Japan Also Rises
rutledge, john
"Japan Also Rises" JAPAN GETS REAL TIME TO SAY GOOD BUY? BY JOHN RUTLEDGE J n 1989, people were convinced that Japanese investors were going to own America and that Japan, Inc. would dominate world markets in...
...They represent almost the entire stock of collateral for the banking system and exert a powerful influence on credit markets...
...Over the past 13 years, each 100 basis-point increase in real interest rates has reduced real growth by 20 basis points...
...This has the virtue of being easy to calculate, but means nothing for the capital markets...
...High real interest rates make this almost impossible...
...But if the change is real, it will set the stage for a reversal of Japan's economic fortunes and a huge opportunity to buy Japanese assets...
...Here's a tip...
...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...
...And this will require a whole new attitude about printing money...
...And it should account for risk...
...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...
...Maybe that's why Deborah Allen and I got such a cold recep tion in Japan with our 1989 book Rust to Riches (published by Harper & Row), in which we argued that it was time to buy Amer ica and sell Japan...
...The volcano of economic change is about to erupt again-this time for the better...
...Japans shortterm borrowing rate last year, for example, was 1.37 percent...
...They also cheat: subsidizing exports, penalizing imports, controlling prices and employing shrewd bureaucrats to coordinate an industrial policy that would have made Machiavelli proud...
...The most direct way to address this problem is to turn bad loans into good loans, by re-inflating asset values...
...Keynesian macroeconomic analysis leaves out monetary policy's most powerful transmission channel, tangible asset prices...
...The nominal rate of interest must equal the expected rate of tangiblegoods inflation plus a term that represents the sum of all the other factors that matter when comparing the risk-adjusted, after-tax returns of financial and real assets...
...With the Soviet Union in Chapter 7 and China turning capitalist, Japan was the one poster child for central planning still hanging on collectivists' walls...
...Back to Japan, where real rates-measured as the difference between the long-term prime lending rate and the annual price inflation of a square meter of Tokyo residential land-have averaged an astounding 9.74 percent since deflation began in 1989...
...Ironically, the most lucid statement of how to do this was written by John Maynard Keynes himself, in Chapter 17 of The General Theory...
...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...
...For WPI, real rates averaged minus 3.6 percent and minus 0.45% on the same basis...
...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...
...The economists at the Bank of Japan must have skipped Chapter 17...
...Clumsy Americans and their companies had no hope...
...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...
...His discussion of an asset's "own rate" of inter MAY/JUNE 2002 • THE AMERICAN SPECTATOR 15 est is the single most perceptive statement of the capital-market choice problem ever written...
...This is the logic behind the widely misunderstood Fisher Equation, linking interest rates, the real interest rate and expected inflation...
...High real interest rates caused by land deflation are a huge drag on growth...
...Such assets can either be in the form of security claims on future incomenotes, bills, bonds or equities-or they can be real goods, such as bushels of corn, machines, cars or houses...
...I am inclined to make a small bet today-by investing in Japanese exchange traded mutual funds-and increase the size of the bet as we see more proof...
...What he-and investors-should care about are relative returns on different assets that can carry over purchasing power to the next year...
...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...
...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...
...rency...
...Deflation is especially hard on manufacturing companies, whose balance sheets are typically made up of tangible assets and financial liabilities...
...In Japan, on the other hand, capital-flow restrictions had just been eased, exposing overpriced assets to global arbitrageurs...
...Real interest rates, therefore, properly need to be measured as the spread between the total after-tax return on a financial and a tangible asset...
...All this could mean that the economists at the Bank of Japan have finally read Keynes' Chapter 17, but I doubt it...
...In fact, Japanese monetary policy has been extraordinarily tight for the past decade...
...They believe monetary stimulus means low nominal interest rates-period...
...They don't know what to do next...
...This compares with the negative rates that drove land prices sky high in the 1980s...
...CPI inflation was minus 0.7 percent, producing an adjusted "real" interest rate of 2.07 percent...
...We thought it was a great time to sell...
...I have always been fascinated by the way a great mind works.You can't learn that from textbooks...
...Keynes would have been appalled...
...No wonder its stock market multiples were five times ours, and the land under Tokyo's Imperial Palacewhich even I could jog around at lunchtime-was worth more than all the real estate in California...
...In Japan, as in the United States, services that are not storable at all make up more than half of the CPI basket...
...Recession, deflation, bad loans, collapsing stock prices, a weak yen, failed stimulus packages and political scandals...
...Most goods and services in the CPI basket are too short-lived-their physical depreciation rates are too high-for an investor to use them to carry over value from year to year...
...The analysis should include everything an investor cares about-interest payments on a bond, the rental value of a house, storage and maintenance costs, liquidity value, the prospect for capital gains and all the complexities caused by taxes...
...The good news is that adjustment is already underway...
...But there is a Catch 22...
...All four measures were negative for 2001, reinforcing the Bank of Japan's misguided claim that they have been pursuing stimulative monetary policy...
...He also understood that people make choices among assets based upon relative returns, not absolute returns or nominal interest rates...
...ONWARD AND DOWNWARD Here's the payoff...
...I know of no example in history where an economy grows, while land prices deflate...
...Un-leveraged, a long-United States, short Japan posi tion made 16.8 times your money, a return of roughly 25 percent per year...
...This time, they may mean it...
...manufacturers were forced to restructure, selling low-return assets and reducing costs.We were due for a boom...
...But rapid money base growth for an extended period will eventually reliquefy the Japanese economy, end deflation and restore growth...
...In order to remain solvent, a company must offset its real cost of money-the carrying cost of its balance sheets-with operating profits...
...They are going to be wrong again...
...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...
...THE REAL THING Most economists measure real interest rates as a nominal interest rate minus CPI inflation...
...Instead ofJapan, Inc., we got Japan, Stink...
...Reagan-era disinflation and tax cuts had dramatically lowered the cost of capital for American companies...
...That's why monetary policy, by directly influencing real asset values, exerts such a huge influence on the economy...
...It is this latter term that measures the real real interest rate...
...Loans go bad because the underlying assets cannot produce the cash flow to service them...
...More likely, it reflects the growing pressure from Prime Minister Koizumi and the White House to end deflation...
...Falling property values would undermine bank balance sheets and cripple the economy...
...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 cur John Rntledge is chairman of Rntledge Capital, a private equity and liedgefiurd management firm based in Neu, Canaan, Connecticut...
...16 THE AMERICAN SPECTATOR • MAY/JUNE 2002...
...would dominate world markets in steel, autos, technology and finance...
...Too bad...
...The Japanese government has gone on the wagon many times before...
...The Bank of Japan has been buying massive amounts of government bonds, increasing the monetary base at a more than 50-percent annual rate over the past six months.Yes, there is a credit crunch and, yes, there are tons of bad loans...
...This is going to have dire consequences for the yen-recent downgrades by rating agencies have made it clear the government cannot continue to borrow and spend money forever, and declining credit quality means a falling yen...
...And therefore macroeconomics (not to mention asset-market analysis) needs to focus on relative returns-the relative prices of claims on future dollars...
...Calculations based upon consumer or even wholesale price data miss all this...
...During the same period, Japan's average CPIbased real interest rate ranged between negative 2.21 percent (using the short-term prime lending rate) and 0.96 percent (using the long-term prime rate...
...Things have now been so bad for so long that people are sure Japan will never improve...
...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, Bohm-Bawerk, Maurice Allais and John Maynard Keynes than their various disciples like to admit...
...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...
...Read the masters, not the students, if you really want to understand their ideas...
...For 2001, it stood at 6.41 percent, which explains why Japanese prices continue deflating and the economy is still in recession...
...During the ensuing 13 years, the Dow Jones Industrial Average quadrupled, while the Nikkei 225 Index has lost three quarters of its value...
...WHAT WENT WRONG WWe didn't think our 1989 long-United States, short Japan bet was such a tough call...
...It turns out to have been a pretty good bet...
...They are shocked that their expansiotary policy has not produced results...
...Deflation cannot end in Japan until the Bank of Japan makes it safe to hold tangible assets again...
...Land, commodities and durable goods make up the bulk of people's net worth...
...No big deal...
...Based on these estimates, the Japanese economy would grow at 2 percent per year if real interest rates were brought down to normal 2-percent to 3-percent levels...
Vol. 35 • May 2002 • No. 3
