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REVISITED COMPARISONS TO JAPAN

The entire world has drawn its attention to the United States and its co-called economic recovery. The recovery itself seems to have been dictated and shoved down our throats by US Govt leaders, their downstream agencies, the unaware press & media, brokerage sell-side analysts, and economic analysts of questionable objectivity and detachment. When under 50% of Americans canvassed by national pollsters vote “NO” to the administration handling of the economy, one must ask tough questions like “is a recovery really underway?” The answer is not so clear. Rising residential real estate values, leveraged carry trade profits, and corporate cost reductions through cuts and Asian outsourcing hardly leave the observer convinced on the health of the engines of income sources and newfound prosperity. Rising debt levels serve as the foundation of capital flow for both the federal operations and household operations, a certain marshland upon which the foundation for recovery rests.

Ever since the early 1990 decade, Americans have mocked Japan for its terminal deflation, wrecked real estate market, insolvent bank sector, and moribund stock market. They point to our thriving capitalism, wide ranging opportunities, diverse resources, skilled labor force, and envied system. The facts do not support such a rosy comparison and dismissal of Japan. Enter China and the resurgence of East Asia following the 1997 Asian Meltdown. Our trade deficits make for Asian trade surpluses, which favor East Asia to a greater degree in almost every single year since China was granted the Most Favored Nation status in 1999. Yet we as a nation continue to mock, discredit, and look condescendingly to Japan, the home of the region’s largest economy and greatest savings rate, whose economy is built upon designing and building things, as opposed to our basis from credit extension, issuing debt, and selling financial paper instruments. Such negative criticism is very much misplaced. There might be an ethnic or racial bias behind such comments, which is noticeable when hearing about work standards, educational performance, tendency to engage party mode, and even their physical stature. This essay will explore why Japan has a vast array of advantages over the United States economically.

In the spring of 2003, my pen produced “Japan, Argentina, Weimar, or Muddle?” in an effort to set the record straight, later revised and updated (with the above applied link). The USA compares very badly to Japan in most respects. We have some distinct advantages, but they are overwhelmed by what is critically important. The consensus claims we will not be plagued by the agony of cycle after cycle of contraction and asset value destruction which prolonged in a stagnant manner for over a decade, as Japan witnessed. No, the USA is not as bad as Japan. WE ARE MUCH MORE DANGEROUSLY WORSE. Apply strong Weimar tools within a stubborn Japan quagmire, when addicted to foreign capital, and you risk shock-ridden Argentine outcomes, not a sloppy Muddle. Expectations of either recovery or muddle through are without grounds.

Since 2001, when the Fed began a dozen rate cuts, the expansion of household debt, the enormous federal deficits, the mind-numbing growth in money supply, the insanity of wasteful consumer spending, all of which continue to spiral upward, these point to an extremely bad foundation for the economy and Weimar symptoms of inflation. Reference is made to pre-Hitler Germany, with the grandest monetary inflation seen in a century, and the risk of widespread price inflation and/or debt default. Since 2001, the degree of foreign central bank support of US credit markets, the accumulation of financial assets by foreign institutions, these point to Argentine risks of foreign dependence and gradual if not sudden departure. An increasingly aggressive, hostile, and adventurous military only adds to the risk of foreign retaliation directed at our great financial weakness. Comparison can be made between the USA and the constant stress in Latin America, the tenuous nature of continued foreign participation, and the risk of foreign flight and abandonment.

So far, a bond market revolt in July last year, another bond market upheaval this spring, and harsh corrections to commodity stock portfolios offer early warning signals of shocks. More shock waves are sure to come. We are in the middle of witnessing the amplified response in effect to higher long-term interest rates. The financial sector dislikes higher rates, due to reversals of fortune to carry trade dependent upon low speculative capital, and due to threats to bond principal, stock values, and housing equity. Chairman Greenspan may boast of “wealth generation,” but when his reliance is on textbook inflation as the power source, small rate increases will quickly expose his incredible arrogance in the face of a miserable personal track record. It seems that the higher the power position in the financial leadership roles, the farther our authorities stray from common sense, from well-tested economic practices, and from anything remotely resembling rational thought. Our economists make it up as they go along.

The real economy has its own extreme dependence upon cheap borrowing costs. Zero percent deals continue for cars are likely to continue perpetually as sales have slumped. Detroit automakers announced June sales declines over 10%. Large electronic appliance sales and furniture sales still depend upon zero deals. These are not likely to go away. The experts might expect easy finance deals to discontinue in a rising rate environment, but we are likely to see even more desperate credit terms in reaction to sluggish sales. The US Govt might be engaged in their own desperate sanitized initiative with both Fanny Mae mortgage bonds and Treasuries. Their printing press is now on steroids. The ultimate source of most cheap capital is the bond market (whose liquidity is still huge), the absurdly low prime rate for reliable corporate borrowers, and certainly a slew of devices such as rate swap contracts to stir the lethal debt brew. Banking leaders boast about international vendor financing by Asia to facilitate foreign trade dependence. This “flexibility” is mindless. Is a loan shark who doubles as a crack cocaine dealer also flexible?

The real economy not only dislikes higher rates, due higher perceived final product costs, but also responds to those higher rates by focusing on increased household debt burdens. Higher rates mean higher costs on home equity loans, quite the rage to pick up the debt abuse baton where refinanced mortgages left off. Small rate increases will expose the weakness of the consumer. Evidence has already begun, with warnings by Wal-Mart, Target, Talbots, TJMax, Veritas, Siebel, Unisys, AutoZone, and Detroit automakers. Wall Street brokerages started out dismissing the shortfalls and warnings as isolated until such statements became cross-sectional. Sell-side motivation interferes with even the simplest analysis.

It is clear that our leaders and falsely labeled experts will deny the vulnerability until it is obvious, then they will blame others. My favorite scapegoats are the Chinese, Arab oil producers, and FOREX currency traders. As our inherent weakness become more evident, a closer comparison to Japan is worth the time, as a revisit of the year-old article. Its main points are very relevant still. In fact, Japan’s recovery is far more real, well-founded, and built upon a substantive foundation than our own within the US Economy. In classical economics, the principle of “first in, first out” applies to deflation and its tight grip. Japan first entered a deflationary environment in 1989, and has endured 15 years to work through the bad debts and excess production capacity. They continued to accumulate the world’s envy of $12 trillion in personal savings. China has now become critical in providing yet another vast consumer economy for Japan to sell products to, and to sell high-tech state-of-the-art equipment to. It is no surprise that Japan emerged from its long slumber only after China emerged as a growing economy. However, my main point is that Japan worked through its deflation, while the US Economy is in its early stages!!! We have increased our debts astronomically in the last few years.

Japan is enjoying a brisk economic recovery of its own. However, unlike the USA, their recovery is built upon the real economy where the manufacturing sector dominates and real wealth is generated. They have their own risk of rising interest rates, and damage to their bond market. As with the Fed, the Bank of Japan is likely to monetize JGB bonds. Inside the US Economy, the financial sector is powering this false and thoroughly illegitimate recovery, via inflated assets and debts spreading like cancer. Both nations are inflating big-time. The impact is sure to be felt across all commodities, including precious metals and energy.

DANGEROUS LIAISON

Disturbing parallels are emerging in the geopolitical and financial fronts between the United States and Europe, when viewed from a pre-WW2 perspective. The strange invasion/ annexation/ occupation/ marriage between the USA and Iraq harkens back to the Weimar Republic with several parallels, as the US Dollar has taken on resemblance to the ReichMark. Old German debts were crippling after the Versailles Treaty in much the same manner that USA debts prevail today. Foreign-held USTBond debt has grown dangerously, with no end in sight. American debts are owed to overridden Europeans, infuriated Arabs, bewildered Japanese, and upstart Chinese. The final disposition of a whopping $80 billion in Baath Nazi debts to the French, German, and Russians, not to mention the USA, has yet to be settled by international creditors debating Iraq’s fate. Debt writedowns and forgiveness might be forthcoming, but commandeering of oil fields and managing Iraqi oil production reminds historians of resource seizure in the late 1920 decade.

Iraqi oil production was supposed to pay for the war effort to depose Saddam, the renovation of Iraqi oil facilities, and pervasive Iraqi upgrades to electricity and water resources. None has happened. US taxpayers (or rather Asian Treasury Bond financiers) have so far footed the bills. German war bonds were used to finance war efforts leading to the Nazi party takeover in the Weimar Republic. Those war bonds ended up being worthless. Today, deficit spending finances the Iraqi War. Some call it war on a credit card. The debt picture for the US Economy, with spiraling twin deficits puts the USDollar at severe unspeakable risk. Capital flow fundamentals are not improving, during a supposed recovery. My personal view is that the deficits (trade gap & federal budget) will worsen during a recovery, and worsen even more drastically when the corner is turned into a recession. American citizens seem totally oblivious to the inevitable USDollar monetary crisis ahead. Such talk and comparison seems to them wild-eyed and crazy. Apart from politics, purely from a financial point of view, when one examines critical energy imports to the largest economy in the world (USA), and the underlying financial deterioration, such claims perhaps are not so radical.

The prescription for an Argentine implosion shock is a combination of debt failures, weak export competitiveness, and sudden departure of foreign capital. Chairman Greenspan might boast to excess about the “flexibility” of Asian credit supply and trade surplus recycle. If and when an Asian credit market is founded and begins formal operations, their surplus reserves might stay home. Such an event would mark an historical change, and deliver to the US financial markets and economy a powerfully damaging blow. Our sense of bravado and security is misplaced. Our vulnerability has never been greater. The risk of foreign flight, even “measured withdrawal” of bond support would be extremely harmful to our economy. These risks are almost totally dismissed by our vast team of economic and financial experts, who helped to get us into the current mess.

UNFAVORABLE COMPARISONS TO JAPAN

The USA compares badly to Japan, despite what is published. For over two years American business leaders, financial leaders, brokerage analysts, media pundits, and investors have denied that the United States is gradually entering a Liquidity Trap bearing strong resemblance to the one that has ensnared Japan’s economy since 1990. Such denials seem patriotic at best, and obtuse at worse. The trap of low interests is now very evident inside the USA. It is not characterized by low liquidity, but rather high liquidity. Official monetization initiatives are kept secret. Suspicions rage that both Fanny Mae mortgage debt and US Treasury debt are in the process of being monetized. This means the US Govt officials, whether from cabinet ministers in the Dept of Treasury, or the independent Congressional contractor called the Federal Reserve, are printing money and buying mortgage and federal debt securities. Can you say “Weimar”? The tight grip of the trap will become crystal clear over time. Interest rates will remain low, since their rise will slow the economy and prompt a bond response. Japan was stuck in the trap for over a decade. Their savings grew every year. Many companies were plowed under, or absorbed in conglomerates. Their bank system grew out of the underwater status when the Nikkei stock index was lifted. Japan slugged its way through the trap. The USA believes it can become the first nation in history to print its way out of the trap. Ain't gonna' happen. When the trap no longer holds the bond market, interest rates will accelerate in a stagflation worse than the 1970 decade. At that time, the risk of foreign flight will hit climax.

Neither Japan nor the USA might stumble in the Land of Muddle much longer. Some believe Japan will muddle forever, since they have muddled for over a decade. It is my belief that Japan is finally emerging from the deflationary environment, whose vicious tight grip cannot be loosened quickly or effectively without the passage of time and adjustment to lower asset prices. Investment in and reliance upon their real economy has laid a proper foundation for Japan to emerge from its trap. The USA is in the early stages of emergence from an encircling, widespread, persistent and pervasive grip of deflation. Our nation has spent its new capital (monetary expansion) mostly on new debt, which adds to the deflationary element of the economic equation. Japan saved, US took on more debt. To expect the USA to sustain a recovery is lunatic. To offer criticism of Japan and its recovery prospects is bad science.

As our government and financial technicians seek to prevent a painful recession (which would surely feed upon itself), we are pulling much the same levers as the Weimar Republic in the 1920’s. A full decade of bailouts have affirmed the Federal Reserve role as last resort guarantor of world economic accidents. We are approaching the Keynesian Monetarist end game. A mere 22 cents of new business activity is produced from every new minted dollar (in credit), while roughly 80% of the current GDP is now devoted to debt service. We are spinning our credit gears. This was precisely the warning issued by the Austrian School of Economics, which has been ignored for decades. The von Mises Institute “students” have warned that late in the debt-based system, government officials will be forced to accelerate the money supply in order to maintain a constant level of economic activity, and ward off a deflationary recession. This is what I have referred to as the “Hyper-Liquidity Endgame,” sure to gather force. As Weimar levers are pulled to escape the clutches of debt deflation, we subject our economy and our financial markets to the extreme risk of foreign capital flight, as seen in Argentina. Unlike domestic bondholders, foreign creditors undergo principal loss due to currency exposure. If they exit our credit markets in response to unfettered Fed monetization and economic stagnation, the Fed action will be vetoed to bring about no change, or even higher interest rates.  Severe currency disruptions lie ahead. Whether from economic breakdown or growth on the back of inflation, gold will thrive.

In their next panic, the Greenspan-led hacks running our Fed will plant the seeds of hyper-inflation, whose germination will be dictated by China. Not all monetary inflation is economically inflationary though. Our queer money supply expansion will likely breed massive debt defaults and economic deflation. In November of 2002, the new Fed Governor Bernanke crowed that the Federal Reserve would avoid the unfortunate Japanese outcome by putting their high-tech printing press to work, early and often. The monetization tools we brandish might resemble a guillotine poised over our financial body, with the US Dollar currency the exposed head. When China decides it must pass along higher material costs, energy costs, and shipping costs, the entire non-Japan Asian Rim will follow suit, inducing the seeds of US price inflation to sprout. When China chooses to withhold its surplus from US credit markets, and foster growth of a pan-Asian credit market, the entire non-Japan Asian Rim will follow suit, forcing higher interest rates inside the USA. China will likely shift gears when their middle class and corporate growth needs dictate it, or else when a trade war with the USA erupts, which in my view is absolutely inevitable.

SPECIFIC CONTRASTING DIFFERENCES

Specific differences between USA and Japan are very unflattering, relating to currency valuation, bankruptcy ease, saving propensity, foreigner debt ownership, financial engineering, monetization techniques, basic integrity, and intervention willingness.

a) Unlike Japan, the US Economy cannot tolerate a declining domestic currency US Dollar
A declining US Dollar has shown to be anathema for our economy, since imports have opened the door to cost inflation. A declining US Dollar imports inflation, reversing the 1990 decade-long trend. A falling dollar brings higher commodity and energy costs. Higher production and living costs are smothering the economy, pinching corporate earnings and consumer spending. In Japan, a decade long undervalued yen currency protected them from imported inflation in prices. A strong mfg base protected them from deflation. A falling US Dollar exposes our entire credit market to the risk of foreign flight, when losses are too painful to incur or confidence in our markets evaporates.

b) Unlike Japan, the US Economy permits bankruptcies as a regular course of business
Our economy is undergoing an acceleration in bankruptcy filings, both corporate and personal, as sluggish wage growth and relentless job outsourcing have stressed high debt levels across the entire economy. The purpose of a recession is to cull unproductive, irresponsible, and excessive debt. However, the entire United States economy is a debt experiment gone amok. Debt levels are a quantum level higher than those seen in 1930.  Debts from federal, state, corporate, city, municipal, and household are all under stress. The stress at the state level is acute. The bankruptcy path feeds upon itself. It should be noted that when a large business or institution is threatened with bankruptcy, the process is thwarted, and taxpayers subsidize the rescue of the wealthy owners. This is done in the best interest of the nation, of course, or should I say the wealthy? Even as money supply is reduced via capital burning, new money enters the economy, but from the financial sector where capital is not offset by real production. It is pure inflation. Japan has muddled along from inefficient capital recycling and release for over a decade. China provided that eventual traction. The exact opposite is true of the United States, where bankruptcy and liquidation might get out of control, and traction is elusive.

c) Unlike Japan, US Economy depends upon consumption & spending
Our nation is comprised of countless citizens who spend compulsively, and live for today. They borrow heavily in order to maintain a standard of living. Many regard our standard as their entitlement. The saving rate went from its historical 6-7% to negative levels late in the 1990 decade. Our financial leaders go so far as to encourage our citizens to consume, raid home equity, all in some patriotic duty. To our misfortune, US economic guidance counselors inculcate the masses to believe that prosperity and foundations for recovery come from final demand spending, i.e. consumption. Japanese citizens are the most prolific savers on the planet, with an astonishing 20% savings rate. It is estimated that Japanese household savings total more than $12 trillion. This energetic nation finances sovereign debt across the entire industrial world. Their economy can benefit from unleashing their savings and foment a riot of consumption that would assist in lifting their economy. The exact opposite is true of the United States, where a stall in consumption will threaten the entire system.

d) Unlike Japan, much US debt is owned by foreigners, with a trade gap widening
Foreign investors own a dangerous amount of debt all across our financial system, with federal govt securities the most widely held, and agency debt picking up speed fast. Corporate debt is also prevalent in foreign portfolios. The actual percentage of the $7.1 trillion federal debt is in debate, but believed to be approximately 45%. The US trade gap and federal debt perpetuate and exacerbate the strain. Our economy requires roughly $1.5 billion per day of foreign capital, just to keep operating. With dependence comes lost control of our fate. A correction to the imbalance is overdue. May and June trade gap numbers confirm that our trade gap has not responded positively to a declining USDollar. Japan has never appealed to foreigners for supplying credit, since they are the greatest savers even seen in modern history. This island nation is not at the mercy of foreigners and their whims of shifting preferences. We are.

e) Unlike Japan, US Structured Finance has created a megalith monster
Since 1990, our ingenious Structured Finance systems have acted as centrifuge fountains of capital to supply the residential real estate sector. Commercial property appeals typically to commercial banks, yoked by shorter terms of amortized loans. Fanny Mae, Freddy Mac, and other GSE agencies appeal to investors with the murky promise of federal guarantees. Japan and China have become major investors of agency debt, lapping up roughly 30% of mortgage debt issued. Originators of loans assemble loan portfolios, with diminishing concern for correctly valued collateral property, creditworthy borrowers, or viable loan-to-value ratios. They package their loans, sell them to Fanny Mae, then recycle the replenished capital to repeat the process, thus socializing home ownership. As mortgage rates fell in the last two years, the refinance process led to reinvestment of the prematurely retired bonds into government treasury securities. In the process a feedback loop was created, which served to reduce interest rates further. In recent months the process has reversed, which forced a quiet transition of agency debt responsibility to the Federal Reserve. The move was made to avoid implosion of Fanny’s balance sheet and enable secretive sanitization of their debt books. The Japanese have no equivalent in financial structures. Banks own their underwater mortgages tied to residential real estate, and called an end to their speculative insanity. In the USA, speculative insanity continues with govt blessing, clandestine support, and public participation, oblivious to the danger. The fundamentals of our economy in no way justified a 30% to 40% rise in housing values. At some point, natural forces will want to reverse the wrong direction.

f) Unlike Japan, US institutions harbor widespread corruption
Glaring evidence in the last three years indicates an institutionalized fabric of corruption engrained throughout much of the US financial landscape. Corporate accounting, brokerage analysis, executive self-compensation, mutual fund sweet deals, Congressional lobby to block reform, foot dragging on prosecution, use of off-shore banks and agents, collusion between govt ministries and financial centers, media bias catering to advertisers, bailouts of large well-connected institutions, all this has changed little in the last two years since Enron made headlines. While Americans believe a movement has begun in our country toward remedy, foreigners see the corruption status quo as deeply entrenched. Japanese exhibit far more honesty in their institutions, but not without an isolated rare episode themselves. Several years ago, we heard of a palladium price fixing case. Bribery occasionally surfaces among govt officials. But by and large, the Japanese are a relatively honest bunch.  Honesty is more rooted in Japan, contrasted with a basic pursuit of honor. The opposite is true in the United States, where corruption is commonplace, contrasted with a widespread moral breakdown.

NEWS TIDBITS

The Japanese Prime Minister won re-election on Sunday, as the ruling coalition kept its majority in the upper house, boosting investor expectations that Koizumi's economic reforms will continue. Results helped lift the Nikkei index 1.4% and the yen currency for a short while. Wal-Mart reported same store sales growth for July so far in the 2 to 4% range. Seven Eleven reported June sales growth of 5.5% for merchandise, 35% for gasoline. Radio Shack reported a 7% decline in traffic, as market share has been lost to Circuit City’s big box. Airlines reported a record full summer for seat sales, but strain under combined $3 billion in losses. Marvel Entertainment (owner of Spiderman rights) approved a $100 million share buyback program. German-American auto maker Daimler Chrysler may cut 6000 jobs and shift some production of the new C-class models outside of Germany, if its works council opposes deeper cost cuts. For the five months to May, payroll jobs grew at a 1.4% annualized pace in California, compared with 2.2% in the nation as a whole, according to the San Francisco Fed. On a national level, gasoline prices fell one penny to $1.93 per gallon for unleaded grade. A refinery fire in Norway has been reported. Lea Fastow, the wife of former Enron Chief Financial CFO officer Andrew Fastow, began serving her one year sentence for a misdemeanor tax charge.

Apple Computer, the maker of the iPod, has sold 100 million songs on its iTunes Music Store, solidifying its position as the leading legal music download site. DeBeers, a world leading diamond company, will plead guilty in a US court to a 10 year old price fixing charge, opening the way for it to resume retail business in America. General Electric stated it is teaming up with Celera Genomics, the company that spearheaded the mapping of the human genome, to develop diagnostic tools that can speed drug research. Morgan Stanley is reported to have settled a landmark gender bias case with $54 million, over claims the Wall Street firm has denied hundreds of women raises and promotions while ignoring lewd male behavior. The NASD said Piper Jaffray agreed to pay $2.4 million to settle charges it engaged in improper sales of hot initial public offerings to win investment banking business. Merrill Lynch downgraded Intel and the rest of the global semiconductor industry, just one week after chest pounding over the SIA report of 37% growth in chip sales, led by wireless. Alcoa closed one of three hotlines at its majority owned smelter in Quebec, after being hit by a strike last Wednesday. Employees at Stillwater Mining have rejected a tentative labor deal and threatened to strike later on Monday, a move that would put at risk nearly three quarters of production by the only US miner of palladium and platinum. NCR said it expects to post better than expected second quarter results, boosted by strong revenues in data warehousing business. Qualcomm, a wireless technology company, announced it had begun sample production of cell phone chips that incorporate both phone functions and a range of advanced multimedia capabilities like high resolution photography and video capture.

Spiderman II took the top box office at $46 million (including me), trailed by Anchorman at $28.0M and King Arthur at $15.2M. Baseball takes a break to divert attention toward the All Star Game, where Roger Clemens is scheduled to pitch to nemesis Mike Piazza in a strange battery combination.

TODAY’S MARKET

Today the Dow Jones Industrials wrapped up at 10,238 (+25), S&P at 1114 (+1.5), Nasdaq at 1937 (-9), TENS yield 4.44% (-2.3 bpt). Currencies closed with Euro at 123.89 (-0.04), JYen at 92.64 (+0.04), Can$ at 75.75 (+0.06). Metals finished with gold at 409.0 (unch), silver at 654.2 (+6.5), copper at 127.75 (-0.10). Energy ended with crude oil at 39.64 (-0.64), natural gas at 591.2 (-28.3), unleaded gasoline at 126.7 (-1.6). Prices are at major futures contracts.

Jim Willie CB

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