Good Morning, We Are Japan

For years there has been a vehement denial by U.S. citizens that we as a nation and culture are not

Japan. This argument generally comes up whenever the U.S. economy struggles and growth slows, not unlike the current environment. Often times, when the U.S. economy slows, the response by the Fed is to stimulate through open market operations, which is just another reference to quantitative easing, with the intended consequence of lower interest rates. The inevitable comparison is with Japan's uneven success with a zero-interest rate policy (ZIRP) for the past two-plus decades. Will we ultimately find success with our version of ZIRP? Are we destined to commit the same mistakes as Japan and follow in their footsteps? The denials are understandable but misplaced as we just might be more like Japan than we would like to admit. Additionally, let's explore whether it will ultimately affect our fate or even matter.

The Inevitable Comparisons

For years Japan was the second largest economy before being surpassed recently by the growing economic powerhouse that is China. Japan's economic model was based on being a large net exporter of goods. As a result of WWII, the US's fear of the spread of communism in Asia and corresponding economic assistance, and Japanese economic protectionism and extreme government intervention, Japan's economy flourished post-World War II through the 1980's (known as the 'Economic Miracle'). As a result of loose monetary policy throughout, asset bubbles were created including but not limited to Japan's land values and stock market, the latter being a function of the former. After peaking in 1989 and a brief resurgence in 1990, in 1991 Japan's stock market fell precipitously, and to this day it has yet to fully recover. On December 29, 1989, the Nikkei 225 closed at 38,915. It currently hovers just under 15,000, as of April 2014.

Japanese monetary and fiscal policy and the resulting economy and asset prices of the late 1980's and early 1990's are worth studying. In the US today, politicians and economists use Japan of that period as an example of where the US might be headed. The comparisons are not unfounded. A cursory review of government economic policies alone seems to support the comparisons between the two. Loose monetary policy in the form of lowered short term interest rates, an increase in the money supply (the US Fed has attempted to achieve this through the increase of its balance sheet) and Yen destruction are all similar to the US's policies of the past five years to combat the 'great recession.' In short, the US has lowered short term rates to basically zero, by doing so the US achieved a weak dollar policy to compete globally, and has additionally stimulated the economy through its quantitative easing policy (QE) of purchasing securities and therefore increasing the money supply (and its balance sheet) and injecting liquidity in to the economy.

Demographics: We're Different, Right???

Some of the arguments against the notion that we are headed for a Japanese style lost decade are based on the idea that the cultures of the two nations are not similar and therefore preclude the same outcome. To be sure, the most common example of this is observed in the savings styles of each culture. The Japanese are famous savers while Americans are famously not. There is a lot of credibility to this argument. While the Japanese are busy stuffing their mattress, Americans are at the mall. The obvious takeaway here is that while Japan's economy is suffering from the lack of a retail spender, the US economy is the beneficiary of rabid American consumer. However, to blindly accept this as gospel could lead to a gross miscalculation of how the US economy might claw its way out of its low growth dilemma. I would suggest the possibility of a changing American consumer, more like the Japanese counterpart. The catalysts of this change could be found in a slower job growth environment coupled with stagnant asset prices and a mild liquidity crunch.

In the past, Americans used the rising values of their primary asset, their homes, and eager lenders, to access that liquidity, to tap funds to fuel their desired consumption. As muted price appreciation and more conservative lending standards take hold, this avenue for funds is either reduced if not completely eliminated. In other words, Americans have no choice but to become Japanese, so to speak. Another comparison is the aging populations of both countries. The US's well publicized 'Baby Boom' generation is believed to be about ready to leave the workforce and pare spending in addition to consuming and investing less. This has been a major concern for Japan's economy for decades, as its aging population and low birth rate (1.39) combine to create a toxic cocktail of fewer productive workers and muted consumers. In addition to Baby Boomers the US does not have a robust birth rate at 2.0 and must rely on immigration to produce young workers. If the immigrant population were not to adopt American spending habits, it's possible that their contribution to the US economy would be limited to low wage workers and not significant consumers.

Every capitalistic economy's number one enemy is deflation. Too complex to delve in to here, just know that it can debilitate a capitalistic economy that is based on lending and credit to function not just efficiently but properly. In a nutshell, inflation, the opposite of deflation, degrades debt and justifies its use. Without it, debt is not as efficient a tool for financing. Japan suffered from deflation and has been battling it impotently since its market collapse in 1991. When prices started falling, the Japanese were happy to sit back and put off spending when they thought prices would be lower in the future. Economists don't believe this will happen in the US when they consider spending habits of American consumers. However, despite historically low interest rates, inflation remains muted, and below the Fed's target of 2.0%. This should indicate a subdued consumer, despite historical spending patterns by Americans.

So Are We 'Turning Japanese'? Maybe It Doesn't Matter!

The argument until now has been, are we destined to experience a Japanese style lost decade. Ironically, it could be that all of the arguments for and against whether the American consumer will be like the Japanese consumer and thus seal our collective fates, may not even matter because it may not be the causal effect. It could be that the factors that cause an American lost decade may come about as a result of US economic policies, both monetary and fiscal (in this case it's more of a lack of policy) that creates asset bubbles that pop and a liquidity crunch in the form of inevitably higher interest rates that limits credit and therefore past exuberant American consumption. In the case of Japan, the Bank of Japan was forced to raise interest rates to battle asset bubbles. In the US case it may the same forced hand of the Fed or some exogenous catalyst that causes rates to rise cutting of an endless rise in asset values, specifically equities. As of this writing, US equity indices sit at historic highs.

Note:

I have not addressed the fact that the Japanese economy is effectively self-funded (savers buy most Japanese debt) versus the US economy which sells its debt globally (Japan happens to be the third largest holder of US debt) because the US dollar acts as the international currency of global exchange and therefore makes for a complex analysis of the impact of either on each economy.

Why Tyrion Lannister Could Run Today's Fed

Outrageous title? Perhaps. Outlandish concept. Maybe not. As the Fed navigates it's waythrough the eventual complete taper of its unprecedented monetary stimulus, it will rely more and more on dialogue than blunt instruments, to achieve what it wants. This is where Tyrion steps in. Tyrion Lannister of Game of Thrones fame is superlative in using his wits and his tongue to manipulate to get what he wants eschewing physical violence when he can.

The Fed has adopted a guidance policy after having used quantitative easing to lift the economy out of one of the worst recessions in U.S. economic history. Unfortunately, to achieve its goals the Fed has increased its balance sheet from roughly $900 billion in 2008 to over $4 trillion today. And while the Fed is tapering, that balance is increasing as purchases will continue through year end. Having used monetary tools, the Fed adopted a forward guidance policy that relies more on using Fed statements and the language in those statements to guide markets and their participants while avoiding actual open market operations. With interest rates at zero and an inflated balance sheet, the Fed has little choice but to change tack.

What Could Tyrion Do For the Fed?

Tyrion has used blunt force to achieve his goals, but given his diminutive stature, he is wise to rely on more esoteric means to get what he wants. Not being particularly physically intimidating, it is more fearsome when Tyrion opens his mouth. How could this benefit the Fed? Toady's Fed, and specifically, Janet Yellen, will lean heavily on its zero-interest rate policy (ZIRP) to help guide markets. At its meetings and subsequent press conferences, the Fed will use language in its official statements and press conference dialogue to guide markets with its intentions regarding its Fed funds rate. Ms Yellen would be wise to mimic Tyrion in his attempts to shape kingdoms and influence outcomes of grand conflicts. Tyrion's big crutch is his family's wealth and his ability to cover what seem to be limitless debts. The Fed has even more limitless resources at its disposal and it is this lethal capability that it can hint at when intimating what it still can do to influence the economy and markets.

Tyrion would be less effective in his efforts if he didn't have the weight of his family's name behind him. Equally, if the Fed did not hold sway over instruments that affect global interest rates, it would be less effective in its policies. The idea that the Fed stands by ready to provide support in the event that the economy stumbles is enough to give market participants the confidence to invest and provide liquidity to the capital markets. The characters in George R.R. Martins' massive literary saga are compelled to behave and be manipulated by Tyrion as he tries to protect the realm and his family's position in it. Tyrion knows that he cannot go to war each time he encounters a conflict. Over time it would erode his credibility and resources and the demise of the Lannister reign would ensue. Diplomacy and subterfuge are Tyrion's greatest and most enduring resources.

Janet Yellen's Own Game of Thrones

For better or worse, Ms Yellen follows in the footsteps of one of the most scrutinized Fed Presidents of all time. It will be interesting to follow how Ms Yellen is treated in the wake of what Ben Bernanke faced as the President of arguably the most anticipated Feds of all time. There is print out there that Ms Yellen will be treated more tenderly as she is embraced as a mother figure to many. That may go a little far but the fact that she is well regarded and undeniably a woman is irrefutable. She does have the benefit of taking over the Fed at a time when the bulk of the heavy lifting is behind the Fed and a more hands off approach should be adopted. Ms Yellen is likely to preside over a Fed that is called upon less to save the U.S. economy and more to help soothe markets with its presence and accommodative posture. As Tyrion cannot survive constant war to protect the realm, Ms Yellen cannot exhaust the Fed's remaining resources ad infinitum and will rely on a more esoteric methodology.