Turning Japanese
Japan's post-bubble policies produced a "lost decade." So why is President Obama emulating them?
The scenario was eerily familiar. A long real estate bubble that had expanded extra rapidly for the previous five years suddenly burst, and asset prices came crashing back down to earth. Banks and financial institutions were left holding piles of worthless paper, and the economy soon headed south. The national government responded to the crisis by encouraging more lending and spending previously unfathomable amounts of money on public works projects in an effort to stimulate consumer spending and restart growth.
But 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.
The Japanese government's easing of credit rates, instead of spurring real demand, created artificial demand. Federal loans and stimulus spending were not economically productive, and they vastly increased the nation's debt and prolonged the economic malaise. Worse, businesses spent critical time on the sidelines, waiting for government bailouts and other centralized actions, instead of speedily consolidating their losses, clearing their balance sheets of bad investments, and reorganizing.
The United States in 2008–09, unfortunately, has started down the same path. Federal intervention and the expectation of additional government action are removing firms' incentive to clean up their balance sheets by selling "toxic" assets. Why accept pennies on the dollar if a deep-pocketed new bidder (i.e., the state) looms large on the scene? The Japanese experience shows that when the government is an active participant in the market, many firms would rather accept state support than initiate the inevitable financial reckoning. Such a status quo does not provide a sustainable foundation for the economy. Instead, it restricts economic growth and creates a cycle of stagnation.
How Bubbles Form—and Burst
The Japanese asset bubble grew out of a long postwar economic boom that accelerated in the latter half of the 1980s, spurred in part by the central bank's loosening of monetary policy. With access to easy credit, businesses sped up the country's transformation into an economy based on technology, most prominently in the consumer electronics, telecommunications, and finance sectors.
The ensuing demand for new and better technology products, combined with increased living standards, fed an asset investment craze referred to as the Heisei boom, after the emperor who took the Japanese throne in 1989. The value of the yen increased during this time, due primarily to the 1985 Plaza Accord, an agreement reached at an international conference in New York that depreciated the dollar against the yen, and Tokyo became a major financial services center. The Japanese Stock Market grew enormously, with the Nikkei 225 (an index similar to the Dow Jones Industrial Average) more than tripling between 1985 and the end of 1989.
Times looked so good that U.S. bestseller lists were sprinkled with anxious tracts about Japan eclipsing the country that had defeated it militarily less than half a century before. But a more real threat was hiding in plain sight: Japanese asset prices, after rising precipitously, were about to come crashing down to earth.
The late-'80s Japanese bubble and the mid-'00s American bubble had similar causes that are worth pondering:
Overaggressive financial institutions and poor risk management that ignored traditional economic fundamentals. In both Japan and the U.S., excessively optimistic expectations led to bad investment decisions from Wall Street to Main Street and a pervasive culture of denial that there was any bubble at all.
Japanese asset inflation was fueled by a 51 percent average growth rate in housing prices and an 80 percent increase in average commercial property values between 1985 and 1991. This spike created an overconfident climate in which investors failed to adequately prepare for a correction. Since that peak, asset values in Japan have fallen by more than 40 percent as of 2008.
Japan was flush with capital in the 1980s, in part due to an export boom that started the decade before. The country was becoming an increasingly important player in the world financial system, and international investors came looking for a stake. In the preceding years, Japanese individuals and firms had built up a large pool of savings and begun investing those resources in real property. This rapid rate of investment pushed the value of land, buildings, and other capital investments higher, encouraging even more investment, and in turn speculation, based on the belief that values and returns would keep rising.
Riding this asset appreciation, Japanese banks borrowed nearly ¥200 trillion ($3.4 trillion in today's dollars) from foreign markets. This sum sloshed throughout the Japanese economy. The lending was further fueled by tiny debt-to-equity requirements, a relatively recent development that encouraged financial institutions to heavily leverage their bets. By 1991 Japanese banks held reserves of only ¥3 trillion to cover the ¥450 trillion they had lent. Normally, such a lopsided portfolio would have triggered widespread concern. But the economic climate in Japan back then was often described as "euphoric." Prudence was not in vogue.
The American housing bubble was bigger, although values have yet to fall as much as those of Japanese real estate. Between 2000 and 2006, average home prices in the U.S. grew by 90 percent, and commercial property values rose at the same rate. Since the peak in July 2006, home prices nationwide have declined more than 30 percent, and certain regions have experienced even sharper drops. Prices were still falling as of press time.
After the twin shocks of the dot-com bubble bursting and the September 11 attacks, the Federal Reserve repeatedly slashed interest rates. And like Japan in the 1980s, the U.S. was seen as an attractive destination for international investment. With more investors using more money to chase high returns, Wall Street began aggressively "securitizing" home mortgages by bundling and reselling bits of loans and doing likewise with the insurance contracts underwriting them. New subprime mortgages became increasingly available to home buyers with spotty credit histories. Because of the risk, subprime loans brought a higher rate of return. But since they were bundled with safer loans, the entire packages received ratings from credit agencies that were higher than warranted.
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.
The market needed time to reassess the mortgage market, given the new information it was facing from the Fannie and Freddie debacle. In the meantime, banks watched the numbers on their balance sheets go from millions to zero. Unable to find sufficient capital to meet the requirements demanded by mark-to-market accounting, institutions such as Lehman Brothers, Washington Mutual, and Citigroup fell prey to their debt. Easing the mark-to-market rules at the onset of the crisis, instead of a year later, would have bought firms precious time to recapitalize their balance sheets in a more stable manner. The banks still would have lost money, but they might not have gone bankrupt and caused a negative ripple effect throughout the economy.
Government housing policy. Both Japan and the United States had explicit government policies that encouraged an unhealthy appreciation in land and housing prices. A 2003 report from the Bank of Japan blamed tax and regulatory policies for an unnatural rise in asset values. In America the Federal Housing Administration has for years encouraged the expansion of mortgage lending, including subprime lending, particularly through Fannie Mae and Freddie Mac. This was done to expand homeownership by low-income families. Such policies span administrations of both political parties, from the Community Reinvestment Act passed during the Carter administration in 1977 to George W. Bush's efforts to create an "ownership society."
The push to expand homeownership had two big effects. First, it greatly increased the number of buyers, driving up housing prices. Second, it provided mortgages to a large number of people who had a high risk of default.
Recession Responses
By early 1992, realizing that the economy was not going to rebound quickly, the Japanese government hurriedly enacted its first recession-fighting stimulus package. Government spending and loans during the next several years propped up failing Japanese financial firms, but the companies' lack of vitality and perpetual operating losses earned them the moniker "zombie businesses."
Given the similar source of the U.S. bubble, American officials should take a careful look at Japan's ineffectual and massively expensive response to ensure that the United States does not duplicate the following mistakes:
Government lending to poorly managed firms. The Bank of Japan tried to ease economic pain by loaning large amounts to businesses. But the attempts to recapitalize the market ignored underlying management problems in the dying firms. It was a costly mistake. Intense lobbying from special-interest groups representing various sectors of the Japanese economy perpetuated the ill-fated loans and funneled government money to zombie businesses.
The United States has already begun to copy this policy, lending billions of dollars to financial institutions and auto companies and buying up billions more in bank equity in an effort to recapitalize the marketplace. The effect has been to keep poorly managed firms alive with taxpayer money.
Just months after a $25 billion investment in Citigroup, the government had to step in with a second bailout of $20 billion. Despite the infusions, Citigroup is now breaking up its holdings, a process that could have been started months earlier if the authorities had not used tax dollars to feed the zombie firm. Instead of letting the Big Three automakers go bankrupt, the administration has kept them on life support with tens of billions in loans to buy enough time for…likely bankruptcy.
Conflicts of interests. With all those loans, the Japanese government found itself deeply entwined in the market, skewing its policy incentives. Daniel I. Okimoto, former director of the Shorenstein Asia-Pacific Research Center at Stanford University, points out that Japan's banking industry and economic bureaucracies were too interdependent. Studies from Okimoto's center and the Bank of Japan concluded that data revealing the scope of the economic malaise were suppressed and that regulations were developed with governmental interests in mind. At the height of financial industry bailouts, there was little transparency or public accountability.
The United States has ventured into the same dangerous waters. In an attempt to recapitalize the banking industry, the Treasury Department forced the major banks to take bailout funds from the Troubled Asset Relief Program, in exchange for which the government took equity stakes. The federal government now owns a majority of the American International Group insurance company, as well as major chunks of General Motors and Chrysler. The dangers of interconnectedness have already become apparent.
With taxpayer money on the line, elected officials feel emboldened to prescribe the marketing, compensation, travel, and other business policies of companies taking government money. Members of Congress and White House staff have criticized specific spending decisions by participating firms. Concern over bonuses to AIG employees led the House to pass an arbitrary tax on a standard business practice that lost public favor. President Obama himself has delved into such business minutiae as whether General Motors should be focusing more on brand consolidation. And a bill now in the Senate would give the Treasury Secretary power to set the salary of all employees, not just executives, at any firm with bailout money burning in its pockets.
Lawmakers' incentives are to serve their constituencies or their own political careers. This can put them at odds with the businesses they are suddenly attempting to manage. The more the government is involved in directing business activity, the less likely those firms will succeed in maintaining long-term growth, and the more likely they will turn into Japanese-style zombies.
Short-term, static political vision. You can blame the length of Japan's asset deflation, recession, and liquidity struggles on an unwillingness to choose hard but necessary policies, such as allowing banks to fail and the market to reset itself. Politicians bent on retaining their power and showing the public they were doing something took actions without regard to their long-term effects.
There was little effort to clean up the banking system or get rid of harmful regulations. The government refused to acknowledge the breadth of Japan's economic troubles, and the Ministry of Finance went so far as to order banks to hide their toxic loans to create the appearance of success. This approach was largely due to fear of the keiretsus, the powerful alliance of Japanese businesses that propped each other up with cross-shareholding and loans. Taking swift action would have upset the traditional way of business and forced the government to admit mistakes.
The principle of creative destruction—the economic mutation that continuously breaks down old forms and creates newer, more productive and efficient ones—was ignored in the hope that legacy corporations could somehow save Japan. From Wall Street to Detroit, under both George W. Bush and Barack Obama, the American government has been equally unwilling to let once-formidable companies fail.
Bad tax policy. In different periods, Japan tried to climb out of its economic mess by both cutting and raising taxes. There were two major tax cuts during the Lost Decade: a ¥5.8 trillion ($69 billion in today's dollars) income tax cut in 1994 that lasted for one year, and a ¥4 trillion ($46 billion) income tax cut in 1998 spread over two years. The problem was that these tax cuts were not permanent and thus did not increase long-term aggregate consumption.
From 1994 to 1995, the Japanese economy began experiencing modest growth, partially due to the first tax cut. But deflation in 1995 reduced government revenues. In an effort to stem surging national debt, the consumption tax was increased from 3 percent to 5 percent in 1997, which slowed the economy again.
President Obama and Republicans in Congress have proposed various tax cuts and tax credits to stimulate the American economy. The American Recovery and Reinvestment Act (the "stimulus" bill) included the president's signature "Making Work Pay" $400-per-taxpayer ($800-per-family) tax credit that eliminates all federal income taxes for up to 18 million Americans. The legislation also increased the amount of losses that businesses may write off on their taxes while providing tax credits to new homeowners, students, and efficient energy developers.
Other ideas, such as the GOP push for reductions in capital gains taxes, have been tossed aside.
As welcome as tax cuts are, without a decrease in spending they will require an increase in taxes later to cover the lost revenue and pay off the debt incurred.
Japan found that temporary tax rate cuts combined with increased spending did not spur economic growth. Neither did an attempt to increase government revenues through tax increases. Reducing taxes for businesses—permanently, not until the next shortfall—allows firms to keep more revenue, which in turn lets them reinvest that money to innovate and expand their business, hire new workers, pay out dividends, or just be inspired to continue their hard work. Tax rate cuts for individuals—all individuals, including those with income over the arbitrary $250,000 threshold—give people more control over their income, allowing them to pay down debt, save, invest, or increase consumption. Those tax policies are the quickest way to stem a recession.
Government infrastructure "investment." In an attempt to encourage growth, the Japanese embarked on a massive, multi-billion-yen infrastructure program. They built roads, bridges, and airports, all with the goal of creating jobs and reviving the economy. This didn't work either.
During the 1990s, Japan passed 10 fiscal stimulus packages, focused largely on public works, totaling more than ¥120 trillion ($1.4 trillion in today's dollars). When one construction plan failed to stimulate economic growth, another was tried. Those plans did not succeed in reviving the economy, but they did saddle the nation with a mountain of IOUs that helped postpone recovery for years. Including "off-budget" borrowing, Japan's debt was estimated to exceed 200 percent of GDP in 2001.
Construction plans often set job growth targets but rarely focused on project prices. From 1992 to 1999, the Japanese government spent more than $500 billion (in today's dollars) on public works projects. Yet the construction jobs were not long-term and did not lead to sustained economic growth. Public debt sky-rocketed, unemployment actually doubled from 2.3 percent to 5 percent, and the economy remained stagnant. As Gavan McCormack, a historian at Australian National University, noted in his 1996 book The Emptiness of Japanese Affluence, "The construction state is in some respects akin to the military-industrial complex in Cold War America (or the Soviet Union), sucking in the country's wealth, consuming it inefficiently, growing like a cancer and bequeathing both fiscal crisis and environmental devastation." The government failed to properly identify which projects should be pursued, ignoring demand signals that the private sector is better at recognizing and responding to.
The United States has started down a similar path. In February, Congress passed nearly $100 billion in transportation and public works spending. Naturally, political interests, not economic viability, are determining how this money is being spent.
An American Lost Decade
The Japanese government's monetary expansion and poor regulation, coupled with the risky behavior and ineptitude it encouraged in the financial sector, led to distortions in private investment instead of economic recovery. Recessions are the unavoidable costs of unsustainable booms fostered by government policy. While politicians would like to stave off the negative effects they create—business failures, unemployment, falling housing prices—bankruptcies and corrections are necessary steps in realigning consumer preferences and the structure of production.
The U.S. government is repeating many of the same mistakes that created Japan's Lost Decade, becoming entangled with the business community through bailout equity purchases and trillions of dollars in loans and guarantees to keep failing American firms alive. This policy is making the recession worse, extending it further than it would otherwise last.
Any attempts to artificially spur a credit expansion through either low interest rates or "fiscal stimulus" will only add to the economic distortions and make the market correction longer and more severe. Spending hundreds of billions of dollars on infrastructure, broadband Internet, and the like may provide some short-term benefits for some Americans, but as Japan discovered the hard way, it won't rescue the economy. The history lessons from Japan are plentiful and clear. If the American government continues its pattern of intervention, the United States may soon be trapped in a zombie business economy and a lost decade of our own, ensuring economic stagnation for a long time to come.
Anthony Randazzo (anthony.randazzo@reason.org) is an economics policy analyst at the Reason Foundation. Michael Flynn (flynn@marengostrategies.com) is president of Marengo Strategies. Adam B. Summers (adam.summers@reason.org) is a policy analyst at the Reason Foundation.
