The Japanese economy went through 15 years of stagnation and 4 years of near zero growth since its peak in 1990. Since the reasons for their economic melt-down and ours are very similar, we can learn from their efforts to right their economy.

What Happened in Japan:

• The world’s 2nd largest economy was expanding at an unsustainable rate from a ballooning credit market.

• A property bubble burst in 1990. Commercial property remains a fraction of the 1990 value.

• The stock market burst (parallel bubble) and remains roughly 70% lower than where it was in 1990. Along the way there have been 4 50% market rallies, that have been given up.

• The amount of wealth lost was 3X annual GDP. This is more than was lost in the US Great Depression on an absolute and proportional basis. Yet Japan did not enter a depression because the federal gov’t stepped in and did all the spending to keep the economy afloat.

• The cost has been a bloated debt at over 220% of GDP that may never be repaid. Mind you the debt is owed to its own citizens (unlike the US). 10% of the Japanese federal budget is for interest payments on the debt—and this is with interest rates on their bonds around 1-2% (I am sorry to say the US is currently in the same boat – about 10% of the federal budget goes to pay interest on our federal debt).

• When the Japanese people slow their pace of buying Japanese bonds – when they begin drawing down their savings in retirement – the Japanese gov’t will have to raise interest rates to find another buyer for their bonds. Higher interest rates (even just average interest rates prior to the boom & crash) will quickly overwhelm their federal budget. See a problem here? Some say this is the situation the US is facing.

What we can learn from it:

• When asset bubbles burst, they can take a long time to recover. Japan is 19 years in recovery and with a long way to go to get back to where they were (if they ever will).

• Since our asset bubble collapse was only 1/3 the size of theirs, we may only see economic stagnation/ or contraction for 5 years. (we’re now 2 years into it)

• The reason asset bubbles are so powerfully bad is because they cause a “balance sheet recession”. Picture a balance sheet. On one side are the assets, the other has liabilities.

• Balance sheet recessions have happened in Japan (1990 – now), Germany (2000 to now), and now the US (2007- now). They are very rare, but bring drastic changes to countries. Other countries sharing in this balance sheet recession: the UK, Ireland, Spain, Greece, Portugal.

• A balance sheet recession is when liabilities remain the same but the assets on a balance sheet are marked down in value aggressively to reflect what they’re now worth. Add leverage to this, and very quickly individuals and businesses become insolvent. Here is a real world example to put it into perspective (yes this situation has happened):

o A man treats himself to a new $1M yacht in 2002. He puts down $200K, and takes out a loan for the rest since the builder is offering a sweet 4% interest rate. He figures he can handle the payments and doesn’t pay attention to the fact that he is borrowing $800K.

o 2007-2009 happens and he loses his job / business goes under.

o He now finds that the only buyers in this economy are bottom-feeders willing to pay $200K for the boat. Now he has a balance sheet issue that is going to cause a major change in his spending habits (a recession). All his equity is gone, the $100K in payments he made has managed to drop the loan principal to $750K, and after he sells the boat, he is left with 0 assets and a loan (liability) of $550K. It will take him decades to pay this loan off – when he does get a job (which, these days is for less money than previously earned). This is analogous to what Japan went through – and why it took 19 years to get to a point where banks & business balance sheets are now healthy.

• Nobody wins from the truth about a balance sheet recession being made public. So the public is basically misled (lied is a strong word) into thinking that everything is OK.

o Companies with viable businesses but with assets worth far less than their liabilities (technically insolvent) are going to do what you’d expect: radically reduce spending, borrow nothing, pay down debt, and tell no one of their situation.(FYI: The International Monetary Fund (IMF) knew nothing of Japan’s poor balance sheets until 1997.) It does not matter that banks are offering loans at historically low interest rates since companies are not borrowing. (and at this time US banks are pretty much still just offering to lend to large companies with stellar cash flows and balance sheets. Small companies are not able to get access to credit. Maybe when CIT comes out of bankruptcy…)

o Banks. If you are the banker for a client with a balance sheet recession, you rightly want to know the financial health of the client / business, but you know that if you find bad news, you will have to call in the loan and force the a client / business –that is otherwise viable– to close down. You don’t get paid back in full, and lose money on the loan. Repeat this a few hundred or thousand times and sooner or later your bank will stop wanting to know what shape your clients are in. You’ll only care that they keep making their payments.

Does this look familiar? This is what happened in Japan and to a large extent is happening here in the US. Recall last week’s letter where I pointed out that many Sr Mgrs of large businesses are not taking loans to grow infrastructure even though they may borrow at spectacularly low interest rates. Surely the business managers are confident that they can deliver higher return on equity to shareholders than 5% from a short term business loan ? No?

If the US consumer is going through their own balance sheet recession (personal debt at 122%!!), they won’t be spending for years either, so there is little reason to expand business for anticipated growth. In the short run, business may cut costs, improve inventory management, apply pressure on wages, and let their accounts payable stretch out (don’t pay your suppliers on time). But absent the US consumer, there will be little economic growth. This is exactly what we’ve seen in 2008-2009. Corporate earnings are 10-20% lower than initial year estimates. Revenue is down considerably, but recently lowered earnings estimates are being delivered/beat by short term business tactics (see tactics earlier in this paragraph).

What’s it all mean? It means we’ll see trillion dollar deficits in the US for years. Mountains of bonds will be for sale from many federal governments. Normally, this mountain of gov’t bonds would run the risk of making it hard for businesses to raise money needed for investment and operations. But since they are entrenched in balance sheet building mode, this is not an issue – for now. Most viable large businesses are going to put their balance sheet in order much faster than federal or state governments will be able to do. So at some point, businesses are going to have a hard time competing with governments for cash when they need it.

It means interest rates will stay low for an extended period of time because many central bankers need them that way in order to manage their burgeoning debt. Obviously this means we’ll see asset bubbles re-flate. Stock markets will go through violent boom / busts. For several years to come, we’ll see stock market volatility on a scale like we’ve seen over the past 2 years, I am sorry to say. Gains will be rented, not owned.

If I’m wrong, and interest rates spike up because of competition to issue bonds, that’s obviously a lot worse. Let’s not go there.