IPA Q4 2008 - Tolstoy wrote that “All happy families are alike; each unhappy family is unhappy in its own way.” One could argue that markets are much the same, all alike when thriving, but each unique when caught in a crisis. This presents a considerable challenge for investors, as we scrutinise market history for clues to understanding today’s crisis.
Having spent most of my career in Tokyo, I notice many similarities between Japan’s banking crisis in the ’90s and the problems confronting the US today. In particular, both crises had garden-variety causes: extremely loose monetary policy, excessive credit growth (featuring reckless bank lending to the real estate sector) and financial deregulation.
However, two unique features allowed a relatively small issue confined to Japan’s real estate sector to snowball into a full-blown crisis. The first was the catastrophic failure of Japanese banks, indulged by regulatory forbearance, to properly disclose their non-performing loans (NPLs). As NPLs mounted, banks became capital constrained and were forced to dramatically shrink their balance sheets. While this prevented them from making new good loans, it did not prevent additional bad loans to ‘zombie’ firms, which avoided bankruptcy and continued servicing their loans, allowing banks to avoid large write-offs. Zombie lending rose through the 1990s and did not peak until early-1999.
Such perverse practices were allowed by the Ministry of Finance, which required little disclosure, lacked a rigorous NPL classification system, and did not adequately monitor NPL provisioning and reserves. By 1997 several big institutions had gone bust and, in the following year, regulatory authority was finally taken from the MoF. The new Financial Services Agency (FSA) developed a clear NPL classification system, but was too lenient until 2002 when PM Koizumi appointed a new FSA Minister, Heizo Takenaka, who pressed banks to clean up their NPLs and raise fresh capital.
For these reasons the Japanese banking sector recorded operating losses in each of the ten years prior to 2002, with almost no new capital being added. As a consequence, more than a decade after the bubble crashed, the capital position of almost all banks remained extraordinarily weak, precluding a recovery from Japan’s financial crisis.
The second unique feature was the weak and belated response by policy makers, whose ineptness condemned Japan to a decade of deflation, stuck in a textbook Keynesian liquidity trap. The MoF’s fiscal policy was erratic and wasteful, deployed half-heartedly and without much success. However, the MoF’s sins pale in comparison to the spectacular errors committed by the BoJ.
Initially, monetary policy was aimed at crushing the last vestiges of the bubble and stayed too tight, for too long. It took the BoJ three years to cut policy rates to 2.0%, during which period the JPY appreciated dramatically. However, the worse mistakes occurred under Governor Hayami, whose five year term began in 1998. Famous for delivering confusing and inconsistent messages, he emphasized: the structural causes of the economic and financial crisis; the beneficial nature of deflation; and that unconventional policies (e.g., Mishkin’s price level target) were hazardous and unwarranted. After much procrastination, the zero interest rate policy was finally implemented in 1999, prematurely terminated the following year (a move often compared to the FRB’s disastrous tightening in 1937) and then restarted in 2001. With just cause, Hayami was hailed by The Economist as “quite possibly the world’s worst central banker”.
In the face of a financial crisis, no country has ever procrastinated for as long as Japan. Consequently, the key lesson from Japan’s experience is that regulatory forbearance and policy inaction adds dramatically to the costs of cleaning up a financial crisis (one academic study estimated that “Japan’s GDP could be on the order of 25% higher today”).
Will the US suffer Japan’s fate and suffer over a decade of poor growth and financial system distress? The speed and nature of the response by US banks, regulators and policy makers suggests not. US financial institutions have recognized their balance sheet weakness and raised fresh capital ($400 bn during the last year) much earlier than their Japanese counterparts did. Further, US regulators have been more proactive and aggressive, with the FRB and Treasury deploying their arsenal of policy weapons relatively swiftly and effectively. One fortuitous reason for this is that Governor Bernanke is one of the world’s experts on the Japanese crisis (see, for example, “Japanese Monetary Policy: A Case of Self-Induced Paralysis.”)
While a replay of Japan’s lost decade is unlikely, consider Aristotle’s warning that “It is possible to fail in many ways…while to succeed is possible only in one way.” Among the many ways to fail are: Fed hawks hike rates prematurely; a renewed sense of crisis leads banks to contract credit even further; ongoing uncertainty leads households to accelerate the de-leveraging of their balance sheets; the US dollar surges, significantly tightening monetary policy; global growth decelerates dramatically; and commodity prices rebound, hurting growth and keeping central banks from easing. While none of these are likely, each is possible, and the twin deficits make the US uniquely vulnerable.