“She’s so cheap that when the government raised interest rates, she sent the economy into recession”: Is America’s Lost Decade Knocking?

What is a lost decade?

The term was originally coined to describe Japan post 1991 when the Nikkei Index fell from its 1980 highs. In inflation adjusted terms, the Nikkei has never recovered from its 1991 high (although the Nikkei 225 has recently surpassed its 1991 high in nominal terms). During the boom, Japan lowered public spending and, toward the end, raised interest rates to attempt to slow the bubble, all while paying down government debt. These inherently set up a deflationary atmosphere even as Japanese companies, flush on foreign cash, found no avenues to further growth, pushing their money toward speculative investments. (This might ring a bell for the US) Following the crash, the Japanese economy suffered nearly a decade of deflation (that was followed by low inflation for nearly two decades). Now, investors are noticing the similarities between the S&P500’s dramatic climb with the Nikkei’s 1980 climb, sparking fears of a lost decade for America.

“But stocks always go up”

Correction: The American S&P500 has historically never had a loss over any two decade period (besides the 1930’s). However, the 20th century was also the greatest era of American innovation, meaning that stocks likely grew with respect to their true value. Now, investors are in a difficult situation: historically low interest rates being unable to fuel further growth and dramatic P/E ratios. To the casual observer, it seems the party must soon end (at least in real terms compared to inflation).

Insane Risk Taking

The market has priced in the realization that the Fed will likely prop up markets during downturns, acting as a lender as last resort. As profit-seeking actors, companies and financial institutions are thus incentivized to increase risk (especially ones with infrequent but large downsides), knowing that the Fed will bail them out, especially if they are considered too big to fail. Investors believe that even if US government debt grows riskier (demanding higher yields), the Fed can and will artificially decrease bond yields through QE, much like Japan has done for the past two decades with little consequence. Unlike Japan though, the US has one major difference: its citizens expect inflation. Investors think that through nearly free borrowing, the government can afford to keep markets afloat and cash flowing. Here comes the danger: market participants are abusing this to make riskier and riskier bets, removing blocks from the foundation to continue building upward until the whole structure collapses. With the recent surge in stocks and hundreds of billions of nearly free loans being offered toward beleaguered companies, investors cannot help but compare the current situation to Japan in the late 1980s. The Fed is creating zombie companies, dependent on bailouts to survive, even as Silicon Valley darlings are applauded for failing to turn profits in exchange for rapid expansion. These companies rack up cheap debt on their balance sheets, but what will happen when they need to renew that debt? If interest rates have significantly risen (as is expected to curb inflation), these companies might find all their profits pouring into interest payments. Soon, debt-fueled growth will end, and with it, the longest bull run in American history.

Why the Japanese Lost Decade won’t appear in the US (it’ll be worse)

Japan’s 1990s story shares many similarities with the US: a booming economy that suddenly collapsed, a central bank that tried to print more and more yet risk-averse banks kept the new money in reserves, and ballooning government debt dependent on low interest rates to roll over (often artificially held down by central bank quantitative easing). As Covid19 quarantines end, both countries face potentially rising inflation and interest rates.

1. Japan enjoyed several advantages over the US. Namely, Japan has historically been a net exporter, so it has fewer liabilities denominated in foreign denominations because it does not need to net pay for foreign imports. However, the US is the largest net importer in the world (and its net imports have been increasing). Thus, the US owes at least some foreign denominated debt annually, and due to increasing globalization, has pushed production to other countries, which made American companies incredibly profitable at the expense of the American people, who are one of the largest consumer bases for American companies. With Covid19, millions of Americans have been left jobless, worsening structural inefficiencies and productive capacity. (It also decreases demand, but the stimulus checks have helped make sure that Americans can at least afford food). Once the dollar begins to weaken against other currencies, the US will be unable to up-production due to structural deficiencies and find its net imports growing as a percentage of GDP, increasing the US’s debt burden. To combat this debt burden, the US will be forced to print more money, worsening the cycle of inflation.
2. In addition, following a decade-long recession during the 1990s, Japanese citizens have been trained to expect deflation. In other words, if inflation does start to rise, Japanese citizens will simply hoard savings, decreasing demand, which will reduce prices. In effect, Japanese perception allows the government to continue financing its massive debt at near zero or negative rates. However, US citizens expect inflation, so as inflation rises, US investors will try to short the dollar, worsening the crisis (by increasing supply and further devaluing it). Thus, without drastic rises in interest rates, the US will enter an inflationary cycle.

Sidenote: Unfortunately for Japan, it is nearly inconceivable to imagine a scenario where Japan succeeded in paying off its debt. To decrease its debt, the government has to either make more money or spend less. However, with its many zombie companies with powerful lobbies, Japan cannot reduce stimulus, but raising taxes incites more saving, further contracting markets and possibly entering a recession (which requires raising debt to stimulate the markets).

3. Finally, while a fringe argument, the US is the most negative in its Net International Investment Position (net foreign investments by the US- foreign investments in the US), meaning that if the dollar begins to lose value or the economy suffers, foreign investors might have a crisis of faith and flee US investments. Meanwhile, Japan has the most positive NIIP in the world, meaning that if Japanese markets suffer, there is much less foreign capital that can pull out (as it doesn’t exist) while Japanese investors might seek cheaper investments at home, causing a capital inflow and providing liquidity to Japanese markets.

4. While Japanese savings now sit at 26% (despite falling in absolute terms), US citizens have historically been low savers, saving only 16.5% of their household income, which is among the lowest of developed nations. Americans have a much smaller threshold before they enter financial distress, meaning the Fed will have to step in far sooner since the economy relies more on easy credit. A contraction will be incredibly painful and likely cause a massive crash in stocks. Thus, the Fed is caught in a bind: to reduce inflation, it must contract monetary supply, but if it moves too fast, it will cause market panic. Unfortunately, I don’t think the Fed will succeed. Instead, the Fed will likely go for the easier option (underestimating inflation) since it’s unlikely American will suffer hyperinflation (as in prices going up 50% a month, but very likely it will experience massive inflation and have its economy lose “real” value)

For further reading on US vs JPY government debt read this. The main ideas can be summarized as:

1. The US is expected to have a larger budget deficit than Japan for the next five years, preventing it from stabilizing its debt/GDP ratio.

2. The Fed’s implied interest rate is set to fall from 1.5% in 2020 to 1.2% by 2025 in order to allow the Treasury to continue cheaply borrowing money. The government needs cheap loans all across the yield curve, not just the short end.

3. The Fed cannot raise interest rates or tighten monetary policy without conflicting with politicians who want a flourishing economy, which means the Fed cannot prepare for future recessions as well.