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Tuesday, Oct. 31, 2000

Hard lessons Japan failed to learn

Staff writer
JAPAN'S FINANCIAL CRISIS AND ITS PARALLELS TO U.S. EXPERIENCE, edited by Ryoichi Mikitani and Adam S. Posen. Washington: Institute for International Economics, Special Report 13, Sept. 2000, 228 pp., $20.

There's an old joke about a politician's plea for a one-handed economist, one who can't say, "but on the other hand . . ." Obviously, the pol wasn't dealing with a financial crisis, because there is a pretty powerful consensus on the best way to handle those. From 1980-1996, 133 out of the 181 members of the International Monetary Fund had major banking-sector problems. In the last 15 years, Britain, France, Sweden and the United States have had their own crises.

That is what makes Japan's response to its financial meltdown during the 1990s so surprising. Such things aren't too hard to figure out.

There is widespread agreement on the causes of financial crises. It goes like this: Liberalization of the finance sector and the maturation of big, low-risk corporations squeeze bank margins. The banks then go after higher-risk borrowers to increase profits, but because the financial sector has been coddled for so long, they are incapable of assessing credit risks. (Sometimes banks are encouraged to look the other way when questionable borrowers ask for money.) Deposit insurance further encourages risky lending.

The economy heads into a downturn (a regular occurrence in the business cycle) and banks are squeezed even more. Deposit insurance allows them to make even bigger gambles to fix their balance sheets, but they usually fail and the mess spirals out of control until the government steps in, recapitalizes banks and forces management to write bad assets off the books. Shareholders take a bath, managers lose their jobs, asset markets tumble but eventually become more liquid, the banking sector is downsized and everyone emerges poorer and chastened.

That is exactly what happened in Japan, explains Yoshinori Shimizu, in this valuable new study of the Japanese and U.S. crises of the '80s and '90s. Shimizu, a professor at Hitotsubashi University's Graduate School of Commerce, blames Japan's "convoy system of bank regulation" for the crisis.

"The fundamental cause of the Japanese financial crisis is the excessive share of the financial market controlled by the banking sector, which requires collateral before loans can be originated," he writes.

The chief culprit was real estate, the market for which plummeted during the 1990s. It was the primary source of collateral, and when loans were due, companies couldn't make payments. Banks were reluctant to call on the collateral, given its limited (and shrinking) value. As they waited, the gap between assets and liabilities grew and the crisis intensified. Knowing that land prices were declining, even willing sellers could not unload property and markets could not clear. Regulators turned a blind eye, fearing that they would be blamed for the mess.

As Shimizu explains, "In a deregulated world with higher economic risks, the social system of risk taking has to be changed to a system of risk sharing among investors capable of evaluating and underwriting these risks. A deeper capital market and a reduced role for the banking system will be needed."

At one time, the convoy system made sense. It was an essential part of the developmental state model. But times change, and unfortunately, Japan did not keep pace.

Ryoichi Mikitani, professor in the faculty of economics at Kobe Gajuin University, blames "the system." "Neither the financial institutions nor the big corporations were willing to take off their protective heavy coat and work with their sleeves rolled up. Instead, deregulation has been conducted in a Japanese way by the Japanese government, with 'gradualism' that preserves the interests of the beneficiaries of the old regime," Mikitani writes.

When the crunch came, Japanese policymakers failed to learn from the grim experiences of others. Rather than stepping in early and cleaning up the banking mess, authorities dithered and denied there was a problem, allowing the situation to get worse. By 1997, there were fears that Japan's financial woes threatened a global meltdown.

The IMF has acknowledged that in 1997-98 Japan experienced the worst recession of any industrial country during the entire postwar era. At that point, the government of Prime Minister Keizo Obuchi intervened, passing a banking bill that imposed discipline on financial institutions and provided a floor for the economy. Robert Glauber, professor at the Kennedy School of Government at Harvard, gives the Japanese government good marks once it got moving. He says the Financial Supervisory Agency has been more effective than many expected in overseeing banks and getting them to clean up their books. He is less enthusiastic about the ability of the newly merged banks to become more effective competitors.

Governments respond to economic troubles on two fronts: fiscal policy, which concerns spending and taxation, and monetary policy, which concerns money supply and is usually the purview of the central bank.

All the contributors to this study agree that the Bank of Japan has aggravated the situation. Ben Bernanke, professor of economics at Princeton University, agrees with "the conventional wisdom that attributes much of Japan's current dilemma to exceptionally poor monetary policymaking over the past 15 years." He believes that the BOJ "could achieve a great deal if it were willing to abandon its excessive caution and its defensive response to criticism."

Adam Posen, a senior fellow at the IIE who was on the staff of the Federal Reserve Bank of New York, says that the BOJ "has increasingly diverged from the norms of central bank best practice."

Posen's introduction and his comments on another paper pretty much demolish the BOJ's arguments for its policies over the last decade. He believes that the bank has not gone far enough to help stimulate the economy; its reliance on the zero-interest-rate policy was a mistake; claims that the BOJ was forced to assert its independence vs. the Ministry of Finance were misguided; the argument that the bank had to raise interest rates to push reform is undemocratic; and the defense that other policies were high-risk because the results were uncertain was beside the point. All policies have potentially unknowable results and the history of financial crises could have guided BOJ decision makers.

There is one dissenting voice in this collection: that of Eisuke Sakakibara, the former MOF vice minister for international affairs. Sakakibara blames the U.S. government for Japan's ills. He says Washington forced Japan to do what it did to appease various American constituencies. By his reckoning, Japan is pretty much incapable of making policy free of U.S. influence.

Jeffrey Shafer, Sakakibara's counterpart at the U.S. Treasury during the first years of the Clinton administration, counters that if the U.S. had the influence with which it is credited, the changes in Japan would have been considerably greater than those that occurred.

While this review has highlighted the Japanese missteps throughout the 1990s, there is no schadenfreude in the volume. The contributors concede that the U.S. may have been a bit more adroit in dealing with the S&L crisis of the '80s, but only just. American regulators were no model.

Worse, there is a sense that the U.S. is in the midst of its own asset bubble. As its economy slows, we shall see just how well the U.S. learns from the mistakes of others. Stay tuned.

Brad Glosserman can be contacted at brad@japantimes.co.jp.

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