Fed Playbook Looks Familiar to Japan

As the Federal Reserve seeks to stimulate markets low on credit with liquidity from U.S. Treasuries, some investors in Asia say that monetary policy committee's Chairman Ben Bernanke is shaping the U.S. in the image of its closest ally in the region: Japan.

The theory, which has gained popularity over the past week, originated in a trading note that has been passed around dealing floors in Hong Kong and Japan. The note, titled "Is Bernanke making the same mistake as Japan?," was issued last Wednesday by Gavin Parry, a director of Hong Kong-based Helmsman Global Trading, a Japanese and Asian trading specialist for U.S.-based hedge funds. So far, it has inspired broad appeal.

"While we are happy to admit we are intellectual minnows compared to the resources available at the Fed, we do fear that the Fed is allowing the markets to dictate monetary policy," Parry explains in the note.

"There are two basic options in front of the Fed," goes the argument. The first is "a quick cleansing of the system," such as dramatic interest rate cuts and subsidies to bail out the financial markets. The downside, Parry argues, would have dramatic social consequences however, such as high unemployment and consumer price inflation.

"Alternatively the Fed can copy the Japanese strategy and put everything on life support and spread the pain over a longer period," writes Parry. This, some argue, is exactly the strategy that Bernanke is pursuing now, which raises the question of whether America will one day begin to look like Japan.

In the early 1990s a crushing financial crisis spread throughout Japan. To date, the country's leading index, the Nikkei, has yet to reach half of its December 1989 high, when it closed at 38,916. Unemployment remains stifling and wages low as exporters continue to depend heavily on the volatile national currency, the yen. (On Tuesday, the Nikkei closed at 12,658.28).

"I think [Parry] is on the right lines," says Andrew Clarke, a trader for Societe Generale in Hong Kong. "[Former Fed chief Alan] Greenspan was the man who let most of this happen and got out while the going was good."

Mark Mobius, who manages $45 billion for Franklin Templeton Investments in Singapore, says there is "definitely a stagflation danger" in the U.S. going forward. Still, he adds that Bernanke has little choice but to act cautiously in stimulating financial markets. The crux of Bernanke's woes is in stimulating lending while challenging inflation and a potential recessionary environment, says Mobius.

"In Japan what happened was that the banks didn't act fast enough and then tried to catch up," says Mobius.

That is the same type of scenario U.S. banks are facing now, according to Bill Prophet, head of fixed income sales for UBS in Tokyo. In a trading note issued Friday, he describes how despite falling home sales and widening credit spreads, the fixed income desk is asked to create a market for between $2 billion and $3 billion of new mortgages a day. The scenario turned substantially worse last Thursday, when Carlyle Capital wasn't able to meet some of the margin calls it received and got a default notice.

The worry is that longer-term damage to what amounts to a highly liquid, $3 billion-a-day market for the U.S. banking system may now be unavoidable.

The recent discussion is especially prescient in light of the Fed's move Tuesday to supply $200 billion in liquidity to markets by exchanging very liquid Treasuries for illiquid mortgage-backed securities.

Still, not everyone agrees that the U.S. is headed down the Japanese route. Those who argue against it point to the enormity of the Japanese bubble, when the three square kilometers of the Imperial Palace in Tokyo was worth more than all the real estate in California combined. It's only natural that prices fell by over 90%, they argue.