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.

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