Against the background discussion being carried on earnestly by economists everywhere as to how much stimulus is necessary to “turn things around”, and as part of a broader study of the current credit malaise, to be published shortly, we took a good look another major insolvent country, Japan, which reached its own ‘second-order’ insolvent condition way back in 1998, in order to help us better forecast what might happen to the US economy in the period ahead. The information that we gleaned is not promising, especially as the US seems determined to follow Japan’s lead out of their problem. For our clients who may wish us to comment and opine on the budget pronouncements and actions, our basic conclusion is that they are all out to lunch.

Well do we remember the great futurist, Herman Kahn, who many, many years ago predicted global economic dominance by Japan. He called it “the Japanese Miracle”, rising as Japan did from the ashes of World War II to become the dominant economy in the 1970’s and ‘80s. But a funny thing happened to this global powerhouse on the way to global hegemony: it got massively over-extended from a credit point of view and crashed and burned in the 1990’s. It has never raised its economic head again in anything but fiscal shame.

As part of our analysis of the US second-order insolvency study, we examined the Japan “model” to see whether or not the circumstances were similar enough to offer any insights into the current US situation. One of the principal reasons that we thought that something might be there is that the great expansion in Japan terminated so abruptly and began a long downwards spiral as far as their capital markets were concerned, never managing to gain any forward momentum since that time. That sort of action speaks volumes to us because without even looking at the numbers themselves, it suggests that a deeply entrenched insolvency must be at work. Hence, we gathered the debt and GDP data for Japan and were not surprised when we found that our inference was quite correct. We show the GDP/Debt Solvency chart for Japan from 1980 through 2007. In 1996, Japan crossed the debt Rubicon – or perhaps, Styx, would be the better term – and entered the netherworld of the second-order insolvents. It was, as we shall see, a truly momentous occasion.

The great boom in Japan up to 1989 (but continuing on at a lesser pace until 1995-6) was, very like that in the United States from the early 1980s through 2007. It was built as much on a rapid growth in the issuance of debt as anything else. What is of particular interest to us is in and around that 1996 time period, the GDP/Debt ratio for Japan reached a .289 second-order insolvency ratio. Subsequent to that time, the country has very modestly worsened from that level on the downside and has not been able to improve since then.

Given what this means – that an entity has sold everything on the shelf and now must sell the shelf itself to survive and thrive – it should come as no surprise that if Japan did nothing about its solvency condition except to desperately try to just hang on, there would be sufficient debt grit in the Japanese economic machine to prevent it from moving forward. And, indeed, that is precisely what has happened. In the following charts, we show what has occurred in Japan.

First off, for all intents and purposes, we observe that the GDP of that country has gone virtually nowhere from 1996 on.

The Japanese GDP reached almost to ¥458 trillion in 1989 with a solvency ratio of .32. It was still able to advance to the ¥500 trillion mark, albeit at a slower pace until 1998 when the Solvency Ratio for Japan hit the .289 mark, at which time its GDP has virtually stalled out, reaching ¥515 trillion in 2007, a growth rate of 0.27% per annum. That compares with an average growth rate from 1980 through 1991 of 6.05% a year. Looking at the private sector, it is easy to see what happened subsequently, in particular the growth of households and business credit.

We certainly know which sectors did not participate in the “growth” of the Japanese economy since 1996. Household debt growth has been in negative ground in several of the years, and corporate debt growth has actually been in a fairly steady decline. Indeed, after tripling in size between 1980 and 1990 alone, Japanese corporate debt has declined by more than a third since 1996. Since the Japanese GDP has been almost dead flat over the period, and corporate debt has fallen, this tells us that the general business climate itself in Japan has been in a modest retreat. Of course, if the stock market had boomed, one might surmise that Japanese business has not had to tap the credit markets and instead has been using equity for the majority of its financing requirements. That is most assuredly not the case since we know that the stock market has declined significantly from its peak 18 years ago, and we can safely assume that Japanese business has not changed its financial modus operandi since then.

Clearly the equity ‘capital formation’ process in Japan has taken a massive hit since the 1989-91 peak and, save for sporadic rebounds, has never managed to get on the right track since then. Many will remember that at the peak of the Japanese expansion in the period 1989-91, the Nikkei Dow reached a level of 39,000 which has stood as a record. In a sense, this peak was more like the US high technology stock peak in 2000, although more broadly based. Since then, the Nikkei Dow has fallen to progressively lower and lower levels, until that Index currently stands at approximately 22% of the 1989 peak.

Nor has the banking system been much of a source of growth. After its great surge, peaking in the 1989-91 period, the overall growth in financial debt has been fairly anemic.

What is interesting is that the massive rise in financial debt from 1980 through 1989 mimics the staggering increase in US financial debt which then became one of the sources of major problems for not only the US but also the global economy as well. Now, if GDP has leveled out, household and financial debt has gone nowhere, and corporate debt has been declining, one would have thought that the Japanese GDP/Debt solvency ratio might have risen (even if modestly) back towards a solvency level which might permit expansion to occur again. One would be quite mistaken in such an expectation as the Japanese government has tried to keep the pot boiling – that is, insofar as there is any heat in that economy worth mentioning – by the continued issuance of credit. In fact, while the Japanese economy has crept forward at a 0.27% annual rate of growth, the growth of government debt since 1996 has nearly quadrupled over the period, for an annual rate of growth of 10.7%.

What the GDP numbers show is that almost all the heavy lifting in Japan to keep that economy at least flat (rather than downtrending) has been bourne by the Japanese federal government (although the total debts outstanding of the state and local governments have grown by 57% over the latest 12 year period). Indeed, the total indebtedness of all levels of government in Japan which was once about 50% of Japanese GDP is now a multiple of two instead.

No matter what reasons have been invoked to support the actions of the Japanese during the entirely of this period, nothing has ever been done to halt the erosion of national wealth. The ability of Japan to advance on the global economic stage of life was brought to a standstill. The decline of the stock market and real estate prices were part of the same bubble that infected the US years later, and were brought about by the same unrestricted expansion of debt which first blew the country into second-order insolvency and then brought the country to its knees. As private sector growth waned, the government moved in and has kept moving in, just like the US government authorities are planning to do today. Indeed, it is interesting to note that among President Obama’s first initiatives are plans for massive infrastructure spending. By steadfastly refusing to deal with the fundamental problem, too much debt, Japan has been stuck in a debt warp, a swamp from which it just cannot seem to escape without a lot more imaginative action than has occurred. After 12 years of close to zero interest rates and massive government credit expansion, Japan in total remains on government-financed life support, its economic pulse virtually flat-lining.

The Japanese have been aided and abetted in their endeavours by the serendipitous rise of the hedge funds and the development of the carry trade. Borrowing in one currency, the yen, and lending in another where there are higher interest rates for a nice spread has been very profitable, and all the more if the yen was weak. This did, of course, create an ongoing demand for the yen which has probably kept it higher in international markets than it probably should have been.

Is this to be the fate of the USA as well? Goodness knows that the American monetary and fiscal authorities seem to agree on the Japanese course of action, cut interest rates as close to zero as possible, goose the economy with massive infusions of [government] credit, and bail out the losers who have demonstrated remorseless greed or a pathetic inability to adjust to the changing global realities. At the same time, there are no plans to prevent the erasure of as much debt as possible in as short a period of time as possible, as those same authorities wish to prevent the short term pain that must inevitably come from those actions.

The new Democratic government under Barak Obama seems bent on pursuing the same course of action – only more vigorously! If the definition of insanity is doing the same thing over and over in hopes of a different outcome, then we would have to apply that term to what the US is trying to do.

From a US economic point of view, the Japanese example is a salutary lesson in what not to do – or at least, we would have thought so. Sadly, Ben Bernanke of the Fed, that “renowned expert” on the Great Depression, has also laid claim to be the expert on what went wrong in Japan during what have become known as the “Lost Years” between 1998 and today. (Is there no end to his talents?) In his opinion, the Japanese government did not do enough to turn Japan around and he is bound and determined to do even more than Japan did when the real troubles started. Given that the Japanese government increased its debt load by a solid 50% in one year alone, about the same degree as is proposed should be done in the US for 2009 (always being mindful that this degree of stimulus is a moving target, depending on who is the forecaster of the moment), we would have to wonder what it is that is in Bernanke’s mind in terms of the stimulus that he would invoke. Correct us if we are wrong, but it seems as if the Japanese have done a lot to try and shake those Flat-Line blues away. However, the fundamental problem is that at that second-order insolvency ratio of .289, additional debt does virtually no economic work at all – that is the nature of that particular (in)solvency ratio, and why it is vital to erase debt, not add to it.

The challenge that the US administration (not to mention the global economy overall) faces is that the US insolvency is roughly 3 times larger than that of Japan. Of course, since becoming a second-order insolvent, Japan has remained in a zero growth condition, but that still means that somewhere in the neighborhood of 30-33% of global GDP lies in two countries which are in difficult financial straights. Financing both of them is likely to prove to be a staggering drag on the rest of the world – with no assurances that it can be done without almost a pure resort to the printing press.

There is an old saying that remains as true today as it did when it was first coined: those who do not learn the lessons of history are doomed to repeat the same errors.

The Outlook for the Stock Market

The bottom line is that Japan’s capital markets have suffered in some anguish over the years as valuations and prices fell steadily lower. Not that there haven’t been some decent rallies along the way, its just that the trend has not been the investors friend for a long time. At issue for our clients – and all investors – is how cheap North American stock markets, especially those in the US, must get to discount zero overall growth.

Obviously, despite the seething pit of credit problems, some things will manage to grow, some will manage to get by…and some things will die. But net, with present trends and policies, the economy will increasingly exist to service the debt, not economize and grow as is its natural function. Regardless of what happens in the shorter term, we doubt that the market is cheap enough yet to successfully discount zero growth.

In the meantime, although we are far from being gold bugs, keep your positions in gold shares.

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