The Lost Decade: How the U.S. Financial Crisis Resembles Japan's Ten Years of Misery - And How to Play it

William Patalon III

Part I of a two-part story.

By William Patalon III
Executive Editor
Money Morning/The Money Map Report

If you think the "Lost Decade" Japan endured during the 1990s was deep and painful, stick around: As the global financial crisis that was jump-started by the meltdown of the subprime mortgage market continues to unwind, the U.S. economy is headed for a financial Ice Age that will make Japan's 10 wasted years seem like a single chilly night.

The two meltdowns started in much the same way - with busted stock-and-real-estate bubbles. With both the United States and Japan, the market manias were ignited by laughably loose credit policies, smoldered under a lack of oversight from government regulators, market analysts or such private-sector sentinels as credit-rating agencies, and were finally fanned into a frenzied financial conflagration by the promise of easy profits.

Americans are already getting financial frostbite. Unemployment is 20% higher than it was a year ago. Zooming meat, dairy and gasoline prices are eviscerating household budgets, meaning that the "real" rate of inflation is probably double or triple what the federal government would have us believe. Mortgage defaults are at their highest level in 30 years. Home prices have fallen so much that they've wiped out all the gains of the past four years. And U.S. stocks have eradicated a decade's worth of profits.

That's all bad, of course. In fact, it's downright awful. But here's the problem.

It's going to get worse. Much worse. And here's why.

Anatomy of a Lost Decade: Japan

Just look at what happened in Japan. Success in the export markets - coupled with a strong tariff policy that protected the home market from imports - pumped up the yen and led to a massive buildup of cash in both Japan's corporate coffers and among its consumers. That spawned an era of easy credit, and that fueled a frenzy of stock-and-real estate speculation unrivaled since the U.S. Great Depression.

Almost overnight, the newly wealthy Japanese were viewed with fear. Americans talked about the invincible "Japanese superman," an unstoppable juggernaut who never made mistakes. Japanese cars filled American roadways, Japanese cars filled American roadways, and Japanese-owned companies treated the U.S. market like it was a private rummage sale. Suddenly, Universal studios, Columbia Records, Rockefeller Center and the Pebble Beach golf course (with its lonely cypress tree) all had new ownership.

U.S. lawmakers sounded the alarm. And so did the news and entertainment media. Fortune magazine carried a piece entitled,
"Where Will Japan Strike Next?" And author Michael Crichton's alarmist book, "Rising Sun," was made into an equally alarmist - but no less fun to watch - feature film that starred Sean Connery and Wesley Snipes.

At the height of the insanity, Japan boosters regularly claimed that the land beneath the Imperial Palace in Tokyo dwarfed the value of the entire state of California - an argument that defied reason, and yet could be substantiated mathematically with actual market values. In 1989, in Tokyo's Ginza district, prime office space was going for $139,000
a square foot.

On Dec. 29 of that year, the Nikkei 225 Index topped out at 38,957.44, before closing at 38,915.87. By the following September, it had nearly been halved - and there was still much more bloodletting to go (despite several subsequent rallies up over the 20,000 threshold, the Nikkei ultimately bottomed at 7,830 in April 2003. It closed yesterday - Wednesday - at 12,760.80, still down 67% from its trading high 19 years ago).

The fallout from that meltdown was incredible. By early 2004, houses were selling at 1/10th their peak value, and commercial real estate was selling for less than 1/100th of its peak-market value. All told, an estimated $20 trillion in stock market and real-estate wealth had been vaporized (although one could easily argue that the peak values weren't real to start with).

As horrific as the damage Japan suffered through that damage sounds, here's the thing: The U.S. financial crisis is much, much bigger, and the resultant "Lost Decade" is arguably going to take much longer to work through.

What's the holdup, you ask? Believe it or not, we expect any recovery to be long and needlessly drawn out largely because of the U.S. Federal Reserve, which is the very same culprit that created much of this mess in the first place.

The Lost Decade - American Style

A dangerously inflationary monetary policy by the Fed fueled two massive U.S. asset bubbles - stocks in the latter half of the last decade, and housing in the first half of this one. If you argue that the beginning of the looming Lost Decade for the United States was very different than Japan's, we'll counter and say that you're wrong.

You see, both were spawned by a massive overflow of liquidity. True, Japan's was created naturally, with a mass of cash from savings that lead to a period of easy credit. And we all know that U.S consumers are lousy savers, meaning that couldn't be the catalyst here. But that's okay. Under Messrs. Alan Greenspan and Ben S. Bernanke, the Fed did that for us artificially - holding rates at ridiculously low levels, even as it continued to stoke the money supply. Despite the different routes the two markets took, the result is essentially the same.

Cheap money drove the Internet boom-and-bust. Cheap money fueled the run-up in housing prices - and induced the U.S. banking system to create "subprime" mortgages so it could reach a bigger pool of potential "customers," and boost its potential profits. All those extra customers flogged home prices, which drew in an even greater number of potential buyers, this time in a group interested in buying second homes as "an investment."  Of course, that pushed home prices up even higher.

All the money flowing in from these mortgage payments (many of them the "no money down"/interest-only variety) forced Wall Street to create all sorts of new asset-backed securities, snipping the mortgages into pieces much like a coupon-clipping consumer used to cut up the Sunday newspaper.

We've already talked about how the financial-crisis fallout has pounded U.S investors and consumers in guise of plummeting asset values and spiraling prices (inflation) in the face of a stagnant - or even stagflationary - economy (rising unemployment and rising inflation).

Just as we've been predicting since Money Morning's earliest issues last year, the financial crisis is already transforming the United States into the World's Biggest Garage Sale. Japan faced a similar ordeal, having to dump off virtually all the trophies it had grabbed during its artificially created salad days.

Foreign-government-controlled sovereign wealth funds already are investing billions in some of our choice companies. And they're making their moves with an almost-surgical shrewdness: They're snapping up financial firms that possess key competencies, are buying into such strategically positioned ventures as stock exchanges, and in some cases are clearly willing to send good money after bad to learn the art of financial deal making that America once dominated - because we were once so good at it.

Dubai just spent $800 million for a 90% stake in New York's vaunted Chrysler Building - the first in what figures to be a long line of "trophy" purchases by foreign buyers. Trust me when I say you'll be able to watch as the sovereign-wealth heavyweights from emerging Asia and Europe, the Middle East - or cash-laden China, with its $1.68 trillion in foreign reserves - begin to snap up high-profile U.S. properties.

But when you're the United States - and are constantly spending more than you make in the form of the twin deficits of budget and trade - you have to finance your shortfall somehow. And you do that by selling off your best assets to your overseas creditors.

The "Lost Decade" vs. "A Lost Copula Years"

Here's a little secret. Just as Japan didn't have to waste the better part of 15 years in the financial equivalent of a locked-room mystery that can't be solved, the United States doesn't have to endure 10 years of wasted time, missed opportunities, and watching countries such as China, India, Brazil and others start to put some real distance between us.

But it'll probably happen anyway. In fact, the longer we wait to take action, the more inevitable it becomes.

Look at it this way. Back in the late 1980s and early 1990s, the United States went through a savings-and-loan crisis right about the same time Japan endured the beginning of its banking-and-stock-market crisis. Today, however, the S&L crisis is hardly a blip on U.S. memories, while Japan's Lost Decade is now part of global financial lore. The reason for this big disparity is simple: We attacked the S&L industry with great energy, shuttered or sold off ailing thrifts, and decisively enacted new guidelines to avoid such problems as under-funded state insurance pools, lousy capital requirements, and major regulatory loopholes.

Japan did nothing. It refused to acknowledge the breadth and depth of its problems, partly because banks are part of complex, societal cross-linking arrangements known as keiretsus. And because taking action would force it to admit it had handled this sector poorly. By the time Japan finally realized it had to take action, the problem was so ingrained and the losses had ballooned so much that it was too late for decisive action - only time and long-term policy changes could bring about the desired conclusion.

This time around in the United States, the Fed opted for the "prop it up" pathway instead of the decisive route. Think about it. When the subprime crisis broke, instead of permitting the free markets to fix the problem, the Fed embarked upon on of its most aggressive rate-cutting campaigns ever, and slashed borrowing costs at a time when it probably should have been raising them.

Then it set a dangerous precedent when it intervened in The Bear Stearns Cos. (BSC) case, setting up a bailout-and-sale deal with JPMorgan Chase & Co. (JPM). When Fannie Mae (FNM) and Freddie Mac (FRE) came around, the Fed was almost obligated by that precedent to bail these two mortgage giants out - not necessarily the best position to be in when additional failures (such as the Federal Housing Administration, or FHA) are in the offing. Indeed, investing guru Jim Rogers calls the Fannie-Freddie bailout an "unmitigated disaster."

For some perspective, consider this: This bailout adds $6 trillion to the U.S. debt load - a liability that's equal to nearly half the value of the output from the U.S. economy for an entire year.

(In his recent "Inside Wall Street" column, Money Morning Contributing Editor R. Shah Gilani makes an excellent argument that the bailouts of Fannie and Freddie, though as undesirable as we say, still were probably necessary and certainly were the only valid exceptions to the "no-bailouts" argument. He'll detail the FHA predicament in an upcoming "Inside Wall Street" report).

By slashing rates, pumping up the money supply and rescuing poorly managed enterprises, Fed Chairman Bernanke has essentially thumbed his nose at the free-market system, as if to say the central bank can do it better. Financial markets are remarkably resilient. If financial ventures are so poorly run that they're poised to fail, the free-market doctrine says to let them do so. The pain will be deep, and will certainly have a broad ripple effect, but in the end the marketplace will have flushed the poorly run venture away, freeing up capital that well-run, opportunistically rich companies can use to grow and create jobs.

Instead, Bernanke and Co. have stepped into the fray in such a way that the virtually assures the United States of a Lost Decade of its own. The artificially low interest rates the Fed has employed to avoid the financial pain from the crisis will continue to put an intense downward pressure on the U.S. greenback. And that, in turn, will fuel additional run-ups in food and energy prices - inflationary pressures that will prolong the U.S. economic malaise for months or even years to come.

Just how long will it last? Opinions vary.

Buyout specialist Theodore "Ted" Forstmann, the chairman of IMG who was one of the players in the "Barbarians at the Gate"/RJR-Nabisco saga, recently told The Wall Street Journal that this financial crisis still has a fair distance to run.

"We are in a crisis the likes of which I've never seen in my lifetime," Forstmann said. "The credit problems in this country are considerably worse than people have said or know. It's hard for me to believe that it gets fixed without an upheaval in the financial system. Things are going to fail. Enterprises are going to fail. The economy is going to slow … I think we are about in the second inning of this."

In response to that prediction, noted Contrarian Investing columnist Bill Fleckenstein recently related the prediction of a trusted industry source that refers to as "The Lord of the Dark Matter," who admitted that he didn't know what inning the financial crisis was in - although he was certain it was going to be a double-header.

We couldn't agree more.

[Editor's Note: In Part II of this two-part story, Executive Editor William Patalon III will look at some portfolio-enhancing ways that U.S investors can avoid the long-term damage of the U.S. Lost Decade, and even line up some additional profits along the way].

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William Patalon III

About the Author

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Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.

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