% in August, up from 5.7% a year ago.

Then there's the government involvement in the U.S. financial sector. Over the past two years the federal government is estimated to have lent, spent or guaranteed around $11 trillion to the financial sector, broadly defined. This is due to Washington's slavish adherence to the absurd notion that financial institutions can be "too big to fail," be they called Fannie Mae, AIG or Citicorp.

All of the above behavior invites legitimate comparisons with post-bubble Japan, where banks took years to be cleaned up as a result of regulatory forbearance. The same kind of forbearance is preventing America's increasingly distressed commercial real-estate market from clearing. Similarly, as was the case with Japan, monetary-base growth has exploded in the U.S. over the past year courtesy of the Fed, while bank lending is declining. This is why there is every reason to fear that America is already in a Japanese-style liquidity trap.

True, Japan's bubble economy was much more about corporate-debt excesses, most of it borrowed against land or property collateral, rather than personal debt, as is the case in the U.S. But if the comparisons between the two countries are far from precise, the Japanese example shows how investment behavior changes if a deleveraging deflationary trend becomes entrenched.

This can be seen in the dramatic change in Japanese institutional investor asset allocation between government bonds and equities. Japanese insurance company and pension fund share of assets in domestic stocks peaked at 37.2% in fiscal 1988 (which ended March 1989, near the height of the bubble) and has since collapsed to 6.4% at the end of fiscal 2008, while their share of assets in Japanese government bonds surged to 36% in fiscal 2008 from 3.2% in fiscal 1990.

By contrast, in America institutional investors remain overweight equities and underweight government bonds. This will change radically if the U.S. truly is in a deleveraging cycle. Still, the process will take time. It was not until 1998 that Japanese insurance companies and pension funds had a greater percentage of their assets in government bonds than equities.
This is why Wall Street should make the most of the rally in U.S. stocks while it lasts. The next bubble in asset markets will not be in the West but in emerging Asia, led by China. The irony is that the more anaemic the Western recovery proves to be, the longer it will take for Western interest rates to normalize and the bigger the resulting asset bubble in Asia. Emerging Asia, not the U.S. consumer, will be the prime beneficiary of the Fed's easy money policy.

—Mr. Wood, equity strategist for CLSA Ltd. in Hong Kong, is the author of "The Bubble Economy: Japan's Extraordinary Speculative Boom of the '80s and the Dramatic Bust of the '90s" (Solstice Publishing, 2005).

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