Lessons from Japan

The twin asset class bubbles in the United States of technology stocks (1996 – 2000) and residential real estate (1996 – 2006) continue to depress economic growth.  Asset class bubbles are a semi-rare phenomenon, occurring when prices spike 2 or 3 standard deviations from the long-term trend in a relatively compressed amount of time.  It does not take a special set of skills to detect an asset bubble.  It is, by definition, a statistical anomaly that occurs globally every 40 years or so on average.  The difficulty with asset class bubbles is not how to spot them, but what to do once they occur.  If you are a professional investment organization, then the prudent course of action would be to avoid asset class bubbles at all cost, as they are the great destroyers of wealth for your clients.  The difficulty with prudence is that it is universally unappreciated by clients until their accounts have been halved in short order by a less-prudent firm.

Asset class bubbles give us an opportunity to learn from the mistakes of our ancestors.  Unfortunately, we usually prefer to repeat their mistakes unless the cost of the error is large enough to warrant reverence.  Asset class bubbles that cause severe economic catastrophe are rare and usually only leave an indelible imprint on a single generation.  Once that generation dies off, the lesson is only accessible through textbooks and campfire tales and the visceral connection between experience (hot stove burns hand) and subsequent action (don’t touch hot stove) is broken.  This poses a challenge for economic policy.  What is the correct level of stern warnings (you will burn your hand if you touch the hot stove) before the damage from the marginal speculator becomes a threat to stability and union?  This is a difficult question to answer, but one that deserves more attention from our best and brightest problem-solvers.

It is unlikely that the United States would be suffering from economic malaise today if Japan had allowed the private sector to contract in full from one of the greatest asset class bubbles in the history of modern civilization.  The Heisei bubble enveloped both land and shares, driving the former up 60% in one year alone.  The subsequent deflation of the twin asset bubbles spanned 15 years (1990 – 2005) and drove down the nominal price of real estate by 87% and the Nikkei 225 (shares) by 70%.  This deflation has only been matched by the Great Depression in the U.S. as a modern peacetime severe deflation in asset prices.  The major difference between Japan in the 1990’s and the United States in the 1930’s was the policy response.  When it became apparent that Japan’s economy was in an asset deflation, the leaders of that country responded with massive spending programs that kept GDP in positive growth territory, albeit at a much diminished rate.  In the 1930’s, the Hoover administration did not use fiscal policy to counteract the rapid decline in private sector demand and the Federal Reserve actually raised interest rates during the early years of the decade to defend the dollar.  The result of Japan’s policy was an average GDP growth rate of 1.5% over the 15 years that asset prices were in a deflation.  GDP in the U.S. contracted over 50% during the early 1930’s and only surpassed the 1929 peak when a massive stimulus package was introduced in 1940 in the form of WWII.  Japan would have most certainly been much worse off today (in terms of unemployment, quality of life and economic stability) if the government sector had allowed the private sector bubbles to collapse without any intervention.  Unfortunately for the United States, this episode was too remote and not painful enough to keep us from reaching for the same deceptively cool-looking burners.

Sources:  Koo, Richard.  The Holy Grail of Macro Economics. John Wiley & Sons, 2009; U.S. Department of Commerce –  Bureau of Economic Analysis

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