According to many respected economists, it is just a matter of time before the largest, strongest Asian economy overtakes the United States as the world’s number one economic power. Since this ruthless competitor stands accused of engaging in unfair trading practices, the US resorts to tough protectionist measures. Relations between the two rivals become dangerously heated. Indeed, innumerable books and op-eds appear and predictions of war are discussed by academics and generals.
Just as the geopolitical temperature reaches boiling point, there is an unexpected development. The Asian nation's economy is rocked by a collapse in real estate values. That drives major developers into bankruptcy and makes people feel much poorer. Consumer confidence plummets, leading to a "fallacy of composition" – a situation where actions, such as increasing savings, that are rational for one actor can be economically disastrous when taken by all actors.
The result is recession and deflation. This is exacerbated by a worsening demographic profile. New social pathologies appear. As youth unemployment soars, young males become listless and give up on having careers.
Household formation suffers as adult children continue to live with their parents for years. Most knowledgeable observers expect this economic powerhouse to get back on track before too long. But in fact, the growth that had once provoked fear and envy never returns.
Big Picture Parallels
Is contemporary China about to follow in the footsteps of Japan in the 1980s and 1990s? The big-picture parallels are obvious. In both cases, real estate prices rose to eye-popping levels.
In 2021, price-to-income ratios in Beijing were at 25x. And they were near 20x in Shanghai. In the Japanese bubble, affordability was less strained with ratios over 10x. But that marked a doubling in three years, and price rises in the commercial sector were equally explosive.
It's hard to make exact comparisons between countries at such different stages of development, with their own systems of taxation and finance. Yet, investment scholar Edward Chancellor notes, using data from real estate specialists Savills, that the total value of Chinese real estate is equivalent to 5.5x the country's GDP.
By comparison, Japan's land-to-GDP ratio peaked out at 4.8x when the bubble burst in 1991. Any way you look at it, China's real estate excesses are of a monumental scale, and purging them will be a painful process.
So far the deflationary symptoms in China are mild, with small declines in the consumer price index and the GDP deflator. But that was the case in Japan too. Deflation was persistent but never deep, which is why policymakers ignored it for so long. Instead, a risk-averse "deflationary mentality" spread. With it, people came to believe that the natural trajectory for wages, rents, and stock prices was down.
The Differences Between Then and Now
There are obvious differences too. One of the most important is that Japan suffered simultaneous real estate and stock market collapses. These fed on each other, creating a larger, all-consuming crisis of asset deflation.
In contrast, there was a significant lag between China's double bubbles. In 2007, Chinese stocks were the most expensive in the world, according to the Shiller price-to-earnings ratio, a long-term measure of value. They soon plunged.
Fifteen years later the Shiller ratio has declined from 55x to 10x. That makes the Chinese stock market one of the cheapest in relation to long-term earnings.
China also has the advantage of being able to learn from Japan's mistakes. Having been the first major economy since the 1930s to experience a large-scale asset collapse and ensuing deflation, Japan had no such guide and was slow and indecisive in its response.
The Japanese financial authorities did not conduct rigorous inspections of the health of the banks until it was too late. They thereby guaranteed a full-blown banking crisis. Monetary policy was kept much too tight, resulting in a massively overvalued currency. And fiscal policy was abandoned in the late 1990s out of illusory fears of a public debt crisis.
The Risks of Income Inequality
If the Chinese authorities are proactive and pragmatic, the healing process could be much faster than in Japan. But will they be? The "economy first" approach, associated with the recently deceased ex-premier Li Keqiang, has long been junked. A "politics first" orientation is in favor now.
Chinese economists have been studying the Japanese bubble economy and its aftermath for a long time. But in many instances their conclusions are of the politically correct "it couldn't happen here" type. They cite China's closed currency system and much earlier stage of economic development as sufficient reasons for better outcomes.
For obvious reasons, those inside the system are reluctant to offer criticism or worst-case scenarios. If there is a countervailing force, it is likely to be social unrest. Such as the outburst which seems to have triggered the dramatic reversal in China's "Zero COVID" policy in December 2022.
According to the China Labor Bulletin, there are roughly 60 million migrant laborers without residency rights working in the construction industry. For reference, in Japan construction investment halved between 1991 and 2010. Significant shrinkage is on the cards in China too.
Recently, Veritas, the Nikkei's financial weekly, headlined an article about China's economic troubles with "China's Lost Three Decades". That is surely an unlikely prospect.
Japan was able to ride out its long spell of deflationary stagnation because of its relatively equal distribution of wealth. Even today, according to Credit Suisse's annual Global Wealth Report, the top 1% hold 18% of the wealth in Japan. That is slightly less than was the case in 2000.
In stark contrast, China's top 1% have gone from owning 20.7% of the wealth in 2000 to 31.1% today. That makes for a 50% increase in inequality in just two decades.
Abating the Risks to Itself and its Neighbors
In fact, there are few societies that would suffer 70-80% declines in land and stock prices with such little social unrest as Japan did. That is not to say Japanese society was unmarked by the experience. The suicide rate soared by 50%, with middle-aged men the main victims. But politically the country was quiescent.
No new populist parties appeared on the scene. There were no moves to raise protectionist barriers or stigmatize foreigners, let alone engage in military adventurism. And with
the coming of Abenomics the number of suicides fell to the lowest level since statistics began.
Historically, though, deflations have been just as socially destructive as inflations. Think the Showa depression in early 1930s Japan which led to the era of "government by assassination." Or the Bruning deflation in Germany, which saw consumer prices fall by 23% in the three years before the Nazi’s election victory in 1933.
Such disastrous economic blunders are unlikely in today’s world. Nonetheless, in the case of a long-lasting deflation, China is likely to present a much greater threat to itself and its neighbors than 1990s Japan ever did. Which is why it is in all our interests that Beijing adopts a radical stimulative agenda. One that stops the deflationary mind set in its tracks, drives the stock market higher and lifts the spirits of consumers and entrepreneurs.
To be sure, China’s problems are not exactly the same as Japan’s. But the common thread is the need to do whatever it takes to combat the malign effects of asset deflation. The alternative does not bear thinking about.
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Author: Peter Tasker