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

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  1. Anonymous

    “We need more concrete ideas”

    As Level 3 assets include real estate, don’t Bhide’s suggestions imply banks don’t ‘do’ mortgage lending?

  2. Anonymous


    “Consideration should be given to collective actions designed to destigmatise cutting dividends or raising equity.”

    Any idea what this means?

  3. TallIndian

    Anon 7:48

    Translating Prof.Summers:

    Share holders should be ecstatic when new management both cuts the their dividend and dilutes their equity after paying billions in severance pay and bonuses to the outgoing management.

  4. reason

    I would have thought that the really big difference between Japan then and the US now is the trade deficit. Why isn’t this even mentioned? If the US tries to inflate its way out of the crisis there is a very real danger of hyper-inflation as the exchange rate collapses. It is already saving to little.

  5. anony

    Why should banks recapitalize solely on the basis of current market values for mortgage related products? Actual mortgage defaults and asset recovery rates will take place over a period of years. Why value all of this now into current capital requirements?

  6. insurance guy

    Is anybody else confused by Krugman’s Backwards S Demand Curve? It seems obvious (to me at least) that demand for risky assets has just shifted down in response to the realization that risky assets don’t always go up in price.

    Economists just won’t believe that prices can be substantially affected by speculative fervour. We’ve had two fantastic bubbles in the last decade, yet economists refuse to admit their existance.

    Is this science? It seems to me that the discipline’s greatest minds are making it up as they go along.

  7. anony

    “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.”

    Arguably, the diffusion of creditor distribution matters quite a bit too. (e.g. bank/shadow-bank; US-global, etc.).

    How does one measure this effect, relative or absolute?

  8. VennData

    How do banks decide “fair rent” for captive tenants? Should the tenants decide it? What about a judge? (The GOP cohort in Congress wants to keep judges out of this at all costs.)

    The good news is there is no housing shortage, so if people are willing to move (yes they’re in their dream house, but it’s just that a dream) they can negotiate a rent prior to moving into a house already on some bank’s books. Maybe give people a tax credit for moving (if they can prove they didn’t trash the old place… with like, a bank letter.)

    The “cost of the losses” depends upon the median house price in 2010 and the pricing trend. If the Japan “experts” know those losses will be less than Japan’s in the day, then they’re right. But no one knows. There’s no fundamental value to home prices. It’s not market rents, they can go down (See above.) It’s not construction cost. Remember the S&L crisis that came as a result of the Reagan’s mistaken partial deregulation of the asset side of banking but not the liability side. Depositors had their deposits guaranteed by the FDIC, and buildings were sold at pennies on the dollar.

    Nobody knows.

  9. insurance guy

    a said…
    “Is this science?” No, and it never was, was it?

    Fair enough. Certainly not a natural science, but Economics is a social science – or supposed to be.

    The problem is there isn’t any scientific method to the perscriptions of DeLong or Summers. It’s all based on a thought experiment by Krugman. Seems like a dangerous way to make policy.

    I don’t buy the argument that prices of risky financial assets are low becasue financial institutions are weak. Haven’t we had weak or at least reasonable prices on risky assets in periods where banks have been healthy?

    For some reason, Krugman, DeLong and Summers feel compelled to defend the pre-crisis price levels. But in my view its the pre-crisis level prices that are abnormal, not the current reversion to the mean.

  10. Anonymous

    The fundamental problem is psychology not just economic. Japan is a modern financial world power so its a good indication of the many problems the USA will experience in unwinding years and layers of worthless debt.
    People at all levels of society will not accept the fact that their wealth is a fraud, shallow and based mostly on leverage and specualation that will unwind and leave them with a fraction of their current paper wealth.

  11. dearieme

    “We need more concrete ideas”: on the contrary, too much concrete has been poured already. Long term, surely some rather sweeping changes to company law are required, to get rid of the perverse incentives for executives to gamble and regamble the shareholders’ capital until it’s all gone.

  12. S

    Intereting letter by two med school residents in this weekend FT (to editor). They gripe that their tax dollars should not go to fund speculators in real estate. Instead the argue government should write off of student debt as it is more productive capital. Welcome to the slippery slope.

    Also interesting article that Kohn is probing the nordic banks handling of the 90s crisis (nationalization) as crisis worsens. [Telegraph – via Drudge]

    Fascinating quote from Secretary Mellon regarding stock market crash. He advocated letting equities liquidate, real estate liquidate and farmers liquidate so asset price could clear and a health rebuilding could begin. he also advocated letting wages fall (not a problem these days – actually maybe the heart of the problem). [from Devil Take the Hindmost – Edward Chancellor.] Instead we got repreated government action that obfuscated the process. Sounds familiar.

    If a comparison is to be made via 29 it might be a China Shanghai collapse as stocks fall and govn’t clamps down on money supply. They at least have industialization ahead. The US on the other hand, well be afraid be very afraid. Especailly with paulsen at the posium talking about how our system is built on innovation – and exactly what has been the net economic benefit of that “innovation” in our financial services stronghold. FYI went negative last Q.

  13. jm

    We live in a courtiers’ society. DeLong and Summers are courtiers, not farmers or engineers or builders or businessmen who produce anything that could be sold to the public at large to earn a living.

    The more senior courtiers — those who select the less senior couriers such as university presidents and professors — will be quite upset if any more junior courtiers start pointing out that the emperor has no clothes — that massive amounts of resources have been malinvested, and that the nation as a whole must face that it is far less wealthy than it would like to think, and that it needs to rebuild its capacity to produce itself the things its people want to consume.

    As courtiers, they are highly constrained in what they can say without being cast out from the court, doomed to wander in essential obscurity like, e.g., Dean Baker.

  14. Anonymous

    All of this fancy talk is just that. The only real question is will greed be subject to regulation or not. I think not. “Privatize gains, socialize losses” pretty much sums up the mantra going on in the minds of the current administration. If you just have a gaggle of talking heads on TV selling it, put a fancy enough wrapper on it or have a big enough smokescreen you just might be able to sell it to the public. Make sure that the financial sector lobbyists line the pockets of congress and voila! Financial problem? What Problem? Everything is just fine, business is handled. No there is no real science here. The real objective is keeping the pigs at the trough. You can call it by different names and have different vehicles for delivery but that doesn’t change what is going on.

  15. john c. halasz

    Where do you get the total debt to GDP ratio for the U.S. economy of 270%? My recollection is that’s more like where it was in 2000. In 2006, it was more like 330%, 13.2 trillion GDP, 43.5 trillion total debt outstanding.

  16. minka

    Our economy will shrink 10% in the coming recession, in my view. The collapse of the debt bubble, at the same time as the collapse of the consumer, means that the current account deficit will be wiped out, through consumer recession, dollar collapse followed by import substitution, and the vicious contraction of the financial sector. This is a shrinkage of about 7%. The remaining 3% will be overshoot.

  17. Yves Smith

    Anon of 7:21 AM,

    Real estate and mortgages are two different things. You may be thinking of how Goldman was trying to assert that its Level 3 assets really weren’t that vaporous, since they included a lot of real estate and private equity principal investments. I am at a loss to understand why kind of real estate Goldman would be buying (presumably office buildings and the like) couldn’t be valued as Level 2.

    In general, I agree the Level 2 prohibition may be too strict (corporate bonds would be Level 2), but some banking experts (Lowell Bryan) in the wake of the S&L crisis, said that depositaries should be restricted to holding only super-safe securities like Treasuries. If they wanted to do riskier business, it would have to be via a separately-capitalized entity.

    john c. halasz,

    Eeek. I saw it in the 24 hours before writing the post, I believe the data came from Morgan Stanley, and I recall seeing chart of same earlier. If I have time I will try to track it down.

  18. Anonymous

    I’m not sure the demand curve, or price has actually shifted. The correvt commodity value is the cost of the house which is a function of the interest rate and the price.

    The Fed created the price bubble with obscenely low interest rates (and new exactly what they were doing). Although prices were rising, the monthly cost was actually declining or staying the same.

    The reversal in credit conditions is forcing a reversal in price to maintain the equilibrium cost. The organized criminal activities of the financial industry is their natural tendency which was facilitated or set free by the anarchy and criminal intent of the republican congress and administration.

    After watching it unfold for the last eight years, it seems clear to me.

  19. john c. halasz

    Well, the rough point is/was that the total debt to GDP ratio for the U.S. economy, however that is captured and figured, has been increasing steadily, at a graphically slightly up-curving slope. Sometime during the 1970’s the ratio was 150%, but has been rising, ever more significantly since. The upshot in the “naughties” is that the increase in the ratio of debt to GDP has been accompanied by a declining ratio of growth of GDP to growth of aggregate debt: 17 trillion in increased indebtedness of all kinds to 3.4 trillion in recorded GDP growth. A “debt efficiency” of 20%. The trend is not new. The excess of the trend over its sustainability is perhaps new, but not sustainable.

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