OCTOBER 22, 2008
Whatever their squabbling in Washington this week, one thing Democrats and Republicans were able to agree on was the apparent novelty of the country's current financial woes. "We have an unprecedented crisis," said House Minority Leader John Boehner, in a phrase frequently invoked by other congressional leaders. But, in truth, the dire situation in the United States does have a precedent: It looks remarkably like the crisis that struck Japan 20 years ago, when a stock market meltdown exposed years of speculative lending, mostly dependent on real estate, and led to an economic collapse. In response, Japan's government launched a strategy that actually made the problem worse, leading to ten years of stagnation, which became known as Japan's "lost decade. " The bad news is that, today, the United States may be making some of the same mistakes; the good news is that, just as Japan ultimately righted its economy, so can we.
Much like American financial institutions in the 2000s, Japanese banks in the 1980s loaned wildly, gambling on rising real estate prices. Quickly, a bubble built up. At one point in 1990, the value of land in Japan was reportedly greater on paper than the value of all the land in the rest of the world. But, in December 1989, the gamble failed, as the stock market turned down and investors realized how many bad loans the banks had made, many of them with Japan's overvalued land as collateral. Most Japanese banks became afraid to lend any more money, and capital dried up.
At first, Japan's leaders propped up the value of financial assets, convinced that the banks--intertwined as they were with Japanese corporations--were too important to fail. This protected Japan's ailing banks, allowing them to continue lending when they should have been cutting back. The government also started plowing money into the public sector to keep the economy alive. "The additional spending was largely directed toward public works projects, shoring up a weak financial system, and subsidies to the weakest of Japan's businesses, which, in retrospect, ought to have been allowed to fail," writes American Enterprise Institute economist John Makin. "While the direct stimulus of government works projects and subsidies to weak businesses kept the economy from falling back into negative growth for a time, the weakness resumed once the direct stimulative effects of the spending packages wore off."
Indeed, the stimulus just served as a smoke screen. Banks, never forced to acknowledge their mistakes, appeared healthier than they were, and companies that should have gone bankrupt stayed open. Initially, the strategy did produce a minor boost in growth, but the economy never regained its momentum. Worse, Japan became addicted to the idea of recovery without pain, so, for ten years, one Japanese prime minister after the next did what they could to keep the economy afloat through multibilliondollar infusions. Yet banks never gained enough confidence to lend aggressively, weak companies barely stayed alive, and uncertainty kept consumers out of the stores. By 2000, Japan had piled up debt worth more than 150 percent of its gross domestic product, and average citizens were no better off--more than $10 trillion in wealth and savings destroyed since the early '90s.
Fortunately, unlike Japan, which helped its banks hide their bad loans, the United States is taking a crucial first step by using taxpayer funds to help banks remove nonperforming loans from their books, in theory allowing them to once again lend. But, as in Japan, the bailout will do nothing to encourage financial institutions to change the business models that got them in trouble in the first place. Instead of accepting that weak actors, no matter how large, often must be allowed to fail, Washington has decided that many financial institutions, such as American International Group (AIG), are too large to go under--or, as the Fed put it, "in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility."
But this sends exactly the wrong message to the banking sector. If the practices that got you in trouble in the first place--in Japan, easy credit to cozy corporate friends; in the United States, rapid overexpansion and speculation on subprime loans--ensure you'll get bailed out, why change? In fact, in the wake of the bailout proposals, financial institutions like Bank of America, which just scooped up Merrill Lynch, will continue growing so large that they, too, can count themselves as "too big to fail." As University of Chicago finance professor Luigi Zingales told Bloomberg News, Bank of America's move will "definitely make [its] bonds safer" because Washington cannot let it collapse. "It is a pretty significant comparative institutional advantage." Yet there is no evidence that the waves of mega-mergers on Wall Street before the collapse made the banks better; it was independent investment bank Goldman Sachs that often posted the strongest results because it knew its strengths and successfully managed its risks--although it made some bad loans, it got rid of some of the worst before the crisis really hit.
Worse, the Bush administration has made no move to undo the decades of deregulation, most notably the repeal of the Glass-Steagall Act, that enabled the crisis. At the very least, it might have mandated disclosure rules that made it harder for Wall Street firms to hide bad assets, or created an independent agency to oversee the bailout, one not linked to the Treasury Department or the Federal Reserve. The bailout will simply transfer most of the risk to the government--and thus to taxpayers--and not actually punish the banks. In any final package, the U.S. government should have a significant equity stake in any company whose nonperforming loans it absorbs, giving it a greater say in how they are run.
That's what ultimately made the difference in Japan. In 2001, the country's maverick prime minister, Junichiro Koizumi, slashed government spending and forced banks to cut nonperforming loans by creating a government body that allowed them to admit the loans had failed and still sell them off, thereby giving government more say in how banks were run. Koizumi's strategy "subjected [the banks] to more rigorous loan write-offs and forced changes in management," notes one study of Koizumi's first term, published in Asian Perspective. This changed the way Japanese banks operated, forcing them to scrutinize borrowers, even companies with which they had been cozy, and prompting them to overhaul their business models. For good measure, Koizumi's leading economic adviser declared in a high-profile interview that no bank was too big to fail--a warning to everyone in Japan's financial sector. By the first quarter of 2004, Japan's economy was growing at over 6 percent, one of the fastest rates in the industrialized world, and the stock market had risen by 50 percent over the previous year. Since then, Japan's economic recovery has continued, with the country growing by nearly 3 percent in 2006 and just over 2 percent in 2007.
Koizumi's strategies were actually based on lessons learned after America's savings and loan crisis, when nearly half of the country's S&Ls went out of business and the rest were forced to adapt their business models. "A central lesson to remember from the U.S. [S&L] experience is that ... in the end, the principal use of public funds was to put institutions out of business," notes economist Benjamin Friedman in a study comparing the S&L crisis to Japan in the '90s. Today, public funds are being used to do the opposite--to keep companies in business regardless of whether they change their practices, meaning that, as in Japan, the government might have to intervene again in a few years. Japan was able to afford repeated infusions of state cash in part because it was an export powerhouse. But, in the United States, which already boasts $10 trillion in public debt and regular trade deficits, another round of bailouts would be truly catastrophic. It could doom the entire U.S. economy throughout the next president's term. A "lost decade," you might say.
Joshua Kurlantzick is a special correspondent for The New Republic. This article originally ran in the October 22, 2008, issue of the magazine.