By Martin Hutchinson
Anyone who has ever visited Japan knows it to be a country where everything works beautifully – and with great efficiency. Right now, however, it's clear that something has gone horribly wrong there.
Japan's exports for February were down a shocking 49.4% on a year-over-year basis. The Japanese economy suffered a fourth-quarter decline of 3.2% – twice the decline of its U.S. counterpart – and is expected to drop by a similar amount during the current quarter.
What went wrong? And, for us investors, are the low current prices of Japanese stocks a buying opportunity or a trap?
Partly because of its efficiency and my fondness for sushi, I have always been inclined to favor Japan and Japanese investments. In 1989, it was obvious that the market was overvalued and I said so – in the process alienating several of my friends who thought they had found safe career niches managing investment funds investing in Japan.
In the 1990s, it was obvious that whatever Japanese governments were doing didn't work, so I welcomed the 2001 arrival of Junichiro Koizumi as prime minister, and from there wrote frequently about Japan's growth prospects – until last year.
Until August last year, it looked as though I would be right in the long run, even if the Japanese stock market tended to droop. Since September, however, it has all gone wrong; Japan's economic performance has gone from adequate to truly dreadful.
Pinpointing the date enables us to pinpoint the reason. In September, Japanese Prime Minister Yasuo Fukuda, who had supported Koizumi's policy of public-spending restraint, resigned and was succeeded by Taro Aso, still of the long-governing Liberal Democrat Party (but from its opposing faction). Aso is an enthusiastic proponent of "stimulus" public spending programs, particularly on public works in rural constituencies. That's the policy that notably failed to conquer recessionary conditions in the 1990s, leaving Japan with a public debt equal to 160% of gross domestic product (GDP).
Aso has already proposed four stimulus programs, raising Japan's budget deficit from 3% of GDP in 2007-2008 to an estimated 11% of GDP in 2009-10. The public debt/GDP ratio is rocketing upwards, because of public borrowing and the decline in GDP. Interest rates, which had been rising gently towards normal levels in 2006-08 (though short-term rates had only reached 0.5%), have been reduced to zero again and the Bank of Japan (BOJ) has begun "quantitative easing" – buying up government debt.
Currently, there's a general agreement among Western politicians that these are the policies to follow. So why haven't they worked in Japan?
At this point, the London merchant banker in me is irresistibly tempted to snarl: "Because they don't (expletive-deleted) work in general."
My own preference is for balanced budgets, low public spending and high interest rates – you may not get much economic growth with those policies, but what you get you've earned – without burdening your grandchildren. Even now, some countries – such as Brazil – are following those policies, and doing quite well.
Setting aside the question of whether stimulative policies work in general – within a year or so we shall have tested them exhaustively in the United States and most of the western world – I do think there may be reasons why they work particularly badly in Japan. Japan has traditionally had very high savings rates; it still has a limited Social Security system and an aging population. Low interest rates may well therefore damage demand from consumers living off savings more than they boost demand by helping companies and other borrowers. While low interest rates boost exporting companies, that boost may simply raise the yen exchange rate to a level at which in a recession exports fall catastrophically.
As for budget deficits of 11% of GDP, if you already have a public debt in excess of 160% of GDP, you may well be at the point at which the extra debt and the uncertainty about how you are going to pay it all back eliminate any boost to demand that the budget deficits would normally bring.
It is thus clear that Aso's policies will work less well in Japan than they would elsewhere. Indeed, they may make matters worse in Japan, even if they would be effective in some other countries.
Japanese voters will have a chance to choose something different at a Diet election due in September or before. The bad news is that, while the opposition Democratic Party of Japan is theoretically pro-market, its leader, Ichiro Ozawa, in practice is a former LDP stalwart, of the faction founded by 1970s' kingpin Kakuei Tanaka that favored heavy public spending.
Furthermore, many of Ozawa's supporters, from the former Social Democrat party, also favor heavy public spending, albeit on different things than the LDP barons. In other words, an Ozawa victory may not bring much of a policy change, at least on economics. What's more, Ozawa himself has now been caught up in a campaign-fund scandal, so even though Aso's popularity ratings are down to around 10%, the LDP still may win – which would boost Aso at the expense of the free-market Koizumi supporters.
The bottom line: In the election this year, if the Japanese people want the economic policies that seem to work, they will have to be damn clever about it. There are many supporters of free-market policies in both the LDP and the DPJ, but they are not currently represented among the leadership of either party.
Japan remains a country in which everything works beautifully – except the politics. But the country is still worth keeping an eye on, though, because if the politics change, the potential from a Japan with higher interest rates and lower public spending is absolutely gigantic.
[Editor's Note: When it comes to banking, there's literally no one better than Money Morning Contributing Editor Martin Hutchinson, who brings to the table the kind of high-level expertise that our readers have come to expect. In February 2000, for instance, when he was working as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians who had been stripped of nearly $1 billion by the breakup of Yugoslavia and the Kosovo War.
Experiences such as this have imbued Hutchinson with special insights in such areas as banking, the financial markets and fixed-income investing. Just last month, the financial Web site Seeking Alpha named Hutchinson to its "leader board" because of his quickly developing online following. And, in Money Morning, Hutchinson cut through the controversy about the health of the U.S. banking system, analyzed the Top 12 U.S. banks, and told readers which ones were "Zombies" and which ones were "Gems." The article was one Money Morning's most popular pieces of the New Year [If you missed the story, please click here to check it out. The report is free of charge].
Fans and followers of Hutchinson's work will soon be able to subscribe to a new product that focuses on income investing that will feature more of his – insights and essays. That should debut in about a month or so.
Hutchinson also writes regularly for our monthly newsletter, The Money Map Report, in which he and other Money Morning colleagues also make investment recommendations for subscribers. To find out more about The Money Map Report – including a special offer that includes The New York Times bestseller, "Crash Proof" – please click here.]