Lessons from Japan for the US financial crisis

[Originally posted, with full hyperlinks, at http://eastasiaforum.org/author/lukenottage/]
Many commentators are belatedly pointing out parallels between the financial markets boom and bust cycle in Japan over the 1980s and 1990s, and that now afflicting the US. However, especially when it comes to solutions for the US and hence the world economy, things are not quite as simple as envisaged by Japan’s then financial services minister, Yoshimi Watanabe, who proclaimed in March: “The US should follow Japan’s example and tackle its sub-prime loan problem using public money. The situation is exactly like what Japan saw 10 years ago”.

Significant parallels clearly do exist between Japan then and the US now. Gillian Tett emphasizes a real estate bubble followed by initial denial by the government, then a hefty bailout – although pointing out that the final taxpayer bill turned out much less than the 60 trillion yen (US$567b) yen earmarked because some of the Japanese government funds were recouped. Kwan Weng Kin, Japan correspondent for the Straits Times, agrees that a common root cause was easy monetary policies, but that Bernanke (then an economist at Princeton, now head of the US Federal Reserve Bank) had also sharply criticised Japan’s central bank for failing to lower interest rates in the early 1990s, after the collapse of share and real estate markets. Kwan also points out that it took Japan six years from the collapse to inject some public funds and then until 2002 (led by Koizumi and Takenaka) to force Japan’s banks to accept more funds to write off bad debts, amounting by then to 43 trillion yen. Yet the former Tokyo bureau chief for Forbes draws parallels between the grand rescue plans periodically announced by the Japanese government over the 1990s and those proclaimed by the US since the subprime mortgage market collapse last year: “Stock markets dutifully took off, only to fall back within days as reality sank in and investors realized the real estate collapse continued unabated, along with the unfolding carnage”.
Hugh Cortazzi, a frequent commentator in Japan since serving as British ambassador to Japan from 1980 to 1984, also notes that “the basic lesson that asset prices do matter was not learned”. Among some important differences, he points out that the main problem in the US (and the UK) has been overlending to individuals with their homes as collateral, whereas in Japan it was secured overlending to companies (although Japan also had its jusen home mortgage debacle over the early-mid 1990s). Cortazzi also emphasizes how lenders in the US, in particular, had “packaged their loans and sold them in ways that disguised the true risks involved” (eg through securitisation), and that bankers failed to assess such risks. He believes “the remedies adopted by the US, where investors have suffered severe losses while mortgage lenders have been saved by the taxpayer, will inevitably discourage investment in financial institutions that remain”, and that there are likely to be further property price declines and re-regulation of financial markets.
However, just as occurred during Japan’s financial crisis in the late 1990s, economists are starting to come up with considerable variations on these main themes. On the causes of the US asset bubble and its collapse, Berkeley’s Barry Eichengreen also points to deregulation of commissions to stockbrokers in the 1970s, and removal of the 1933 Glass-Steagall Act’s restrictions on mixing commercial and investment banking in 1999. Unintended consequences followed from these arguably sensible policy decisions (both, incidentally, a major part of Japan’s “Big Bang” financial markets deregulation in the late 1990s). They eroded investment banks’ traditional profits, encouraging them to branch into riskier businesses (such as originating derivative securities) and to pursue higher returns through higher leverage, outside the purview of banking regulators. Eichengreen also highlights the Bush administration’s decision to cut taxes, and the Fed’s cut in interest rates in response to the 2001 recession. This boosted US spending and reduced savings, matched by inflows particularly from China into US treasury bonds but also the government-backed mortgage lenders, Fannie Mae and Freddie Mac. This fed the securitisation machine, as well as propping up the dollar and reducing the cost of borrowing for US households. Eichengreen expects the bloated US financial sector to retrench considerably, with US households being forced to save more, reducing the US current-account deficit and the Asian surplus.
As for concrete measures to get to a more balanced situation both within the US and globally, many economists were critical of the proposal by US Treasury Secretary Henry Paulson (supported by Bernanke) to commit $700b to buy up troubled assets, mainly the mortgage-backed securities. Martin Wolf believes it fails to address massive increases in US household, financial sector and aggregate debt levels in the US between 1980 and 2007. This system is now threatened by fears of mass insolvency, not just the illiquidity of some assets, which can result in the “debt deflation” described by Irving Fisher in 1933 and experienced by Japan over the 1990s (see also discussions at www.ft.com/wolfforum).
Paul Krugman basically agrees. Paulson’s “Trash for Cash” might indeed break the vicious circle whereby financial institutions selling assets in turn drives their prices down even further. But even so, the financial system will remain undercapitalized, following the losses caused by the collapse of the asset bubble, unless the government (at taxpayers’ expense) hugely overpays for the distressed assets. Krugman therefore urges instead recapitalization by the government in return for ownership of the bad financial institutions themselves, as happened earlier in September with Freddie and Fannie (now sometimes referred to as “Fraudie” and “Phoney”!).
William Isaac, former chairman of the Federal Deposit Insurance Corp, proposed revisiting a FDIC scheme from the 1980s that helped struggling Savings and Loan assocations by issuing them promissory notes to shore up their capital base, so they could resume lending to worthy borrowers. Paulson himself now seems to have endorsed banks selling distressed assets to give some sort of equity warrant to the government, so taxpayers can share in any profits. And last Thursday, House Republicans proposed that the government sell insurance policies to struggling banks to help shore up their distressed assets, along the lines of a paper by Laurence Kotlikoff and Perry Mehrling (”Will the $700 Billion Bailout Turn A Profit for Taxpayers?”, The Japan Times, 30 September 2008, p 11). The final deal struck between the Bush Administration and the US legislature on Monday, likely to be finalised tomorrow, apparently allows – but does not require, the government to insure some assets rather to buy them (”US House Girds for Bailout Vote”, ibid, pp 1 and 11).
Other economists had proposed various alternatives. Government exposure can be reduced by lending to distressed firms, with their assets as collateral. Or the government can purchase only the better assets, like a hedge fund. Or it can find ways to reduce the amount of debt owed by struggling homeowners, for example by working to restructure the underlying loans. A precedent for the latter comes from a Depression-era institution, the Home Owners Loan Corporation. Bush had already signed a Bill, taking effect from 1 October, that aims to prevent foreclosures by allowing an estimated 400,000 homeowners to swap their mortgages for more affordable loans, but only if their lender agrees to take a loss on the initial loan.
But a more comprehensive solution should include re-regulation of the marketing and contract terms used by consumer credit suppliers, who have increasingly taken advantage of borrowers’ behavioural biases and other characteristics of this field. Requirements for more responsible lending – in home mortgages, but also credit card lending (also in Australia) and cash advances (also in Japan) – would reduce risks of default, as well as incentives for financiers to avoid whatever new regime is introduced to regulate how they raise funds for lending to consumers. This therefore constitutes a complementary “demand-side” measure to address another root cause of the current debacle in the US, which should also be useful for other countries in our region struggling with rising consumer over-indebtedness. Free market advocates may complain about the possible costs of such further re-regulation, but they pale into insignificance compared to the trillions of dollars incurred directly or indirectly in clearing up contemporary financial crises. Government attempts to staunch such crises over the last three decades have cost 16% of GDP, according to a recent IMF Working Paper. Yet prevention is usually better than cure.

Author: Luke Nottage

Prof Luke Nottage (BCA, LLB, PhD VUW, LLM LLD Kyoto) is founding co-director of the Australian Network for Japanese Law (ANJeL), Associate Director (Japan) of the Centre for Asian and Pacific Law at the University of Sydney (CAPLUS), and Professor of Comparative and Transnational Business Law at Sydney Law School. He specialises in international dispute resolution, foreign investment law, contract and consumer (product safety) law.