Deflation: Bad for Japan, but Brutal for the U.S.?
With chances of a prolonged period of falling prices getting stronger, many on Wall Street are looking to Japan's dreaded lost decade starting in the 1990s for insights about how things might play out in America. And while it's easy to argue that U.S. stocks may hold up better than their Japanese counterparts did, thanks to relentless layoffs and financial maneuvering by American companies, investors need to look at a much bigger picture.
Unfortunately, bigger here doesn't mean better. Indeed, a seriously deflationary scenario would likely be much more brutal in the U.S. than it was in Japan. With buffers like low indebtedness, a propensity for households to hold safe assets and more egalitarian income distributions, the Japanese economy may have been far better equipped to endure deflation back then than the U.S. is currently.
The Spoiler Is Housing
For now, some Wall Street analysts are striking an optimistic note about how U.S. stock markets might hold up. Citigroup strategist Robert Buckland recently noted that "U.S. companies have been very successful in cutting costs to maintain profit margins." And companies could use their massive cash reserves to buy back their own stocks -- "de-equitization," a trend that's on the rise recently – and prop up share prices in the process.
The spoiler, though, may be the starkly different conditions of the U.S. and Japanese housing sectors. American households sport enormous debt burdens and have their assets concentrated in investments like stocks and housing. Household debt as a percent of GDP was close to 90% in the U.S. as of 2006. In Japan, it was about 45% then, and it was under 35% in 1990, according to a recent paper by Bank of Japan researchers.
Japanese household assets are also held much more safely. "The average Japanese household has a financial balance sheet that is far more conservative than that of the representative household in other industrialized countries," the researchers wrote. They point out that cash and deposits tend to make up half of Japanese household financial assets, compared to just 16% in the U.S.
And with wealth spread out more evenly in Japan, the country's housing sector has been able to absorb losses without triggering waves of defaults. In Japan, the upper quintile -- or top fifth -- of households accounted for 34% of overall net worth, compared to 63% in the U.S. as of 2004. Perhaps more tellingly, the bottom quintile accounts for 13% of net worth, versus 1% in the U.S.
The Stock Market Isn't Everything
"Thus, regardless of income level, Japanese households are in general resilient to shocks thanks to a sizable buffer of assets and moderate leverage," the researchers note.
Wall Street's fixation on stock prices means the relative performance of Japanese equities -- down 69% from their 1989 peak, compared to a 28% drop for the rest of the world -- tends to paint the whole picture for that country's economy. But "the finances of Japanese households were not severely damaged by the mid-1990s bursting of the bubble," the Bank of Japan researchers note.
Indeed, unemployment in the U.S. is soaring to rates north of 10% (or perhaps much worse). By contrast, despite experiencing a much more brutal downturn in the last recession in terms of lost GDP, unemployment in Japan is hovering around 5% instead.
As talk of severe deflation in the U.S. grows, Japan tends to be trotted out as the nightmare scenario. But a U.S. economy packed with speculative assets and built for growth may face much harsher consequences.