Lessons from Japan Versus Wishful US Prescriptions (Summers/De Long Edition)

Two articles in the Financial Times, one a discussion of the implications of Japan's crash for US policy, the other the latest in a series of comments on the credit crisis by Larry Summers, take different views of the best remedies for our economic woes. Unfortunately, the Japanese prescription seems likely to be necessary, yet the Summers article (and some online commentary on it) suggests the US is a long way away from embracing realistic solutions.

Note that the analogy to Japan presupposes that our mess is of a similar magnitude to theirs. A lot of experts don't accept that, since their asset bubbles (stock market and real estate) were on paper much greater relative to the sustainable value of the underlying assets than ours.

But I am not persuaded that anyone has done the right analysis. What matters is not so much how big the market cap of the various inflated assets got to be, but how much credit was extended against them. For instance, in Japan, corporations borrowed heavily against the value of urban land (Japanese banks would lend 100% against the nominal value), but unlike the US, homeowners did not have vehicles for extracting their inflated equity, so the residential real estate bubble did not have the same systemic impact that the commercial one did. Some very simple numbers would shed light on the debate. Moreover, we have far more levearge on leverage than Japan did (geared hedge funds and investment banks owning CDOs, which themselves were sometimes leveraged; hedge funds of fund adding another layer of borrowing on top of the borrowing at the hedge fund level). The debt to GDP ratio in the US is 270%, higher than the level before the crash of 1929, when it was 250%. What was the level in Japan in 1989?

Further, I am not certain a US GDP leverage measure tells the full tale. Per the wonders of our originate-and-distribute model, US mortgage and corporate paper is in a lot of foreign hands. Similarly, some levered players in our markets don't necessarily borrow from US concerns (think of all those London-based hedge funds, who probably borrow at least in part from foreign entities). And we also have various derivatives exposures which are not captured in any formal computations of leverage (that's going a bit far, but not by much, since Basel II give the banks considerable latitude in how the compute the equity that needs to be held against derivatives positions).

And to what degree do we offset Japan's very high domestic savings at the time of the crash against its bubble? Consider: even if our credit mess is on paper less bad, we aren't in a position to resolve it internally. Our continued and not-likely-to-reverse-anytime-soon dependence on foreign capital (we had better hope it doesn't change in the near future; the alternative is a dollar crash, which would wreak havoc here and abroad). That is a more complicated problem to parse.

Finally, the article mentions that the US does not face the risk of deflation. We are witnessing liquidity hoarding in the interbank markets. I already have economically literate readers who tell me that they are holding large cash balances at home our of fear of a bank holiday and are trying to find a bank they deem to be safe. A couple of bank failures and we could be well on the way enough withdrawals from banks to generate a money supply contraction, no matter what the Fed does with the monetary base.

That is a long-winded way of saying that the powers that be may be deriving false confidence from looking at incomplete measures of the financial service industry's gearing.

So back to the FT. in "Japan’s ‘lost decade’ offers dire pointers for the Fed," Gillian Tett and Krishna Guha argue that the big lesson from Japan was in the end, the government had to recapitalize the banking system and delay only made matters worse. Yet rescuing banks was highly contentious in Japan, and keep in mind that unlike here, banks were not highly profitable pre-crash and executives were not paid princely sums. In other words, they lacked the controversy of the financial services industry lining its pockets before it went belly up.

But let's tease out the Japan hypothesis. Let's say that, in the end, the banks will have to get a public injection of funds. What might be some implications?

First is that all these measures to shore up markets are a very indirect, inefficient, and therefore costly was to try to finesse the real problem, that a lot of institutions are or shortly will be insolvent. That says we should quit propping up the mortgage market, particularly since letting housing and mortgages find their level will entice cash on the sidelines to come in, and deal with the damage to institutions directly, It similarly suggests that we might deal with the damage to families frontally rather than by trying to prop up home prices (for instance, Dean Baker's own to rent, which has homeowners stay in their residence as renters, is a government-mediated version of a longstanding banking practice, deed in lieu of foreclosure, where the homeowner would hand over the deed but stay in place as long as they could pay a reasonable rent, at least until the bank found a buyer. The Baker plan would give tenants somewhat stronger rights to remain if they stayed current in their lease payments. Other measures might address job or wage losses).

Second, if these institutions are insolvent, the government has no reason to be shy about nationalizing institutions, and that means wiping out the equity holders before any funds are injected. Yet people like Summers seem remarkably loath to even voice that idea, as if it were somehow anticapitalist. Huh? What is anti-capitalist is privatizing gains and socializing losses. No more free lunches for those who get salvaged by taxpayers.

We also need more serious discussion of new regulator approaches, not charades like the Paulson plan that pretends that reorganization is tantamount to a new supervisory regime. My colleague Columbia professor Amar Bhide sent an elegant recommendation that he presented last November:

Severely circumscribed ‘regulated’ institutions

�� No Level 2 or Level 3 assets
�� Limited diversification

Totally unregulated ‘hedge funds’

�� No limitations of innovation/ immunity from
securities laws
�� May choose ‘private’ monitoring
�� But no credit (or other funding) from regulated
institutions

We need more concrete ideas.

Finally, there is a longish post by Brad De Long on Summer's article, in which he uses as point of departure a simple construct first posted by Paul Krugman (admittedly, De Long pushed around this model in an earlier post at some length). Krugman posited that there might be an S-shaped demand curve (supply is vertical, since at any point in time there is a fixed amount of securities). He further reasoned that there was a high-priced equilibrium, and a low-priced one that could be induced by panic, and the Fed was trying to get back to the high equilibrium (for reasons of space, I did not replicate his so-called cartoons, but you can see them at his post). But he concluded:

But at this point a series of rate cuts and other stuff just hasn’t done the trick — which suggests that maybe there isn’t a high-price equilibrium out there at all.....And in that case, the Fed can’t rescue the financial markets. All it — and the feds in general — can do is to try to limit the effects of financial crisis on the rest of the economy.

Yet De Long blithely ignores the conclusion that Krugman reached, and by implication, so does Summers.

What about "bubble" don't you understand? That high priced equilibrium was not stable, it was created by unsustainable leverage. Per Herbert Stein, "That which is unsustainable will not be sustained." It is neither good economics nor good policy to try to keep an asset bubble aloft.

First the Tett/Guha article on Japan;

A decade ago, senior American officials regularly travelled to Tokyo to deliver sermons on how to handle a banking crisis....

These days, the tables have turned with a vengeance. In recent months, the Tokyo markets have been a relative oasis of calm amid the global credit woes.....Most Japanese officials are far too polite to crow publicly about the reversal of fortunes. But, in private, wry smiles abound – and some are starting to take a once-unimaginable step: to offer the US a little advice themselves.

“It is essential to understand that given Japan’s lesson, public fund injection [into the financial sector] is unavoidable,” Yoshimi Watanabe, minister for financial policy and administrative reform, recently told the Financial Times....

Exactly how Washington might respond to this advice remains unclear. By a quirk of history, Ben Bernanke, who as US Federal Reserve chairman is in the eye of the storm, is an acknowledged expert on the Japanese crisis: he was also among those who travelled to Japan as a Fed governor to offer advice on how to fight back with unorthodox monetary policy. Timothy Geithner, the head of the New York Fed, is also deeply familiar with Japanese financial lessons, having lived in Tokyo in the 1990s before serving in the US Treasury’s international team.

These men, along with other American economists, see significant differences between the current US problems and those that beset Japan. The US is not plagued by deflation, which created a “debt-deflation” trap in Japan, in which the real value of debts increased as prices fell.

The scale of the US problem also appears smaller in proportion to the size of the economy, not least because the securitisation of mortgage loans spread credit losses around the world.

“The cost of the losses in the US economy will be much smaller than they have been in Japan,” says Ed Lincoln, a US economics expert on Japan.

Yet US policymakers also recognise that there are similarities between the crises. Most notably, the current credit crisis – as in Japan – is not just centred on one bank; instead it reflects a loss of confidence in the system.

In practical terms, the Japanese experience already appears to be shaping US policy in several ways – in terms of showing possible solutions as well as offering examples of what not to do. US economic policymakers believe Japan’s lost decade was not the inevitable result of an asset price crash but the consequence of policy mistakes in the aftermath of that crash. They are determined to avoid repeating this error. As a result, US regulators are insisting that Wall Street banks come clean about losses more quickly than happened in Japan. “Japan dawdled for years ... but the US has moved much faster,” says Robert Feldman, chief Japan economist at Morgan Stanley.

The aggressive mark-to-market accounting regime in the US forces both banks and policymakers to confront problems rapidly rather than let them fester. The Japanese saga appears to have encouraged the US to rescue Bear Stearns before it collapsed, on the idea that its failure would have had devastating spillover effects.

“The US has traditionally felt that if a financial institution was broken it should be sold or liquidated,” says Timothy Ryan, former vice-chairman of JPMorgan. “Now it seems that the government believes that some form of open bank assistance may be the least-cost resolution – I think they’re right.”

However, the big question now is the one Mr Watanabe raised: whether the US will go a step further and intervene with public funds to prop up the financial system. Many Japanese officials are now quietly convinced that this has become inevitable – by directly rescuing banks or purchasing troubled mortgage assets or both.

However, this concept remains highly controversial in Washington. US officials are not yet convinced that the economic outlook is bleak enough to justify outright use of public funds. The US can use government-sponsored institutions, such as Fannie Mae or the Federal Home Loan Banks, as a “back-door” channel to the credit market and to the banks, without the need for explicitly taxpayer-funded intervention.

In general, the US political system is much more biased towards action than Japan’s consensus-based system. But while senior Democrats in the US Congress are increasingly advocating more public intervention, the White House remains firmly opposed to the outright use of public funds. “There is no way that this current administration can sign up to a bail-out of the banks – I just don’t think that is going to happen,” says one senior Wall Street figure.

To some Japanese ears, this invokes a dangerous sense of déjà vu. After all, they point out, when financial institutions started to collapse in Japan in 1994, politicians in Tokyo were equally opposed to using public funds. As a result the Bank of Japan used its own, separate balance sheet to rescue two banks. This, however, later left the central bank shouldering losses.

By 1998, the banking problems had swelled to a point where the government finally recognised the need for a bail-out fund. Yet this was repeatedly delayed by political squabbling. It was not until 1999 – five years after the crisis started – that Tokyo produced a Y60,000bn package earmarked for steps such as the purchase of bank preference shares.

This was big enough to allay concern – although ironically, only a fraction of this money was ever used and much of the cash deployed was later recouped. “Our experience shows that waiting does not help,” says one senior Japanese official. “You have to explain to politicians why you need to act.”

But, for the moment, Washington is resisting this conclusion, even though the Fed believes that taxpayer-funded intervention could be justified as a last resort in some circumstances. When Mr Watanabe meets his US counterparts at next month’s Group of Seven gathering, in other words, it could provoke some lively debate; almost as lively, in fact, as the conversations that occurred at the G7 back in 1998.

Now to Larry Summer's article. Note that he acknowledges that the government cannot keep asset prices from declining to their fundamental value but does not consider the implications. Even more bizarrely, he dances around the role of Freddie and Fannie, on the one hand arguing that they should be lenders of the "first, last, and every resort" (um, that means they are serving a public purpose) yet will not address the need to nationalize them. What gives? Similarly, he makes a motherhood statement that if banks get help from the government they should anticipate that that costs arecattached. But this is a charged area where details are far more helpful than platitudes.

From Summers:

It is sometimes darkest before the dawn. For the first time since last August, I believe it is not unreasonable to hope that in the US, at least, the financial crisis will remain in remission.....

Wise policymakers hope for the best but plan for the worst. Liquidity provision and government efforts to support the mortgage markets can address problems of confidence. But they cannot ultimately prevent asset prices from declining to true values or make troubled financial institutions solvent.

While spreads have come in somewhat, markets continue to price in significant probabilities of default for even the most apparently strong financial institution, reflecting in part concerns about their solvency. At the same time it needs to be recognised that the federal government is bearing credit risk in extraordinary ways through its implicit guarantee to the GSEs, the lending activities of the Fed and the general backstop it is providing to the financial system.

All of this implies that a priority for financial policy has to be increases in the level of capital held by financial institutions. Capital infusions to date fall far short of prospective losses. Without new capital, the financial sector will operate with too much risk and leverage or will put the economy at risk by restricting the flow of credit.

On a favourable economic scenario, increases in capital will accelerate the return to normality in sectors such as municipal finance and student loans where credit has dried up, and will offset the moral hazard created by lending to financial institutions.

On an unfavourable scenario, increased capital will protect the taxpayers who bear the burden of government and Fed guarantees, will make possible more immediate and honest recognition of losses and will reduce the risk of vicious balance sheet contraction if asset values decline again.

The policy approach should start with the GSEs. These institutions’ viability with anything like their current operating model depends on the implicit federal guarantee of their several trillion dollars of liabilities. It is appropriate at a time of crisis in the mortgage markets that they become, as their regulator put it last week, the “lender of first, last and every resort”.

It is not appropriate that their shareholders’ “heads I win, tails you lose” bet with the taxpayer be expanded for this purpose. Given their past and prospective losses, their regulator – supported by the Treasury, the Fed and, if necessary, Congress – should insist that they stop paying dividends and raise capital promptly and substantially as they expand their lending. In the unlikely event that the boards of these institutions refused, policymakers should put them into an appropriate form of administration that insures that their obligations will be met.

Because they do not have a similar public mission and are operated with more financial rigour and closer regulation, the situation is somewhat different with respect to other financial institutions.

As part of its dialogue with financial institutions, the Fed should push for further efforts to raise capital. Consideration should be given to collective actions designed to destigmatise cutting dividends or raising equity. The idea of linking access to Fed credit and measures to attract capital should also be explored. At a time when much is being given to financial institution shareholders and management, action to help the economy and protect the taxpayer should be expected in return.