U.S. Federal Reserve Chairman Ben S. Bernanke and Congress agreed Friday that the financial system – not the American taxpayer – should bear the costs of bank bailouts. Sheila Bair, head of the Federal Deposit Insurance Corp. (FDIC), wants the banks to ante up $45 billion – three years’ worth of deposit-insurance premiums – to bail out the fund that insures bank deposits.

When it comes to bank stocks, we all know that there were a number of Money Morning readers shrewd enough to buy Citigroup Inc. (NYSE: C) shares when the foundering giant’s stock price was below $1 a share.

If you’re one of those investors, good for you: With Citi’s shares now trading at nearly $4.70 a share, that shrewdness – or courage – has been amply rewarded.

But the question we have to ask at this point is: Why would anyone buy banks stocks right now?

Bailouts Revisited

When the Bush administration bailed out the banks last autumn, I opposed the bailout. But I understood the rationale for it. The Lehman Brothers Holdings Inc. (OTC: LEHMQ) bankruptcy had clearly done a lot of damage to market confidence. Thus, a series of high-profile failures – however well merited – could push the market into a behavioral funk that might take years to emerge from.

After all, as we were incessantly reminded, the banks were all intimately inter-connected – not in the least by the diabolical credit-default-swap market. So a big failure could trigger a mass-market meltdown.

That justified the immediate bailout back then. But it did not justify the continued existence of those banks and other financial institutions – especially Citi, Bank of America Corp. (NYSE: BAC) and insurance giant American International Group Inc. (NYSE: AIG) – a year after the bailout.

Even if there was an argument for preventing the immediate meltdown of those companies – to prevent panic – there was no good argument for allowing them to continue in business as zombies, distorting the market forever after. An orderly liquidation was what was really needed.

But if the plans called for these three bad actors to be liquidated, it should surely be happening by now. Two of the three have even kept their top management for the intervening year. The exception has been BofA, where Chief Executive Officer Ken Lewis is now being shoved – kicking and screaming – toward the exit. (However, I have no doubt he’ll end up being well rewarded for the indignity).

Japan’s ‘Lost Decade’

Economically, keeping banks and other companies alive after they should be dead is the mistake Japan made back in the 1990s. After Japan’s massive stock market meltdown, most of the banks were technically insolvent. A decline in the value of the stocks the banks held had gnawed away their capital, while their assets were shredded by the collapse in the value of their real-estate loans.

Despite this, Japan opted to prop up many insolvent companies, which kept the country’s entire banking system on life support until 1998 – hence the “Lost Decade” of financial legend. And a true resolution of the problem did not come until it was forced by Prime Minister Junichiro Koizumi in 2003. The result was more than a decade of economic stagnation and a mountain of public debt that actually exceeded 200% of gross domestic product (GDP).

For the banks themselves, the fallout can be even worse.

An ‘Artificial’ Market

At first blush, the profits of the last few months look pretty good. And the record bonuses being threatened on Wall Street suggest that all is fine. However, there are two problems. First, bank earnings have been propped up by an extraordinarily bank-friendly monetary policy, keeping short-term interest rates at close to zero and buying up more than $1.5 trillion of bad bank loans from the markets.

That simply can’t last. If it does, we’ll end up with a bad case of hyperinflation.

As for the bonuses, does anybody think that if Citi had gone bust, and ex-Citibankers were now selling apples on the street corners of New York, bonuses would be zooming so high?

If the market for overpaid bankers had been allowed to clear properly, they would no longer be overpaid.

If the Japan’s Nomura Securities (NYSE ADR: NMR) wanted to double its U.S. staff, as it announced Monday (an extraordinarily shareholder-hostile decision, given Nomura’s lousy U.S. track record), it could just lean out of its office and whistle, and a parade of ex-Citibankers, ex-AIG executives and ex-BofA execs would rush in, begging for scraps.

It appears that the concerns that Soros expressed are well justified.

A Grim Reaping For Bank Investors

Since there are more competitors in the market than there should be, once the Fed’s over-generous monetary policy is corrected, there will be too much competition, so bank profits will be squeezed. Conversely, there will be too many jobs in the industry, so banker pay scales will be artificially propped up.

If that’s a recipe for good shareholder returns, I’m a Dutchman.

There’s more. The populist fury against the banking system doesn’t look like it’s doing much about banker pay. However, it will almost certainly result in special extra taxes being levied on surviving banks, to pay for the bailouts.

The costs of those taxes will be passed through to shareholders, because competition from all the zombies that are still in business will prevent banker pay from being squeezed much. The extra levies that Bair, the FDIC chief, is employing to keep the deposit-insurance fund solvent also will fall on banks, although in this case it will be the small and medium-sized that will suffer the worst.

Squeezed profits, expensive staff, extra taxes and special FDIC levies – it doesn’t look to me as if there will be much left for bank shareholders.

Expect 2010 to be a grim year for them.

Source: Hidden Traps Make Bank Stocks a Bad Deal

Japan’s exports for February were down a shocking 49.4% on a year-over-year basis. The Japanese economy suffered a fourth-quarter decline of 3.2% – twice the decline of its U.S. counterpart – and is expected to drop by a similar amount during the current quarter.

What went wrong? And, for us investors, are the low current prices of Japanese stocks a buying opportunity or a trap?

Partly because of its efficiency and my fondness for sushi, I have always been inclined to favor Japan and Japanese investments. In 1989, it was obvious that the market was overvalued and I said so – in the process alienating several of my friends who thought they had found safe career niches managing investment funds investing in Japan.

In the 1990s, it was obvious that whatever Japanese governments were doing didn’t work, so I welcomed the 2001 arrival of Junichiro Koizumi as prime minister, and from there wrote frequently about Japan’s growth prospects – until last year.

Until August last year, it looked as though I would be right in the long run, even if the Japanese stock market tended to droop. Since September, however, it has all gone wrong; Japan’s economic performance has gone from adequate to truly dreadful.

Pinpointing the date enables us to pinpoint the reason. In September, Japanese Prime Minister Yasuo Fukuda, who had supported Koizumi’s policy of public-spending restraint, resigned and was succeeded by Taro Aso, still of the long-governing Liberal Democrat Party (but from its opposing faction). Aso is an enthusiastic proponent of “stimulus” public spending programs, particularly on public works in rural constituencies. That’s the policy that notably failed to conquer recessionary conditions in the 1990s, leaving Japan with a public debt equal to 160% of gross domestic product (GDP).

Aso has already proposed four stimulus programs, raising Japan’s budget deficit from 3% of GDP in 2007-2008 to an estimated 11% of GDP in 2009-10. The public debt/GDP ratio is rocketing upwards, because of public borrowing and the decline in GDP. Interest rates, which had been rising gently towards normal levels in 2006-08 (though short-term rates had only reached 0.5%), have been reduced to zero again and the Bank of Japan (BOJ) has begun “quantitative easing” – buying up government debt.

Currently, there’s a general agreement among Western politicians that these are the policies to follow. So why haven’t they worked in Japan?

At this point, the London merchant banker in me is irresistibly tempted to snarl: “Because they don’t (expletive-deleted) work in general.”

My own preference is for balanced budgets, low public spending and high interest rates – you may not get much economic growth with those policies, but what you get you’ve earned – without burdening your grandchildren. Even now, some countries – such as Brazil – are following those policies, and doing quite well.

Setting aside the question of whether stimulative policies work in general – within a year or so we shall have tested them exhaustively in the United States and most of the western world – I do think there may be reasons why they work particularly badly in Japan. Japan has traditionally had very high savings rates; it still has a limited Social Security system and an aging population. Low interest rates may well therefore damage demand from consumers living off savings more than they boost demand by helping companies and other borrowers. While low interest rates boost exporting companies, that boost may simply raise the yen exchange rate to a level at which in a recession exports fall catastrophically.

As for budget deficits of 11% of GDP, if you already have a public debt in excess of 160% of GDP, you may well be at the point at which the extra debt and the uncertainty about how you are going to pay it all back eliminate any boost to demand that the budget deficits would normally bring.

It is thus clear that Aso’s policies will work less well in Japan than they would elsewhere. Indeed, they may make matters worse in Japan, even if they would be effective in some other countries.

Japanese voters will have a chance to choose something different at a Diet election due in September or before. The bad news is that, while the opposition Democratic Party of Japan is theoretically pro-market, its leader, Ichiro Ozawa, in practice is a former LDP stalwart, of the faction founded by 1970s’ kingpin Kakuei Tanaka that favored heavy public spending.

Furthermore, many of Ozawa’s supporters, from the former Social Democrat party, also favor heavy public spending, albeit on different things than the LDP barons. In other words, an Ozawa victory may not bring much of a policy change, at least on economics. What’s more, Ozawa himself has now been caught up in a campaign-fund scandal, so even though Aso’s popularity ratings are down to around 10%, the LDP still may win – which would boost Aso at the expense of the free-market Koizumi supporters.

The bottom line: In the election this year, if the Japanese people want the economic policies that seem to work, they will have to be damn clever about it. There are many supporters of free-market policies in both the LDP and the DPJ, but they are not currently represented among the leadership of either party.

Japan remains a country in which everything works beautifully – except the politics. But the country is still worth keeping an eye on, though, because if the politics change, the potential from a Japan with higher interest rates and lower public spending is absolutely gigantic.

Source:  Investing in Japan: Lots of Potential, Little Growth

That doesn’t sound much to get excited about, until you consider how well the Chinese and Japanese economies fit together.

Think of it this way: With China’s boundless supply of low-cost labor and Japan’s superb education system – and an ability to work together that’s clearly founded on considerable commonality of thinking – these two countries, as a pair, will be world-beaters.

In fact, they’ll be world leaders.

The Past has Passed

The summit – while modest – marked an important policy change from the mutual hostility during the premiership of Junichiro Koizumi, whose tilt to the United States and suspicion of Chinese motivations was symptomized by his love of Elvis Presley and visits to the Yasukuni Shrine, controversial because it includes convicted World War II criminals. Nevertheless, while Japan and China have many historical reasons to hate one another, so did France and Germany after World War II, and those countries have now been partners for more than 50 years in the European Union. Thus, a close economic partnership between Japan and China is by no means unthinkable.

Economically, China and Japan have much to offer each other. Both have shortages of raw materials and strong manufacturing sectors. However, the relative shortage of labor in Japan’s aging society, its superb education system and the surplus of labor in China all combine to make them natural partners. Already, Japan is China’s second-largest trading partner, taking 10% of its exports and supplying 15% of its imports. Conversely, China in 2007 surpassed the United States as Japan’s largest trading partner, taking 14% of its exports and supplying 21% of its imports.

Between them, China and Japan have a population of 1.4 billion people, more than twice that of the European Union or the North American Free Trade Association. Their combined gross domestic product (GDP) of $8.4 trillion at market exchange rates in 2007 was about half that of the EU or NAFTA, but was combined with growth of 7% in 2007, a current account surplus of $560 billion (compared with deficits in the EU and the United States) and foreign exchange reserves of $2.4 trillion.

Thus, even a loose bilateral trade association between China and Japan would be a powerful economic force. Free trade and free movement of labor between the two countries would enable them to deepen their economic relationship still further, making the Japan-China trade axis the most important in the world – even more so than any bilateral U.S. relationship. Longer-term, an EU-style economic union – perhaps including such neighbors as Korea, Taiwan and Vietnam – could become the world’s leading economic power, surpassing even the United States and the EU itself.

As a U.S. geo-strategist, one worries somewhat about this. The United States has traditionally been able to count on Japan as a counterweight, both economically, and to a limited extent, militarily against a resurgent and aggressive China. That no longer seems to be so certain; an immensely powerful alliance between Japan and China might develop into the United States’ military equal, and would certainly be animated by a world view very different from that of the United States or, indeed, the EU countries.

As an investor, one rejoices in it and seeks to find sources of future profit from the two countries’ deepening relationship. One such source of profits are major Japanese companies such as Toshiba Corp. (PINK: TOSBF). This major manufacturer of computers, medical electronic equipment and telecommunications systems has developed a highly integrated manufacturing capability in China, enabling it to synergize its technical innovation with China’s highly skilled, low-cost workforce. Toshiba’s shares are trading at about 22 times earnings, reasonable for a high-tech company.

Another might be a Chinese automotive manufacturer such as Brilliance China Automotive Holdings (ADR: BCAHY), already a strong automobile and bus manufacturer in the Chinese domestic market, which has a joint venture with Bayerische Motoren Werke AG, better-known as BMW, and potentially can benefit from its lower labor costs to attack the Japanese market. As relations between China and Japan improve, and tariff and non-tariff barriers in Japan are reduced, companies such as Brilliance may be major beneficiaries. Brilliance China trades at a pricey 48 times earnings, as it has only recently returned to profitability in the highly competitive Chinese automotive market, but its long term prospects appear excellent.

There are two categories of beneficiaries from a trading relationship between China and Japan that’s closer and more-barrier free.

The first group consists chiefly of Japanese high-tech companies that are able to take advantage of China’s lower labor costs and more-profitably attack the world markets.

The second group consists of low-cost, China-based manufacturing companies that can sell to Japan as a particularly juicy nearby market with similar cultural and taste characteristics – unlike the unfamiliar west.

Both types of companies are likely to be big long-term winners from this trend.

[Editor’s Note: For additional China profit plays, check out this special offer by Money Morning that includes a free copy of investing guru Jim Rogers’ new bestseller, "A Bull in China." The book details Rogers’ investment outlook for China plus his opinion on dozens of China-based public companies.]

Source: Two Ways to Profit as China and Japan Quietly Forge the Most Powerful Trading Alliance in the World