Published in Samurai Jinsei no Tatsujin (“Samurai Master of Life”) September 2013 edition
Prime Minister Shinzo Abe has changed my life. A year ago Japan was a forgotten country in investment terms. There was more interest in places like Mongolia and Turkey than in the world’s third largest economy. As a result I had plenty of time on my hands for reading, traveling, catching up with old friends and watching classic Japanese movies of the 1950s and 1960s.
Now there’s no time for any of that. Investors from all corners of the world, from the frozen north of Europe to the verdant pastures of South America are eager to know what is going on.
Is Japan really changing , or is this another false dawn? How many arrows are being fired , and in what direction? What about the debt? What about the demographics? TPP? Taxes? Casinos? Creches? Corporate governance?
All good questions to which nobody, not even the prime minister himself, can give a definitive answer. All we can do is trace the logic of events and try to chart a path through the fog of uncertainty.
It is difficult to imagine now, but when the bubble economy burst in 1990 Japan was lauded, hyped and feared as the new economic superpower, rather as China has been more recently. Best-selling books proclaimed that Japan was on track to displace the US as the world’s largest economy, thanks to the brilliance of its bureaucratic planners and the far-sightedness of its corporate managers.
I was probably the most bearish analyst in the market at the time, but even so not in my wildest dreams did I imagine the weakness in stocks and real estate would carry on for twenty two years.
As of 1990, Japan had next to no public debt and a massive trade surplus. Its banks were rated Triple A. Japanese companies bestrode the commanding heights of the world economy , with top market shares in semiconductors, consumer electronics and other high growth sectors. Sony, Sharp and JVC were the names on everyone’s lips.
All the macro indicators looked wonderful – but in fact it was the most dangerous time to invest. Japan was about to enter the long dark tunnel of deflationary stagnation.
Now we have the reverse situation. Japan’s public debt is the highest in the world and the trade account is in deficit. The banks’ main function is to borrow money from the public at zero percent and lend it to the government at zero percent. Some of the giants of Japanese electronics have disappeared from the radar screen; others need serious restructuring. The names on everyone’s lips are Samsung, Apple and Google.
All the macro indicators look terrible – but I feel the potential is there for Japan to emerge from its long malaise of economic decline and political marginalization.
But the key word is potential. Nothing is written in stone. Any mishap or misstep could cause another plunge in confidence – and this time there would be no way back.
Ultimately Abenomics is a delicate experiment in psychological alchemy. The result depends not on Prime Minister Abe himself, but on you, dear readers. Were you satisfied with the two lost decades, or do you aspire for something different?
The key is ki.
“Keiki”, the Japanese word for economic conditions, contains the character “ki”, meaning “spirit.” Keynes also emphasized the importance of “animal spirits” in influencing the decisions of entrepreneurs and consumers.
“A large proportion of our positive activities,” he wrote, “depend on spontaneous optimism rather than mathematical expectations.”
It is a commonplace now that large companies all over the world are hoarding cash on their balance sheets, rather than investing or engaging in M&A activity, because they “lack confidence” in the global economy. What are they waiting for? The appearance of that mysterious “ki” that has suddenly gone missing. Or, to put it another way, they are waiting for each other to act.
Normally monetary policy works by reduciing interest rates and thus making borrowing more attractive. But when interest rates are close to zero, monetary policy can only work by influencing expectations. Hence the importance of “guidance” , inflation targets and the firmly announced intention “to do whatever is necessary.” One of the problems with Japan’s previous monetary regime was that Bank of Japan officials often expressed doubts about the effectiveness of their own policies, thereby throwing buckets of ice-cold water on any nascent revival of animal spirits.
Changing the psychological climate is never easy, but it can be done. We have already seen it happen in reverse.
In the early 1990s many commentators asserted that the plunge in Japanese stock and real estate markets would have no effect on Japan’s strong fundamentals, which were said to based on super-competitive manufacturing, heavy R&D spending and a highly-educated workforce. They could not have been more wrong. The collapse in asset markets changed everything, including “the fundamentals.”
In the early 1990s, George Soros came up with the idea of “reflexivity.” His theory maintains that the financial markets do not just reflect reality, as standard financial theory assumes, but help to create it as well. Richard Koo’s concept of the “balance sheet recession” described one crucial transmission mechanism. Declines in asset prices create holes in the balance sheets of households, companies and financial institutions. Suddenly they have less equity than they thought and more debt. Their natural response is to increase saving and pay down debt.
When that happens to one sector or one region, the effects can be absorbed easily. Not so when everybody, from the head of the largest political faction to the local ramen shop owner, has participated in the preceding gigantic, multi-decade boom. When the bust comes, you get trapped in a ”fallacy of composition” – what is sensible and rational for each individual actor inflicts serious damage when everybody does it at once.
Put together reflexivity with the idea of a balance sheet recession and you have the mechanism for a complex feedback loop between the “symbolic economy” of asset prices and the “real economy” of consumption and capital investment. The negative feedback can continue for an amazingly long time, as we have seen in Japan. To modify Keynes’ explanation, “a large proportion of our negative activities depend on spontaneous pessimism rather than mathematical expectations.”
The result – animal spirits die and reptilian spirits take over.
To glimpse the practical effects, consider the housing market. Assume that the cost of a 30 year mortgage is 2%. Assume that the cost of depreciation is also 2%. In such a case, the total cost of ownership is 4%. In this simplified case, if the rental yield exceeds 4%, it makes more sense to buy the property than to rent it.
However, in post-bubble Japan the price of housing land has been falling at 3% per year. Add that to the calculation and you get an entirely different picture. Now it doesn’t make sense to buy unless the rental yield is north of 7%.
Now imagine a future in which Japan generates inflation of 2% and house prices rise in synch with that. Suddenly the breakeven yield for purchase falls to 2%. Yes, that’s right – in an Abenomical world the breakeven could fall from 7% to 2%.
That’s the difference between a continuing bear market in residential real estate and a ferocious bull market – and the same goes for other assets too.
Back to that word “ki” again. In English rising markets and falling markets are characterized by the two animals, bull and bear. In Japanese the terms are “strong spirits” and “weak spirits.” Japan’s “strong spirits” have been absent for so long that many people have forgotten they existed. “The Japanese are conservative investors who dislike risk” – how many times have we heard that? But it was far from the case in 1989, when Japanese individuals were lining up to buy shares in NTT with borrowed money and Japanese entrepreneurs were speculating in Fijian real estate.
In the spoof spy movie “Austin Powers”, the main character wakes up one morning to find that his mojo has disappeared. A mojo is a magic talisman familiar from the songs of blues artists like Muddy Waters. What it looks like and how it works remain mysterious, but without it our hero is shorn of his charisma and manly confidence.
Japan has experienced something similar. Its “strong spirits” went missing in the 1990s and ever since it has lacked the inner power that made it so formidable. There have been brief periods when confidence rose, only to droop again almost straightaway.
Can Japan do what Austin did and recapture what was lost? The timing, at least, could not be better.
Nothing lasts for ever – even negative feedback loops lose energy in the end. In the financial markets, weak spirits have been in the ascendency for an unusually long time. Major bear markets – such as gold and oil in the 1980s and 1990s and German equities from the early 1960s to the early 1980s – have rarely lasted longer than twenty years. Likewise, it is almost impossible for Japanese government bond yields to fall any further. The negative trade is all played out.
In recent years there have been signs of positive incremental change that tended to be ignored until the arrival of Abenomics. The most important has been corporate profitability, which has managed an impressive rise since the turn of the century, despite the headwinds of a strong currency and weak domestic demand. At the top of the cycle in 1999/2000, the Topix index generated earnings per share of a mere 25 yen. This year over 80 yen is expected.
The fertility rate and the suicide rate are two social trends that also appear to be past their worst. Japan’s total fertility rate hit a low of 1.26 in 2005, but has now risen for seven years in a row to 1.41. In 2012, the number of suicides fell below 30,000 for the first time in fifteen years and it looks like there will be a further fall this year. Until 1997 – the year of the first banking crisis and the onset of deflation – the number of suicides was stable at just over 20,000. It then jumped by almost 50% in a couple of years, with middle-aged men the main victims.
Are choices of whether to have children or to take your own life moulded by “ki” too? If so, the conditions were ripe for change. All that was needed was a catalyst.
In his book Anti-Fragile, Nassim Taleb posits the existence of three types of phenomenon. The fragile – which appears to be stable but breaks under stress – is exemplified by the New York banking system. The robust, which is insensitive to stress, includes low volatility financial products and medieval belief systems Then there is a third type, the anti-fragile,which uses harm positively, to renew itself and thrive. Taleb’s examples include organically developed networks such as Silicon Valley and the common law system.
Historically Japanese society and culture have exhibited some “anti-fragile” characteristics – meaning the reaction to trauma has been strengthening and growth. The coming of the black ships triggered the Meiji Restoration and breakneck industrialization. Defeat in the second world war spurred reconstruction and the economic miracle.
Conditions are very different now. Japan is a mature society with a high standard of living, so spectacular leaps or changes of direction are unlikely. Nonetheless, in the past few years Japan has suffered severe shocks which resounded deeply throughout Japanese society, leading people to reassess their assumptions and reconsider their personal priorities.
The first was the natural and man-made disasters of 3.11, which revealed both the strengths and weaknesses of the Japanese system to the world and to the Japanese themselves.
The second was the clash with China over the Senkaku Islands – a small issue in itself, but highly significant for what it means for the future balance of power between the two countries. For if China continues on its current path of growing influence and military capability and Japan continues down its recent path of economic weakness and diplomatic inertia – in such a case, what will the state of China-Japan relations be in twenty years’ time?
The two shocks conveyed the same message. The status quo is much riskier than it looks.
The word Abenomics appears to be based on Reaganomics. It is fair to say that Ronald Reagan probably did not have a great command of economic theory, but he knew what he wanted to achieve – to make America feel good about itself again after the disasters of Vietnam, Watergate and the Iranian hostage crisis. Economic optimism – “morning in America” – was part of a package that also contained greater national pride and assertiveness.
Abenomics is similar. It is almost impossible to imagine Japan reflating successfully in economic terms – “Japan is back” – without a simultaneous recovery in cultural self-confidence and global presence. On the other hand, if Abenomics fails, Japan’s national prestige will continue to deflate with ultimately perilous consequences. The stakes could not be higher.
The success of Abenomics depends on durable economic recovery – which depends on jamming the balance sheet feedback loop into reverse – which depends on the asset markets shifting from weak spirits to strong spirits – which depends on perceptions of the success of Abenomics.
In other words, everything depends on something else.
So we are right back where we started. The ki is key. Your ki.