A Few Reasons Why The U.S. And Europe Are Not “Turning Japanese”

The US and Europe clearly have problems, and excess debt is a serious part of that problem, but not all excess debt is the same, and the underlying causes of their debt crises are fundamentally different from the underlying causes in Japan. For that reason the resolution is likely to follow a very different path.

As I see it, Japan’s problem was that during the 1980s it was so addicted to investment-led growth and artificially cheap financing that it misallocated capital on a massive scale and failed to include the resulting implicit losses in its GDP calculations. Especially after the Plaza Accord, Japan went on an investment binge that left it with a huge amount of wasted investment.

Because of this overinvestment Japan grossly overstated its true GDP during much of the 1980s. Japan’s share of global GDP, after all, nearly doubled in that decade, which is almost too extraordinary to be true, in my opinion.

If it had correctly valued the true economic losses on the various investments, or if it had liberalized interest rates and “de-socialized” credit, and so correctly valued the subsequent rise in non-performing loans, Japan’s reported GDP growth rate in the 1980s would have been much lower. Japan’s true GDP, in other words, was never as high as its reported GDP – and the margin between the two was substantial.

So what happened in the past two decades, when Japan’s share of global GDP declined by over 50% (from 17% in 1991 to 9% last year – another number too extraordinary to be true, in my opinion)? I would argue that in real terms Japan didn’t actually suffer from zero growth.

It kept growing, but because it had to write down all of that false GDP during this period, real growth was sharply understated in the official GDP numbers. Of course the fact that Japanese banks and corporations did not even begin to write down the losses for a very long time meant that capital continued to be misallocated, albeit at a slower pace than before.

There is some corroborating evidence for my claim that Japan’s real economy actually did better after 1990 than the numbers suggest. If you look at real per capita household income and household consumption growth during the period of Japan’s great stagnation, you will find that both of them rose fairly rapidly in the past 20 years.

Production vs consumption bubbles

This isn’t what typically happens during a US-style financial crisis, when household income suffers. Japanese households on the other hand continued to do better, year after year, after the crisis, the difference being that their wealth increased more slowly than reported GDP before 1990 and increased more quickly than reported GDP after 1990.

So the problem with Japan – and indeed with every other country I can think of that suffered very long periods of post-boom stagnation – was massive over-investment based on a very distorted investment-driven growth model. The period of stagnation was partially caused by the struggle to service excessive levels of debt, partly caused by the continued capital misallocation, albeit at a slower pace, and partly caused by the effective writing down of all that overstated GDP.

These – with the possible exception of the debt – are not the problems from which the US or Europe are suffering. They suffer from a typical debt-fuelled overconsumption boom, whereas Japan suffered from a typical debt-fuelled over-investment boom, and Japan’s period of over-investment was much, much more extreme (centralized investment booms can last much longer and go much further than decentralized consumption booms). This is why I think the Japanese experience tells us almost nothing about what Europe and the US will go through.

On the other hand, it might tell us a lot about what China will go through. In fact we can make a more general point. Command economies (Japan, the USSR, Brazil and many others during their “miracle” periods) tend to have much more rapid investment-driven growth during the good times and much more difficult and longer-lasting adjustments. Capitalist democracies are more prone to consumption-driven booms, which aren’t as extreme and don’t last as long, and their adjustments tend to be brutal but relatively quick.

This is a great generalization, of course, and every specific country departs from the generalization in very specific ways. For example I would argue that a very undervalued currency and low interest rates in the US in the 1920s managed to create in the US more of an overinvestment boom, and the adjustment was especially difficult and brutal. I suspect that we may see Germany’s adjustment will also be a very difficult one, more so than say the US, the UK, and France (although on the other hand I think much of peripheral Europe will have a very difficult time of it because of the combination of limited monetary adjustment mechanisms and excess debt).

But the key point is not the broad generalization. It is that Japan had a massive overinvestment problem that was at the heart of its economic malaise. The Japanese crisis was not “caused” by the collapse in the Japanese stock or real estate markets any more than the Great Depression was caused by the 1929 stock market crash. They were simply symptoms of overinvestment, which is what caused the crash, the surge in debt, and the subsequent economic stagnation.

These are not the problems from which the US and Europe have suffered in the past decade. There is no reason, I would argue, to assume that their adjustments should at all be similar.

This is an excerpt of a newsletter published at China Financial Markets.