Change Of Mindset

Andy Xie is a former Morgan Stanley analyst now living in China


The biggest policy debate this year has thus far been when and how fast to exit from last year’s stimulus policies. Last year, in a moment of panic over the global financial crisis, central banks and governments poured monetary and fiscal stimulus into the global economy. The side effects of these misguided policies are already showing up: asset speculation has engulfed the global financial market again and consumer price inflation is creeping up uncomfortably fast, especially in emerging economies. Despite the visible need for tightening, the consensus is demanding a slow and delayed exit. Japan’s “early withdrawal” is touted as an example of what could happen otherwise.

Japan has experienced two decades of economic stagnation since the collapse of the infamous bubble it suffered in the 1980s. The most popular explanations are that Tokyo wasn’t aggressive enough in stimulating the economy after the bubble burst, or that it withdrew its stimulus too early – or both. This line of thinking is popular among elite economists in the US, where it is rarely challenged. But few Japanese analysts buy it.

The Americans liken an economy in a slide to a car with a dead battery: it can be jump-started with a forceful enough push. But there’s no sound logic behind such thinking. After a big bubble bursts, an economy suffers a terrible misalignment between supply and demand. Through high prices, a bubble diverts investment and labor to needed activities. It takes time for an economy to normalize. The bigger the bubble, the longer it takes to heal.

The argument to “stimulate until prosperity returns” is popular because it doesn’t hurt anyone in the short term. When a central bank prints money, its nasty consequence — inflation — takes time to show up. When a government spends borrowed money, repayment is in the future. Nobody feels the pain now. Indeed, when debt is sufficiently long-dated, nobody alive need feel the pain. So analysts who advocate stimulus are popular with politicians because it sounds like a free lunch. Japan’s tale is just a nice story that seems to support the argument.

At the peak of Japan’s bubble, the biggest in history, the excess value of its property and stock markets was more than five times its gross domestic product – more than the entire world’s gross domestic product at that time. In comparison, the excess asset value in the US bubble was less than twice its GDP, or half the global GDP. So how is it possible to just stimulate an economy back to health after such a massive correction?

Japan has run up the national debt equal to 200% of GDP — the greatest Keynesian stimulus program in history — all in the name of stimulating the economy back to health. It has failed miserably. Japan’s nominal GDP is about the same as when the stimulus began. Those who advocated the policy blame Japan’s failure on either the stimulus being too small or not being sustained for long enough – that is, the dosage, not the medicine itself, was at fault.

The bankruptcy of Japan Airlines is a sobering reminder of what is still wrong with Japan. It stayed with unprofitable routes for years without its creditors or shareholders being able to do anything about it. And by making credit cheap and easy, the stimulus prolonged the airline’s business model — actually, an anti-business model — for a long time. Zombie companies that have first claims to resources have trapped the Japanese economy in stagnation for decades. The lack of shareholder rights has given the moribund companies the luxury of being able to disregard capital efficiency. The government stimulus has prolonged this inept business practice.
What ails Japan is a lack of reforms, not stimulus. The prolonged and massive bailout has only allowed a bad situation to continue. As governments around the world look at their own problems, this is the lesson they should draw from Japan – not the wrong one that insists Japan should have spent more.

We are hearing the first major departure from the mainstream consensus; US President Barack Obama has just announced a proposal to limit proprietary trading on Wall Street. This is his first major step to address the root cause of the crisis.

The crisis happened because financial professionals had incentives to bet other people’s money in a game they could not lose. With so many getting in on the act, the liquidity they threw into the trades made them effective, turning bankers into heroes, but only for a while.

The crisis showed that their behavior was indeed rational: while the losses to shareholders and taxpayers surpassed all the accounting profits that Wall Street reported during the bubble, those who made the trades are still rich, because they paid themselves bonuses in cash, not derivatives.

Obama has not been well-advised. His so-called accomplishment — stabilizing the financial system — comes from throwing trillions of taxpayers’ dollars at financial firms. He has behaved like a Wall Street trader: spending other people’s money with no thought of consequences. Anyone can do that. Hopefully Obama has fundamentally changed his approach.

Reform, not stimulus, is the solution. Only by limiting financial speculation can the foundations be laid for a healthy recovery, and to prevent another crisis.

A Change Of Mindset
Andy Xie
CIB March 5, 2010

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