Killing zombies isn't typically the responsibility of America's president or treasury secretary. But if the country is going to get through the current financial crisis, President-elect Barack Obama and his economic team better get out their shotguns and aim for the head.
Today, our economy is plagued by struggling markets, liquidity concerns, and frozen credit. Twenty years ago, Japan faced nearly the exact same problems. Then they fell prey to the zombies.
After Japan's asset bubble burst in the late 1980s, their economy took a sharp downturn, prompting government officials to try bailing out banks and investing in infrastructure, much like the activity and proposals floating around America today. The results were terrible.
With the government propping up poor business models rather than allowing further job losses, firms wound up operating over the long-term without making a profit or adding any value to society. Their utter lack of vitality earned these perpetual money-leaching entities the moniker "zombie businesses." And unless American policymakers understand the failures of the Japanese response, we will suffer the same zombie fate.
Remember that the Japanese asset bubble and the American housing bubble have eerily similar origins. Both were driven by aggressive behavior in financial institutions. Wall Street, which sought new ways to get quality returns on investments, turned to securitizing everything it could and issuing unwise subprime mortgages—all highly valued by the rating agencies, and all highly misunderstood. The Japanese aggressively pursued real property assets to the point where the inflated values were unsustainable.
In both cases, the rapid rise in rates of return led to over confidence. In Japan, it is said that the market experienced a sense of euphoria, and poor investments were driven by excessively optimistic expectations of future economic development.
The Nikkei, Japan's stock index, rose from 18,000 in 1986 to an intraday high of 38,975 by the end of 1989. Similarly in the U.S., the Dow Jones went from 7,591 in July 2002 to an intraday high of 14,115 five years later.
These large growth trends led to inadequate risk management, over-leveraged investments, and depleted capital reserves. In both bubbles, loans were given out like candy, often times to people that the banks knew were high risk.
Government practices during both bubbles share many unfortunate similarities as well. In Japan, increased capital requirements caused many firms to struggle when their assets started to depreciate. Similarly, the inflexible mark-to-market regulations in America forced firms to raise capital quickly, sometimes driving them towards bankruptcy.
In America, Federal Housing Administration policies encouraged the expansion of subprime mortgages, particularly through Fannie Mae and Freddie Mac. The idea was to expand homeownership for low-income families, though the increased demand drove housing up until the market was eventually oversaturated. Japanese regulatory policies and tax codes also caused land prices to unnaturally rise until they ultimately burst.
Given these similarities, U.S. officials should take a careful look at how Japan's response to the crisis lead to the more than ten years of recession and stagnation known as "the lost decade." We do not want to duplicate Japan's mistakes.
First mistake. The Bank of Japan tried to ease economic pains during their downturn through the 1990s by loaning large amounts of money to businesses. However, such attempts to recapitalize the market were counteracted by underlying management problems endemic to the dying firms.
According to Shigenori Shiratsuka, Deputy Director and Senior Economist at the Bank of Japan, even though firms became unprofitable, the government still encouraged lending to them to prevent losses from materializing. There were heavy concerns about a failing firm increasing unemployment.
The intense lobbying from special interest groups representing various sectors of the Japanese economy further perpetuated these ill-fated loans, funneling additional funds to zombie businesses. As Shiratsuka notes, "under such circumstances, loans to unprofitable firms become fixed and funds are not channeled to growing firms, holding down economic activity."
Unfortunately, we're seeing a disturbingly similar trend in America today, as the cost of bailing out AIG continues to rise and Congress moves forward with a bailout for the auto industry. The $8.4 trillion (and growing) cost of "saving" firms deemed too big to fail completely ignores the inefficiency and poor quality of the very businesses the government is trying to save.