History and predictions

From Zero Hedge:

By the early 1980s, Japan’s economic success was beginning to lead to unrealistic expectations about future prosperity. Many commentators, abroad as well as at home, used the ‘fool’s guideline’ of extrapolation to contend that Japan would, in the foreseeable future, oust America as the world’s biggest economy. The international expansion of Japanese banks and securities houses was reflected in the proliferation of sushi bars in New York and London. Boosted by the diversion of still-cheap capital from industry into real estate, property values in Japan soared, peaking at $215,000 per square metre in the prized Ginza district of Tokyo.

Comforted by inflated property values, banks made loans which the borrowers were in no position to repay. The theoretical value of the grounds of the Imperial Palace came to exceed the paper value of the entire state of California. Meanwhile, a soaring yen was pricing Japanese exports out of world markets.

Though comparatively gradual – mirroring, in true bubble fashion, the relatively slow build-up of asset values – the bursting of the bubble was devastating. Properties lost more than 90% of their peak values, and the government’s policy of propping up insolvent banks and corporations created “zombie companies” of the type that exist today in many countries. Having peaked at almost 39,000 at the end of 1989, the Nikkei 225 index of leading industrial stocks deteriorated relentlessly, bottoming at 7,055 in March 2009.

The Japanese economy was plunged into the “lost decade” which, in reality, could now be called the ‘lost two decades’. In 2011, Japanese government debt stood at 208% of GDP, a number regarded as sustainable only because of the country’s historic high savings ratio (though this ratio is, in fact, subject to ongoing deterioration as the population ages).

With hindsight, we now know that the Japanese asset bust was an early manifestation of the ‘credit supercycle’, which can be regarded as ‘the biggest bubble in history’. The general outlines of the super-cycle bubble are reasonably well understood, even if the underlying dynamic is not. To understand this enormous boom-bust event, we need to distinguish between the tangible components of the bubble and its underlying psychological and cultural dimensions.

Conventional analysis argues that tangible problems began with the proliferation of subprime lending in the United States. Perhaps the single biggest contributory factor to the subprime fiasco was the breaking of the link between borrower and lender. Whereas, traditionally, banks assessed the viability of the borrower in terms of long-term repayment, the creation of bundled MBSs (mortgage-backed securities) severed this link.

Astute operators could now strip risk from return, pocketing high returns whilst unloading the associated high risk. The securitisation of mortgages was a major innovative failing in the system, as was the reliance mistakenly placed on credit-rating agencies which, of course, were paid by the issuers of the bundled securities. Another contributory innovation was the use of ARM (adjustable rate mortgage) products, designed to keep the borrower solvent just long enough for the originators of the mortgages to divest the packaged loans.

We agree with the history regarding both Japan and the US. Pretty disturbing. With the MBS’s, mortgages became simply bundled bets, with the bookies the only ones sure to make money. A fool’s game, but apparently fun while it lasted.

As you would expect with an analysis of this sort, things are predicted not to end well in the credit super-cycle. There are lots of predictions (here and here for example) that China will go the way of Japan. We don’t know about that. As for the US, with its unique ability (so far) to print money or have the Fed finance Treasury borrowings, it’s hard to believe that this will end better than it did for Japan. We’ll see.

One Response to “History and predictions”

  1. Neil Says:

    1) What choice do the banks have? They no longer have control over long-term interest rates–the Fed and Fannie do.

    2) “Japan” is not an option for China. Their tree must grow to the sky, or the Mandate of Heaven is lost. What comes after that is anyone’s guess.

    3) “Japan” is an option for the U.S., at least for a while longer. The Fed’s ZIRP has simultaneously destroyed the value of pensions and annuities, 401k expectations, and savings accounts, resulting in a baby boomers’ savings rate that has shot the moon. At the same time, banks have been forced to put an awful lot of their liabilities into Treasuries. We have thus re-created the Japanese postal savings system that facilitated their lost decades, but deviously and with corruption built-in.

    This will not end well.

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