The below chart is the spread (difference) between the interest rate on a 30 Year Fixed Rate mortgage, and the interest rate on a 30 year US government bond. The 30 Year US government bond serves as a basis for mortgage rates. This means a 30 year mortgage rate is the bond rate, plus some risk premium associated with consumer lending.
In the run-up to the financial crisis, the spread, as seen in the chart, hovered around 1.5%. Between February 2006 and June 2008, the spread didn’t budge. What did budge was the spread between the Federal Funds Rate (which is a measure of very short term interest rates), and the 30 year Treasury bond. At one point, the interest rate to borrow money for less than 1 year exceeded the interest rate to borrow for 30 Years. This is called yield curve inversion, and you can find many, many, many discussions on this today. The reason? The yield curve today appears poised to invert, possibly foreshadowing a new crisis. You can see the potential of inversion in the chart below:
What is dangerous about an inverted yield curve? An inverted yield curve tells investors, borrowers, and lenders, that interest rates for short term loans or investments, are higher than interest rates for long term loans, or investments. This is counter-intuitive. Locking up money for a long time can only be made worthwhile if an investor is compensated accordingly, via a higher interest rate/return. When the yield curve is inverted, it makes no sense for an investor to lock up money for a long time; an investor will choose to rather lock up money for a short term, reassess when the term ends, and invest in the short term again if the long-term return still is not compensatory. Without long-term investment, sustained real economic growth cannot happen.
In the lender/borrower relationship, when the yield curve is inverted, lenders suffer. When lenders suffer, they stop lending. The reason is lenders make money by borrowing in short duration at a low rate, and lending out in long duration at a higher rate. Banks make money on the difference between borrowing short and lending long. In the worst case scenario, an inverted yield curve also implies the following: in the immediate future, inflation expectations are higher than they are in the medium to long-term future. This can be translated into a combination/sequence of inflation, followed by low economic growth. What does that imply? It implies the worst case situation for an economy: STAGFLATION. Stagflation occurs when there is high inflation, and low demand (caused by weak economic growth). Stagflation occurred in Japan during the Lost Decades that followed the 1980’s property market bubble. Economically speaking, the 1990’s and the 2000’s in Japan were lost; GDP growth on a per capita basis was nil for much of those two decades. From 1993 until the bottom of the Great Recession in 2009-2010, Japan’s economy stagnated.
The primary measure of an economy’s growth and value is GDP. GDP can be measured in real or nominal terms. Let’s make sure we know and understand the difference between real and nominal GDP. Japan’s GDP and inflation situation over the recent decades is a perfect way to illustrate this. The difference is, real values are adjusted for inflation, while nominal values are not. Since we are talking about Japan, let’s note that Japan experienced something that no nation has experienced in history, and that is, in the words of Haruhiko Kuroda, the Governor of the Bank of Japan,
“…prolonged, persistent, moderate deflation.”
Kuroda emphasized greatly how unprecedented this type of deflation is/was. In the US, during the Great Depression, Kuroda notes that there was a,
He used the world “shock” to emphasize the short term nature of US depression-era deflation. Prices declined in the US, by 10% in 1931, and another 10% in 1932. The difference, though, is that this deflation only lasted 4 years. From Kuroda’s speech,
“In contrast, Japan’s deflation has been 4.1% over the past 15 years, between 1998 and 2013. On an annual basis, its only 0.3%, but because of time value of money, this type of prolonged deflation is worse than a short-term shock.”
Kuroda continues by saying that when deflation persists as so, people tend to stop investing, preferring to save, and/or pay off debt. In deflationary environments, just as prices decline, so do the value of investments. Cash becomes king in deflation; recall, this is what US banks did in the early days/weeks/months of the Great Recession. They hoarded cash, refusing to lend or invest. Japanese banks did this also, realizing that loans made at a time of declining prices, would have negative expected yield. This should ring a bell; an inverted yield curve also implies negative expected yield, since long term yield minus short-term yield is negative under inversion. When lending doesn’t happen, investing doesn’t happen. The effect is recycled and reinforced. This is one reason why crises are so bad, because they have real and psychological effects that reinforce each other in a very negative cycle.
To further understand what happened in Japan in the 1990’s/2000’s, and in the post-Great Recession era, we have to gain a bit of understanding on the rebirth of Japan after it was reduced to rubble in World War II. There is a wonderful piece written by Thayer Watkins of San Jose State University that we will refer to. After the Emperor Hirohito of Japan surrendered to August 14, 1945, General Douglas MacArthur took over as the governing authority of Japan. His title was Supreme Command of the Allied Powers, or SCAP. We will also refer to the governing organization in Japan as SCAP going forward. Recall that in 1945, Franklin Roosevelt was the president of the United States. Roosevelt was a liberal, but MacArthur was actually a conservative, being a military man. With that said, most of the civilian force that worked at SCAP in bureaucratic capacity were New Dealists, from the Roosevelt administration. It’s no surprise then that Japan’s new economy post World War II was modeled after a kind of hybrid, socialist-capitalist system. At the time, this was called Corporatism. Mr. Thayer Watkins wrote another great piece on Corporatism that is also worth a read. The way corporatism was built up in Japan initially by SCAP was to focus on political reform, as opposed to economic growth. First, there was a clear attempt at destroying the elitist class in Japan, which the Americans considered the prime reason for the devastation caused by the war. MacArthur did this by forcing the land owning class of Japan to sell their property to SCAP. SCAP then redistributed the property to the farmers and peasants who had worked that land centuries. There is a very interesting detail in how this was conducted which proved the fatal blow to the elitists of pre-war Japan. They were paid by SCAP in yen denominated bonds, but at prices that did not reflect the high inflation of the post-war period. This high inflation was due to the fact Japan was in ruin, and the government had zero tax revenue. The Japanese Central Bank resorted to printing money in order to pay its bills, and this of course led to massive inflation (aka hyperinflation). The bonds had a duration of 30 years, which if inflation lasted a long time, the compensation the elites received was more or less zero. SCAP did this on purpose, to punish the Japan’s ruling class for the war; it was an attempt to build a new Japanese society, and it worked. But inflation effected everybody, and all the social reforms in the world could not fix the underlying problem which was that Japan was in ruin economically. And so, quoting from Mr. Thayer Watkins,
“SCAP then embarked upon what was called the reverse course. That is to say, SCAP began to undo some of its policies which it had promoted in the interest of democratization and replaced them with policies intended to promote economic recovery.”
As we said earlier, Japan’s pre-war ruling class was made up of landowners, dating back to the 1800’s during the Meiji Period. During this period, families and clans of wealthy landowners got together to try and consolidate power. The goal was to,
“…move[d] from being an isolated feudal society to a Westernised form.”
To do this, wealthy clans and families formed, “Zaibatsu”. Zaibatsu were,
“…large pre-WWII clusterings of Japanese enterprises, which controlled diverse business sectors in the Japanese economy. They were typically controlled by a singular holding company structure and owned by families and./or clans of wealthy Japanese. The zaibatsu exercised control via parent companies, which directed subsidiaries that enjoyed oligopolistic positions in pre-WWII Japanese market.”
The key word there is “oligopolistic”. This means that zaibatsu basically were cartels; a few businesses worked together to keep competition out, and keep competition within at a minimum. If this doesn’t sound familiar, it should, because many of Roosevelt’s New Deal policies tried to do the same thing for certain businesses.
SCAP completely destroyed zaibatsu after the war. As this piece from FindLaw states,
“From 1914 to 1929, three zaibatsu (Mitsui, Mitsubishi and Sumitomo) controlled 28% of the total assets of the top 100 Japanese companies. Even as of 1945, the same complexes possessed 22.9% of the total assets of all Japanese stock companies.”
By 1946, the percentage of the total assets of all Japanese stock companies owned by zaibatsus was 0%. Again from FindLaw,
“The Imperial Order of 1946 Concerning the Restriction, etc., of Securities Holdings by Companies also forbids certain interlocking relationships among former zaibatsu members via personnel, shareholding, loans, and contractual ties. In all, 1200 companies and 56 individual members of zaibatsu families had their assets frozen and transferred to what was known as the Holding Company Liquidation Commission.”
The Holding Company Liquidation Commission was put in place by SCAP, but it was done so under the Imperial Order of 1946, which was an order put in place by the Emperor. This struck me as interesting, since the Emperor at the time was the same Emperor who had guided Japan during the war, Emperor Hirohito. During SCAP’s initial political upheaval of Japan, MacArthur had ordered the hanging of the wartime prime minister of Japan, Hideki Tojo, along with 19 of his top associates. He had also forced out 200,000 top admins of business (zaibatsu) and government, jailing many of them. But he spared the Emperor; moreover, he gave the emperor much respect, according to Thayer Watkins:
“In September [1945, just one month after surrender] the emperor sent a message to MacArthur asking if he might come to see MacArthur. The emperor arrived at SCAP prepared to give deference to MacArthur but MacArthur made a point of walking to the emperor to let him and all observers know that MacArthur considered that he and the emperor were meeting as equals. MacArthur’s treatment of the emperor proved wise when later he was able to obtain the emperor’s support for the measures SCAP was promoting, such as the new constitution.”
It’s no surprise that around this time, Republicans (anti-New Dealers), had taken control of Congress in the US. A General by the name of William Draper was sent to Japan. Draper was a former Wall Street financier. Along with Draper came former banker from Detroit, a man name Joseph Dodge. Together, they laid the framework for Japan’s economic recovery. In looking at the Nine Point Program, it was all about stabilizing the economy. The policies were also known as the Dodge Line. The theme of the program was austerity so as to stabilize prices; it was all about getting inflation under control. This led to what was known in Japan as the Dodge Line Recession. From Toyota-Global,
“These abrupt measures to control inflation led to a rapid stabilization of prices, but at the same time the reduction in the money supply plunged industry into a serious shortage of funds, leading to unemployment and a series of business failures constituting the so-called ‘Dodge Line Recession’”
Another part of the Dodge Line was price controls. We know that price controls are anti-capitalist in nature, but in Japan, the idea behind them was to control production. It was a way of forcing companies, like Toyota, to not produce cars. The price controls limited the price of iron ore/steel and also the price of the final product, cars and trucks. This had the effect of further constraining inflation. Around the time of the Dodge Line Recession, China was emerging from its Civil War. To the angst of MacArthur and the US, Communism had prevailed in China’s Civil War. Maoist Rule in China had begun. A Communist movement in Japan was starting to take hold, and the labor unions that had grown powerful under earlier SCAP reforms, were now led by Japan’s Communist party. Something had to be done.
Something was done. First, SCAP reduced the number of Japanese firms to be dissolved, by way of the Holding Company Liquidation Commission, from 325 to 100, to finally, the largest 9. This was done at the request of General Draper, the Wall Street financier. This was a massive shift, part of “reverse course”. It’s important to note that some of these firms, if not all, were zaibatsus. So instead of dissolving them, laws and rules were placed on them so that they would not regain their oligopoly status. This paved the way for some concept of business structure to replace zaibatsu; that came to be known as Keiretsu. Suddenly instead of being villainized by the SCAP, Japanese business was supported. Why the sudden change? Quite simple: the Cold War had begun, and the US needed all the friends it could get. As Wikipedia puts it,
“The Reverse Course resembled Europe’s Marshall Plan. The occupation had begun with various moves toward democratization, including land reform, the purge of officials responsible for Japan’s ultra-nationalism, and the suppression of both the zaibatsu and the yakuza. This extended to Japan’s new constitution, which included an article that barred the government from maintaining a standing army. This constitution and related policies had been written by Rooseveltian New-Dealers. The Reverse Course changed such policies in favor of the containment policy.”
That containment policy was containment of Communism. It became the number one priority in American foreign policy. When the occupation of Japan ended in 1952, Japan was on its way to recovery, thanks significantly to the Korean War. Why? Because suddenly Japan was the provider of equipment for the Allied Forces on the Korean peninsula. The Dodge Line Recession ended with the beginning of the war. Quoting Thayer Watkins,
“Prime Minister Nakasone Yasuhiro [the PM of Japan at the time] asserted that the procurement demand for the Korean War was like divine aid to the Japanese economy. The Allied Powers had originally envisioned a Japan agriculturally oriented with only light manufacturing. Instead the Japan that developed ultimately devoted itself to steel, cars, ships and electronics.”
Whereas in 1947, MacArthur had to squash labor union uprising in Japan, by the 1949, unions and businesses were working closely together to transform Japan. From Toyota-Global again,
“On December 23, 1949, Toyota Motor Co., Ltd. and Toyota Motor Co., Ltd.’s labor union (All Japan Automobile Workers Union Toyota Koromo Branch), signed a memorandum in which they undertook to cooperate in overcoming the crisis. Among the main points of the agreement were that labor and management were to cooperate in implementing concrete proposals for rationalization aimed at cost reduction and that the company was at all costs to avoid job cuts as a means of overcoming the crisis, in return for which the labor union was to accept a 10 percent cut in the basic wage.”
Unions were brought into Keiretsu, teaming with corporations, rather than fighting them. Soon, Keiretsu evolved to become structurally similar to Zaibatsu, but with one major, key difference. From FindLaw,
“In contrast to actual zaibatsu, however, large financial institutions, under the influence of MOF [Ministry of Finance], have been said to play a central role in corporate governance.”
This meant family, clan based elites did not control the Keiretsu; banks did, and the banks were under the influence of the Japanese government’s Ministry of Finance. We could call this state sponsored capitalism. A very telling speech was given on February 28, 1950, at a Toyota Management Council meeting. The speech was given by the then president of Toyota Motor Co, Ltd, Kiichiro Toyoda. From this speech, we can see the roots of bank leadership in Keiretsu:
“…the lack of confidence in Toyota has arisen from the fact that our development of technology has preceded our development in business management (nowadays the situation is reversed and finance comes before business management and technology), and from the impression that when you lend money to Toyota, it is not clear how it will be used. To remedy this situation, the finance industry is willing to send a representative to join Toyota’s management, and we held an informal meeting to discuss this with business representatives from the finance world on February 18. Additionally, we need, first of all, to restore the confidence of the finance world and, secondly, to remedy the precedence of technology and create a more streamlined operation. We have already strengthened our management team’s abilities in relation to internal and external issues and are working to establish a sales company at the earliest date possible.”
By bringing banking and labor into the Keiretsu fold, Japan had laid the foundation for explosive growth. By the 1960’s, six Keiretsus had emerged from the zaibatsu mist. They were:
- Dai-Ichi Kangyo
The first three of these were simply reorganized Zaibatsus, the same ones that were spared due to Reverse Course. Today, they are still powerhouses of in Japanese business. The above Keiretsu came to be known as Japan Inc, because of their inter-locked nature, and government support umbrella. Japan Inc rose was nothing more than a product of the New Deal policies that were imported into Japan immediately after its surrender. It was Corporatism, and the Japanese refined and tailored it through the post-war decades. Japanese New Deal policies authorized the “government guidance and mediation” that became so crucial to Japan Inc’s success. Industrial companies in Japan became tightly knit networks; companies bought each other’s shares, giving each other incentive to support one another. This would have been illegal under MacArthur’s original reforms enacted in Japan’s Antimonopoly Act, but those reforms were slowly taken off the books in 1949, and again in 1953, as this excerpt in FindLaw testifies:
“By 1953, financial companies were permitted to own up to 10% of the outstanding shares of non–financial companies and the prohibition upon holding the stock of competing companies was eliminated.”
Banks and financial institutions were becoming the new elite families in control of Japanese industry. Also in 1953, from FindLaw again,
“…the Ministry of International Trade and Industry’s (MITI, now known as METI) Industrial Rationalization Counsel called for the grouping of trading and manufacturing companies to concentrate scarce capital in the domestic economy. Antimonopoly restrictions were also relaxed during this period. In this environment the currently existing corporate groups began to crystallize.”
In Jesse Colombo’s article, he states the impact of company cross-holdings [owning each others shares] was to,
“…guarantee[ing] long-term stability and developing lasting business relationships…”
I would even go one step farther to say, it de-incentivized competition, especially considering,
1) the interconnectedness, i.e interbank lending, and…
2) the potential for banks to be invested in multiple of the same companies.
By the 1970’s, keiretsu had evolved into just that, a bunch of inter-locked industrial businesses built around Japanese banks, and looked after by the Japanese government.
The realization came to International competitors came to realize they weren’t competing against one company in their same business; they were competing against the entirety of “Japan Inc”.
The corporate interconnectedness in Japan nurtured an environment of sharing in Japan that was unique to the world. Japanese companies innovated, especially in manufacturing, like no other in the world. Japanese products gained a huge competitive advantage over the rest of the world via innovation in manufacturing. You can read more about that here and here. Japanese companies made products better than the rest of the world. They revolutionized quality, and quality control. For example, Japanese cars from Toyota and Honda, to Nissan and Lexus, were revered for their superior quality over their American counterparts. The Japanese put luxury car quality into budget and middle income cars. Something very worth noting is that Japan’s lack of natural resources should have been a huge competitive disadvantage. Japan imports almost all of its energy requirements, from oil and gas, to iron ore and coal. Japan was forced to revolutionize processes for raw material production; Japanese became masters of efficiency, thereby spiking productivity, and offering more for less to consumers. The Japanese have a special name for process improvement, whether it be manufacturing or management: Kaizen.
Innovations in manufacturing, productivity, and efficiency in Japan had the effect of driving prices down, otherwise known as deflation. In the mid 1980’s, the US economy was just emerging from a period of first inflation, and then stagflation. The below chart illustrates stagflation. Notice in the 1st quarter of 1980, inflation had not yet peaked, but a recession had started (grey shaded areas indicate recession). Workers were losing their jobs and stock markets were crashing, but the price of everything from food to a roof over your head was rising at a rate of 10%/year. This is stagflation, and it did not peak until Q4 of 1980. The recession, that restarted in 1981, did not end until Q1 of 1983. Inflation tumbled after Q4/1980, and it bottomed in 2010 at a mere 1%. Most of that tumbling happened in the early 1980’s; Inflation collapsed 70%, to 3% annually. Globalization enhanced this effect; Japan especially, was exporting deflation to the world with its ability to deliver more for less.
The above chart compares inflation to the US deficit, specifically, the Current Account Deficit. Notice how between Q1/1987 and Q1/1989, inflation increased from 2.8% to 4.7%. Notice how the Current Account Deficit became a Current Account Surplus shortly after inflation peaked at 4.7%. Inflation is a leading indicator of the Current Account Deficit, because inflation helps to bring down deficits. It reduces the value of US Dollars, requiring more US Dollars to buy stuff. Inflation makes the price of everything go up, from labor to food. When labor is more expensive, people make more money, which means the government collects more taxes. This means that old debt, or old loans the government took out to pay for a highway, for example, become a smaller percentage of revenue. That’s because a highway that cost $1 Million when inflation was low (e.g. 1%), still costs $1 Million when inflation is suddenly high (e.g. 10%). The construction company that built the highway can’t call the government and ask for an extra $100,0000 ( because inflation is now 10%). The government just timed it right. Now that inflation is 10%, the government, which may have been collecting $10,000,000 of tax revenue last year, is now collecting $11,000,000 of tax revenue. The government can pay the highway off it built last year and still have the same amount of money it had at the same time last year; in other words, inflation built the highway for free! This is why the current account deficit became a surplus between Q4/1987 and Q1/1991; inflation made money appear out of thin air. Of course, there was a side-effect to this inflation; it led to a recession in 1991. Why? Because the Federal Reserve raised interest rates to tame inflation; they didn’t want inflation to get out of hand. They wanted to make it worthwhile for people to save and get real returns. Since the US economy is consumer driven, the lack of spending led to a recession, companies laid off workers, which led to even more savings. The Federal Reserve and government went back to reducing interest rates and spend mode soon after; consequently, the deficit skyrocketed.
Japanese innovation demonstrated that technology is deflationary. Technology reduces costs and drives down consumer (and producer) prices. Here’s a short read with simple evidence on how technology is deflationary today in 2018. This has been big in the news recently because of Amazon’s effect on reducing consumer product prices. Another piece on this same topic is here; it is also worth a read. In that piece, Business Insider talks about the deflationary effect of the Apple iPhone, which is real. The iPhone replaced the camera, the MP3 player, the modem (if you use it as an internet connection device), the mobile phone (think Motorola Razr, the original Blackberrys, Palm Pilot), and the GPS device (think Garmin).
All of the above devices have been stuffed into one, the smartphone, which means consumers spend a lot less money on maintaining, upgrading, and servicing their electronic devices. So the question becomes, if the iPhone deflated prices, can we extrapolate backwards in time, and explain Japan’s deflation by its own technology revolution? And since Japan is a huge exporter, can we explain the lack of inflation in the world by Japan’s technology revolution?
Let’s us the above chart to try and understand a bit more about Japanese inflation as it relates to GDP. GDP measures the value of an economy. In Japan, nominal GDP, represented by the green line in the chart, stayed pretty much unchanged between 1994 and 2009. That means, without considering inflation, the economy did not grow. Now, let’s take a look at the red line, which is GDP adjusted for inflation (real GDP). This is strange. Adjusted for inflation, Japan DID experience economic growth. But how is that possible. Subtracting out inflation, which is how Real GDP is calculated, means the value should be decreasing, not increasing. The reason is that inflation was actually decreasing. It went negative in 1995, and again in 1999, and has stayed around there ever since, as you can see below.
When inflation is decreasing, or negative (deflation), Real and Nominal GDP get closer and closer together. When inflation is 0%, Nominal GDP = Real GDP. When inflation is negative, nominal GDP will actually be LOWER than Real GDP. This happened in Japan in 2012, as you can see above. This is fascinating because it shows first that, inflation can eat away at economic growth. We need growth in economics to keep up with (and actually beat) inflation, otherwise we don’t grow. It’s furthermore critical that central banks and governments don’t do anything stupid to make inflation exceed economic growth, like what happened in the mid 1970’s. On the flipside, deflation is also a bad thing. Deflation means that although the price of goods and services decrease, something the consumer may very much like, the time value of money becomes negative. Nobody, not even consumers, likes it when money doesn’t grow. Show me one person who likes it when their savings account yields 0.01%!
“Exports boomed on the back of a super-cheap yen and America’s consumer binge. Japan did not have housing or credit bubbles, but the undervalued yen encouraged a bubble of a different sort. Japanese exporters expanded capacity in the belief that the yen would stay low and global demand remain strong, resulting in a huge misallocation of resources.”
The above two quotes are taken from the economist article referenced above, and are made in the context of why Japan was so badly affected by the Great Recession, given that it did not experiences a second property bubble, on par with what happened in the US. The reason again, as to do with deflation. Deflation caused the Japanese Yen to be very, very cheap relative to other world currencies. Therefore, Japanese manufacturers, trying to do anything possible to avoid doing business in Yen, ramped up exports. Japanese manufacturers had to depend entirely on foreign countries to buy their products in order to make a profit. They invested in foreign operations heavily, since domestic deflation was making domestic investment a losing proposition. Of course, when the world economy collapsed in 2008, so did that house of cards did. This devastated the Japanese economy, and deflation became even worse.