Episode 3: Japan-Yen & Now

Jim Grenn: It’s 1991.  Japanese real estate developer Takeshi Sekiguchi is finishing up construction on his masterpiece; The Grand Hyatt Wailea hotel in Hawaii, one of the most expensive hotels ever built.

The grounds of the hotel cover 42 hillside acres featuring swimming pools with grottos, canyons, and a smoking volcano.  10,000 flowering plants cover the open-air atrium and $30 million of art work line the walls.  One of the restaurants on the property is a Japanese country inn built in the middle of a reflecting pool surrounded by 800 tons of rock delivered straight from Mount Fuji.  The restaurant alone cost $19 million… I could go on… but I think you get the picture.

The total cost of the hotel was 600 million dollars - an average of roughly $750,000 for each of its 787 rooms.  It was the crowning jewel for Japanese development on American soil.  At the time, the Japanese already owned Pebble Beach golf course and 45% of all commercial real estate in Los Angeles.  But the Grand Hyatt Wailea – well it was the cherry on top.

There was just one problem.  There was almost no way the hotel could charge enough per room to make any money.

In the 1980s Japan was poised to become the economic leader in the world.  Books were written about their work ethic, financial innovation and management styles.  For many economists it was a near certainty that Japan would soon surpass the US as the largest economy in the world.    

So why didn’t they?

This is Domino, an examination of a historical event that had a ripple effect on the global economy.

Hi, this is Jim Grenn, the host of Domino.  Today we are going to examine some strange things that caused Japan to stumble and what caused what should have been their economic golden years to crash and burn.

Kent Oliver: Japan didn’t become a dominant economic power overnight.  Following World War II Japan’s economy was in shambles, but they began to emerge from the ruble in the 1960s and by the 1970s they were emerging as a leader in technology.

Jim Grenn: that’s Kent Oliver.  He’ll help us paint the big picture. 

Kent Oliver: It was really the auto industry that made people sit up and take note of Japan.  The Japanese had a knack for making smaller, more fuel-efficient cars and they began outselling their US competitors when gas prices shot up in the 1970s.

Jim Grenn: I got an old, tiny Japanese car when I was 16, and it lasted forever.  Why was Japan better at smaller cars?  What exactly led to that advantage?

Kent Oliver: The Japanese had a totally different approach to car manufacturing than auto-makers in the US.    The big boys in the US were churning out automobiles faster than ever, but with tremendous inefficiencies in the process.  The US guys focused on quantity over quality, churning out parts and materials regardless of their usefulness.  On the other hand the Japanese focused on quality, inventory control, and efficient use of labor; which in turn lead to a dramatic cost advantage.  By doing so, Toyota and Honda, for example, could earn an excess profit of $500 to $1,000 per car more than their American rivals.  For guys like us, Jim, it meant less time in the shop and lower cost of ownership.

Brady Raanes: Japan’s dominance in the automobile industry made headlines, but it wasn’t just cars.  Soon Japan became a dominant player in all sorts of technology.  Japanese companies became household names in America: Panasonic, JVC, and Sony, and of course Toyota and Honda.

Jim Grenn: that’s Brady Raanes, he will fill in the details. 

Brady Raanes: In 1975 VCRs went mainstream.  For the first time, households could record a television program or watch a movie in their own homes.  VCRs were too expensive for most households early on, but eventually, prices came down and three Japanese companies came to dominate the market: 

Kent Oliver: You know there are several theories as to why VHS won the battle with Betamax.  The one that raises an eyebrow or two is tied to the adult film industry. Sony’s Betamax (the precursor to VHS tapes) prohibited adult videos in their format while VHS had no such restriction.  It has been reported that “75% of videocassettes sold in 1978 and 1979 were of the adult variety.” Coincidence? … perhaps not.

Brady Raanes: That’s some interesting trivia Kent!  You can share at our next dinner party! 

Jim Grenn:  oh no.

Brady Raanes: Japan also invented the portable music industry.  Sony’s ‘Walkman’ became a household name.  As the story goes, Sony’s co-founder traveled often for business and asked the company president to configure some way for him to listen to music on the go.  He wanted something small, portable and lightweight; something he could listen to when walking around.  In 1979, Sony released the Walkman, a fourteen-ounce cassette player with a leather case. 

Sony’s expectations were the Walkman were minimal, initial projections called for sales of 5,000 units a month.  Sony sold 50,000 in each of the first two months.  They had accidentally created a cultural phenomenon.  Cassette sales boomed, surpassing vinyl for the first time in 1983.  Japan’s technological innovations quickly became the envy of America companies who scrambled to compete.   The ability to carry music on the go also led to a workout revolution in America as the aerobics industry boomed.

Jim Grenn: I’m picturing Olivia Newton John in that MTV video with the spandex. 

Kent Oliver: I grew up in the 80s so Japanese dominance, especially in electronics, was pretty noticeable as a child, but a few years earlier America was already taking notice. 

A Harvard professor named Ezra Vogel fueled the fire of Japanese dominance in his book “Japan as Number One”.   Vogel’s best-selling book Japanese workers as the most efficient in the world.  Vogel opened American eyes to other areas of Japanese dominance citing the infant mortality rate as the lowest in the world, and life expectancy amongst the highest.  Japan’s dominance in the car industry was a microcosm of their emerging economic dominance in the late 1970s and early 1980s. 

Jim Grenn:  So, the US begins to believe maybe their economy want be the greatest.  Did this make the US nervous?  Did they do anything at the time? 

Brady Raanes: well, the automobile industry was real concerned.  Japanese dominance in the early 1980s led the American auto industry to pressure congress to impose quotas and tariffs on foreign automobile imports to balance the playing field.  Japanese officials argued that the increased popularity of Japanese cars was not only providing a needed benefit, but also creating jobs in America as Japanese firms increased production.

Jim Grenn:  which was probably true, yes?

Brady Raanes: Probably, but in early 1981 legislation was proposed to restrict Japanese imports in the name of protecting the American auto workers.  The proposal received broad support.  Ronald Reagan had just become President, but tariffs weren’t really Reagan’s thing, he was a proponent of free trade.  In this instance though, he felt that the support for the legislation may be too great for him to override.  Instead of fighting against it, Reagan and his staff went straight to the source and encouraged Japan to issue a self-imposed quota on their own auto industry rather than impose a tariff to allow the American companies the time to re-tool and re-design.   

Jim Grenn: self-imposed quotas.  That’s a difficult concept to really wrap your mind around.

Kent Oliver: Yeah, it really is.  In hopes of avoiding a trade war, Japan agreed.  In May of 1981 they imposed a two-year self-imposed quota on their own auto industry.

Jim Grenn: but doesn’t that defeat the purpose of avoiding a trade war?  I mean the main downside to a trade war is the reduction of imports – which is what Japan did with the quota.

Kent Oliver: well, it allowed Japan to dictate the condition of which cars were sold, how long the restrictions would last, and most importantly, the Japanese auto industry was able accrue the benefits of rising prices… you had this perfect supply and demand situation that allowed car makers to reap the rewards of higher prices without getting taxed through a tariff. 

The quotas also encouraged Japanese car manufactures to focus on selling vehicles with the highest profit margin which lead to inflow of luxury cars under brand names such as Lexus and Infiniti.

Jim Grenn: OK so these self-imposed quotas more or less led to the growth of the luxury car market.  Interesting.  But do these restrictions satisfy the US?

Brady Raanes:  It sort of pacified the auto industry, but Japan is still kicking the United States’ tail in global trade.  The US dollar was much stronger than the Japanese Yen in the mid-1980s which made US products much more expensive than comparable Japanese products to the rest of the world.  So, US officials still wanted to something to rebalance trade. 

Jim Grenn:  this sounds somewhat similar to the current administration’s policy on global trade.  We hear a lot in the news today about unfair trade. 

Brady Raanes:  Yeah, it’s the same discussions.  Currently, we are talking about imposing tariffs on certain countries to rebalance trade. 

Kent Oliver:  but in 1985, the US took a different tact.  Imagine this scene in the fall of 1985, representatives from the US, Germany, the UK, France, AND Japan met at the Plaza Hotel in New York to discuss a strategy.  You see, one way to try and rebalance global trade it by altering currency values.  If the value of a currency shoots up in one country it makes their good seem more expensive to the rest of the world.  So anyway, these countries meet at the Plaza Hotel in New York and each agree to something we refer to now as the Plaza accord… essentially, they agree to manipulate currency values to make the Japanese Yen more expensive. 

Jim Grenn: I imagine Japan was feeling a bit awkward in this meeting… Why would they want to go along with that plan?

Brady Raanes: I agree it does seem strange.  The most logical reasons are that Japan saw this alternative as the lesser of two evils.  They feared tariffs and trade embargos that would have crippled exports, they may have also seen the strengthening yen as an opportunity to buy cheap imports, or perhaps they felt that the stronger yen would play well on the global stage to increase the prominence of the currency.

Jim Grenn: ok, gotcha

Kent Oliver:  So anyway, the plan was pretty simple; collectively, the countries agreed that they would all sell US dollars at once, out of the blue, on the open market.  The action, they reasoned, would force the value of the dollar lower, thereby making other currencies, like the Yen more expensive on a relative basis. 

Jim Grenn: Currency manipulation on the highest level. 

Kent Oliver: The key to the trick was that it had to be done in complete secrecy. 

Jim Grenn: ok, so did it work?

Kent Oliver: Oh yeah, the dollar began to fall, and didn’t stop for two years, dropping more than 50% against the yen over the next two years.

Jim Grenn: Problem solved. Right?

Kent Oliver: Eh… yeah, kind of.  I mean, yes, Japanese products got more expensive, but US consumers still bought Japanese cars and VCRs despite the higher prices. The other goal of the meeting was to incentivize the Japanese to buy more American goods.  The weak dollar was supposed to make our stuff more attractive.  And it did… but it kind of got out of hand.  Rather than buy products from our US based companies, the Japanese started buying the companies themselves.

Brady Raanes:  Currencies changes can play a major role in international finance.  In simple terms, Imagine you’re a rich Japanese investor with 200 million yen at an exchange of 200 yen per dollar.  In 1985 you could have converted your money into $1million USD.  If the exchange rate changes to 100 yen per dollar, then suddenly the same Japanese investor with 200 million yen can convert that money in $2 million.  Even though the price hadn’t changed in US dollars, the stronger yen allowed foreign investors to buy US assets cheaper. 

With more purchasing power, these Japanese companies and individual investors turned their focus to the US and began scooping up U.S. asset indiscriminately with the stronger yen.  And that’s when the story starts getting weird.

Kent Oliver:  So, by 1987 it’s pretty apparent that the original plan to weaken the dollar and strengthen the yen had worked really well.  Maybe too well.  For the second time in two years, an emergency meeting was called.  In February of 1987 the same countries that orchestrated the Plaza Accord rendezvoused again, this time at the Louvre museum in Paris and came up with a new plan.  The idea was to undo everything they had done at the Plaza hotel two years earlier.  Now they wanted the dollar to strengthen, so they came up with another concerted effort to manipulate currency prices.

Brady Raanes: This time, however, the effort wasn’t as responsive.  Perhaps word got out.  Perhaps forces had already been set into motion.  Either way, the dollar actually weakened more despite the concerted effort.  The Japanese yen rallied another 20% against the dollar by year end sending the Japanese buying shopping spree into overdrive. 

Jim Grenn: And that was the exact opposite of what they wanted to happen, right?

Brady Raanes: exactly. 

Jim Grenn:  Interesting.  So… this collection of big important countries get together, and they try to impact currency prices up and down to help one country over another, and it works really well the first time, so they try again a second time but it kind of backfires.


Brady Raanes: The Japanese started buying everything in sight.  Key properties on the Vegas Strip, properties that dotted the New York skyline, massive resorts in Hawaii and tons of office space in Los Angeles.  Rockefeller Center in New York sold to Japanese investors, Sony bought Columbia Pictures for double what the company was worth at the start of the year. 

Kent Oliver:  Back in Japan, real estate prices were soaring as well.  Land prices in Tokyo reportedly increased by more than 50% in 1987, then another 22% in 1988.  Across the country, real estate prices had reached unimaginable heights.  Valuations in Tokyo’s highest-end real estate market topped out at a ridiculous $130,000 per square foot, more than 100x the cost of premium real estate in Manhattan. 

Jim Grenn: That blows my mindBut this can’t all be just from a strong yen and weak dollar.  I mean, I can see where currencies play a role in there but there has to be something else at play. 

Brady Raanes: Good point.  It’s far too simple to say that currency fluctuations were the only thing causing this massive real estate bubble, because the bubble was taking place in Japan too.  I mean, there is no reason that a weak dollar and a strong yen would make property values in Japan soar too.  The real culprit behind the bubble in both places was the Japanese banking system. 

Jim Grenn: Interesting.

Brady Raanes:  Let me tell you a little about the banking system in Japan at the time.  If you’re a bank in the US.  Your primary role is to take deposits and make loans.  When the bank accepts a deposit, they keep some amount of that deposit in reserves and you use that as the basis for making a loan.  The capital that the bank holds when you give them a deposit is invested in some kind of interest-bearing bonds.  Generally, something pretty conservative.  Highly rated, low return, etc.  If the banks want to make more loans, they have to get more deposits.  I realize that’s a dramatic oversimplification, but you get the idea. 

In Japan, the banks didn’t have to buy highly rated boring bonds.  They could use the deposits they received to buy stocks.  As stocks went up in value, which, by the way, they tripled in the 1980s the banks could loan more and more money.

Jim Grenn: Interesting.  So soaring stock prices allowed the banks to be able loan more?

Brady Raanes:  Yes, the increasing stock market was literally creating available credit inside the banks, and it feeding into this bubble cycle.

Jim Grenn:  So, in the US, we have the Federal Reserve that dictates a lot of our monetary policy and has some say so in the available capital banks can lend…they have some control over the monetary supply and they can raise interest rates if things start getting overheated.  Does Japan have a similar system?

Brady Raanes:  Japan has a central bank that does something similar aptly called the Bank of Japan.  They basically do all the same stuff as the Federal Reserve, but they went one step farther in the 1980s.  Stay with me here, because this is pretty important.  Japanese banks operated under a system known as ‘window guidance’ in which, unofficially, banks made lending decisions based on ‘recommendations’ from Japan’s central bank: the Bank of Japan (BOJ).  The guidance was reportedly so detailed that it gave specific loan quotas for each sectors of the economy as well as specific quotas for increasing lending. 

Jim Grenn:  So, the bank of Japan was pulling the strings in determining which industries received loans.

Kent Oliver:  Yeah, and the prescriptive approach worked beautifully for years, effectively creating an even distribution of economic growth.  That’s really a lot of the reason that Japan was able was able to grow so quickly and make such progress. 

Brady Raanes: You see, Japan doesn’t rely on a corporate bond market the same way we do in the US.  Japanese companies didn’t regularly issue bonds to raise money, they borrowed money from banks the same way you and I do.  Japanese companies wishing to expand in the 1980s were effectively at the mercy of the banks. 

Kent Oliver: Furthermore, this ‘window guidance’ removed much of the burden of detailed credit analysis from the Japanese banks when analyzing potential borrowers.  They just pretty much followed the lead of the Bank of Japan.  A lender there basically had the easiest job on the planet.

Brady Raanes:  That’s right.  Strangely, and inexplicably, however, despite the boom times of the late 1980s, the Bank of Japan continued setting remarkably high growth quotas for bank lending.  In time, as the economy expended, fewer productive projects could be found.  As such, lending shifted into less productive lending such as real estate speculation.  Regardless, bankers continued to increase lending to meet growth quotas.

Jim Grenn: let me try and summarize that for our listeners.  (pause) Stocks in Japan are rising, partially from Japanese innovation and partially from a weak yen.  As stocks go up Japanese banks are able to make more loans. Meanwhile, the Bank of Japan keeps cheering them on; telling them to make more loans.

Brady Raanes: Bingo! 

Kent Oliver: So, this madness goes on for a while and things start getting crazier.  In the fall of 1990, at the peak of Japanese speculation, a Japanese investment group bought the Pebble Beach Golf Course. 

Kent Oliver: If you know anything about golf, you know Pebble Beach.  Pebble Beach provides sprawling 180-degree views of the ocean and is widely known as one of the more challenging courses in the country.  In addition to the golf course, the Pebble Beach property consists of two hotels and hundreds of acres on the Monterey Peninsula.

Jim Grenn:  The course is still open to the public, too, yes?

Kent Oliver:  Yeah, that one of the most unique things about Pebble Beach.  It’s one of the few world-class golf courses that has remained open to the public since it’s opening in 1919.   And that’s one of the first things the new owners wanted to change.  These Japanese investors buy Pebble Beach and announce that they are going to make the course private.  People freak out.  The Japanese investors announce that they are going to sell memberships for two hours of preferred tee times each day for life for the price of $150,000.

Brady Raanes:   Shortly before the Pebble Beach purchase, a new president is appointed at the Bank of Japan.  I won’t attempt to pronounce his name, but the new guy is concerned that the Japanese economy was overheating from the soaring real estate prices and unsustainable debt loads.  Housing affordability in large cities is ridiculous at this point.  Housing prices are like 15x the average income. So, finally, the central bank decided to take action.  They increase interest rates and make the surprising decision to cease the practice of ‘window guidance’ altogether and allow banks to decide for themselves which borrowers were worthy of loans.  And almost overnight credit markets freeze.

Jim Grenn: and the bubble pops.

Brady Raanes:  yeah, and it was one hell of a bubble. The total Japanese purchases in America up that point came to more than $100 billion of prime property and key business assets.

Kent Oliver: At about the same time, the US economy begins to slow down a bit.

Jim Grenn:  what year is this? 

Brady Raanes: early 1990s.  1991-1992-time frame.

Kent Oliver: Rental rates begin to decline.  By 1992, the Rockefeller Center was bleeding nearly $50 million a year in cash. In LA the scene is far worse… Japanese investors owned roughly 45% of all premium commercial square footage.  Losses mounted as property prices plummeted.

Brady Raanes: Sony Corporation too, was experiencing large losses after purchasing Columbia Pictures for a dramatic premium.  Escalating costs and box office flops began to take their toll on Sony’s movie business. In November 1994, Sony announced a writeoff of nearly $3 billion dollars from its Columbia investment. 

Kent Oliver: The property slump was impacting American real estate moguls as well.  In an ironic twist, some guy named Donald Trump was forced to file chapter 11 bankruptcies on four separate properties including the Plaza hotel, the meeting place for the Plaza Accord; the agreement that played a pivotal role in fueling the real estate problems.

Jim Grenn: What’s going on with real estate prices in Japan?

Kent Oliver: Real estate prices were weak in America, but in Japan they were falling off a clip at an epic rate.  For many corporations, the business strategy turned from speculation and greed to sheer survival as they scrambled to pay down debt with any free cash flow to avoid bankruptcy. 

Brady Raanes:  Japan’s situation was somewhat similar to what occurred in the US in the 1930s.  As stock values and real estate prices collapsed in the early years of the Great Depression, corporations turned their focus from ‘growing’ to simply ‘surviving’.  Individuals and corporations stopped borrowing, stopped spending, and began hoarding cash to repay debt.   Defaults mounted as companies went bankrupt.   

Now Japan was experiencing a similar problem.  Stock prices in Japan plummeted 60% during the summer of 1992 as economic growth came to a halt. 

Jim Grenn: which, in turn, would also really impact the bank’s ability to make loans. 

Brady Raanes: That’s right.  The crossholding ownership added an extra layer of risk to the bank’s balance sheet.  By 1990, Japanese financial institutions owned more than 40% of all outstanding stock in Japan.    

Jim Green: good lord. 

Brady Raanes: The collapse in prices erased trillions of yen from the bank’s balance sheet, effectively reducing the amount of money available to loan in the process.  Japanese policy makers watched as the supply of yen in circulation fell by nearly a third.

Jim Grenn: so what does the Bank of Japan do?

Kent Oliver: The Bank of Japan opted to decrease interest rates to try and incentivize borrowing again, but the response was muted.  So they lowered interest rates again.  Nothing.  Companies refused to borrow more so Japanese officials decided to increase government spending in hopes of buoying the economy through the rough patch. 

The Ministry of Finance began pumping money into the stock market in hopes of boosting prices, so much so that they accounted for one-third of all stock transactions in the spring of 1993. 

Jim Grenn: Interesting, so, how are the banks holding up in Japan?

Kent Oliver: horrible.  Official reports of non-performing loans at Japanese banks were found to be $425 billion.  Behind closed doors, the real estimate was believed to be closer to $1 trillion. 

Brady Raanes: Less than a decade earlier, Japanese bankers had appeared to be the best and brightest in the world.  Japan boasted the largest 10 banks in the world in at the end of the 1980s.  but the banking system was in shambles.   Eight years after the real estate meltdown, delinquent and worthless loans still accounted for more than 25% of the entire economy. 

Jim Grenn:  that’s insane.  So, what did Japan do to get their economy back on track? 

Brady Raanes: I’m not sure they really have yet, but they tried all sorts of stuff.  The Bank of Japan began pumping money back into the economy with bond purchases in a program called “quantitative easing” much like what tried about 2008.  They also adopted a zero-interest-rate policy in the spring of 1999 as a last-ditch effort to stimulate the economy. 

Kent Oliver: Four years later, in the spring of 2003 the Japanese stock market index, the Nikkei 225, was still down more than 75% from its peak 13 years earlier.  The Bank of Japan had tried everything along the way, but the economy hadn’t responded.

Jim Grenn: That’s all so eerily similar to what happened in the US after our banking fiasco in 2008.  There was a lot of fear that we were heading off a cliff with massive bank losses and an economy that couldn’t seem to get going.  But ultimately, our policies worked better.  Our stimulus package, most economists would argue, worked pretty well.  But apparently that wasn’t the case in Japan.  It’s crazy to think that the second largest economy in the world could experience a collapse like that. 

Brady Raanes: Yeah, it’s kind of sobering.  Japan struggled through almost two decades of deflation and a shrinking economy following the meltdown.  Japanese total government debt stood at 67% of the total size of the economy in 1990 when the deflationary spiral began.  By 2015, the debt load had ballooned to 250%; larger than any developed country in recorded history.  Really, only one thing keeping the debt burden from crushing the country: low interest rates. 

Jim Grenn: yeah, I’ve read about all of Japan’s recent efforts to kick start growth and inflation, but they seem to be having a hard time.  What’s the next steps at this point?

Kent Oliver: I’m afraid they are fighting a losing battle.

Brady Raanes: me too. Forty years ago, Japan’s population was young and well educated.  Demographics played a huge role in Japan’s success.  For instance, in the 1950s, there were 11 working age people for every one person over age 65.  By 2013 the ratio was down to 2.5 working age people for every person over age 65.  Even on an absolute level, Japan’s work force was actually shrinking.  The population was aging so dramatically, that the death rate surpassed the birth rate.  The total population was declining each year, making overall economic growth much more of a challenge regardless of the amount of stimulus. 

Jim Grenn: So, Japan doesn’t look like they are going to overtake the US anytime soon.

Brady Raanes: It doesn’t appear so.

Kent Oliver: Yeah, I agree. The Japan boom and bust is a really interesting example of what can happen when an economy relies on excessive credit growth.  Which is the real story behind Japan’s rise and fall and the reason that Japan didn’t claim their spot as the world’s most prominent economy as so many predicted.   

Jim Grenn: fascinating.  That hotel – the Grand Hyatt Wailea?  The $650 million-dollar behemoth?  Yeah… it sold in 1998 for 263 million dollars.  By the way, you can still go to it if you like.  Though it was one of the gaudy outliers of Japan’s losses, the same story could be told for billions of more dollars of countless business deals -- a lesson to be learned from excessive credit growth - perhaps a good lesson for policy makers today.