From the 1950s through the 1980s, the Japanese economy benefited from a special Cold War relationship with the United States. This relationship allowed Japanese firms relatively easy access to American technology and American consumers. In addition, the Korean War and the Vietnam War provided Japan with an unusual external fiscal stimulus from American procurement spending that poured billions of U.S. dollars into Japanese firms who supplied the American war effort. During the Korean War, over sixty percent of Japanese firm's hard currency earnings were related to this procurement spending. These funds helped to fuel investment by Japanese firms in new plants and equipment. The multiplier effects of the external stimulus, coupled with the access to American markets for Japanese exporters, helped to create the conditions for an investment boom in Japan, as well as a speculative bubble in Japanese land and financial markets.

Easy money, open access to American's pocketbooks and technological inventiveness, careful planning by the Japanese bureaucracy (in particular, the Ministry of International Trade & Industry) and Japanese firms, and extraordinary achievements in quality control and productivity within Japanese manufacturing were among the reasons for the rapid growth in the Japanese economy during this period. These successes, however, led to overconfidence. Overconfidence is, by definition, the catalyst for a speculative bubble. Investors in Japanese assets began to project what would prove to be unsustainable growth rates in exports and domestic demand (exports are actually less important to the Japanese economy than most people recognize) into the foreseeable future, bidding up asset values (both real estate and Japanese financial securities) to unrealistic levels. Investment in brick and mortar --- new factories, new equipment, expanded research and development programs, etc. --- were also driven, in part, by the optimism that Japanese firms would be able to continue their mastery of cutting-edge technology and concomitant rapid market share growth rates. If asset values reflect the discounted future cash flows that can be generated by such assets, then the rapid rise in value of Japanese equities and real estate was projecting extraordinary increases in the cash generating ability of the Japanese economy and a relatively low discount rate (perhaps underestimating the risk that Japanese firms would "overinvest" and produce more supply than could be justified by future growth in demand). Even a rather casual perusal of business publications from the early to mid-1980s would find ample evidence that professional analysts were, indeed, making such overly optimistic projections. Investing in Japan, Inc. was understood to be a no lose proposition.

Japanese banks joined in the speculative bubble by not only financing the overinvestment boom of manufacturers but also financing real estate projects that depended on the aforementioned rapid rates of output and market share growth to generate the incomes that would make these real estate ventures profitable. Bankers expected that economic growth would generate more demand for office space, keeping occupancy rates high and generating growing rental incomes. Everybody seemed to be expecting the same thing --- that somehow Japan would keep growing both domestic demand and exports until the world was awash in Japanese goods and there would be little room left for American or European or any other manufacturers but the Japanese. The domestic side of this calculus did not seem to take into account the rapid aging of the Japanese population and the impact such aging would have on domestic demand curves. As for export expectations, in order to satisfy the earnings growth that seemed built into market valuations of exporters would have required the complete capitulation of American and European (and, perhaps, other Asian) firms to the Japanese corporate behemoth. Among other things, this growth would have required that Japan continue to produce the most advanced products in a wide range of sectors, including consumer electronics, computers and semiconductors, and automobiles, and do so (profitably) at prices well below that of their competitors. Whether this was a case of irrational judgments about the future or rational calculations of irrational numbers, in the end it comes out the same way --- a speculative bubble (not unlike what is happening to internet related equities in the current period). History tells us that pure optimism can drive up asset values only so long before someone begins to ask --- where's the underlying value? The reality was that Japanese firms could not possibly generate enough cash flow from exports and/or the domestic economy to justify the values of either real estate or financial securities that prevailed by the late 1980s (with Tokyo real estate worth more than all the real estate in California and the Nikkei average knocking on the door of 40,000).

Indeed, Japanese manufacturers recognized that they would have difficulty maintaining export growth. Unfortunately, this recognition was only partial. The manufacturers thought the only serious impediments to continued rapid export growth was the high cost of manufacturing in Japan and the need to open up more "emerging markets" to Japanese exports. To alleviate these problem, Japanese industrial enterprises had expanded their off-shore manufacturing, particularly in Southeast Asia. Japanese banks happily provided the loans for this expansion. Cheap labor, ready access to certain raw materials, relatively cheap currencies (given the yen's strength against the U.S. dollar), and cooperative (even if often dictatorial) regimes would guarantee the Japanese firms low-cost outputs that would remain globally competitive, provide immediate entre to Asian "emerging markets" for the products of these (and other) Japanese firms, and make it possible to stay on the rapid export growth path.

The Japanese banks bought into this story-line and even expanded their loans to non-Japanese firms in these "neo-colonies" on the belief that the multiplier effects of Japanese investment in economies like Indonesia and Thailand, along with the growth in more indigenous exports from those countries, would guarantee that the loans would be repaid. And in the meanwhile Japan would gain a foothold in these "emerging markets" before their U.S. and European competition could make any such inroads. However, along with their failure to recognize the limitations of an export-oriented stategy (and the critical role of the Cold War in the prior effectiveness of such a strategy), the Japanese manufacturers failed to recognize that a dramatic shift of technological gestalt was well underway and the products demanded of this new technological gestalt had to be engineered in a completely different way from the "Fordist" systems the Japanese had mastered. The so-called high technological revolution was built upon a paradigm of very rapid technological change, invention, and innovation. Smaller more nimble firms are better at this process than the giants. And even in the United States, those giants that proved most capable of competing in this environment were those that found ways to decentralize decision-making internally and to foster what some call entrepreneurial activities (such as Hewlett-Packard and, more recently, IBM). Japan, Inc. had been so good at the manufacturing paradigm of the 1960s and 1970s that its leaders did not recognize the sea-change that had taken place in the 1980s. In addition, the very success of the Japanese system had led to the contradictory development of rapidly falling prices for certain consumer goods (e.g. consumer electronics) and growing real wages for Japanese workers. Japanese workers continued to be enculturated in traditional patters of savings and consumption. However, the shift to higher "value added" consumer goods did not compensate for the combination of conservative spending behavior, higher incomes and falling costs (and relative prices) for many consumer goods, not only new goods such as computers and electronics but even older consumer goods like textiles, and consequently there was a rapid increase in total savings in the Japanese economy. Quietly the so-called paradox of thrift was working its negative effects on the Japanese economy. Nevertheless, overconfidence distorted decision-making by policy-makers in the government, managers and directors in the corporations, and portfolio investors in the Japanese financial and real estate markets. For all these reasons, the bubble had to burst.

The bursting of the speculative bubble had serious repercussions in the Japanese banking system. Banks in Japan used their holdings of stock and real estate as part of their overall capital base upon which they determined the size of their loan portfolio. As equity prices and real estate market values collapsed, so did the capital base of the banking system. The banks were forced to severely contract their lending. Hardest hit by this credit crunch were smaller, more agressive firms that are often the catalyst for major technological and marketing innovations in an economy. In the United States, we can see this dynamic clearly. It has not been the corporate behemoths, like General Electric, that that has led the way into the new technologies, such as the internet, but smaller, more aggressive firms, such as Yahoo!, Amazon.com, and Netscape. The big firms tend to lag in this process, although this doesn't mean they won't find a way to steal the thunder of these smaller firms once they figure out where that thunder is. In Japan, the big industrial firms, often members of the same keiretsu system as some of the ailing banks, were already suffering from the effects of their earlier overinvestment and had no real desire to expand their borrowing, so the credit crunch did not make much of a difference in their plans. The managers in these large industrial firms watched as their inventories accumulated well beyond all reasonable expectations and they were unsuccessful in finding enough export outlets to alleviate this problem. The expansion into Southeast Asia, and other offshore areas, did not solve the problem of an intensifying global competition and built-in limits to how much foreign market share Japanese firms would be able to conquer in the "short term"given global conditions and their own failure to stay at the crest of the technological waves. In addition, the growth in indigenous firms in other Asian countries attempting to compete with Japan in a wide range of markets only made matters worse. A classic overproduction crisis, on a global scale, was rapidly getting underway and along with this overproduction crisis was to come a tidal shift from overconfidence to extreme pessimism in the Japanese economy.

If supply exceeds demand and there is no reasonable expectation that demand will pick up then the boards of directors of firms will not approve productive investment. Lower interests rates won't solve this problem. Afterall, who would borrow at any positive real rate of interest in order to build new plant and buy new equipment to produce output that goes unsold? Negative expectations can become reinforcing. If board members in major corporations in Japan are pessimistic about growth prospects, they will reduce productive investment. Reductions in productive investment can drive aggregate demand lower and make a whole panoply of other economic agents feel more pessimistic. As wage laborers (who are also the vast majority of consumers) become more concerned about their future then they become less likely to spend and aggregate demand falls further. Cuts in interest rates may even have the perverse effect of convincing economic agents that the economy is worse than they thought and reinforce the negative behavior that drives the economy lower (thus proving their assessment was correct). The Bank of Japan did not seem to get the basic point that expectations about future prospects for the economy can override interest rate cuts in determining the impact of monetary policy --- this was a point that John Maynard Keynes had made abundantly clear in his General Theory of Employment, Interest, and Money. Keynes called this problem a "liquidity trap." That's a good name for it. Japan was quite certainly trapped in something and the mood of economic agents in Japan and about Japan was rapidly deteriorating. Every cut in interest rates by the Bank of Japan just seemed to further convince all the players in the economic game that Japan was dead in the water and sinking.

The Japanese government is not absent any understanding of Keynesian theory. They simply seem to have only read some parts of Keynes and ignored the rest. For instance, they seem to have read the sections in which Keynes makes an argument for using fiscal stimulus to get an economy out of the dreaded liquidity trap. Indeed, the Japanese government tried to jump-start their economy by over a half trillion U.S. dollars worth of spending on infrastructure over a five year period. However, many view this burst of public spending in the 1990s as mostly "pork barrel" politics in which the Liberal Democratic Party (LDP) padded the purses of their supporters in the construction industry. Perhaps the Japanese administration proved that the simplistic interpretation of the role of fiscal stimulus wasn't correct. It is often argued that it ultimately doesn't matter so much what a government spends money on to get out of an economic slump (particularly one in which the country has fallen into the dreaded liquidity trap) but that the government spends money on something. Of course, Keynes understood (and said) that it did matter, but his point was that some spending, even if it was only boondoggles (putting the unemployed to work building holes in the ground?), was better than a Hoover-like "do nothing" approach. Nevertheless, we must not ignore Keynes' extensive and intensive discussion of the role of expectations in shaping the decisions of economic agents and the consequent adjustments in the economy. The infrastructure spending in Japan did not spark the sort of productive investment by the keiretsu and other Japanese businesses that was needed to get Japan out of its liquidity trap, nor did it have much impact on improving Japanese firms technological competitiveness, because no one expected that this construction spending was anything more than a short-term fix for economic stagnation and one that would not have any real long-term impact on Japanese competitiveness. Thus, directors in large and small Japanese firms did not anticipate any long-term cash-flow gains would come out of this policy and therefore did not approve new productive investment simply because of a short-term bump in aggregate demand. But, perhaps, it was not a complete failure. This aggressive spending may have temporarily staved off the wide-scale collapse in aggregate demand in Japan that we have seen of late (which was clearly exacerbated when the LDP prematurely decided to shift from expansionist policies to austerity measures).

The Japanese government's concerns about a growing budget deficit and the future of social security in a country that is rapidly aging caused them to prematurely abandon attempts at fiscal stimulus. What they should have done is better target their fiscal stimulus to those sectors of the Japanese economy most likely to have a strong multiplier effect (where the intersectoral linkages are most highly developed), more likely to have longer-term effects on improving the technological competitiveness of the Japanese economy, and that might improve the confidence of economic agents in the Japanese economy. Fiscal stimulus concentrated in spending on the traditional construction industry can put lots of potentially unemployed laborers to work, generate some indirect increase in consumer spending, and, under conditions of economic stagnation, have little inflationary impact, but the ripple set in motion by such a process may be relatively short-lived. Stop the fiscal stimulus and the ripple dies out. In other words, construction spending could not act as much of a stimulus to the sort of investment that would transform expectations about the development potential of the Japanese economy.

The Japanese government needed to stimulate those areas of the Japanese economy that have the highest "value added" or the greatest percentage of relatively advanced technology as inputs and outputs. Rather than construction spending, the Japanese government might have gotten more "bang for their buck" by spending on improvements in the high technology infrastructure of schools, colleges, universities, and the governmental bureaucracy; spurring increased research and development spending within Japanese firms (and not just the keiretsu industrial firms); and, on significantly reducing the environmental problems in the country (which could have spill-over effects in technological development and a positive effect on the "psychological mood" of Japanese citizens, at the same time). But no less important than doing a better job of targeting fiscal stimulus, the Japanese government needs to improve the lives of the Japanese citizens, to restore their confidence in the future, and by this approach to encourage more consumer spending and portfolio investments in Japanese equities.

At present, planned investment continues to fall in Japan, indicating that negative sentiment continues to predominant in the board rooms of Japanese corporations. Over the past eleven months, consumer spending has continued to show declines (year over year), although at a decreasing rate. The most recent results from the Economic Planning Agency showed three consecutive quarters of economic decline, with a fourth quarter (from July to September) certain to add to the streak. Economic agents in Japan and outside of Japan have come to view all policy statements from the LDP leadership with skepticism. If these were the only factors that needed consideration, then the future for Japan, and no doubt for the entire global economy, including the U.S.A., would be grim.

The bottom line is that the pessimism borne of Japan's crisis has blinded most analysts to these changes and the enormous impact they are likely to have on future profitability (and openness) of Japanese corporations. No, I do not believe Japan is on the brink of a new golden age. It will take time for Japanese banks, corporations, and the government to work through the debt problems that have built up since the 1980s speculative bubble burst. However, just as overconfidence fed the earlier speculative bubble in Japan, the current pessimism about Japan, despite clear signs of extraordinary changes in progress, provides the basis for a significant positive adjustment in expectations. In an environment of such extreme pessimism, any positive news, such as a quarter of positive GDP growth or a month or two of positive growth in consumer spending or a major hostile takeover that results in the bidding up of the shares of a large Japanese firm, is likely to cause a major upward break-out in Japanese asset values, particularly in Japanese equities. It doesn't take a golden age to move valuations from current low levels, just the belief that Japan isn't going to remain comatose any longer. This is why I believe that Barton Biggs, Morgan Stanley's senior equity analyst, is correct in saying that "Japan is the next great trade."

11-11-98