Analysis: Japan’s Lost Decade Still A Risk For U.S. Economy

Teni Sow | September 20, 2011 | 0 Comments

NEW YORK (Steven C. Johnson) – As the U.S. economy slouches toward another recession and confidence in policymakers erodes, investors are coming to grips with the notion that the country may already be several years into a Japan-style lost decade.

If so, the years ahead could be a very tough slog. U.S. households, unlike those in Japan, have higher debts and lower savings, while massive deficits have sapped political support for the type of robust government spending Japan relied upon.

In short: in a prolonged period of anemic growth, the U.S. economy may have a slimmer margin for error.

“I’m more convinced we are headed in that direction,” said Scott Mather, portfolio manager at PIMCO, the world’s largest bond fund with $1.2 trillion in assets under management. “We might have an even harder time than Japan did.”

Not all economists believe the United States will repeat the Japanese experience, but markets have been flashing warning signs.

Three years after the United States’ housing bubble burst, 10-year Treasury yields are struggling to stay above 2 percent, while stocks have declined every month since April.

Japan’s 10-year yield has not closed above 2 percent since 1999 and the Nikkei is 77 percent below a peak hit in 1990 before a commercial real estate bubble burst.

U.S. economic output through the second quarter of 2011 has yet to surpass the level seen before the crisis hit in 2008 and may not do so soon; economists polled by Reuters give the country nearly one-in-three odds of falling back into recession over the next year.

“The financial turmoil of the last three or four months has been the markets coming to terms with a period of prolonged slow growth,” said Andrew Scott, professor of economics at London Business School. “With households paying down debt and not consuming, it’s hard to see where growth will come from.”

MISDIAGNOSING THE DISEASE

Boosting exports — an early objective of the Obama administration — won’t be easy since most of the developed world is also ailing, with Japan, Britain, Switzerland, China and others wary of allowing their currency to gain too much strength.

That means America can’t rely on steady dollar weakness — Europe’s ongoing debt and banking crises have recently boosted the greenback against the euro — to sell more abroad.

“Japan (in the 1990s) had a world that was booming around them, and they are an export-oriented economy that could take advantage of that,” Mather said.

And while Japanese households were net savers, U.S. consumers relied on rising home prices to fund their spending, an option that dried up when the housing bubble burst.

“We will be lucky to do as well as Japan, because they at least had a stack of cash to help them through,” said Michael Cheah, who helps manage $1.5 billion at SunAmerica Asset Management in Jersey City.

Some economists argue both Japan and the United States misdiagnosed their economic diseases. When credit-driven asset bubbles burst, an indebted private sector — companies in Japan, households and banks in the United States — focused exclusively on paying down their debts.

In such instances, even slashing interest rates to zero, as both the Federal Reserve and Bank of Japan did, won’t boost activity because there is no demand to borrow.

“That’s when the classical economics taught in universities goes out the window,” said Richard Koo, chief economist at the Nomura Research Institute and author of “The Holy Grail of Macroeconomics: Lessons From Japan’s Great Recession.”

STIMULATING DEBATE

Koo said Japan’s eventual embrace of robust fiscal stimulus filled the gap left by the private sector and kept the economy from tumbling into full-fledged depression. By 2006, Japanese growth had started to recover and interest rates to rise, though momentum dried up when the 2008 financial crisis hit.

“It took Japan 15 years to recover because policy was applied in such a zig-zag fashion,” he said. “If the United States could maintain fiscal stimulus for three to five years, I’m sure the economy could pull itself out sooner.”

For investors, that’s a big “if.”

With the United States already running one of the largest budget deficits as a share of output since World War II, political opposition to fiscal stimulus is high and rising. President Barack Obama proposed a $447 billion job creation plan this month but Republican leaders in Congress oppose plans to pay for parts of it with higher taxes on the wealthy.

Standard & Poor’s stripped the United States of its top AAA credit rating in August, citing concern politicians could not agree on ways to reduce deficits over the long run.

The subsequent stock market sell-off was driven partly by “the realization….that there will be less ability to stimulate the economy with fiscal measures,” John Chambers, head of S&P’s sovereign ratings committee, said last week.

Almost half of outstanding U.S. government debt is held by foreigners, and recent Treasury data shows demand has slipped in recent months.

Of course, massive spending swelled Japan’s debt burden, too — it’s now more than 200 percent of output. And while the government has been able to finance it by borrowing from its citizens, that may change as its aging population retires.

But “Japan faced a depression and avoided it. They could have done much worse,” said Robert Madsen, senior fellow at the MIT Center for International Studies. “The responsible policy was to use fiscal policy.”

DEFLATION OR INFLATION

Alan Wilde, who helps manage $52 billion as head of fixed income and currency at Baring Asset Management, said he “remains to be convinced” that the United States is destined for a “Japan-style lost decade.”

For that, he credits the Fed, which acted more swiftly than the Bank of Japan by pumping trillions into the financial system through asset purchases and avoiding deflation.

In fat, he says bond investors may need to keep an eye on inflation. Data last week showed core consumer prices, which remove food and energy costs, rose 2 percent in the 12 months to August, extending a recent upward trend.

“My hunch is we end up with much higher inflation,” he said, as “bond markets show much greater volatility than previous years as we lurch from strong recovery to abject disappointment with more regularity.”

That could limit the future Fed flexibility, too. Markets expect the central bank to tilt its bond portfolio toward longer-dated maturities when it meets September 20-21 to try to push long-term interest rates lower, a move that won’t add to the money supply and, some say, won’t do much for growth.

“To get banks to lend, we’re going to flatten the curve? The 10-year is already there, and if you can’t stimulate the economy with a 10-year yield at 2 percent, 1.5 percent isn’t going to do it either,” said David Brownlee, head of fixed income at Sentinel Asset Management in Montpelier, Vermont, with $28 billion under management

“For years up to 2008, the economy lived large on leverage, and now we’re unwinding all of that,” Brownlee added. “You could easily see a decade of slow growth.”

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