Turning Japanese

Japan's post-bubble policies produced a "lost decade." So why is President Obama emulating them?

Anthony Randazzo, Michael Flynn & Adam B. Summers from the July 2009 issue

(Page 2 of 4)

Investment patterns suggest that most Americans thought rising stock values and AAA ratings on securitized mortgages were safe financial bets. This overconfidence led most major Wall Street firms to decrease their capital ratios, taking on more debt and decreasing the amount of cash on their balance sheets. By 2007 the investment bank Lehman Brothers was leveraged 30 to 1, meaning just a 3.3 percent decline in asset values would wipe out its capital—which is in fact what happened.

Stock market bubbles. In both the U.S. and Japan, the rapid rise in property values fueled gains in the stock markets. The Japanese stock index Nikkei 225 rose from 13,000 in 1986 to an intraday high of 38,975 by the end of 1989. But the implosion of the property market sent the index crashing. It had dropped to 15,025 by July 1992, and it continued a steady decline throughout the Lost Decade. By April 2003, the Nikkei had fallen to 7,603, less than 20 percent of its peak.

Similarly, the Dow Jones Industrial Average went from 7,489 in July 2002 to an intraday high of 14,115 in October 2007. After that high point, the market began a modest decline, reaching 10,850 on September 30, 2008, then plummeting to 7,552 by November 20. The Dow continued to fall over the ensuing months and closed at 6,547 on March 9. (It has since rallied to just over 8,000.) In the U.S. as in Japan, the quick run-up in stock valuations lured people to invest money they did not have. The result was inadequate risk management, over-leveraged investments, and fragile capital reserves. Investors did not adequately plan for any contingency other than continued high growth and largely ignored those who warned that such growth was not sustainable.

Monetary policy errors. Although private financial institutions played a key role in the booms and busts of both Japan and the U.S., monetary policy was a critical root cause. In both cases, the central bank helped set off a boom in asset prices by expanding credit and driving interest rates to artificially low levels. This encouraged individuals and businesses to take on debt they otherwise would not have accepted and make investments they otherwise would not have considered.

When a central bank inflates the money supply and drives interest rates below those that would exist in a free marketplace, it sends a false signal to businesses to borrow and invest more in capital projects and goods than they otherwise might. Similarly, consumers respond to the signal by taking on higher mortgage and/or credit card debt, saving less, and spending more. Credit binges cannot last forever; when interest rates increase again, the bad investments are revealed, and it becomes painfully clear that much of the outstanding credit cannot be paid back.

Between January 1986 and February 1987, the Bank of Japan cut its discount rate—the interest rate charged by the central bank on loans to its member banks—from 5 percent to 2.5 percent, leading to an increase in real estate and stock market prices. Realizing a bubble was forming, the central bank then raised rates five times in 1989 and 1990, to a high of 6 percent. This increase revealed that many investments were built on extensive, unsustainable debt. Stocks began their long and painful slide.

When a recession began to set in after the 1990 stock market crash, Japan responded by reversing its tight money policy, cutting rates to 4.5 percent in 1991, 3.25 percent in 1992, 1.75 percent from 1993 to 1994, 0.5 percent from 1995 to 2000, and as low as 0.1 percent in September 2001.

A similar pattern took place in the United States. From 2000 to 2002, the Federal Reserve slashed the target discount rate from 6 percent to 0.75 percent. Fearing irrational exuberance, to borrow Alan Greenspan’s famous phrase, the Fed then raised the rate as high as 6.25 percent in June 2006. But now that the bubble has burst and the economy contracted, the Fed has cut the discount rate 12 times, lowering it to the current 0.5 percent. Federal Reserve Chairman Ben Bernanke has repeatedly stated that he sees interest rate cuts as a way to “support growth and to provide adequate insurance against downside risks.”

In both the Japanese and the American cases, post-bubble policy makers believed that lowering interest rates would make credit easier to obtain, thus recreating the environment that had spurred economic growth to begin with. But this meant that the supposed cure for a bubble created by easy credit was to extend even more easy credit.

These rate cuts only perpetuated the distortion of economic decisions and prevented savings, investment, and consumption from realigning with true preferences, as opposed to the illusory ones created by easy credit and artificially low interest rates. The lesson is that when monetary policy is used to “smooth” or “tweak” the market, it inevitably causes unintended consequences that in some cases can be very damaging to long-term economic growth.

Regulatory Responsibility

The current American debate often falls into broad-brush discussions about whether the nation had “too much” or “too little” regulation. The real issue is how the existing regulatory order helped spawn the financial crisis. We see it doing so in at least a couple of areas:

Capital reserve requirements. In 1988 the Basel I Accord between the Group of 10—which then included the U.S., Switzerland, Japan, Germany, France, and the U.K., among others—set new capital requirements for banks around the world. But the requirements were focused on loan amounts and did not factor in a debt’s underlying risk. In other words, a loan to a sound borrower required the same percentage of capital to be set aside as an equal amount lent to a high-risk borrower. There was already a developing atmosphere of heavy lending and insensitivity to risk, but the Basel requirements rewarded firms for making loans to shaky borrowers because they could earn higher interest rates that way without having to set aside any more capital than they would for loans to safe borrowers.

The chief problem was not that the requirements were too low. It was that the rules created a false sense of security for investors and lenders. Banks were meeting their legal requirements, although it was never clear what kind of debt they were holding capital to cover. Without a standard or competing standards for transparently measuring the value and risks of portfolios, Basel I proved ineffective at preventing systemic rot.

In the United States, when firms calculated their reserve requirements, they were required until recently to mark many assets “to market,” i.e., value them at the price they could be sold for immediately. When asset values started falling, and categories of assets stopped trading, firms scrambled to find capital to shore up their shoddy-looking reserves. The collapse of the government-created mortgage behemoths Fannie Mae and Freddie Mac suddenly devalued mortgage-backed securities, and that meant banks holding large swaths of these assets had to come up with millions in cash overnight to meet their capital ratios. Many of the worst or most toxic mortgage-backed securities could not be sold immediately because their values were hard to determine. Under “mark to market” accounting rules, they were in effect worth nothing for the time being.

Comments

Fascitis Necrotizante|6.2.09 @ 7:10AM|#

Obama having turned Japanese.

Chad|6.2.09 @ 7:39AM|#

My first three cents:

1: Yes, we are going to experience something similar to Japan's lost decade. It is a direct consequence of our need to de-leverage and shift towards saving an appropriate fraction of our incomes. Nothing the government can or should do will prevent this.

2: Randazzo seems to fall deeply into the "The government did X, then Y happened to the economy, therefore X causes Y" mentality. This idea is almost always false, as changes made by governments are almost always tiny relative to the economy. In the short term and individually, no single policy will have a measurable effect, and in any case, you don't know what would have happened without the policy. For example, did Japanese infrastructure spending prevent the Lost Decade? Obviously not. But did it make it slightly less bad or slightly worse than it otherwise would have been? Only God knows. Odds are, it made it slightly less painful...and at least the Japanese have incredible bridges, dams, roads, and trains that will last generations rather than the junk we tend to blow our money on.

3: Long-term growth rates are going to be much lower than current projections. We should be budgeting for 1% growth, and considering anything else a bonus.

JLM|6.2.09 @ 8:11AM|#

I'm glad I get to read this online before I get my print copy. Wait, what?

|6.2.09 @ 8:23AM|#

Randazzo seems to fall deeply into the "The government did X, then Y happened to the economy, therefore X causes Y" mentality.

So if the economy does well, it isn't due to the Obamassiah's economic policies?

Xeones|6.2.09 @ 8:54AM|#

So why is President Barack Obama emulating it?

Because he really does believe that central authority drives all things. The man is a totalitarian, and to a totalitarian, having his hands all over an absolute ratfuck is better than sitting back and letting things stabilize on their own.

Also: hi, Chad! This one's not your best. Maybe you could have tried harder?

Chad|6.2.09 @ 9:00AM|#

So if the economy does well, it isn't due to the Obamassiah's economic policies?

Odds are, Obama's policies will make things slightly better than they otherwise would have been, perhaps 2-3% larger GDP. But we will never know, because we don't know what the GDP would have been with the status quo or any alternative policy choices.

People who claim that they can discern the impact of policies by looking what happens to the economy after they are adopted are just plain wrong. Unfortunately, that includes, well, just about everyone, because people can ALWAYS find a policy change they don't like that occured just before the bust, or a policy change that they did like that occured just before the boom. They can then use false causalities to harden their beliefs.

You will not find me making such claims. Instead, you will find me noting that our current economy is a function of a wide variety of factors, including hundreds of policy decisions made both here and abroad over many decades. The impacts of any recent policy changes are almost always minimal and lost in the noise.

As another point. The Democrats and Republicans are arguing over about 2% of the GDP, as the rest of government spending is pretty much agreed upon. Do you honestly think that wild fluctuations in the world economy rest upon what the government does with that tiny fraction of our economy?

Fascitis Necrotizante|6.2.09 @ 9:02AM|#

Chad just won't be happy until we're all doing cosplay while being tentacle raped on a bullet train. Deru kui wa utareru, says Hello Kitty via telescreen.

Spoonman|6.2.09 @ 9:10AM|#

This idea is almost always false, as changes made by governments are almost always tiny relative to the economy.

Um, government spending is what percentage of GDP this year again? That seems pretty huge relative to the economy.

|6.2.09 @ 9:21AM|#

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Chad|6.2.09 @ 9:35AM|#

Um, government spending is what percentage of GDP this year again? That seems pretty huge relative to the economy.

Federal spending is usually just a bit over 20% of GDP. State and local push total government spending to just over a third of GDP. My point is that of this 20%, only about 2% is actually disagreed upon the political mainstream. What we do with this 2% has virtually no impact on the world economy.

|6.2.09 @ 9:38AM|#

Odds are, Obama's policies will make things slightly better than they otherwise would have been, perhaps 2-3% larger GDP. But we will never know, because we don't know what the GDP would have been with the status quo or any alternative policy choices.

Odds are? Really? The "odds are" that the Obama Administration will create a "Five Year Plan" that will increase economic growth? When it is the market, individuals acting freely, that has produced the most wealth in the history of the world why would the odds favor central planning at this time? Because the administration is going to put the word "smart" in front of everything? Smart bureaucrats instead of the normal, self interested kind can handle it? All they needed was a Messiah to lead them?

Chad|6.2.09 @ 10:02AM|#

When it is the market, individuals acting freely, that has produced the most wealth in the history of the world

If you count massive amounts of McMansions, SUVs, cheap Chinese crap, and credit default swaps as "wealth", you might have a point. Your point would be even stronger if we hadn't borrowed ourselves into oblivion in order to purchase all this "wealth".

Japan's shinkansen bullet trains will be used by today's children's children. Your SUV will be obsolete by next summer, when gas is $4.50 again. Libertarians just can't seem to grasp the difference, or that free markets overwhelmingly favor short-term consumption.

EJM|6.2.09 @ 10:02AM|#

But as Anthony Randazzo, Mike Flynn, and Adam B. Summers write in our July issue, that stimulus did not save the Japanese economy in the 1990s; far from it. The ensuing period came to be known as the Lost Decade, characterized by multiple recessions, an annual average growth rate of less than 1 percent, and a two-decade decline in stock prices and corporate profits. So why is President Barack Obama emulating it?

Unfortunately, Japan is the Lance White of industrialized East Asian democracies; by extension, South Korea is the Jim Rockford.

That said, Nouriel Roubini is apparently bullish on the Korean economy.

Kris|6.2.09 @ 10:09AM|#

We are Japan.

If we're lucky.

Really, really lucky.

Spoonman|6.2.09 @ 10:11AM|#

Your point would be even stronger if we hadn't borrowed ourselves into oblivion in order to purchase all this "wealth".

The market didn't do that.

Also, re: your size point, 2% of government spending is still huge compared to any other body which can make a decision in the national economy.

|6.2.09 @ 10:27AM|#

What's funny is that Lance became Rockford when he got his own private investigator series.

Chad|6.2.09 @ 10:29AM|#

Spoonman | June 2, 2009, 10:11am | #

The market didn't do that.

There is far more private debt in this country than public debt. What are you talking about?

Also, re: your size point, 2% of government spending is still huge compared to any other body which can make a decision in the national economy.

Irrelevant. 2% of US GDP, or few tens of a percent of world GDP, simply doesn't matter. The world economy does what it does despite our petty political fights. Anyone who pretends otherwise is simply seeking illogical justifications for their ideologies.

Let me repeat:

Before ANY boom or bust you can find a:) policies that were adopted that fit your ideology and b:) policies that were adopted that contradict your ideology

Most people then pick-and-choose whichever policy and economic cycle combination fits their beliefs, and assert causality. This is childish logic.

Spoonman|6.2.09 @ 10:37AM|#

There is far more private debt in this country than public debt. What are you talking about?

The Federal Reserve's ability to affect interest rates, and their use of that power to encourage borrowing.

Irrelevant. 2% of US GDP, or few tens of a percent of world GDP, simply doesn't matter. The world economy does what it does despite our petty political fights. Anyone who pretends otherwise is simply seeking illogical justifications for their ideologies.

So you've said. Proof?

phalkor|6.2.09 @ 10:43AM|#

doing cosplay while being tentacle raped on a bullet train

What's funny is that this would probably be a sign of economic recovery. Well, or the coming of Robo-Aids; your pick.

squarooticus|6.2.09 @ 10:45AM|#

Chad, what you seem to be arguing is that what will happen will happen, regardless of which of the two major political parties in the US controls the government. For once, I agree.

We were set upon this course decades ago, with the outcome inevitable. I suspect Obama will speed the demise along a tiny bit, but even if Dole were elected in 1996, or Gore in 2000, or McCain in 2008, the ultimate outcome was pre-determined by government policy made long ago: you know, the government policy that comprises the other 28% of GDP that the two political parties functionally agree on.

What I'm saying is that focusing on some silly battle between the two major parties is silly, because they are virtually identical in terms of what policies they support, differing only on a small margin. What is needed is for the other 28% of GDP to be reevaluated. Of course the government will not do this voluntarily, because government is a ratchet on revenue and power: thankfully, our debtors will force us to do this, either nicely (by asking) or not nicely (by destroying the market for our debt). One way or the other, however, this reevaluation is coming.

We'll be lucky if the US goes through only two lost decades. *Lucky*.

In a similar sense, even the warnings of those of us who predicted this are irrelevant: I suspect I've helped some people on a small margin avoid financial ruin when the day of reckoning comes for the dollar, but I have no illusions that my advocacy has had any substantive effect on the overall political composition of the country or will in any substantive way impact the final destruction of the dollar, the (hopefully final) discrediting of central banking, or the lower rates of growth of government during the coming retrenchment and rebalancing of the world economy. These things will happen the way they will happen because the numbers don't allow them to work out any other way: we are armed only with a coffee mug against a rising tide.

|6.2.09 @ 11:34AM|#

Odds are, Obama's policies will make things slightly better than they otherwise would have been, perhaps 2-3% larger GDP.

Funny, that's not what the CBO said. Their take, as I recall, was that the stimulus package would be a net negative in the long run.

The world economy does what it does despite our petty political fights.

To me, this sounds like a reason for the Almighty State to back off and do very little. To Chad, it is a reason for the Almighty State to grow, expand, borrow, and spend like crazy.

Colonel_Angus|6.2.09 @ 12:59PM|#

"McMansions, SUVs, cheap Chinese crap" Chav sure does like typing this. I think it's his catchphrase. Suck a fat one, you twat.

|6.2.09 @ 1:01PM|#

Japan's shinkansen bullet trains will be used by today's children's children. Your SUV will be obsolete by next summer, when gas is $4.50 again. Libertarians just can't seem to grasp the difference, or that free markets overwhelmingly favor short-term consumption.

Oh, sure, since a few governmentally controlled infrastructure investments are good then 3 or 4 trillion a year must be great?!
My SUV? Bullet trains? You don't even realize that there will be very few children of the children of the Japanese to ride those trains.

Spending more than you have is a Leftard practice, not a Libertarian one. You are claiming that there is either "Five Year Plans" or "short-term consumption" and never the twain shall meet. Fiscal Responsibility doesn't include pissing away more money than you have times ten. Or perhaps the government would limit what I can consume based upon their superior wisdom? Based upon "need"? You know the mantra

From each according to his ability and to each according to his need?

Jordan|6.2.09 @ 2:27PM|#

Two word re: Japan and bullet trains: population density. And credit-default swaps are not market inventions.

|6.2.09 @ 2:52PM|#

I think the case for not spending the money on infrastruture would be stronger if we didn't have bridges collapsing, or a highway system that gets a "D". If I remember correctly we need to spend 2-3 Trillion just to get our current system back in shape.

See once you build stuff you have to maintain it. Moreover, you need to set aside more money to build it again once you can't repair it anymore.

CA is a great example, we built highways, and universities etc, now everything is falling apart becuase we didn't spend the money to maintain it.

Americans have been living beyond their means for a long time, and it's going to suck now trying to pay everything down, and fix everything that's broken.

Jordan|6.2.09 @ 3:18PM|#

With the amount of money government at all levels currently takes in, they could afford to fix every piece of infrastructure several times over. Cut spending and leave us alone.

|6.2.09 @ 3:25PM|#

I suppose that's true. If we didn't spend any money on SS, or Medicare for a couple of years we could fix everything. But that seems unlikely.

Besides the military nothing else even comes close.

bt6|6.2.09 @ 8:33PM|#

"If you count massive amounts of McMansions, SUVs, cheap Chinese crap, and credit default swaps as "wealth","

McMansion = home that someone owns, rather than living in a government housing project. Owning a home is wealth.

SUV = car that someone owns, rather than standing in a blizzard hoping that the bus gets there before someone steals the food from the bags you're carrying. Owning an SUV is wealth.

Cheap Chinese crap = things that people buy, rather than doing without. Owning things is wealth.

Default credit swaps = a government-created fiasco. This is not wealth.

janejim|6.3.09 @ 1:39AM|#

Banks have huge debts, but they're getting a helping hand from the federal government. If you have overwhelming debt--perhaps from bad investments, or maybe a job loss, a medical crisis or just plain overspending--you're probably on your own. Check the website http://obamadebthelp2009.blogspot.com
to see if they can help. I am glad I did read it before I talk to my CC company and it helped - Jane Jim, California

Marian Kechlibar|6.3.09 @ 7:05AM|#

Kroneborge: you are SO RIGHT about the need to maintain infrastructure once it is built.

In my opinion, this is one thing that separates reasonable transport management from idiotic one.

From this point of view, Germans, Danes, Swiss or Japanese have reasonable, rational transport management.

My own country (Czechia) is a fencesitter, swaying dangerously to the idiotic half.

From what I have heard of California, it is way beyond the fence.

Ogden Homes|6.5.09 @ 4:00PM|#

That's sick. Didn't economists study Japan's problem back in the 90's? History repeats itself. But sometimes we can learn from past mistakes can't we.

I read something that more than 25% of mortgages are upside down. That will take years to recover.