The Skeptical Investor(TM): December 1997

THE SKEPTICAL INVESTORTM
Issue No. 7. December 1997

Posted 27.XII.1997

In addition to what have become almost routine daily reports of the latest bad news from the region, the world's financial press is devoting a lot of editorial space to the financial and economic crisis in Asia. There are the explanations of the causes, of varying plausibility, but also the now almost obligatory prescription for what to do to arrest the crisis and cure the problems. The prescriptions vary of course--though Keynesian policies rear their ugly head rather too frequently--but they all have one very important thing in common: they start from the unstated premise that something can be done to fix things. Therefore the only question is deciding what this 'something' should be.

I am not at all convinced that the premise is valid. The illusion that we have power over everything is a pervasive human conceit. It is an illusion that all of us--except for a few Buddhist and Taoist monks!--share to some extent. We need it to keep going, living, making decisions about our lives. It is a sort of incantation to help us keep inchoate nature at bay. But still it is only an illusion and it is as well to beware when it goes beyond a useful fiction and turns instead into a dangerous trap.

A fortnight ago, I was treated to a private preview visit to the new exhibit of Titanic artifacts at the Maritime Museum of the Atlantic here in Halifax, Nova Scotia, Canada. The opening was scheduled to coincide with the release of the new blockbuster film on the sinking. By the way some of the footage in that film was shot here. Halifax has a close association with the disaster. Many of the victims were brought ashore here and are buried in a local graveyard.

Anyway, the loss of the Titanic is perhaps the most widely known and gripping sea tragedy of all time. But why is it so compelling: it is not the worst; there have been even greater losses of life at sea? It is probably because the sinking of this great ship was not just another sea tragedy but a story that has the proportions of a powerful myth: a special story that contains a great lesson about the nature of the world around us. The Titanic was designed to be unsinkable. No one doubted it. The nineteenth century with its great technological achievements had just ended, and belief in the power of design and engineering was almost a religious faith. But it sank, on its very first voyage, and it sank quickly.

I do not want to fall into the trap of arguing by analogy. I use the Titanic story merely as a vivid and apt illustration to drive home my point that mankind's belief in its own power can sometimes be spectacularly and tragically wrong. My point is that the almost universal belief that the authorities can control the market forces that drive events such as those now unfolding in Asia is not at all a self-evident premise. It is questionable, at best, and a good dose of humility might be a better guide to what may be going to happen next than all the lectures of all the economists in the world. It is possible that in its efforts to bail out the Asian Tigers the International Monetary Fund may turn out itself to be nothing but a paper tiger. The last few weeks in Asia certainly offer no evidence to the contrary ....

What an extraordinary statement! By making it Prime Minister Hashimoto was admitting that a global crisis is possible. He was not speaking off the cuff. This statement came after weeks of high level closed door talks between ASEAN nations, the USA, European nations, the IMF and the World Bank. It is also known that Japan has been put under great international pressure to "do something" about its domestic economy. So, as of mid-December we had absolutely convincing evidence, "straight from the horses mouth" so to speak, that (a) a global crisis is a real possibility, and that (b) Japan is the key. It is no longer just obscure newsletters such as The Skeptical InvestorTM making such claims!

Well, Japan has been attempting to "do something". But this brings me back to the point I made above about the Titanic disaster: it is not certain that anything can be done: anything effective that is.

The story we are told goes something like this. The Great Depression happened because President Herbert Hoover and the Federal Reserve failed to flood the economy with liquidity after the stock market crash. A few years later Roosevelt was elected, reversed course and ended the Depression. Extremely oversimplified, but that is the gist of it.

Apparently all the excess credit and excess capacity built up during the 1920s were going to magically disappear given the "right" fiscal policies. This is ingenuous nonsense. Hoover and the US Administration understood that the system had to go through a cleansing process and begin afresh with clean balance sheets:-

"Liquidate labor, liquidate stocks, liquidate real estate. Values will be adjusted, and enterprising people will pick up the wreck from less-competent people." Treasury Secretary Andrew Mellon (1930).

It should be obvious that by the time Roosevelt came to office this cleansing process had been completed. The US economy was by then ready to start growing again. It would in fact have recovered much earlier but for what was the Hoover administration's real major policy error-- keeping wages artificially high--but was anyway already recovering before the start of the Second World War.

The Japanese government (perhaps partly due to their non-western religious and philosophical background) is less susceptible to the myth of human invincibility, and has been adamantly refusing to embark upon massive deficit spending and similar policies. Hashimoto has been called "the Asian Herbert Hoover". But they were apparently allowing the effects of the 1989/1990 crash to work themselves out and, in fact, the Japanese economy has been slowly recovering for several years. Which is what would be expected--a rapid collapse and a slow, fitful recovery. But then the regional crisis erupted, well before the Japanese economy was strong again.

As mentioned already, the Japanese government has been under incredible international pressure to abandon its "Hooverite" policies, do a U-turn and try to massively stimulate domestic demand. For illustration the following is a fairly typical example of the sort of hectoring one reads:-

"The result would be a poisonous cocktail for world markets. It is urgent that Japanese authorities reverse course--now. They should repudiate their Hooverite fiscal policy and announce a credible package of deregulation measures. And finally remove the bad debt from banks' balance sheets. To do less would be to risk consequences that both Japan and the rest of the world would rather not have to endure." Kenneth Courtis, Chief Economist, Deutsche Bank Group in the Asia-Pacific.

Japan has given in to the pressure (we of course do not know what if any under-the-table deals have been made). It has been expanding its money supply at a rate of 1 percent a day to help reinflate the economy. And on 17th December Prime Minister Ryaturo Hasimoto announced a package of new stimulus measures. Top of the list was 2 trillion yen in special income tax breaks to be included in the current 1997-1998 (Apr-Mar) fiscal year's supplementary budget. This reversed the 2 trillion yen of income tax breaks repealed last April. There was also a separate package of tax and budgetary stimulus measures which Minister of Finance Hiroshi Mitsuzukasaid amounted to 5 trillion yen, or 1% of GDP, and which included 840 billion yen in corporate, securities and land tax cuts, 1 trillion yen in disaster spending and 1 trillion yen for public works, and further much larger than expected 20 trillion yen of public funds to stabilize the financial system. This comprised a 10 trillion yen raised from government bonds, and 10 trillion yen in government-guaranteed Bank of Japan loans. Both amounts are to fund the Deposit Insurance Corporation, to protect the depositors of failed banks.

But, and this is the theme of this Issue of The Skeptical InvestorTM, it is not at all certain that such fiscal stimulus--or anything--will arrest the unwinding of a huge credit bubble. Give people a little more money to spend through a tax cut but, in difficult economic times, they are more likely to save it "for a rainy day" than spend it. (Keynes recommended that governments faced with this problem steal it back again and spend it for them and/or steal future earnings and savings through deficit financing--in case you are wondering why I am so hostile to the ideas of my fellow Briton!). Flood the banks with liquidity but if they have become gun shy of risk they won't lend it on. And there will not be many enterprising entrepreneurs and businesses willing to take risks and borrow anyway. Even reducing interest rates--and in Japan they have been reduced almost to zero with the official BOJ discount rate at 0.5% since September 1995--does not stimulate business activity if no-one is willing to borrow and invest. In this kind of situation, with increasing liquidity that is not being absorbed by bonafide productive enterprise, the result is inflation. Allowed to continue, it can gather momentum and turn into runaway hyperinflation.

I can't see Japan allowing that (hyperinflation) to happen. But I do think that the stimulus measures will be ineffective and Japan will slide into recession. The markets seem to agree with me so far. The first response to the17th December announcements was a solid bounce in the Japanese equity markets and a very sharp rise of the Yen against other major currencies.It shot up five Yen against the US dollar. But both moves have subsequently been convincingly reversed and the Nikkei 225 Index for example has now fallen back below 15,000. It is very close to its lowest close this year.Not much of a vote of confidence.

Watch closely for more ongoing evidence of a credit crunch in Japan i.e.are the banks severely restricting credit. The recent collapse of food goods trader Toshoku--the fourth-largest bankruptcy in post-war Japan--was an indication of exactly that: Japanese banks have tightened lending policies so severely that the economy is on the verge of a full-scale credit crunch. On 22nd December Japanese Finance Minister Hiroshi Mitsuzuka held a meeting with Naotaka Saeki, chairman of the Federation of Bankers Associations of Japan, to ask Japanese banks to alter their cautious stance toward lending "which is raising concerns about more corporate failures".