A number of writers and commenters on Seeking Alpha frequently predict that the US is about to go the way of Japan. They expect that the US will enter a long period of economic stagnation, marked by low inflation (if not deflation) and low economic growth, despite massive expansion of the monetary base.
This article lays out why I disagree with these people. The specific focus here is on the banking system as an illustration of cultural differences. I hope to discuss some other elements in at least one other article. The US may, in due course, suffer some bad times, but I am convinced they will not resemble those of Japan. I end with some thoughts about the implications for portfolios.
I want to emphasize at the outset that I do not know what will happen. I am a card-carrying member of the "do not know" crowd identified by Howard Marks. And, I am certain enough of my uncertainty to allow that the US could possibly experience a long deflationary depression. If so, however, it will not be like that in Japan. Here, I explain why.
Throughout this article, I will quote extensively from the book, "Saving the Sun," by Gillian Tett, designated by GT. This book is focused specifically on the fate of LTCB, the Long Term Capital Bank. Quotes without attribution come from this source. The experience of reading this book for me was like stepping into the Twilight Zone. I've read descriptions of Japan's banking crisis, from a Western perspective, for 30 years. This book is written from the Japanese perspective and is mind-blowing.
Japan has never had Western capitalism
Capitalism in Japan has never been like that in the US or other Western countries. GT quotes Yoshiyuki Fujisawa, former chairman of the International Bank of Japan, saying,
"After the war we had a system that was really a type of socialism under the disguise of capitalism. The bureaucrats directed everything, in a wise way, and we all accepted that and worked together very hard. The system worked well for a few decades."
Japan did not quite have full socialism, whose contradictions lead inevitably to failure, as is ably described by Hayek. Quasi-socialism has often worked for some decades. Another example is Sweden, where the personal trust and aligned visions of key leaders in government, business, and labor enabled the success of quasi-socialism for some decades after World War II.
As the leadership in Sweden changed, though, things fell apart. By the 1990s, Sweden also had a major financial crisis. In contrast to Japan, though, Sweden rapidly resolved the crisis and responded by adopting a capitalist economy. They retained a large degree of social welfare, well paid for. Ironically, in recent years, they retain a reputation for socialism while, in fact, scoring higher than the US in economic freedom.
As we shall see, Japan was culturally unable to adapt to the failure of their version of socialism. In contrast, it took the Japanese nearly 20 years to resolve their banking crisis and put partial structural changes in place.
These challenges are not entirely unique to Japan. Michael Pettis is a Carnegie Fellow and also a professor of finance at Peking University's Guanghua School of Management. He points out, in Barron's, on April 4, 2019, that,
"Every country that enjoyed many years of an investment-driven economic "miracle" has faced the same difficult challenges that China now faces: how to resolve the deep demand imbalances and the ballooning debt that drove growth in its final stages. None have managed the transition without a significant, and probably inevitable, downgrading of longer-term economic, technological, and geopolitical prospects."
He explicitly cites Japan as an example.
The inscrutability of Japanese culture
It took me years of interacting professionally with the Japanese to really grasp that I was unlikely to get a straight answer from them about anything. What I did not grasp even then was that the cultural expectation is that no answer should be a straight answer.
One event that occurred a decade after the beginning of the Japanese banking crisis illustrates this aspect. GT reports that, in 2001, after some tense interactions with the government, the Shinsei Bank issued this apology:
We accept the criticisms that our posture in the recent past may have been rather straightforward, and caused some anxiety to customers …
Look at this! The implication is that proper business behavior by a bank is to be obscure and oblique, and to avoid causing anxiety amongst customers who are on the brink of bankruptcy.
Figure 1. The Japanese custom of bowing fits naturally into their cultural emphasis on harmony and peacefulness. Source
These days, the banking crisis appears to have been resolved, and perhaps, it was. The larger point, though, is that the culture still exists. This is a culture that avoids problems, hides them, and considers peaceful consensus more important than financial viability.
A participant and close observer in some of the events was Vittorio Volpi, former head of UBS Tokyo. GT reports that he recently published a book calling on Japan to reform, and quotes him that,
I think that there is a huge capacity for self-delusion among the Japanese. This country is dangerous because they cannot rationalize things. There is just this huge self-deception about reality.
Former Fed Chair Paul Volcker also had extensive involvement in attempts to create what became the Shinsei Bank. He later observed.
"There is this tendency [in Japan] to just keep putting things off."
How Japanese socialism failed
Japan specifically had an educated population well-prepared to grow a modern economy at the end of WWII. All the banks had to do was shovel money at companies which were able to apply the technical skills of the Japanese to the needs of the world market, enabling staggering growth for more than 30 years.
One telling fact from GT is that, as of 1990, "No bank had ever dared to force a client into bankruptcy or abandoned a closely related company, because they never believed they needed to." This is incredible. Even in the recent good times in the US, more than 20,000 businesses go bankrupt every year.
Unfortunately, the Japanese did not really understand banking or real estate as businesses, and for various reasons, their banks got sucked into one of the largest real estate bubbles in world history. When the bubble burst, they ended up holding a lot of bad (non-performing) loans. Two paragraphs from GT tell an amazing story.
Japanese culture has traditionally assumed that a distinction exists between "public" or "official" reality (known as tatemae) and "private" truth (known as honne). It was accepted that companies would want to keep "embarrassing" secrets out of public view and LTCB itself had done this before. When the Bank of Japan announced that it was conducting an inspection of LTCB's operations in the early 1990s, for example, the most junior bankers were ordered to pack any "embarrassing" files into boxes and carry them down to a "B3" basement, three floors beneath the bank building, before the inspectors arrived. There they were hidden away in a concrete manhole. "It was an absolute pain," one of the young bankers later recalled. "We went up and down, carrying these heavy boxes, to put them in this manhole thing-and then when it was all over we had to do it again!
Exactly the same principles were applied to accounting. In Japan companies were only required to reveal what was happening in their subsidiaries if they owned a significant stake in them. In the case of LTCB-and most banks-there were dozens of subsidiaries and affiliates that were effectively controlled by the bank, but below the radar screen since the legal relationship was small. Thus, it was relatively easy for a bank to park problems in these subsidiaries for a period, hidden from outside eyes. Subsidiaries could act as the accounting equivalent of a concrete manhole to hide embarrassing secrets.
Take note of the difference with the US. In the US, before the Great Financial Crisis, banks parked high-risk investments in off-book subsidiaries, with the goal of making a lot more money by avoiding annoying regulations. In Japan, banks parked bad, non-performing loans in off-book subsidiaries to save face. Moreover, the Japanese were completely convinced that they were doing the right thing.
They considered this proper behavior and proper accounting. When questioned about not accounting for the bad loans they had buried in the subsidiaries, LTCB president Onogi pointed out that "in Japan's system of accounting, parent banks never needed to make provisions for subsidiaries because it was presumed that the parent could not abandon a subsidiary, which meant that they could never fail, and thus had no risk. "In Japan, we don't have to make provisions for subsidiaries," Onogi said. "They are part of our family, our children!"
I am sure that this made no sense to you the first time. Read it again! It still won't. But it makes sense to Japanese culture.
LTCB executive Takashi Uehara, who eventually killed himself after he became a scapegoat, sought out and found good ideas for how to revive the bank, and advocated them to his seniors. Their answer was that an American bank "could do that because it was in the United States. We cannot do that same thing in Japan!' The rejection was so clear-cut that [Uehara] couldn't pursue it."
Onogi was eventually convicted and given a suspended sentence for hiding the bad loans. In the process, the court took three hours to explain that they did not want to do this and seemed to have no choice. The court noted that Onogi and others "had been acting in accordance with the accepted standards of behavior at the time, with the knowledge of the Ministry of Finance." GT reports,
"Onogi was utterly poker-faced as he listened. He had no intention of trying to point out the obvious: namely, that if he was a criminal, so was almost everybody in the Japanese government and banking world …"
(Even having read this repeatedly, my mind just exploded again.)
"There is only so far that honorable people can go, before the system traps them in Japan. The Japanese have this bad habit of protecting the tribe at all costs. Things that we might consider quite criminal in Italy or America just are not considered wrong in Japan if they are done to protect the group."
LTCB ended up being bought out by an American-led, private-equity group and renamed Shinsei. Eventually, after several tumultuous years that make a good read, they got the bad loans cleared out and made good money with an IPO. Along the way was one event that reflects the gap in culture and market development between Japan and the US:
Shinsei had enjoyed a morale-boosting success in the capital markets. In late 2001 it repackaged part of its loan portfolio as bonds, the first such deal ever struck in Japan. A local newspaper dubbed this "raising finance the American way"-and, in typical fashion, the FSA [the government regulator] promptly told Shinsei that it hated the whole idea. To bureaucrats, it seemed distinctly "un-Japanese" to water down the relationship between a bank and its borrowers, by turning them into bonds.
Other banks also managed to resolve their non-performing loans, and the related governmental reforms continued through 2006. They are known as the Koizumi reforms.
Have things finally changed?
Countries never change their cultural essence, despite the predictable problems that follow. A recent report from 2016, by Naomi Fink, looks at the period after 2006. Regarding the Koizumi reforms, she writes,
The 2006 market reforms were successful in overcoming a degree of policy immobilism but were ultimately incapable of resolving Japan's "lost decades" of growth, particularly given the 2008 Lehman shock.
Idiosyncratic application of the rule of law is a potential hurdle for cross-border M&A into Asian economies.
Specifically, regarding the May 2006 Commercial Code enacted as part of the reforms, it is worth emphasizing Fink's point that shareholders still were not owners in a Western sense. Instead, suppliers, employees, business partners, financiers, and shareholders are all viewed as stakeholders. She says,
It is pertinent to note that the intended beneficiaries of corporate governance under the commercial code are not the shareholders first and foremost, but all stakeholders. Indeed, peppered throughout the legislation are references to the interests of the stakeholder, which at times are at odds with those of shareholders. On top of this, the legal framework in Japan (even after reforms to the outdated Commercial Code) leaves substantial room for interpretation. Putting these together, the Ministry of Justice is given substantial discretion to arbitrate these conflicts, without the underlying assumption of shareholder primacy.
In a publication of the Center for Strategic and International Studies, Yoshihiro Sakai says that,
Koizumi's experience with structural reform suggested that the Japanese people might not like to change the business model that, for almost half a century, protected them with lifetime employment and don't want to change the social system in general. Prime Minister Abe therefore chose a more moderate approach to structural reform.
Fink similarly concludes,
The Japanese model, born of an era of far less flexible financial policy, is not without its benefits - including stability throughout the supply chain and plentiful private-sector support for innovative R&D. However, among other rigidities, the shareholder's power to drive change is much blunted in comparison to the US shareholder. Existing stakeholders may see insufficient benefits to the US model to abandon the Japanese model wholesale. Thus protection of stakeholders' interests may remain a structural characteristic of the Japanese economic model that will not disappear.
In summary, some things have changed in Japan. But the Japanese economy and government remain very far from those of the West. A recent article promotes the structural changes in Japanese corporate governance and claims that cultural changes are occurring. This may be true at the edges, but I do not believe that national cultures change so readily. My expectation is that the changes lauded by Western investors are widely resented and are viewed internally as impositions by the gaijin. It would not surprise at all if additional, long-standing problems in their banking and business world were to find their way into public knowledge.
There is an inherent conflict between the extremely high-value Japanese culture places on harmony and consensus and the need for creative destruction in a capitalist economy. This will always mean that they are slow to resolve misallocation of capital. They are enchained by their own culture and may never again prove able to sustain robust economic growth. But theirs is not and never will be the culture in the US.
Figure 2. The Japanese emphasis on the culture of "wa" is often translated as "harmony," no doubt a very incomplete translation. This culture has led to the enormous beauty one finds there but also adapts poorly to Western capitalism. Source
As to the US, we are in an extended period of foolishly low interest rates. Will this doom our economy? At the end of the day, a few unprofitable companies may be able to hang on longer in periods of low interest rates. This is only a threat to the economy and a potential driver of long-term stagnation if the fraction grows substantial and if the government becomes directly involved in promoting subsidization. Both these elements were present in Japan in the late 1990s. The participants in the US economy and regulatory system have long understood the need for creative destruction. This won't change.
US banks are making good money now. More importantly, we can expect that bad loan problems in the US will get fixed much more quickly than they did in Japan. This happened in the US during the Great Financial Crisis, but also happened in Spain, Ireland, and other Western countries, and has happened historically in Sweden and elsewhere. The US banking system will never play the role that the banks in Japan have in sustaining a period of deflationary low growth. The reasons, at root, are cultural.
The material above shows that the Japanese way of thinking about banking and business is extremely different from those of the West. If you have been fearing a major deflation, because of the superficial similarities between Japan and the West, then I would strongly suggest that these fears are overblown.
Could the US stumble into a major deflation? Of course, it could. But, if you prepare for that by holding gold or other hard assets, consider limiting how much of your assets you divert. I personally have come over the decades to have great confidence in the resiliency of free economies. While I once held some gold, in fear of the extremes, I don't any longer. Instead, I favor having an extremely diverse portfolio that focuses on investments in profit-making enterprises. But that is a topic for another time.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.