Japan Gets Real

Akio Morita's best-seller Made in Japan told us that the Japanese study harder, work harder, save more and invest more than we do. They also cheat: subsidizing exports, penalizing imports, controlling prices and employing shrewd bureaucrats to coordinate an industrial policy that would have made Machiavelli proud. Clumsy Americans and their companies had no hope.


No wonder Japanese growth rates were higher, inflation was lower, the budget and trade were in surplus and the yen was the world's strongest currency. No wonder its stock market multiples were five times ours, and the land under Tokyo's Imperial Palace—which even I could jog around at lunchtime—was worth more than all the real estate in California.


Maybe that's why Deborah Allen and I got such a cold reception in Japan with our 1989 book Rust to Riches (published by Harper & Row), in which we argued that it was time to buy America and sell Japan. Too bad. During the ensuing 13 years, the Dow Jones Industrial Average quadrupled, while the Nikkei 225 Index has lost three quarters of its value. Un-leveraged, a long-United States, short-Japan position made 16.8 times your money, a return of roughly 25 percent per year.


Instead of Japan, Inc., we got Japan, Stink. Recession, deflation, bad loans, collapsing stock prices, a weak yen, failed stimulus packages and political scandals. Things have now been so bad for so long that people are sure Japan will never improve.


They are going to be wrong again. The volcano of economic change is about to erupt again—this time for the better. Big changes in Japanese monetary policy are pushing Japanese (real) interest rates lower, which could end the deflation and restore growth, with profound effects on the economy, the stock market and the yen.

What Went Wrong

We didn't think our 1989 long-United States, short-Japan bet was such a tough call. Reagan-era disinflation and tax cuts had dramatically lowered the cost of capital for American companies. U.S. manufacturers were forced to restructure, selling low-return assets and reducing costs. We were due for a boom.


In Japan, on the other hand, capital-flow restrictions had just been eased, exposing overpriced assets to global arbitrageurs. Falling property values would undermine bank balance sheets and cripple the economy. We thought it was a great time to sell.


It turns out to have been a pretty good bet. The average price of residential land in Tokyo, measured in yen per square meter, has fallen every year since 1990, shedding well over half its value in total. Land is Japan's largest asset class, and property deflation has been its black hole—the direct result of the hard-headed and misguided policies at the Bank of Japan. The BOJ's Keynesian-trained macroeconomists, who mistakenly equate low nominal interest rates with monetary stimulus, followed their textbooks and drove land values into the, well, ground, destroying a mountain of net worth and crippling Japan's economy in the process.


Keynesian macroeconomic analysis leaves out monetary policy's most powerful transmission channel, tangible asset prices. Land, commodities and durable goods make up the bulk of people's net worth. They represent almost the entire stock of collateral for the banking system and exert a powerful influence on credit markets. That's why monetary policy, by directly influencing real asset values, exerts such a huge influence on the economy.


Economics is about how people make choices—between goods and services, between work and leisure, and between consumption now and consumption later—using the information embodied in relative prices to help them make decisions. And therefore macroeconomics (not to mention asset-market analysis) needs to focus on relative returns—the relative prices of claims on future dollars.


Ironically, the most lucid statement of how to do this was written by John Maynard Keynes himself, in Chapter 17 of The General Theory. (His discussion of an asset's "own rate" of interest is the single most perceptive statement of the capital-market choice problem ever written.) Keynes understood that assets are simply devices for carrying over purchasing power into the future and that there are as many ways to do this as there are nonperishable goods. He also understood that people make choices among assets based upon relative returns, not absolute returns or nominal interest rates. His examples included a calculation of the rate of interest for a bushel of corn, which shows that his definition of an asset was not restricted to bonds, bills or other paper assets.


Here's a tip. Read the masters, not the students, if you really want to understand their ideas. I have always been fascinated by the way a great mind works. You can't learn that from textbooks; you have to read the master's original work—all of it—and try to understand the historical context in which it was written. That's why I know there is a lot more in common among Irving Fisher, Knut Wicksell, Böhm-Bawerk, Maurice Allais and John Maynard Keynes than their various disciples like to admit.


The economists at the Bank of Japan must have skipped Chapter 17. They believe monetary stimulus means low nominal interest rates—period. They are shocked that their expansionary policy has not produced results. They don't know what to do next.


In fact, Japanese monetary policy has been extraordinarily tight for the past decade. Japanese real interest rates have been the highest in the world for the past decade and quite possibly the highest for such an extended period in recorded history.

http://www.gilder.com/AmericanSpectatorArticles/RutledgeMay-June.htm