WHAT CRITICAL LESSONS CAN BE DERIVED FROM THE JAPANESE FINANCIAL CRISIS OF THE 1990’s?

Introduction

History is replete with examples of financial crisis; they appear to be an intrinsic feature of market-oriented credit and financial systems. In recent years, the march of globalisation and concomitant increases in capital and trade flows has led to increased volatility in international financial markets, and as a result, financial crises have become increasingly common across the globe. While each financial crisis is no doubt distinct, they also share striking similarities with one another, and an examination of the longer historical record finds stunning quantitative and qualitative parallels. This begs the question; can previous recessions provide us with lessons on how to handle the current financial crisis?

The current financial crisis is the first major financial crisis of the 21st Century, and it has developed rapidly, becoming increasingly virulent, causing widespread disruption to both industrial and emerging economies across the globe. Nevertheless, it follows a well-trodden path laid down by centuries of financial folly, and to understand this crisis and determine optimal policy responses, many analysts have compared the current turmoil to the collapse of Japan’s bubble economy in the early 1990s and the need to prevent the kind of prolonged slump that hit Japan.

Similar to the current global financial crisis, Japan’s ‘lost decade’ began with stock market and real estate bubbles. At the beginning of the 1990s these speculative asset bubbles began to burst, first with a reduction in the Nikkei Stock Index, followed in early 1992 by a fall in land prices (Amyx, 2004). From its 1989 peak of 38,916, the Nikkei Stock Index average fell by 63% during the 1990s (McCurry, 2008). Similarly, land prices slumped; commercial land values fell by roughly 80% in a decade, a far cry from the days when the grounds of the Imperial Palace in Tokyo were rumoured to be worth more than all the real estate in California (McCurry, 2008). Both companies and individuals were rendered unable to repay loans secured by these assets, leaving the nation’s banks with an enormous burden of non-performing loans, triggering a banking crisis (Amyx, 2004). The result was more than a decade of low growth, deflation, and output persistently below potential.

The Japanese economic model had gone horribly wrong, and recovery failed to materialize. At first, the Japanese Government’s strategy was forbearance, more than six years passed from the onset of severe financial distress before the Government initiated aggressive measures to tackle the bad debt problem and instigate fundamental financial reforms (Amyx, 2004). In 1996, following the bankruptcy of several specialised housing loan companies, known as jusen, the Government made its first capital injection to purchase assets from ailing lenders (Nanto, 2008). In total the Japanese Government pumped $495 billion (¥60 trillion yen), or 12% of GDP, under five different bailout packages, into the banking sector (Nanto, 2008). The motive behind the Government’s capital injections was that if it could keep banks and lenders operating their profits from operations and capital gains from equity holdings could fund the write-offs of bad loans (McCurry, 2008). However, the bailout packages came at a cost. Free to lend again, banks simply used funds to keep countless ‘zombie’ companies afloat. Between 1995 and 2003, Japan’s banks wrote off a cumulative total of $318 billion (¥37.2 trillion) in non-performing loans, but new ones appeared so fast that the total outstanding amount kept increasing and peaked in March 2002 at $330 billion (¥43.2 trillion) or 8.4% of total lending (Nanto, 2008). The Bank of Japan was similarly unresponsive to begin with, waiting seventeen months before cutting interest rates, and did not bring it down to 0% until 2001 (McCurry, 2008). Nevertheless, interest rates were eventually slashed, and remained at 0% for almost six years (Fackler, 2008).

Overcoming the crisis in Japan took a combination of capital injections, new laws and regulations, quantitative-easing, stronger oversight, a reorganization of the banking sector, and a constantly low interest rate. The process took more than a decade and full recovery, given the current economic environment, remains elusive. The Nikkei Stock Index is still 70% off its 1989 peak, and property prices are at roughly 40% of their 1990 values (McCurry, 2008). However, one of the silver linings of adversity is that it teaches us valuable lessons, so what lessons does Japan’s experience offer for the rest of the world?

Literature Review

Overview
This report reviews the major actions of the Japanese Government in dealing with its crisis, highlighting some of the lessons learned from their experience. It will then proceed to determine whether these lessons are being applied today, assessing if there is any evidence of an improved response. To tackle this core thesis, it is necessary to examine the literature related to five distinct aspects of the Japanese financial crisis. This review will begin with literature detailing the circumstances and effects of the Japanese financial crisis and then progress to analyse the approaches and tools employed by regulators in response to the crisis. Section III will then draw on literature examining the key lessons distilled from the Japanese financial crisis. Subsequently, the paper will examine whether these lessons are applicable to different financial crises. Finally, section V will assess whether any of the lessons obtained from Japan’s experience are being employed in response to the current financial predicament, concentrating on the responses of the US and UK.

I.I Literature on the circumstances and effects of the Japanese financial crisis

The first step in assessing the responses to the Japanese crisis is understanding the nature of the meltdown and its root causes. There is a high degree of consensus on the nature of the crisis; the collapse of the bubble economy of the 1980’s and the fall of real estate prices. There are many examples of literature detailing these issues. For example Vogel (2006), Cooper (2001), Amyx (2004), Nakaso (2001) and Nanto (2008) focus on these twin aspects and the implications held for the Japanese economy. Nanto is particularly informative, producing a comprehensive portrait of the pre-crisis bubble period and the effect of the ‘burst’ on the financial sector. Cooper expands upon this issue, providing a broader overview of the effects of the crisis, incorporating GDP growth rate, employment, living standards, and foreign trade balances. He highlights that the crisis severely crippled the Japanese economy, bringing their growth rate below that of any OECD country. Moreover, there is a wealth of insightful commentary into the nature of the crisis from Japanese and international press coverage focusing on the core effects.

However, there is more disagreement amongst analysts regarding the underlying causes of these economic problems. Most serious analysts acknowledge that Japan’s economic problems were caused by both macroeconomic policy failures and structural inefficiencies, but they differ in the relative weight they ascribe the two factors. One school of thought argues that Japan’s macroeconomic policies played a more important role. Posen (2004) argues that the burst in the bubble was caused by inappropriate concretionary fiscal and monetary policies in the late 1980’s. He further argues that when the Government introduced fiscal stimulus to boost demand, it was too little too late. Similarly Krugman (1999) supports this school of thought, but emphasises the role of monetary policy. He argues that the Japanese economy entered a liquidity trap; at very low interest rates individuals will hold all additions to the supply of money, thus rendering monetary policy ineffective.
Another group of analysts argue that structural rigidities within the Japanese economy were more important than these macroeconomic policy failures. These economists view the bubble economy as a symptom of underlying structural problems rather than a cause of the prolonged stagnation (Vogel, 2006). One such economist, Richard Katz (1998), argues that Japanese economic problems are rooted in its ‘dual economy’. He asserts that the pre crisis Japanese economy could be regarded as two separate entities; one was highly efficient and competitive whilst the other was inefficient and survived because of protective government regulations. According to Katz, the Japanese economy was able to thrive up until the 1990s because the competitive part of the dual economy propped up the non-competitive segment. He uses the example of car manufacturers, who would buy glass, steel and other components from domestic manufacturers at higher prices than more efficient foreign suppliers. Katz suggests that over time the Government shifted its emphasis from the competitive to the protected sector and with the sharp appreciation of the yen in the 1980s, the efficient sectors could no longer bankroll the system without losing their competitive edge. Masahiko Aoki (2000) puts this point slightly differently, contending that Japan’s fundamental dilemma was that competitive sectors naturally drifted away from the Government’s industrial policy framework while less competitive sectors relied increasingly heavily on government support.

Vogel (2006) stresses a different type of structural problem, a chronic excess of savings due to an inadequate social safety net and the lack of a comprehensive retirement program. This high level of saving fuelled investment, but also implied suppressed consumption. The Japanese economy was left with a stubborn investment savings gap and could not shift from investment driven to consumption driven growth (Vogel, 2006). Scheade (1996) puts forward a different argument, suggesting that the crisis was more the result of the inappropriate design of the regulatory system. His argument is based around the premise that the Japanese financial system and its regulatory structure did not evolve after the post-war period of rapid growth, 1950 - 1973. He states that the system was characterized by collusive regulation, referred to as dango gyose, and administrative guidance, resulting in an entanglement of regulators and regulates and consequently neither party were interested in disclosure or rule enforcement, as well as the high degree of fraud (Scheade, 1996).
This debate identifies a central piece of the story, it is clear that both policy failures and structural inefficiencies were to blame for the economic malaise. Therefore in assessing Japan’s responses to the economic problems it is important to consider both issues.

I.II Literature examining and analysing the responses of Japanese authorities

There is a vast array of sources detailing the Japanese Government’s financial reforms and recovery efforts. Cooper (2001) has produced a comprehensive report examining the core aspects of the Government’s response; fiscal measures, monetary policy, banking reform and other structural changes. Further sources build upon this level of detail and analyse a specific area of the Government’s approach. Nanto (2008), for instance, focuses on the five bailout packages and other sources of fiscal stimulus. Similarly, Nakaso (2001) provides an exceptionally detailed overview of the nature of the banking reform up to March 2000, utilising his prior position as a manager of the Bank of Japan.

Analysis of the tools employed by the Japanese regulators is typically critical. Most commentators agree that intervention took far too long to materialise. Amyx (2004) highlights this issue, stating that the Government’s delayed response translated into lost output and enormous fiscal outlays. Similarly, Vogel (2006) supports this view, stressing that the Bank of Japan moved too slowly and too gradually to lower interest rates. He also notes that when they eventually did lower interest rates to zero, they still remained bound by their post war fixation with combating inflation. Hwang and Schaefer (2002) examine the factors impeding the implementation of policies to address Japan's economic problems and attempt to answer why intervention was so late. They highlight factors such as bureaucratic intransigence, lack of political will, powerful interest groups with much to lose under reform, and the relatively minor impact of the crisis on the daily lives of the average Japanese citizen.

Likewise, many analysts regard the Government’s financial reforms and recovery efforts, once implemented, as ineffective. A number of authors attribute much of the economy’s disappointing performance to “exceptionally poor monetary policymaking” (Bernanke, 2000, p. 150). Additionally, Kuttner and Posen (2002) find that Japanese fiscal policy was contractionary over much of the 1990s, and attribute part of the protracted downturn to insufficient fiscal stimulus. Moreover, Amyx’s (2004) statistically based analysis asserts that policy remedies were unsuccessful. Kobayashi (2009) supports this contention with his conclusion that the fiscal stimulus packages proved ineffective because the Government did not pursue a serious policy effort to make banks dispose of their non-performing loans. Furthermore, Katz (2003) supports this line of thought with his argument that certain reforms, such as aggressive tax reforms, only exacerbated Japan’s economic woes because they reduced households’ capacity to consume.

The combination of timid monetary policy and counterproductive fiscal policy resulted in a macroeconomic strategy that failed to restore aggregate demand, defeat deflation, and return the Japanese economy to growth (Sheard, 2008). An examination of the Japanese Government’s responses therefore suggests that the crisis could have been handled better. Thus, it ensues that lessons can be derived on how to better tackle a crisis of this nature.

I.III Literature examining the key lessons derived from Japan’s experience

The context of the current financial climate has led many economists to examine what lessons can be derived from Japan’s policy failures. As Blanchard notes “this may not be a bad time to assess the lessons from the Japanese full experiment” (Blanchard, 2000, p. 185).
Drawing on the findings of many analysts, one of the clearest lessons emerging from studies of Japan’s banking crisis is that action should have been swifter. The delayed response by Japanese authorities to the bad debt problem only exacerbated the issue and escalated the costs of recovery, a mistake that should serve as a key lesson for the current crisis (Amyx, 2004). Sheard (2008) supports this view, asserting that the Japanese Government acted far too slowly and timidly on all accounts. One way in which he illustrates this view is with the example that it was not until 1998 that the deposit guarantee was funded and an institutional infrastructure was implemented to deal with the troubled assets (Sheard, 2008).
Japan’s five bank bailout packages also hold some lessons for today’s global policymakers. Hoshi (2008) identifies one such lesson, asserting that recapitalization attempts were nowhere near large enough to solve the capital shortage problems of Japanese banks in the long run. By 2005 cumulative losses totalled over ¥96 trillion, roughly 19% of GDP, clearly dwarfing the amount injected by Japanese authorities (Hoshi, 2008). He concludes this point with the view that Japan’s experience suggests that small and repeated capital injections are, at best, only temporary fixes. Kobayashi (2008a) also highlights a similar lesson related to Japan’s capital injections. He suggests that capital injections are unlikely to succeed in eradicating payment uncertainty, but if fiscal stimulus is to work then stringent asset evaluation is necessary. Moreover, Nanto (2008) documents that when Japan announced its first financial bailout package, it placed stringent conditions on the assistance that banks were unwilling to accept. The net result was that the banks ignored the package and tried to bolster their balance sheets by not lending.
Further lessons can be derived from Japan’s recapitalization policies. Hoshi (2008), for instance identifies that Governments attempting to implement their own recapitalization policies must conduct due diligence on the financial institutions receiving public funds. In Japan, many small but important regional banks were recapitalized, only to eventually fail (Hoshi, 2008). Additionally, banks that receive public funds should not be forced to lend to small and medium sized firms. As the goal of recapitalization is to enable banks to continue to extend credit, the Japanese Government opted to require banks to lend to small and medium sized firms, but this policy kept credit open to many insolvent ‘zombie’ firms (Hoshi, 2008). Hoshi concludes that both these mistakes contributed to Japan’s subsequent decade of economic malaise.

Regarding monetary policy, Kobayashi (2008b) makes the point that it should not be heralded as a perfect solution in an insolvency crisis. In this respect he adopts a similar view to that of Nobel laureate, Professor Lucas, who remarks that “monetary policy should concentrate on the one thing it can do well; control inflation. It can be hard to keep this in mind in financially chaotic times, but I think it is worth a try” (Wall Street Journal, September 19, 2007). This view is further supported by Daniel Leigh in his IMF paper (2009). Other scholars, however, draw less sceptical lessons from Japan’s monetary policies. Sheard (2008), Woodford (2008), and Posen (2009) argue that quantitative-easing was an effective strategy for addressing deflation, despite the policy’s shortcomings. As Woodford points out, a lesson to be absorbed is that central banks should signal that they are expanding the balance sheet consistent with their calculation of how much money should be in the economy after re-flation is successful (Woodford, 2008).

Furthermore, there are a number of additional lessons to be taken from Japan’s experiences. Kobayashi (2008a), for instance, highlights that debt restructuring is absolutely necessary to prevent a vicious cycle and that public asset management companies may need to be established to prevent debt deflation. Similarly, Kanaya and Woo (2000) document that Japanese regulatory authorities needed to take a proactive attitude towards supervision, and that transparent accounting standards could have been an effective tool to do so. Moreover they recognize that uncoordinated deregulation can be harmful, and that the sequence of deregulation is also important. They support this view by highlighting that Japanese banks were not allowed to underwrite securities whilst the bond market was being liberalized, it was not until 1994 when banks were allowed to set up security subsidiaries, and this weakened banks (Kanaya and Woo, 2000).

It is therefore apparent that a number of potentially relevant lessons can be derived from Japan’s experience. Having critically analysed the literature, these core lessons are: action should be taken early (Amyx, 2004), policymakers must be flexible and willing to employ a broad range of measures to stabilize the financial system, including aggressive fiscal and monetary stimulus (Kang and Syed, 2009). Moreover, policy responses should be coordinated and attack the underlying problem of bad debt (Kobayashi, 2009), and finally, an exit strategy from the rescue policies must be carefully planned and implemented when signs of recovery emerge (Sheard, 2008).

I.IV Literature examining the applicability of these key lessons

It is not clear at this stage whether the lessons identified are applicable to the current, or even future, financial crises. To assess whether it is possible to successfully leverage these lessons to other financial crises many authors have compared Japan’s crisis with the current financial crisis. Such comparisons have revealed considerable differences, leading several authors to assert that the fundamentals of Japan’s crisis are too distinctive, limiting the applicability of Japan’s experience beyond the generic level.

Hoshi (2008) has pointed out that Japan’s problem was essentially nonperforming loans affecting the solvency of the commercial banking system. Conversely, in the US, the source of the crisis has been a housing market bubble involving subprime loans and mortgage-backed securities with very complex financial structures. Therefore, compared to Japan’s crisis, what is happening in the US is much more of a market liquidity problem, as it also is in Europe and the UK (Hoshi, 2008). Moreover, he highlights that in Japan stock prices peaked and collapsed just before real estate prices, while in the US the two happened almost simultaneously.

Similarly, Sheard (2008) has stressed that the reach of the current crisis is much greater than it was in Japan. Whereas Japan’s crisis was primarily a local phenomenon, the current crisis has had global consequences, since bad assets were securitized and spread throughout the global financial system. He concludes that the current crisis is a far more complex problem to address compared to the Japanese crisis, and this limits the applicability of lessons distilled from Japan. In this respect he adopts a similar view to that of Akio Makabe, an economics professor at Shinshu University, who remarks that “The Japanese policymakers of yesterday designed their bank resolution policies in a more stable macroeconomic and financial global setting” (JETRO, 2009, February Newsletter, p.3).

Furthermore, the view that the applicability of Japan’s lessons is limited is touched upon by Kobayashi (2008b) who notes that Japan’s problems were concentrated in about twenty financial institutions, where as the current crisis affects a large number of banks and many nonbank financial actors. Kobayashi also highlights that today public trust in the financial system and its agents is extremely low; a sharp contrast to Japan in the 1990’s.

However, analytical research on the comparative aspects of both crises also reveals striking similarities. For instance, the causes of the two crises are sufficiently similar. Cooper (2001) notes that the impulses driving the boom that preceded both crises can be traced to financial innovations and some form of financial liberalization, setting off a credit boom that fuelled rapid increases in asset prices, particularly house prices (Cooper, 2001). Moreover, he also points out that both booms were supported by lax monetary and fiscal policies and that in either case financial supervision and regulations were inadequate to prevent the emergence of large financial imbalances. Hoshi (2008) highlights the similarity that both Japan and the US experienced the unexpected failure of one of their largest financial institutions; Yamaichi Securities in Japan and Lehman Brothers in the US, which in both cases led to a spike in interbank loan rates.

Moreover, broader studies of the comparative aspects of financial crises indicate that financial crises are inherently similar. Of particular interest is a recent paper (Reinhart and Rogoff, 2008) which surveys a broad array of data to compare the scope and impact of the US subprime crisis with a number of previous financial crises, including the Japanese financial crisis. The paper asserts that the subprime crisis shares striking similarities with the financial crises that have preceded it, particularly in the run-up of asset prices, in debt accumulation, in growth patterns, and in current account deficits. The authors conclude that whilst the situation of the US is slightly different, in many ways, the mechanisms behind the crisis remain the same.

Hence, despite the idiosyncratic aspects, most economists believe that the Japanese model of bank resolution can serve as a source of guidance for countries facing financial crisis. Thus, Japan’s experiences can be seen to be relevant for other countries currently experiencing similar problems because they go to the heart of what a financial crisis is.

I.V Literature examining whether any of the lessons are being applied in the current financial crisis.


With the knowledge that lessons from Japan can be used as a form of guidance for countries facing financial crisis, the question arises; have countries dealing with the current financial crisis learned from Japan’s experience?
The economist Paul Sheard (2009) of Nomura Securities International, asserts that countries such as the US and UK are certainly behaving as if they have. He highlights the fact that in both countries, policymakers are acting aggressively on all fronts. “Fiscal, monetary, banking system and housing policy have all been mobilized to tackle the financial crisis, restore liquidity to financial markets, prevent deflation, and to end the recession” (East Asia Foundation Journal, Vol 4, No 1, Spring).

Moreover, Sheard (2009) suggests that the policymakers have learnt from Japan’s mistake of delayed intervention. Focusing on the US, he draws attention to the fact that it took just over one and a half years for the Government to put in place a large scale bank recapitalization framework (the Troubled Assets Relief Program), where as it took Japan roughly seven years to get to that point (Sheard, 2009). Similarly, he notes that by October 2008, the Federal Government had doubled the size of its balance sheet and engaged in a quantitative-easing strategy. In contrast, it took Japan over a decade to establish its quantitative-easing policy, and under it, the Bank of Japan only expanded the size of its balance sheet by about 35% and took about three years to do so (Sheard, 2009). This view is further supported by Tokyo based analyst Richard Jerram of Macquarie Securities who noted “the speed and aggression of the US response gives hope that it will avoid following the path of Japan in the 1990s” (JETRO, 2009, February Newsletter, p.3).

Furthermore, the view that the US has learnt from Japan’s experience is supported by the fact that Federal Chairman Ben Bernanke and Treasury Secretary Henry Paulson have explained that they formulated their responses to the current financial crisis after considering past crises (Faiola and Cho, 2008). In particular they looked at the US savings and loan episode of the 1980s and the bursting of Japan's economic bubble. From their analysis, they ultimately decided that the response to the current crisis needed to be a fast and substantial, two of the core lessons derived from Japan’s policy failures (Faiola and Cho, 2008). Furthermore, when the US Treasury planned the $700 billion bailout package (Emergency Economic Stabilization Act of 2008) to address the financial crisis, it reportedly examined the experience of Japan from when it grappled with its banking crisis (Nanto, 2008). Moreover, as the US acts on the lessons obtained from Japan, so do other countries around the world follow suit (Kobayashi, 2009). The UK and many European countries have responded with similar vigour and aggression. Regarding the UK, Adam Posen (2009), a member of the monetary policy committee and Bank of England, highlights the speed and vigour with which monetary policy has responded in the wake of crisis.

Although US and European policymakers have responded to the ongoing crisis with much greater alacrity than did Japanese policymakers, at this stage it remains to be seen whether global policymakers have effectively attacked the underlying problem of bad debt (Kobayashi, 2009). Some analysts, such as Kobayashi (2009), feel that the US and Europe have failed to recognize one of the most important lessons from Japan’s experience; that market confidence can only be restored when progress is made on the painstaking process of disposing of nonperforming assets. He suggests that, whilst fiscal stimulus will help economies it will not resolve the crisis. He suggests that once the ‘painkilling’ effect wears off, US and European economies will plunge back into crisis. In this regard, US and European policymakers can be seen to be repeating the mistakes of Japanese policymakers, acting slowly to tackle the daunting task of solving nonperforming asset problems, clinging to wishful thinking by hoping that all of the current global economic problems will solve themselves in due time (Kobayashi, 2009).

Nevertheless, it is clear that global policymakers have taken onboard many of the lessons derived from Japan’s experience. Cementing the fact that the Japanese model of bank resolution has become a precedent for country’s formulating their own responses. However, literature detailing these issues has not yet had time to properly developed due to the contemporary nature of the current crisis.

Concluding Statements

In conclusion, academic research detailing the nature and causes of the Japanese crisis, as well as the policy responses implemented to resolve it, are well documented. However, there has been much less scholarly focus on extrapolating lessons from the crisis and very few authors have examined whether they are being applied to tackle the current financial crisis. Moreover, as the effects of the current crisis are still being digested, few authors have yet examined whether there is evidence of an improved response. This paper will attempt to go beyond the limits of existing literature by examining whether the lessons from Japan’s experience have been taken into consideration of governments addressing the current financial crisis. In this regard, this paper is intended to act as a basis for further discussions concerning effective crisis prevention and management to address potential financial disturbances.
 
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