We are all Japanese now

By Chan Akya

This is the way the world ends
This is the way the world ends
Not with a bang but a whimper.
The Hollow Men, TS Eliot, 1925

Reading all the prognostications of an impending economic recovery, I am going to have to admit something that should have been apparent a few months ago; namely that the last nails in the coffin of free-market capitalism are now being readied. Whatever hope I had that the Keynesian fraud that has been perpetrated on the world economy would be unveiled as a hoax has been dashed by the steady "improvement” being seen in a number of key statistics.

Why is the situation any different from what it was a few weeks ago, when world stock markets had been rallying merrily into the storm of poor economic data? Indeed, I myself in two recent articles characterized the turnaround in the world economy as being a false note (see Raining on the Blue Fox, Asia Times Online, July 4, 2009, and Faith-based investing, Asia Times Online, August 5, 2009).

To be very clear, this article isn't about economic data or valuations. I still believe that economic data will flatter to disappoint and that stock market valuations will be dented in the fourth quarter.

My base case expectation for the S&P 500 by the first quarter of next year is 750 to 850. Make of it what you will (and all my usual disclaimers about using your common sense when trying to act on the words of a pseudonymous commentator such as myself applies to a larger degree here).

That said, the more important question does beckon - is it too late to save capitalism for future generations? After mulling the question for a while, I have to conclude that the act of saving capitalists from 2007 to now as done by the United States and Europe has essentially doomed capitalism itself, its place taken over by the smoky world of Japanese capitalism, where it isn't what you know but rather who you know that counts.

All hail the herald
My article last week (see Prada to Pravda, Asia Times Online, August 29, 2009) elicited an interesting query from a reader - namely whether I would be moving closer to admitting the death of capitalism with as much fervor as the death of communism barely 20 years ago?

This person noted - quite accurately - that I had been fixated for long on the evils of communism and perhaps it was time to look closer to home and figure out what it was that I was essentially supposed to be "protecting". Or words to that effect.

He (or she) had a very good point. If the collapse of the Soviet Union 20 years ago marked a watershed that has been called the seminal event in the collapse of communism, would not the collapse of the United States, in concept if not form, not mean the same for the future of capitalism?

As I mulled over the question (I did have a particularly long flight), it struck me that the essence of the question was not only fair but also accurate. The causal relationship between the collapse of US-style economic management could accurately be described as heralding an era of greater government intervention and the death of laissez faire as we know it.

It doesn't stop with the notion that capitalists had to be rescued by the state, or indeed that they were the ones desperately seeking bailouts from the very governments whose regulatory powers had been dismissed as pointless barely a few years ago.

That poisonous act, abetted by the Goldman Sachs clique in the US government, soon saw to it that the financial sector was mollycoddled by the US and European governments. In the process, government debt has ballooned even as bank balance sheets remain inflated.

To avoid the specter of capital being wiped out by loan losses, state-sponsored banks have taken the extraordinary steps of actually increasing their loans to problem sectors, hoovering up problem securities in the US and Europe while extending fresh loans to decidedly undeserving borrowers.

This system of targeted purchases of toxic debt, combined with the mere act of extending new loans to anyone threatening to default (as an easy way of avoiding the classification of problem loans) means that banking losses are back to being vastly understated. Meanwhile, with their funding costs restored to much lower levels and benefiting from a steep yield curve, banks are back in the black (especially as they no longer have to reckon with loan losses).

There is only one trouble with this comfortable arrangement: we have seen the movie before, and all it resulted in was a lost decade of growth for the Japanese economy. Or two decades, if one is perfectly honest.

Revenge of the zombies
There is a saying that the Japanese can make pretty much anything, except profits. The heart of that comment isn't so much about an obdurate system of corporate management, jobs for life or obsessive product quality. Rather, it is the simple failure of aligning the price of a product with its value.

As producers rapidly were priced out of the market for exports, the Japanese, instead of rationalizing capacity, simply took to using non-manufacturing sources of profits such as property speculation to buttress their results. Eventually, this led to a spectacular bust in the economy when a combination of banks, property companies and even general manufacturing companies all faced ruin.

How the Japanese muddled through for 20 years after the bubble is a subject unto itself, but governments which have a vastly different predicament are now misapplying some of the lessons learned through the period. [1]

In the case of the Soviet Union, the failure of the state in allocating resources helped to create colossal waste that over a period finally accumulated enough toxicity to destroy the system itself.

In much the same way, the crisis of 2007 was caused by a colossal misalignment of savings towards debt originated in the US and Europe, as savers from Asia piled into these assets as a safe haven from their own internal risks.

As a generic rule, this wasn't the failure of capitalism in the classic sense of the term, but rather the logical (capitalist) effect of resource misallocation. That distinction is for all intents and purposes semantic, as the effect was to have capitalist societies (the US and Britain mainly) being overextended to the point of ruin.

If governments in these countries had simply allowed many of the banks to fail, while protecting retail deposits, the capitalist solution would have worked out perfectly well:
1. Balance sheets of banks would have shrunk.
2. Borrowers would have been forced to cut their debts.
3. Worldwide deflation.
4. Unprofitable and overleveraged companies would have been closed down.
5. Economies would have contracted to the point where (some) capacity became profitable again.
6. Higher returns from such activity would have prompted new investments from surviving capitalists.
7. Economies would have resumed profitable growth, albeit at the lower trajectory.

Instead, we are left with the Keynesian nonsense of:
1. Government debt has ballooned to the point of no return across the Group of Eight leading industrialized countries.
2. Banks continue to have significantly overextended balance sheets.
3. Loan losses are being suppressed by irresponsible lending and vast quantities of money floating around.
4. Investors have resumed random gambling - also known as the stock market.
5. All this activity has created enough noise to warrant calls for a new global economic recovery.

The point isn't so much that the above situation isn't sustainable - even a 10-year-old can figure that out - but that a failure from this stage will not resurrect the capitalist spirit. Rather, we should expect people to wail for more government aid, higher allocations to certain industries and jobs and so on.

The greatest takeaway came from last weekend's elections in Japan that ushered the Democratic Party of Japan into power. Much of the world's media has marveled at the change in the power structure and so on, but failed to note that the underlying message was one of direct handouts to consumers as differentiated from handouts to construction companies, as was the norm under the outgoing Liberal Democratic Party.

So great is the fear of repeating the events of 2007-08 that caused political changes in the US (and soon possibly across Europe) that governments won't dare to utter the word "reform", to mean greater efficiency in government, for a generation at least.

We are all Japanese now.

Notes
1. The Holy Grail of Macroeconomics by Richard C Koo (Wiley, May 2009).

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