Nobody has wanted to heed the lesson of post bubble Japan until way too late.
Early in the crisis, the Japanese took the uncharacteristic step of telling American policy makers loudly that Japan had made a big mistake in how they handled theirs. They stressed that the most important step was cleaning up the banks. Then the IMF had the bad fortune to release a study of 124 banking crises on the heel of the Lehman and AIG meltdowns, which meant its findings were ignored, since the finance officialdom was too busy trying to deal with the wreckage to process new information. But it too came squarely down on the side of making banks take their medicine:
Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.
Cross-country analysis to date also shows that accommodative policy measures (such as substantial liquidity support, explicit government guarantee on financial institutions’ liabilities and forbearance from prudential regulations) tend to be fiscally costly and that these particular policies do not necessarily accelerate the speed of economic recovery.5 Of course, the caveat to these findings is that a counterfactual to the crisis resolution cannot be observed and therefore it is difficult to speculate how a crisis would unfold in absence of such policies. Better institutions are, however, uniformly positively associated with faster recovery.
This section of the IMF report is particularly germane to austerity-mad Europe:
Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.
Now in Europe, the salvaging of otherwise insolvent French and German banks isn’t being done via anything as straightforward as “blanket guarantees” but the result coming to look a lot like that, despite all the smoke and mirrors involved.
One of the major features of the current programs, which also emulate Japan but was not analyzed in IMF paper, which focused on fiscal operations, has been the use of extraordinary monetary measures, at first to stabilize asset values and then to encourage new borrowing by putting money on sale. That hasn’t worked at all in Japan, where overly cheap loans have not done much to spur new investment but have served to prop up inefficient borrowers who remain on life support. This was a concern early in the crisis: Japan’s super competitive exporters stood in sharp contrast with a very inefficient retail sector, and in some industries, mom and pop suppliers too. Japan prioritizes stability of employment over profit, so initially, this seemed like a sensible move at first.
But the super-cheap funding has become permanent as the economy has never attained liftoff and the cost of incurring a lot of pain is still perceived to be too high. Now John Plender of the Financial Times, citing some new research from JP Morgan, argues that zombification is an inevitable result of distorting the price of capital. Note that we’ve been on the path of distorting capital markets prices for a very long time. The Greenspan, later Bernanke put, has been perceived (correctly so far) of reducing the downside risk of speculation and the degree of support has grown over the last 25 years as the amount of intervention it takes to staunch crises has only kept growing.
From the Financial Times (hat tip Joe Costello):
The deeper problem is that this monetary ease tends to freeze the existing industrial structure. Looked at from the Austrian perspective of Von Mises, Schumpeter or Hayek, the Japanese bubble that burst in 1990 fostered economic distortions they dubbed “malinvestments” – credit-driven investments in real capital that prove loss making when a credit bubble implodes. The results of these misconceived investment decisions take a long time to work their way out of the system, while industries that expanded in response to high demand in the bubble are left with excess capacity. The elimination of this excess and the process of adjustment to a new industrial structure to reflect changed demands, which in Japan’s case means a greater service orientation to address an ageing population, is invariably painful.
In effect, low funding costs in Japan have impeded the process that Joseph Schumpeter dubbed creative destruction because “zombie” companies have been kept afloat at high cost to the competitiveness of others. Worse, the public credit guarantees introduced to help the banking system lend to industry and commerce have had unintended consequences. The Bank of Japan fears the banks’ capacity for credit assessment is being diminished, while the restructuring of non-viable small and medium sized businesses is discouraged.
If you know anything about Japan, the idea that the Japanese banks have managed to get worse at judging credit risk is truly scary. The part of the Japanese financial debacle that isn’t discussed widely enough is that Japan had a highly regulated banking system through the mid 1980s, when the US pressed it hard to liberalize its market. Being a military protectorate of the US, it wasn’t exactly in a position to say no, with a result that it deregulated rapidly.
The result was not, contrary to US fond hopes, that American banks were able to get a strong foothold and make oodles of money. Japanese strongly prefer doing business with established Japanese firms, except for clearly foreign business (and even then, a lot of medium and large corporations would prefer a Japanese firm) and foreign banks also found it hard to attract top Japanese graduates (Western firms didn’t offer lifetime employment, nor were they as prestigious). But what did happen was Japanese banks raced out to do all sorts of things they had been formerly prohibited from doing, and started doing it badly. When I had Sumitomo Bank as a client (and it was seen as one of the best run, most innovative banks in Japan) I was horrified to see how far behind US banks it was on pretty much every front, except being a super low cost operation. A couple of simple indicators: branches (and its New York operation was a branch) had six month revenue targets. No notion of risk weighting or funding costs. So my revenues in no-risk M&A were treated the same as up front fees on $500 million of lending to Campeau (a famous turkey LBO that the bank did indeed lend to, along with a host of other terrible deals).
Plender points out that the bad behavior of the bubble years continues in reduced form, and (similar to Michael Pettis) he suggests China is following the same failed playbook:
Also extraordinary is that with declining investment, Japan has achieved the same kind of distortion China has brought about through the excessive investment that followed fiscal pump priming after the Lehman collapse.
Tadashi Nakamae, eponymous president of Nakamae International Economic Research, believes Japan is entering the final stage of a structural adjustment that began in 1990, a Schumpeterian endgame; industries with too many companies need the less efficient to be wiped out so profitability can be restored…
This is also worrying for China as it tries to make the transition from a high to moderate growth economy. Japan’s high growth period ran from the mid-1950s to the early 1970s. Average growth was 9.7 per cent, just short of China’s 10.1 per cent since 1990. When the excess labour in China’s rural areas runs out, the country will have to cope with increased wage pressure and declining labour productivity growth. Meantime, the Chinese working population will start to decrease from 2015. A measure of the challenge is that it took all of 30 years from the point where excess Japanese rural labour ran out for Japan’s working age population to decrease.
This means, sport fans, that a slowdown in Japan and China could produce much worse outcomes than conventional thinking believes is possible. It might be time to prepare for a rough ride.