Saturday, December 5, 2009

Big in Japan

As the economic mess continues to unfold, there is no lack of bewilderment about what's going to happen and when. There are people calling for everything from runaway inflation to runaway deflation... all the while no one is anymore sure what is coming next year, then they are about tomorrow.

In our little niche of the blogosphere here we discussing housing bubble here in Alberta, and through much of Canada for that matter, those bullish on the market all have their theories as to why they feel prices are sustainable. The arguments largely focus on either inflation jacking up incomes, or interest rates staying at their current record lows for years on end. Some even cite a combination of the two, apparently blissfully unaware that they are mutually exclusive

In the case of the low interest rates scenario, they point to Japan as an example. So, today we're going to take a look at just what happened in Japan. Then in subsequent days we'll do some further comparisons with what happened in Japan, to what happened in the US, to what's happening here. Even so, brace yourself, it's gonna be a big'uns.

Interest Rates
First up, interest rates. The best I could find was their prime rate, which is as good as any, so we'll use that. Also, just for reference purposes, I included the prime rate we Canucks have witnessed. We can that their interest rates have been lower than ours going right back to the late 70's. But what we really want to focus on is the period from the mid 90's through now, as it was in the mid 90's that the Bank of Japan intentionally started to set their rate VERY low (in an effort to attract the carry trade).

Japan first dipped below the 3% mark in July of '95, and after a couple years bouncing around the mark, they haven't eclipsed it again since May of '97. Over this period the Canadian prime rate have been averaging in the 5-6% range, while in Japan it's been more like 2%... coincidently, a range that we now find ourselves currently.

We're not really here to discuss what the future holds for interest rates (though it seems the current consensus is that they'll eventually go up, but for now they will remain for at least another six months). The question we're looking at is in the even these rates stay long term, will that alone support a real estate bubble? Beyond that, what kind of effects would it have on the greater economy?

In this regard, Japan is actually a great case study. You see, in the early 90's Japan was right at the acme of their own massive asset bubble... of which real estate was right at the forefront.

Japan Housing Bubble
This is a look at the National Wooden House Market Value Index, quite a mouthful. It's index point (=100) is 2000, which is actually the same as the Case-Shiller index in the U.S.... but in the case of Japan, by then their bubble was in their rear-view mirror. Regardless, we'll get into all that business sometime next week, for today we're focusing on Japan.

Here we can see a very distinct bubble pattern, particularly in their index of the six major cities (Tokyo, Yokohama, Nagoya, Kyoto, Osaka, and Kobe). They don't break them down into individual cities, or at least I couldn't find any data on individual cities, but I have a hunch that's probably got more to do with my non-existent understanding of the Japanese language then anything.

At their peak in 1991, the national mark was 126.1, and major cities mark was 223.4. As of their most recent publishing in September the national index was 68.8, and 6-major-cities index stood at 79.3. Which would equal a national 45% decline from peak, and 65% for the major-cities.

This also goes to show that even with ultra-low interest rates, it's done nothing to stop the decline... they may have slowed it, but that's all. Prices are back to where they were in the early 80's. Other then a little bounce in the major-cities recently, that has largely since dissipated, it's been a very smooth trip down. So yeah, ouch, very ouch. But believe it or not, that's a mere tickle compared to what happened in commercial real estate.

Japan Commercial Real Estate Bubble
Looks very similar, but note the scaling... this mofo topped out at almost 520 in the major centres! The national decline from peak is currently sitting at 74%, and the major cities at 85%. That's approaching Tulip Mania types numbers.

Japan Inflation and Interest Rates
Now lets take a look at why high inflation and low interest rates are mutually exclusive. Other then just intuitively, as if inflation is high, generally everything is earning a high return and thus to attract money even low risk investments like bonds would need to offer higher returns, and as we all know, higher returns on bonds = higher interest rates. Conversely, if inflation is low, nothing is really offering a return, thus interest rates can be very low.

In the graph above we can see how inflation and interest rates have played out in Japan. Here we note that as interest rates plummeted, inflation flat-lined. ¥1,000 will pretty much buy you just as much today as it would in 1992.

Japan and Canada - Inflation
Now lets compare the Japanese situation to ours here in Canada, where inflation has been more typical. Here, to buy the same amount of stuff $1,000 would get you in 1992, would cost you roughly $1375 today. That's basically how inflation works, over time the purchasing power of a dollar erodes , in the case presented by 38% over the last 17 years... whereas the Japanese experience has effectively been 0% inflation, purchasing power is exactly the same today was it was in '92.

Japan and Canada - Incomes - Nominal
Therein lies the rub of a sustained period of low interest rates... there is no inflation, everything tends to stagnate. Including as we see in the above graph, incomes. Here we can see in nominal terms that Canadian incomes have steadily increased all along, whereas in Japan where they grew through the early 90's, but since incomes have actually declined slightly since they changed monetary policy.

I'm typically a stickler for using medians rather than averages for items such as incomes, but I could only find averages for Japan. Thus, I figured I'd better use them for Canada just to be consistent. So, in case you were wondering, that's why.

Japan and Canada - Incomes - Inflation Adjusted
Here is the same data, only adjusted for inflation. We note the Canadian incomes have been much more flat historically once inflation is considered. What's more interesting is the Japanese numbers, who had a rise, plateau, and then slide.

From the 90's on we'd expect to see that pattern as we know inflation has been effectively non-existent, and thus it should replicate the pattern from the nominal graph. That we expected, but what's compelling is seeing the very noticeable gains in real incomes between 1970 and 1991. In 1970 the average family in Japan was making roughly ¥4.26M... by 1991 they were making over ¥6.86M.

It warrants repeating, these are in inflation adjusted dollars, not just nominal, that's a 61% improvement in incomes over and above increases in the cost of living. That's very significant, and with that kind of improved purchasing power you could see why there would be for the potential of a real estate bubble. Compare that to Canada, where we're currently at our highest point in history, but even that is only up about 17% over the last 30 years.

Japan and Canada - Incomes - Inflation Adjusted
Did this graph just for kicks, it's inflation adjusted earnings for both nations again, but this time converted into Canadian dollars (historical exchange rate). Shows the power of exchange rate fluctuations, as we know nominally in Japan incomes really haven't changed significantly in the last 20 years.. but in Canadian dollars they've been up and down, anywhere from $54,000 to $97,000. Interesting? Perhaps. Useful? Not so much.

Japan - Various Indexes
And this mercifully brings us to our final graph for today (I told you it was going to be a big'uns, and just be thankful I condensed or eliminated a bunch more). This is various indexes available from the Japanese statistics bureau, except the income index, which I devised from the data we discussed earlier (all index points have been set to 2000 for comparative purposes).

The two that jump out first are obviously the residential real estate ones, the rest are much more gentle. The others are income, inflation and rental indexes. Income and inflation again we discussed earlier, so we'll just take a sec and talk about the rental index (yellow line).

We can see it's been very smooth over time, and has been virtually flat since '97. As we know from experience here, rents are stickier then real estate prices, as such move much slower. It's interesting that there really didn't seem to be any short term surge at all when the bubble occurred, nor did it dip as prices declined. Seems rents just found a long term equilibrium and eventually settled into it. Even as inflation halted, rents continued to rise through much of the 90's, then finally levelled off. Even since then as real estate prices have continued to slide, rental prices have remained stagnant.

Anyway, I just wanted to include that graph to display the interplay of all the factors and give you an idea of the overall picture of what happened. I think I've covered all the bases I wanted to touch on today, so I'll try to wrap this up. What we should take away from this is that when the fundamentals get way out of whack, there is no easy way out. Even manipulating interest rates long term in the wake of an asset bubble, has done nothing to keep asset prices from declining.

Japans spend and borrow response to the aftermath of their asset bubble has done nothing to prop up those assets, but has left the nation crippled with debt, and on the brink of economic collapse. Now in the wake of asset bubbles bursting world wide, much of the developed world is now copying the very policies that got the Japanese in trouble. One can only hope that they truly are only going to be temporary, because as we've seen, they're not only ineffective, they're destructive.