A Japanese tale

By Daan Joubert

In early 1991 I read in Newsweek that the land value of Greater Tokyo was worth 20% more than the whole of the USA.

If a hypothetical owner of Tokyo sold his property in early 1991, he could have bought outright all 50 states of the USA and still have 20% of his capital available to develop his new home - the US of A. Unreal!

As an ex-physicist and ex-computer systems analyst turned technical analyst with an interest in markets and economics, this fact to me spelled Disaster with a capital D. From that time on I gathered as much information I could find about what was happening in Japan and why the situation had developed in the first place. This became more urgent when the property bubble burst later in 1991 and it became evident to me why the whole world was being caught up in a vortex that would drag most economies into its depths.

We begin with a brief review of why this situation developed at all and then see how the property meltdown was handled in Japan, what it probably meant to the Japanese economy and also how the rest of the world reacted to this. The next section is of perhaps the greatest interest to Americans. It deals with certain changes in Japan’s posture towards the US and what these changes could mean. These hint that Japan could be preparing for an economic Pearl Harbor in the not too distant future.

Either that, or the mother of all kamikaze attacks.

Finally, we take an exploratory look into the future in the light of what is presented here.

Historical background

After the Second World War, the devastated Japanese economy started its recovery to a great extent through the manufacture and export of relatively and often quite shoddy goods. Authorities soon realised this was not a long term solution for growth and instituted the Ministry of Trade and Industry (MITI), which is still a major force today. New rules stated that nothing could be exported without MITI’s seal of quality, This was just what was needed to make a mark in the post war world hungry for consumer goods.

One other matter that was of concern for the authorities was to find a source of working capital so that the new companies could maintain the steep growth curve that was fast becoming a reality. They knew, probably from past experience in their small island state, that property was always a good investment in a strong economy. They therefore allowed companies to revalue any land they owned on an annual basis, knowing that the rising demand for land would keep prices in a steep trend. By this means the balance sheets of companies would be strengthened annually, enabling them to obtain ever increasing facilities from the banks.

This worked like a charm. As the Japanese economy grew, making ever greater demands on the relatively small amount of land suitable for industrial use, land prices rose steeply. Companies were able to obtain additional working capital after each revaluation of their property and it can be assumed that banks were keen to lend to the full value of such good collateral.

The 1973 oil crisis.

Matters went along smoothly and the Japanese economy grew by leaps and bounds, becoming the envy of the rest of the world. Then the 1973 oil crisis erupted and energy poor Japan entered a period of high inflation. Interest rates soared and so did mortgage rates, which of course meant that companies were tempted to sell their property holdings to get their hands on the very extensive capital gains, after which they could earn interest on the cash so realised.

Authorities were again quick on their feet and, realising that a sell-off in property would lower prices and put financial institutions at risk, they instituted a measure to stop the rot. It was ruled that any company that sold its property and then failed to put the proceeds into a more expensive property within one year would have to pay an 80% capital gains tax, if I remember the figure correctly. As can be expected, this measure nipped the threatening sell-off in the bud and added additional incentives for companies to hold onto the land they owned. Further, this meant that financial institutions viewed fixed property as by far the best form of collateral for any loans they may make.

Of course, with this measure in place the after-burners were lit and property prices really took off.

For obvious reasons, mortgages was a favourite among financial institutions and it can be accepted that they had little hesitation in writing a mortgage very close to or for the full amount of the purchase price.

CNN reported at one point in time that by about 1989 Japanese authorities became very concerned about the degree of exposure of the banks in Japan to mortgages. They addressed the potential problem by placing a moratorium on the ability of banks to write new mortgages. The report went on to say that the banks circumvented this rule by lending large amounts of money to the building societies, which, of course, meant that the new regulation had no effect on the intended limitation of the banks’ exposure to risk.

During the next two decades prices of property first went through the roof and then continued higher. When, according to Newsweek, the value of greater Tokyo in 1991 was 120% of the value of the US, it was clear to me that the situation had become completely irrational according to every possible interpretation of the basic principles of economic theory. Sooner or later something had to give; the slump started in second half 1991 and by late 1992 property prices were as much as 40-50% off their early 1991 highs. Prices continued to slump and are now more than 60% of their highs.

The reaction in Japan.

According to a report on CNN, once property prices fell by 40% and more, many property owners stopped paying installments on their mortgages – the reasoning being, why should one pay good money on a mortgage of ¥10 million if the property is only worth ¥5 million?. Surely it is wiser to put the installment money into a special account and later, when the property market has bottomed, use that money as deposit for the purchase of the same or another property.

Even if the bank should foreclose on your property, it sooner or later has to sell it by auction and then you can buy it back at a much lower price – and end up with a much lower mortgage!

Of course, if your property was owned by your company and you had borrowed against the balance sheet, this option was not as readily available. Matters really had to become very tough before the company as a whole would be placed at risk of foreclosure by defaulting on servicing the loan.

The squeeze on institutions.

With their cash flow drying up, financial institutions were suddenly being squeezed. In addition, they also faced a more serious problem of a regulatory nature – information again courtesy of CNN. In Japan, if payments on a mortgage are six months or more behind, the lending institution must consider the full outstanding amount of the bond as bad debt.

Given the magnitude of the situation, this could not be allowed to happen. According to CNN, the banks and building societies came up with an ingenious solution. Once an account is five months behind, the bank approaches the lender with the following proposal: ‘We are prepared to make you an interest free loan, repayable only after the mortgage itself has been paid in full, on one condition: you must use the loan to pay the installments in arrears that are now due.’

Since the borrower knows that the odds of the mortgage ever being paid in full are rather small, if not non-existent, there is of course no reason to refuse such a generous offer.

It was also about this time that CNN reported, quite tongue in cheek, that members of the newer golf clubs in Japan were taking out insurance to obtain cover for the very large amounts of money they had to pay just to join the golf club. The reason for this strange behaviour, it turned out, was that the market value of the land on which the golf clubs were situated had fallen so far below the amount of the mortgage that the banks were foreclosing. This they apparently could do, because the practically vacant land was much in demand from speculators who could turn a profit by turning the golf club into a housing estate.

Given the Japanese fascination with and passion for golf, this said a lot about the severity of the situation.

It is of interest to note that a front page article in the NY late in July 1998 in which the situation in Japan was reviewed, stated that a similar practice was being applied to overdrafts and loans to companies that were no longer able to service their debt.

The magnitude of the problem

When property prices fell steeply, it was of course no secret that Japanese financial institutions were facing a spot of bother. Some minor - and even not so minor - building societies and banks were in real trouble and had to be baled out.

The problem of course was due to bad loans and non-performing mortgages on property, which, as noted above, was to quite a significant degree concealed from public view. The question therefore becomes, ‘How large is the total amount of potential bad debt faced by the banks.’

Initially, the amounts bandied about in the media and by government spokesmen were of the order of $4-5 billion. This was gradually pushed up, at first to $7-8 billion and then to much larger amounts. Quite early on, time the government established a ¥9 trillion (about $90 billion at the time) fund to support banks with bad property loans. It would appear that this fund was oversubscribed within a day. Much later there was a large jump in the estimates, to $250 billion or thereabouts and more recently the government indicated that the problem could be in the vicinity of $500 billion..

It is interesting that all comments so far – even the ‘outrageous’ $500 billion estimate – as a rule only referred to non-performing loans, mostly mortgages that had gone sour. Is this the true picture?

The loan books of Japanese banks.

Trying to analyse the state of the loan books of Japanese banks is of course a matter for speculation. The key to this speculation is the question of what the exposure to property as collateral of the total loan book is likely to be.

Given the above history, combined with the fact that between 1989 and 1991 – when the banks were constrained from writing mortgages - much money was lent to building societies, it is clear that the exposure to property must have been a significant percentage of the total loan book. Property prices, we know, were extremely inflated – if Greater Tokyo was worth 120% of the value of the USA, then the whole of Japan could easily have been worth double the value of the USA.

However, even though astronomical amounts have been supplied against mortgages, this is likely to be only the tip of the iceberg.

It can be stated with near certainty that property constituted the single biggest asset category - and in many cases nearly the full asset base – of most Japanese companies. It means that when these companies obtained overdrafts or other facilities from their banks on the strength of their balance sheets, the funds loaned to them were largely secured by the underlying value of the property owned by the company.

Under these circumstances, the percentage of the total loan book of Japanese banks with property as collateral could easily be in the range of 70%-80%.

It was reported in an article on Reuters in early 1997 that the total loan book of Japanese banks is of the order of ¥750 trillion – or just less than $7 trillion.

If the above reasoning is correct and if a 50% fall in property prices is assumed, the amount represented by the fraction of the loan book that is now unsecured be about 35-40%, or about $2,45 - $2,8 trillion dollars.

To place this in perspective, the unsecured portion of the loan book is estimated to be about one third of US GDP and probably about 60% of Japanese GDP.

This estimate of course does not represent officially recognised bad debts due to lapsed payments of mortgages and other non-performing loans – the sole topic of discussion in the media so far. The perhaps $2,8 trillion is the amount of ‘missing’ collateral, which represents the potential shortfall in depositor’s accounts if the deterioration in the economic situation in Japan continues, as seems to be the case still.

Any attempt by the banks to foreclose on bad and non-performing loans and then to sell the newly acquired property would of course increase the magnitude of the problem they were already facing.

The current situation.

It is common knowledge that the Japanese economy has been in a decline for all of the 90’s. A massive attempt in 1995 I think it was, to stimulate growth through extensive Government intervention and spending proved to be quite unsuccessful. It also depleted the treasury and placed the country into such deep debt that it is only now, when the situation there has reached critical proportions, that a similar attempt is to be repeated.

The implications for the world are of course momentous. If Japan – the world’s banker - goes under, the shock to the world will dwarf the effects of the 1929 collapse on Wall Street and what followed in the years after. Of course, since the collapse of the property market in Japan in the early 90’s the rest of the world has ignored this potential problem completely. It seems either to have taken the announcements of a relatively small volumes of non-performing mortgages at face value or, perhaps closer to the mark, the western world treats practically every development on the domestic front of countries in Asia as something that is of little concern to markets in the west. This of course started to change with the Asian Flu in October 1997 and the subsequent new focus on problems in China and in Japan - and as a result of the ever escalating estimates of the magnitude of the problem faced by Japanese banks.

Two factors are now of interest. Firstly, Japan may just have a chance of weathering the storm if it could repatriate the vast wealth – by all accounts – of its investments in the USA. These are mainly in US Government bonds and investments on Wall Street. The problem, of course, is that the repatriation of these funds would have widespread effects on the US economy, its markets and those of the rest of the world. It would be ‘an act of war’, in the words of someone interviewed on CNN’s Business Day in the mid-nineties.

The second factor has to do with Japanese culture – the obligation not to ‘lose face’. This manifests itself, among other things, in not being the bearer of bad news, not being seen as the cause of a problem. If the problem under discussion, as anticipated, will assume global and historical proportions, the compulsion not to be seen as the primary cause becomes so much greater to the Japanese psyche. In the extreme, this factor translates into the kamikaze principle – if you are going to be the loser, do not let your opponent live to gloat over his victory.

Given these traits, then, obviously, if the risk of collapse becomes real, the powers that be in Japan simply have to take steps to ensure that if the unimaginable must happen then – at best – if Japan should survive it must not carry the primary blame for what has happened and – at worst – if there is little potential for economic survival, Japan must not be the only one to sink into the economic morass

The only acceptable scapegoat in this matter is of course the United States of America. Nobody would feel any sympathy for Japan if they tried to lay the blame for their financial woes on a Zimbabwe, a Sweden or even a Great Britain. Only if it could be clearly shown that the USA was the primary cause of these problems, would Japan’s efforts to shift the blame be credible and would Japan escape being recorded in the history books as the villain of the piece.

The question then becomes how Japan could orchestrate the affair to its own relative advantage, What are the basic requirements that could let the world point its collective finger at the USA instead of Japan?

Of course, the answer is quite simple – matters must be managed so that the USA is seen and perceived as the economic aggressor – wearing the black hats – and Japan as the (almost) innocent injured party, wearing white hats.

As Marshall McCluhan has said, ‘The world is as it is reported’. It follows that, from the perspective of the media, the US should be made to appear ‘the unreasonable aggressor’. If Japan can be successful in this attempt, the US would become the scapegoat of the whole affair.

From this, a simple strategy follows: Japan has to prod the US into taking very visible actions – from a media perspective – that would clearly label it as the bully, while Japan is just as clearly the injured party who has been desperately trying to keep talks and negotiations alive to ensure a mutually acceptable outcome, and to try and comply with American requests.

In the light of this conclusion, consider the following discussion of certain events that occurred in 1997 and which seemed to have set a pattern for the way Japan has behaved since then.

A change in posture: What could it mean.

For many years Japan could almost – but not quite – be considered a vassal of the USA, in the literal and medieval meaning of the term. In many respects Japan followed the lead set by the USA, particularly in foreign affairs and defense matters.

Where it deviated from American guidelines – generally because of Japan’s economic self-interest and financial well-being – the deviation was seldom extreme and Japan was always willing to negotiate, even if negotiations often lasted months and years and in most cases seldom resulted in the changes US negotiators desired. Some exceptions, such as the hunting of whales, were quite minor from a global perspective, while others, such as the matter of the strongly out of kilter trade balance between the two countries, have been the subject of extensive talks over many years without being brought to a satisfactory conclusion.

A case in point is the venerable dispute over Japan’s auto exports to the US, which have been making a large dent in the profits of US motorcar manufacturers – and which fuels the US’s trade deficit – and which has been discussed with Japan on and off for a long time. In 1995, when the USA finally threatened sanctions, an agreement was hammered out which may have been a moral victory for the Americans, but which, even to a non-expert, was clearly not going to have much effect of any substance on the situation.

No wonder US auto makers had another delegation over in Japan only 2 years later, in 1997, to negotiate a new agreement. Their efforts seemed to harp on the same themes as before: the Japanese should export fewer cars to the USA and open up their local markets to US imports. The Detroit delegation left in a huff. The measure of their disappointment in what they failed to achieve and their degree of desperation are illustrated by the fact their CEO’s called a meeting with pres. Clinton to explain the situation and to insist that it has become high priority for much firmer treatment of the recalcitrant Japanese.

This rebuff – by standing firm and not really giving way on any of the US delegation’s demands – was one of five significant events in the US-Japanese relationship that indicate a recent and marked change in Japanese behaviour.

The other four events that deviated sharply from the historical relationship between Japan and the US took place or culminated during the span of only a few weeks of the departure of the disappointed auto delegation.

Suddenly, after years of almost routine negotiations, the way Japan behaves changes. Strangely enough, the change consists of Japan cocking its snoot at the might of the US – its mentor and its source of inspiration ever since the documents of surrender were signed in Tokyo Bay in August 1945 and thereby placed Japan under US military rule.

Being a needle in the side of the USA and then willing to talk about the problem for years on end – with nothing really changing - is nothing new. However, for the Japanese to act directly contrary to US policy guidelines on matters relating to such fields as foreign affairs and defense is a major change in posture. Suddenly, in the course of a few weeks, there are five incidents where the Japanese directly and openly snubbed America.

The first one, which involved the delegation from US automakers mentioned above, is the only one that can be classed in the traditional mold of Japanese obduracy when it comes to negotiations regarding trade between the two countries. But the Japanese seemed to have been much more obdurate than usual that time.

The second event is of more intense significance and needs a bit of a preamble. The Rio de Janeiro summit on the Earth led to a resolution that all countries would strive to return to 1990 levels of CO2 emission by the year 2000. The US, which throughout was very sceptical about this summit and hesitant about participation, initially made positive noises about this resolution, but then quickly swung around into saying that the target was not attainable without severe effects on the US economy.

Except in campaign speeches, US politicians have been only lukewarm on the subject of reducing emissions that could enhance the hothouse effect. Very few measures and little action of any real substance have come out of Washington. Now, suddenly, the Japanese, who have also been notoriously slow to implement measures with a green tint, came forward with a new proposal for the reduction of CO2 emissions that, despite being less harsh than the Rio de Janeiro resolution, would still be an embarrassment to the US. The US reaction was quite swift and not at all complementary to the hosts of the conference.

At that time, the Nobel peace prize went to an organisation that for some time had as its mission the outlawing of landmines – in particular the use of anti-personnel mines. With the death of Princess Diana, who was a prominent figure in this campaign, it could almost have been predicted that the Nobel peace prize would be awarded to this cause.

The US is officially not in favour of this campaign on the grounds that landmines protect US lives on the North-South Korean border. Japan has for a very long time almost blindly followed the US lead in military matters. Suddenly, out of the blue, the Japanese minister of defense requests the military to report on the consequences for Japan if they should sign the agreement to ban landmines. This was a third and very direct slap in the face for the US in less than as many weeks.

Number four on the list is also an affair that had been building up over many years, similar to the auto trade question. American shipping lines have been outraged for a long time because of costly practices in Japanese harbours and apparently also as they were being discriminated against in the process. Pressure on the Japanese government to resolve this problem was met by the disclaimer that unfortunately the problem had its origin between management and labour in the harbours and that it was government policy not to intervene in such affairs.

Matters came to a head in September of 1997 when the Federal Maritime Commission (FMC) set an ultimatum for some results. These failed to materialise and a surcharge of $100 000 was placed on ships of three large Japanese lines as and when they should enter US ports.

A payment of near $4 million became due on the 15^th of October. On the 16^th, the three Japanese lines announced that they would not be paying the fines. Later the same day, the FMC voted on a motion for US ports to refuse entry to any ships of these lines and to detain any ships that are in port. The motion was passed and an order to the Coast Guard was drawn up – to be implemented on Friday, 17^th October.

Soon after these sanctions were announced, the Japanese shipping interests made two separate announcements. The first stated that they never refused to pay the fines; they only felt that it was not necessary to pay up while negotiations on the matter were still under way in Washington. Secondly, blame for the whole mess was laid at the door of the Japanese government and its handling of the problem!

The final event again relates to the long standing dispute between the two countries on the matter of the US trade deficit. The Japanese economy has stagnated for some years and shows no sign of recovering – rather, matters appear to be getting much worse. The US has long been very vocal in advising Japan to stimulate its economy through fiscal and other internal measures and not to attempt an export led recovery. At the recent G7 meeting and in subsequent speeches by major political figures, the US have been most insistent that fiscal measures – i.e. a major cut in taxes to stimulate spending, should be employed to re-align the economy on a growth path.

Late in September of that year it was announced that information on a comprehensive package to restart the economy would be released on Monday, 20^th October. It was soon leaked that the package contained ¥2 trillion (almost $170 billion) of tax relief. This news caused the yen to firm against the dollar as it seemed that the Japanese government was quite serious in their efforts.

On the same morning that the FMC announced their retaliatory sanctions against the shipping lines, the Japanese minister of finance released a press report that stated Japan could not afford a cut in taxes – the reasons being the accumulated national debt and the effect of a tax cut on the annual deficit.

Again, the timing of this particular refusal to toe the US line is just too good to be pure coincidence.

Since then there has been numerous occasions where the US was needled by Japanese politicians and officials. This even included occasions where senior officials – even the prime minister – who made statements that favoured the American position, were later contradicted by their juniors. I rigidly hierarchical Japan this would call for summary execution or at least hara-kiri if it had not been done with prior arrangement.

Yet the Japanese avoid outright confrontation. If the US really turns on the heat on a particular matter, the Japanese are quickly to say, ‘Let’s sit down and talk.’

Interpretation

One possible interpretation of these events is that they are all steps in a larger strategy to achieve some very important objective.

The motivation for this statement lies in the traditional Japanese approach to negotiations and their handling of confrontation. Without further elaboration, the following statements describe the relevant points of this motivation.

· All elements of Japanese society have always co-operated closely in matters of national interest – this includes even the Yakuza , or ‘Japanese Mafia’. Whenever there is danger on a national level, even minor affairs are centrally coordinated

· The Japanese are well-known for planning strategy on a large scale and with a long time horizon, yet paying close attention to even minor detail.

· Traditionally, their books on strategy and tactics emphasise the use of misleading information and feints to keep the opponent off balance and to prevent recognition of the place and means of the final attacking moves. ( From Musashi’s ‘The Five Rings’, a textbook on strategy and tactics, written by perhaps Japan’s greatest samurai 300 years ago, which finds excellent application in the turnabout when a junior official corrects the ‘misinterpretation’ of what a senior official had said just when it seemed as if the Japanese were going to toe the line.)

· Japanese place a very high premium on ‘maintaining face’, of not being seen as the villain of the affair. They failed to do so at Pearl Harbor, because of a feeling of superiority and a belief that after the war they would be writing the history books. They then failed in their objective, suffered the consequences and will never ever again run the same risk.

Given these facts and subsequent history, the conclusion that something is afoot becomes almost unavoidable. While some of the events recorded here are merely repeats or extensions of a long drawn out drama, the change with respect to foreign affairs and military matters in particular are new and so is the degree to which Japan is deviating from traditional US-Japan relationships.

The question then becomes what the real reason for this behaviour could be. Trying to answer this question leads us into speculation, no longer interpretation.

Speculation.

It would seem that Japan is gradually trying to provoke the US into certain actions that would enable Japan to be perceived by history as the injured party with respect to some matter, whatever this turns out to be. None of the events taken singly are of major consequence – nothing so serious that, whatever might transpire later, the event should be seen as the primary cause of trouble between the US and Japan. They are mere pinpricks, not sufficient cause for (economic or trade) war.

In combination and over time, these events must have markedly increased the level of frustration in the White House – probably the primary target of Japanese strategy, if these assumptions turn out to be valid.

Depending on the timing, it can be accepted that the Japanese would appear to give way the moment the US places too much pressure on one item in the list, only to prick a new pin somewhere else. They are unlikely now – and perhaps even later when matters unfold – to stand up against the US in full frontal confrontation. They want to wear the white hats when the history books are written, not the black or even grey ones.

It is possible to speculate about certain characteristics of the reason for this behaviour. It is clear that whatever the problem is, it should fit the following:

· The problem must be known well enough in advance, to enable the construction of an elaborate web of disinformation and feints – the strategy that appears to be unfolding over the past few years

· It must be of a magnitude that places the interest of the whole nation at risk and can therefore be used to mobilise widespread secrecy and co-operation

· The solution to the problem must be one that has major ramifications outside Japan – ramifications that has a very negative effect on other countries

Probably the only such problem is the one discussed earlier – the vast hole in the banking system in Japan that would sooner or later require the repatriation of Japanese assets from abroad. A step that would deplete much of the financial world of its liquidity, cause bond yields and other interest rates to jump sky high and topple the ladder on which the Dow and other major stock indices are currently reaching for the clouds.

The nature of the problem and the nature of the only practical solution – and the nature of the effects on the rest of the world – make it imperative for the US to be seen as the scapegoat for the whole affair.

If this speculation should turn out to be valid, we have already seen the first steps taken by the Japanese to ensure that history will, look kindly upon them for what is almost bound to happen – a major depression for the US and probably for the rest of the world too.

Similar events should continue to take place until the Japanese have what they want: an excuse – a credible reason, one that can be sold to the media – why America has placed the Japanese in a position where they have to repatriate the stake they have built up in US debt and equities and the interbank loans that have fueled the liquidity that, in turn, has made credit cheap and easy to get in most countries of the world.

The future – even more speculative

If there is some substance to these speculations – apart from the known fact that the hole in the Japanese financial system is larger than most people have imagined – then it should be possible to continue this line of speculation into the future. What is about to happen and how will Japan try to orchestrate it?

Two possibilities are mentioned here.

The first is an extension of the above reasoning. Japan address their problem through the repatriation of foreign assets. To do so, they must first enter a very visible crisis mode and ideally it should be a crisis that can be presented to the world and the media as ‘Made in USA’, so that the US can take the blame.

A development that could be made to fit this definition is the following:

Under the many different pinpricks from Japan, some of which were mentioned above, and because of Japan’s recalcitrance to implement the measures that the US sought from them to get their economy into gear, the US also changed its posture vis à vis Japan. The initial hints from the US for Japan to kick-start their economy gradually turned into ever more stringent advice and recently just about reached the point where the statements have become very specific instructions and orders to the Japanese government. To which the Japanese quite naturally took strong exception, but then proceeded to implement exactly what was asked, or instructed

The advice mainly harped on three topics: cut interest rates so that consumer spending can take off; increase government stimulatory spending and cut taxes, so that there is more individuals will have money to spend and thus kick-start the economy.

Interest rates have reached 0.5% and can not realistically go any lower. So we are left with government spending and tax cuts.

The Japanese government recently announced what is probably the greatest stimulatory and financial support package the world has seen, due to take off in 1999. In doing so, they have toed the American line and now Japan will carry the heaviest debt load of any developed country. If this final attempt should fail, after which there would be no other solution in sight except repatriation of foreign assets, it would be relatively easy to build a case, acceptable to the media, that it was American advice – direct orders! – that proved futile and which bankrupted the country..

And fail it will, for a very simple reason.

Assume that you are a productive Japanese worker with a reasonably good income. As is still the practice in much of Japan, you still live with or very close to your parents in an extended family. Every day you see how your parents and other older retired Japanese really battle to survive on the very low income they derive from their savings – of which they have ample, but the low interest rates are almost literally killing them.

Now assume that you get some windfall, either as a tax rebate or as extra work on a subsidised project. Would you, as a prudent person with an eye on the future, spend the money on a new TV or hi-fi or a microwave. Or would you save the cash to make better provision for the day when you yourself have to exist on the interest income your savings can generate?

The answer is simple. Extra money – all money not spent on essentials – in practically every Japanese family go to join the estimated $12 trillion of Japanese household savings (of which a good proportion of course no longer exist except as entries in the banks’ books, swallowed by the unrecoverable loans).

After almost a decade of recession and deflation and low interest rates, no amount of stimulation and no degree of tax cuts will result in any significant and lasting increase in domestic expenditure in Japan. The spiral will run its course, irrespective.

And Americans will eventually hear, to their great surprise, that they are to blame for this catastrophic situation in Japan. Apart from the fact that of all countries they will be the hardest hit when Japan finally acts to ensure the survival of their economy.

In the light of the above reasoning, which explains in simple terms why the Japanese are reluctant to spend, it seems strange that for so long there has been such strong insistence on lower interest rates as a solution for the sluggish economy.

Consider what would happen if the interest received by the Japanese households were to increase 5-fold overnight, from 0,5% to 2.5%. Firstly, the total income received on household savings would jump from $60 billion to $300 billion per year. Tax on interest could be halved and the Treasury would still gather more than now, while household income would jump. Pensioners would suddenly move above the survival line and have money to spend on comparative luxuries.

Secondly, your productive Japanese worker would have less reason to save every yen that comes his way and perhaps opt for a new TV or microwave. This shopping spree, in turn, would suddenly have companies out looking to hire people to take care of the increased demand.

Yes, the interest rate would be 5 times higher at 2.5%, but that would probably still be the lowest rate in developed countries. Yes, this move flies in the face of accepted economic theory, but other countries cope well enough with interest rates above 2.5%, why not Japan?

Is there another solution to the problem?

Even if they went the way of higher interest rates and spent themselves into a new growth phase, the Japanese still have to find some means to make good the real and potential loss suffered by depositors in Japanese banks – a matter of perhaps some $2.5 trillion. If they repatriate assets, the effects will be disastrous and acute. What else can they do.

One that comes to mind – often a favourite when the problem is very large - is to float a long term bond issue. I am not knowledgeable in this field, but it is obvious there would not really be buyers for R2.5 trillion worth of bonds unless the yield was astronomical. The risk of default by a struggling Japan on an issue of that magnitude would be too high.

Unless, of course, the bonds were backed by gold.

I hear somebody say there is not enough gold in the world to back such a large issue?

I agree – at $300/oz there isn’t. But gold need not remain at $300/oz.

Many commentators have addressed the question of hedge funds who are reputedly short of megatons of gold and, since Southeast Asia started its meltdown, continually have to sell even more gold in order to keep demand satisfied and the price in check – perhaps even they could be beginning to lose hope on winning this war. Many commentators have wondered or speculated where all this gold – many years of global production and perhaps even more than resides in the vaults of the NY Fed – have gone to.

Could it be that one day in the not too distant future Japan announces a bond issue – or some similar solution for their problem – backed by gold, knowing that the mere announcement of the fact will make mincemeat of all the holders of short positions and the writers of call options by sending the gold price into orbit?

Of course, if this plan works they would not need to repatriate their assets, but its my guess that the eventual effect of such a move could prove as devastating for foreign economies as would the repatriation of assets. Remember, the $2.5 trillion provided by the buyers of the bonds must come from somewhere, but then it won’t be the Japanese who siphon off assets from the rest of the world, but the buyers of the new bonds. The Japanese assets will still be firmly in place, just like the white hats the Japanese will be wearing.

But the effect of their actions on much of the rest of the world and the US in particular, will be the same as if they had declared economic war by repatriating their foreign assets.

Conclusion

The hole in the Japanese banking system is real. And very large.

The fact that Japan changed their posture vis à vis the US in 1997 – when Japanese authorities finally realised and accepted the inevitable disaster facing Japan’s economy? – is a matter of record. Surely there must be a very good reason for such a change.

That Japan has a strategy in place to end up wearing the white hats when everything has gone bust, is speculation. But it would fit both their natural character and the precepts of Musashi’s ‘The five rings’, one of the most widely studied books among people in positions of power in Japan.

It seems axiomatic that normal stimulus packages in Japan are doomed to fail, because very low interest rates and increased insecurity in a recessionary environment simply must intensify the historically strong urge to save that is so characteristic of Japanese households, to where it becomes a compulsion that applies to every available yen.

Whether a five-fold jump in interest rates will confound economic theory and get the Japanese economy going is pure guesswork on my part. But perhaps it may just work. At least such a move will be welcomed by a large part of the electorate.

Whether the Japanese have some form of hidden agenda for gold, either to back bonds or to launch a third global reserve currency, I really do not know. But who else has the kind of money – and a reason – to buy up most of the gold that has been dumped on the market over the past three years through short and central bank sales? They may well be holding anywhere from 6000 to 12000 tons of gold, or even more, almost on a par with what is reputed to lie in the Fed in New York. They could even be accumulating the gold calls that some central banks are said to be writing, knowing that when they spring their surprise on the world the gold price will move through the strike price of the options like a hot knife through butter.

It would be nice if they did put us back on a de facto gold standard, with gold backing a really hefty bundle of cash to the tune of several trillion dollars. Although this would definitely not be received kindly in much of the rest of the world.

Whichever way Japan lets this situation develop, it seems the Chinese curse will apply - one should prepare for interesting times ahead.