Ask Colin

Is it possible we will see a Japanese style bear market in the US?

There are several ways that a market bubble can be unwound. Some of the main ones are:

The free-market response where asset inflation is unwound by a rapid fall in prices. If governments do not interfere with the market too much in this situation, there will be a sharp recession or depression, in which many investors lost large parts of their capital. Some large businesses and many small ones will go to the wall. Many others will survive, but with large losses, as asset values are ruthlessly written down. This is what usually happens in Australian, and the US. Out of this we get a bear market, whose severity depends on the extent of the preceding asset inflation in the bubble.

The alternative seems to be the Japanese model, where the government interferes in the process. What happened essentially is that the banking system in Japan was bankrupt - insolvent, what ever you want to call it. The banks had loaned large slabs of their capital on real estate. When real estate values fell, the owners were essentially wiped out. This should have meant that the banks wrote off the loans, which were then of no value. However, that would have exposed their insolvency. So, the government allowed them to keep the loans on their book, creating a fiction that the banks were still solvent. However, while the banks stayed in existence, they had no way to trade out of their problem because they had no capital to loan out. Therefore businesses could not expand, because they could not borrow funds. The economy stagnates. This is a simplification, but the general ideas are right.

The Japanese government then reduced interest rates to zero and ran a big fiscal deficit, trying to get things moving. However, it did not work and now they have fired off all their guns and there is actually price deflation. This is a spiral opposite to inflation, where prices fall, squeezing profit margins and making it even harder for business to expand. On top of that, the Japanese system allowed unemployment for the first time and this has also reduced demand. It is going to continue until time does the work in rebuilding bank assets or they take the medicine they should have taken in the early 1990s.

Now, back to the real world. Once we have a bear market there are two basic models. There is the big price falls on the stock market as in 1929-32. There is also the 1960s - 1980s model when prices went essentially sideways (an exaggeration because they fell about 40% in 1973-4). However for the best part of two decades the Dow remained below 1000 points, testing it several times with dips in between of which 1973-4 was the worst. The post war boom was dissipated in a sideways market, because we had stagflation - stagnation, but with high inflation. Thus, prices went up sharply, but stock prices held their own. Without the inflation, stock prices would have fallen like 1929-32 - and in real terms they did - see Shiller's book Irrational Exuberance, where there is a very stark chart of real stock prices that showed how inflation destroyed wealth just as deflation did in the great depression.

The real risk this time seems to be deflation, because inflation is very low going into the bear market. Therefore we have already seen a very severe bear market. However, prices in the real economy have held with slight inflation. The risk is that prices begin to fall out of control and we spiral downward into a serious recession or depression. This danger should not be underestimated. US interest rates are already historically extremely low and cannot go much lower or they will be zero. That cuts off monetary policy to get the economy moving. Bush has also cranked up the fiscal deficit and is running a huge current account deficit that means he has to keep selling US assets to the rest of the world. There is a limit to this somewhere and at some point the dollar will have to fall sharply so that US assets seem cheap to the rest of the world. This would be the deflation scenario, which we will see if the fiscal stimulus does not work.

We will have to wait and see. As the Chinese curse puts it "may you live in interesting times."