Part 2: Historical Comparison

The Economist recently published an article contrasting our current economic crisis to that of the Japanese banking crisis. In an attempt to learn from history, I will highlight the main points of this article and transform these points into pieces of my investment strategy.

Japanese Banking Crisis:
People often tell me that the Japanese banking crisis isn't comparable to today's predicament because of the Japanese government's excessive stalling before taking necessary action to curb the problem. Yes, they were late to the game...by about 5 innings, but it's actually their differences rather than their similarities that make this case study so interesting. Unfortunately, our dilemma may prove harder to fix. Japan's underlying problem was rooted in the over-borrowing of firms, and as a result Japanese firms spent years carrying out a massive balance sheet clean up. This deleveraging process alone would have taken an even tougher toll on the Japanese economy had it not been for a rebound in Japanese household consumption, mainly due to huge amounts of government stimulus. This partial offsetting in aggregate demand came at a huge expense to the Japanese government, with public debt now standing at north of 170% of GDP. However, thriving exports timely aided the government's efforts.

U.S. Credit Crisis:
We are in the midst of a household credit crisis. Our firms (excluding our banks) entered this crisis relatively well positioned in terms of cash. On the other hand, as seen from my last post, our households entered this crisis heavily indebted. Unfortunately, household balance sheets tend to be more difficult to repair than corporate balance sheets. People, especially babyboomers, will be forced to drastically increase their savings. As a result, U.S. equity markets will likely have a tough time gaining traction on the upside due to continued selling into rallies. As of October, the average American doesn't trust the stock market. The psychological healing process will take time. With firms dependent on the consumer, firms will likely delay major investments until the consumer has recovered. This slow-down in investment coupled with a major slow-down in consumption results in a nasty outcome. With the U.S. running a massive trade deficit, it's unlikely that we'll be able to weather the storm by huddling behind a mountain of exports (like Japan). The government has just issued its first dose of stimulus and it probably won't be its last. As money flows into the pocket of the consumer, the consumer will proceed to do two things: Pay down debt and save. Remember, we have lost 20% of our wealth over the past six months...an increase in savings is inevitable. Due to the anatomy of a household versus a corporation, government spending won't be nearly as effective. We have to hope that most of this spending will be focused on infrastructure, helping create jobs. The sooner that unemployment starts declining, the more likely aggregate demand will begin shifting out. The government is taking an interesting approach to this crisis. Instead of helping the average American deleverage, they're attempting to artificially drop borrowing costs in order spur the consumer into an even more indebted state. It will be quite interesting to see how this all plays out. Next post I will cover my investment ideas given this current economic outlook, so stay tuned!

Sources: The Economist
CIA Factbook