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March 27, 1998
As went oil, so went interest rates; and the slippery bond market slope steepened with news from the housing market. Oil jumped from last week's $13/bbl low to $16.83/bbl, which is not enough to ignite inflation, but was more than enough to suppress the deflationists. Bonds are barely holding below 6.00%, mortgages around 7.25%.
"Ignition" hardly describes the housing news. Existing home sales were expected to continue their already-record 4.4-million annual pace in February, and instead exploded to the 4.75-million level, an 8.7% gain. Too hot for comfort.
In the last four months, I've been skeptical of the magnitude of the Asian Contagion. While I continue to believe the effects here will be minor -- the economies involved so far are too small to cause much effect -- there is reason to be concerned about the big domino: Japan.
The banking problem there has been so widely reported that it's ultimate solution tends to be taken for granted here. Other than numbing repetition, the reason for complacency is the "Japan-is-rich, Japan-saves" mantra recited in all stories about Japan's troubles. Many mention the sum of Japanese personal savings -- 9.5 trillion dollars -- as the certain buffer against any economic problem there, no matter how mismanaged.
These savings are at risk, not a buffer; and their evaporative nature is at the heart of Japan's trouble.
Here's how: suppose I'm a bank, with a trillion dollars on deposit. I have invested those deposits in good deals (U.S. Treasurys, loans to Toyota) and bad deals (real estate loans, Japanese stocks). I'm a well-capitalized bank, with a net worth equal to 5% of my deposits, about $50 billion.
However, I'm a Japanese bank. My investments are not worth a trillion dollars any more: if I were forced to sell them, they are only worth $900 billion. If I were forced to liquidate, my capital would be gone, together with $50-billion worth of my depositors' money.
Today, Japan has about a trillion-dollar bad-investment problem, and that portion of its savings are imaginary. Every day that Japan flinches from real solutions, another several billion in investments go bad, and a like amount of savings evaporates.
It takes a long time for $9.5 trillion to evaporate, but as the process continues, the system is more and more exposed to an uncontrolled fire sale -- a "deflationary spiral".
Japan's problems are solvable -- just a bigger version of our S&L bailout, which took us a decade to resolve.
Meantime, news from Japan each night is a wild card in the bond and mortgage markets, and floating an interest rate has more risks than the usual economy-inflation-Fed mix.
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