stephen roach: post -bubble pitfalls

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    Global: Post-Bubble Pitfalls -- Yet Another Lesson from Japan

    Stephen Roach (New York)

    Japan’s fourth recession in a dozen years is a grim reminder of the downside of a post-bubble economy. So, too, is the nation’s lingering deflation, which has now persisted for more than seven years.

    So far, America’s post-bubble experience has been very different — merely one recession and nothing worse than a brief deflation scare. Yet it may be premature to conclude that the US has avoided the dreaded Japan syndrome.

    Since the bursting of Japan’s equity bubble in late 1989, there has been a painful rhythm to the nation’s post-bubble recessions. The first downturn commenced quickly in early 1991 and lasted for about two and a half years.

    The next contraction didn’t occur for another three and a half years — beginning in mid-1997 and running through early 1999. Japan’s third post-bubble recession came a scant seven quarters later, starting in late 2000 and running through early 2002.

    And then two years later, in the second quarter of 2004, the most recent downturn commenced. The pattern is important — an immediate post-bubble shock followed by several years of recovery, which then gave way to a more frequent series of rolling recessions.

    There are some striking similarities in the US experience. America’s equity bubble popped in March 2000, and the US economy lapsed into recession by the middle of that same year — a slightly quicker initial response than the four-quarter reaction time of Japan’s first post-bubble recession.

    Interestingly enough, America’s post-bubble recovery has now lasted 13 quarters — not unlike the hiatus Japan enjoyed after its first post-bubble downturn. To be sure, there are scant signs of an imminent relapse that would put the US on track to match the next twist in the Japan experience.

    But America’s fragile underpinnings — especially twin deficits, subpar job creation and income generation, record household debt, and an unprecedented saving shortfall — certainly don’t rule out that possibility.

    The shifting incidence of Japan’s post-bubble recessions also bears on the US experience. Japan’s first recession was dominated by a severe contraction in business capital spending; the fall in the sector was more than 80% larger than the cumulative decline in real GDP over the 1991–93 interval. Similarly, America’s first post-bubble recession, as well as the early stages of the recovery from that downturn, was dominated by a precipitous decline in capital spending.

    From their peak in late 2000, US business expenditures on plant, equipment, and software fell by 15% over the next two years. For both Japan and the US, the similarities of the initial post-bubble shakeouts are striking: In both cases, these recessions largely reflected a purging of the massive overhang of excess capacity that was built up during the equity bubble.

    The corollary of that observation is that consumers are usually spared from the first wave of post-bubble aftershocks. That was the case in Japan in the early 1990s and has also been the case so far in the US. But that initial resilience may be deceiving.

    The post-bubble purging of excess capacity invariably leads to a wrenching wave of restructuring, which then deals a sharp blow to job and income security that eventually imparts a downward bias to consumer demand. That trend kicked in with a vengeance in Japan’s second post-bubble recession; in the downturn of 1997–99, the sharp contraction of real consumer spending accounted for fully 72% of the cumulative decline in real GDP.

    Nor has the Japanese consumer quickly bounced back. Private consumption growth has averaged just 1.2% per year since 1996, well below the 3.3% growth trend of the prior decade. Moreover, the Japanese consumer led the way in the country’s most recent recession.

    Real private consumption fell at a 0.6% average annual rate in the final three quarters of calendar 2004 — enough of a drop to have accounted for fully 50% of the total contraction in real GDP now estimated over this period. Japan was quick to purge its bubble-induced overhang of excess capacity. But it has taken a much longer period for its consumers to adjust to harsh post-bubble realities.

    By contrast, the United States has yet to face this phase of its post-bubble adjustment. Like their Japanese counterparts, American consumers barely flinched in the first post-bubble recession; growth in real consumption slowed to a +1.5% average annual rate in the first three quarters of 2001.

    But is was still positive growth — albeit not the sharp wealth-induced contraction in consumer spending that many feared would occur in the aftermath of the devastating contraction in equities. Moreover, the American consumer never looked back after the initial post-bubble shakeout. Despite an unprecedented cyclical shortfall of job creation and labor income generation, growth in real consumption reaccelerated to a 3.7% average annual clip in the 13 quarters that followed the shallow recession of 2000–01.

    The consumer has been the bedrock of America’s post-bubble resilience. In my view, this was a direct outgrowth of the Fed’s aggressive post-bubble containment strategy — one that attempted to draw heavily on the lessons of Japan (see the now infamous Federal Reserve staff research paper by Alan Ahearne, Joseph Gagnon, Jane Haltmaier, Steve Kamin, et al., “Preventing Deflation: Lessons From Japan's Experience in the 1990s,” June 2002).

    On the surface, the Fed’s success looks stunning. But keep in mind that this initial period of resilience is not all that dissimilar from that experienced in Japan in the immediate aftermath of the bursting of its equity bubble in the early 1990s. Moreover, I have long argued that the Fed’s success has come at a real cost.

    Courtesy of extraordinary monetary accommodation and a building sense of froth in asset markets, wealth creation shifted seamlessly from equity to property markets, and American consumers migrated from the job- and income-dependent spending models of yesteryear to the asset-based mindset of today.

    As a result, households have been more than willing to take the income-based personal saving rate down toward zero, while, at the same time, turning to the home mortgage refi market as the principal means to extract newfound purchasing power from increasingly overvalued property assets. And, of course, US consumers have gone deeply into debt in order to monetize this claim on the asset-based portion of their income stream.

    But now the Fed faces a most perilous post-bubble exit strategy — taking real interest rates up to a more normal level. That, in my view, will be an exceedingly delicate exercise. Still suffering from subpar job creation and income generation, the overly indebted, saving-short, and asset-dependent American consumer is exceedingly vulnerable to higher interest rates and to the corrections in overextended asset markets that invariably occur in a Fed tightening cycle.

    The US central bank bought time with its “prevent-Japan” drill in the immediate aftermath of the bursting of the equity bubble. But that time has now run out as the Fed seeks to normalize interest rates.

    Ironically, the US probably has more to lose from a consumer capitulation than Japan. In large part, that’s because the excesses of America’s consumer culture dwarf the role of the Japanese consumer. The US buying binge of recent years was sufficient to boost consumption to a record 71% of real GDP in early 2003 — a sharp breakout from the 25-year trend of 67% that prevailed over the 1975–2000 period.

    By contrast, the Japanese consumption share has hovered at only around 55% of GDP since 1990. Japan knows very little of the rampant consumerism that has dominated America’s post-bubble experience. That could well come back to haunt a US consumer who is far more overextended than the Japanese counterpart.

    If America’s interest rate and wealth dynamics go the other way in a Fed tightening cycle, then all bets could be off for consumer resilience. The key lesson from Japan, in my view, is that the consumer ultimately holds the key to the severity of the post-bubble endgame. So far, the US has dodged the consumer bullet. It is very much an open question as to whether that will continue to be the case.

    America is not Japan. Market structures of the two economies are different, as are the two financial systems. But both economies have had to cope with the aftershocks of a major asset bubble. And there are similarities to the time profile and mix of the two post-bubble shakeouts. Both economies initially experienced capital-spending-led recessions and consumer resilience.

    That resilience crumbled in Japan but has yet to do so in the United States. But pressures are building on the saving-short, overly indebted, job- and income-constrained, and wealth-dependent American consumer. The coming normalization of US interest rates could well be the catalyst that takes the US economy into the next phase of its post-bubble adjustment.

    Financial markets are priced for ongoing resilience of the American consumer. Should that not turn out to be the case, the dollar would undoubtedly fall further and the US bond market could stage a Japanese-style rally. It is far too soon, in my view, to dismiss the lessons of Japan.

    [Note: I am indebted to my colleague Osamu Tanaka of our Japan team for his statistical assessment of the post-bubble Japanese economy.]

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