Kabuki Financial Regulation

Much speculation has been made recently about the possible similarities between Japan’s lost decade and financial crisis during the 1990s and the current US Financial crisis.  It’s impossible to get through any graduate program in either finance or economics without spending time with the mounds of research the decade ignited.  Since many folks are talking and writing about this period in the popular business press and speculating on the chance of an L-shaped recovery similar to the one experienced by Japan, I thought I’d focus some on Japan’s Lost Decade.   There are some similarities but some important differences too.

About a month ago, The Economist asked if America’s crisis could rival Japan’s. Their answer was yes.  This article examines something we’ve looked at twice before. That would the IMF study of banking crises. Both the Nordic banking crisis and the Japanese banking crisis are including in the database and highlighted by the study.  The experience of these  rich country crashes have both been bandied about as possible road maps to financial system recovery.  Sweden nationalized its banks.  There was also the lesson from South Korea. This country recovered after two years. The there was Japan. It  let its banks languish. Japan became infamous for its decade of economic stagnation. Are we turning Japanese?

Japan’s property bubble burst in the 1980s and its run up prior to the bubble was smaller than ours.  Additionally, Japan has a high domestic savings rate.  America is the world’s largest debtor.

Judged by standard measures of banking distress, such as the amount of non-performing loans, America’s troubles are probably worse than those in any developed-country crash bar Japan’s. According to the IMF, non-performing loans in Sweden reached 13% of GDP at the peak of the crisis. In Japan they hit 35% of GDP. A recent estimate by Goldman Sachs suggests that American banks held some $5.7 trillion-worth of loans in “troubled” categories, such as subprime mortgages and commercial property. That is equivalent to almost 40% of GDP.

The authors of The Economist articles see both other differences too.

Japan’s central bank took too long to fight deflation; its fiscal stimulus was cut off too quickly with an ill-judged tax increase in 1997; and it did not begin to clean up and recapitalise its banks until 1998, almost a decade after the bubble had burst. But the history of bank failures suggests that Japan’s slump was not only the result of policy errors. Its problems were deeper-rooted than those in countries that recovered more quickly. Today’s mess in America is as big as Japan’s—and in some ways harder to fix.

Let’s look at the first statement about deflation.  We’re not experiencing deflation in all sectors.  The latest numbers from the BLS still show slight inflation.    However, we are looking at some tax increases in the near future.  Both Japan and the Roosevelt administration in 1937 instituted tax increases before both of these major financial crisis had be solved.  In 1937, it led to a second economic and financial market down turn. In 1997 Japan, it slowed down recovery.

Our dollar is strengthening as the financial crisis impacts the global economy.  Japan’s yen is similarly a strong world currency.  The dollar is still seen as a safe-haven asset.  However, Japan is a net exporter while the US is a net importer.  Japan is not a debtor nation, but a creditor nation.  Japan could still rely on exports to deliver some economic stimulus.  The US does not have that luxury.  However, while South Korea and Sweden’s currencies weakened and helped make their exports look cheap, Japan’s yen stayed somewhat strong.  This crippled Japan’s ability to fully use exports as stimulus making its recovery much longer than either those of South Korea or Sweden.  The dollar continues to strengthen which also makes any exports we send to the rest of the world relatively expensive.  It also continues our reliance on imports as they stay relatively cheap.

In some ways America’s macroeconomic environment is even trickier than Japan’s. America may have a big current-account deficit, but the dollar has strengthened in recent months. America’s reliance on foreign funding means the risk of a currency crash cannot be ruled out, however. That, in turn, places constraints on the pace at which policymakers can pile up public debt. And even if the dollar were to tumble, the global nature of the recession might mean it would yield few benefits.

I already mentioned that Japan’s households were historically good savers.  This meant only the Japanese corporations had to ‘deleverage’ or get rid of debt during the Japanese crisis.  I remember watching Japanese commercials at the time from the government extolling patriotic Japanese households to go spend like crazy at the same time the US government was telling Americans to consider saving.  Well, that trend is reversing.  Japanese households are beginning to decrease their savings rates, while Americans have rediscovered thrift.  This is also something we’ve talked about.  Here’s how that played in Japan and could play out differently here.

Nonetheless, the rebuilding of American households’ balance-sheets is likely to force a reliance on government demand that is bigger and longer-lasting than many now imagine. In the aftermath of Japan’s bubble, firms spent more than a decade paying down debt and rebuilding their balance-sheets. This sharp rise in corporate saving was countered by a drop in the savings rate of Japanese households and, most importantly, by a huge—and persistent—increase in budget deficits.

A similar dynamic will surely play out in America’s over-indebted households. With their assets worth less and credit tight, people will be forced to save much more than they used to. The household saving rate has risen to 3.6% of disposable income after being negative in 2007. For much of the post-war period it was around 8%, and in the short-term it could easily exceed that. But, whereas dis-saving by Japanese households countered the corporate balance-sheet adjustment, American firms are unlikely to invest more while consumers are in a funk. Propping up demand may therefore require more persistent, and sustained, budget deficits than in Japan.

The FT’s Martin Wolf also made some suggestions last month on the types of lessons the US could take from the Japanese experience. Again, Wolf points to the fact that our asset price bubbles are much larger than Japan’s was, their savers are prudent and we basically have no savers,  they rely on exports, we rely on imports, and their experience went on for such a long period that basically the global economy recovered somewhat to help their export-based economy. (We had a slight recession right after the first gulf war around 1991 which didn’t help them in the least bit.)   The entire global economy today is completely in crisis.

How far, then, is Japan’s overall experience relevant to today?

The good news is that the asset price bubbles themselves were far smaller in the US than in Japan (see charts below). Furthermore, the US central bank has been swifter in recognising reality, cutting interest rates quickly to close to zero and moving towards “unconventional” monetary policy.

The bad news is that the debate over fiscal policy in the US seems even more neanderthal than in Japan: it cannot be stressed too strongly that in a balance-sheet deflation, with zero official interest rates, fiscal policy is all we have. The big danger is that an attempt will be made to close the fiscal deficit prematurely, with dire results. Again, the US administration’s proposals for a public/private partnership , to purchase toxic assets, look hopeless. Even if it can be made to work operationally, the prices are likely to be too low to encourage banks to sell or to represent a big taxpayer subsidy to buyers, sellers, or both. Far more important, it is unlikely that modestly raising prices of a range of bad assets will recapitalise damaged institutions. In the end, reality will come out. But that may follow a lengthy pretence.

Wolf also points to the fact that the recessions we experienced in the 1980s are quite dissimilar to the ones we’ve experienced recently.  For example, our 1980 recession during the first Reagan term was brought on by tight monetary policy attempting to rein in inflation.  We had room in our monetary policy targets to bring us out of recession.  However, the Japanese lost decade introduced us to the idea of the zero bound.  Their interest rates were so low that they had no room for lower targets.  We are similarly in that position.  At the time, Japan began its quantitative easing policy and announced a policy of keeping interest rates near the zero level.  The Japanese central bank went back on its policy once, and completely blew its credibility.  An academic paper by Ben Bernanke (prior to his Fed days) outlines all the ups and downs of Japanese Monetary policy at the time so I’m certain he won’t repeat that mistake.

This point by Wolf is the one that particular hits my sensibilities.

The Japanese lived with zombie banks for nearly a decade. The explanation was a political stand-off: public hostility to bankers rendered it impossible to inject government money on a large scale, and the power of bankers made it impossible to nationalise insolvent institutions. For years, people pretended that the problem was downward overshooting of asset price. In the end, a financial implosion forced the Japanese government’s hand. The same was true in the US last autumn, but the opportunity for a full restructuring and recapitalisation of the system was lost.

We’ve had discussion of zombie banks before here.  A zombie bank will  drain bailout capital from the government while not engaging in any meaningful lending.  It runs up government debt while not adding anything of value to an economic recovery.  Zombie banks were the hall mark of the  Japanese lost decade.

This brings me to comments made by Bernanke today.  He realizes that nothing close to a recovery in either the markets or the economy at large will happen with out  a solution to bank problem.  The spector of zombie banks follow Bernanke everywhere. Today,  Bernanke zeroed in on the question of big banks, the fate of which has been hovering over financial markets.

The continued viability of systemically-important financial institutions is “vital” to the recovery, Bernanke said in a speech to the Council of Foreign Relations.
“We have reiterated the U.S. government’s determination to ensure that systemically important financial institutions continue to be able to meet their commitments,” Bernanke said.

Okay, we get that and we got that last fall.  We also got a bear market rally led by Citi and a few other financial stocks. Just yesterday, I said the market’s been looking for one of those.  Citi even managed to announce today that its earnings looked good for the quarter. However, ANY one can take free bail out money and lend it out at a higher rate and make a buck.  Right? Are we going to keep funding Citi to make arbitrage profits off the taxpayer?

Citi shares led all gainers, rising about 35% following remarks from Chief Executive Vikram Pandit that the firm has been profitable in the first two months of the year and that its capital is strong.

Why not just have the Treasury lend the money directly to households and businesses, lower their interest rates, and cut out the middle man in that case?  Should we pay more for our loans AND eventually our taxes so Citi can boost its stock price?  Look at this one from the same MarketWatch referenced article in the previous paragraph.

Financial stocks, and banks in particular, have been under pressure in recent weeks from short-sellers, who borrow shares and sell them, hoping to buy back the shares and return them later while pocketing the difference as a profit.

When shares they have borrowed begin to rise, the short-sellers often jump back in as buyers, adding to a stock’s gains.

If the problem with bank stocks is short-sellers, then there’s an easy solution.  Stop the market from short-selling bank stocks.  The SEC can do that.  It doesn’t take an act of Congress.  That has to be cheaper than to continue pouring money into banks with no promise of loans or returns.  Barney wants to bring back the uptick rule. Oh, that’s Barney the Congressman, not Barney the Dinosaur.  However, that would only slow a downward momentum in stocks that are perceived as stinkers, it wouldn’t actually stabilize them.

In all of this back and forth, I still don’t see a panacea for the banks.  Bernanke hinted that a few had failed their stress tests.  He then turned around and assured us he’d keep propping them up.  Ummm, excuse me … chotto matte kudasi, Senseisama.  Isn’t that telling us that you’re just setting up a few zombie banks? So, are we really solving the problems inherent in this crisis?  Something tells me no.

First, we have stimulus and budgets built on all too rosy scenarios that have more pork and tax cuts than stimulus.  Then, we still haven’t discussed bringing transparency to the financial markets.  We see no rules proposed for hedge funds, for investment banks, and for Fannie and Freddie.  I’m still waiting to hear what they plan to do with all those CDOs and Swaps sitting out there. Are we going to get zombie insurance companies?  Oh, wait, we have one of those already. That would be AIG.  Fannie and Freddie are huge zombies.  Can some one quit testifying, speechifying, and summitifying for a moment and actually come up with a plan?  Even better, can we come up with some new bank and finance oversight and rules and let’s try now, not 10 years from now.