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The Saga of Japan: Boom to Bust

October 26, 1998

The cronyism of the Japanese system was hailed as enlightened "government-business partnership" during the heydays of the 1980s when we were being told that America too must adopt this system or cede economic supremacy to the East. Now we know that half of all funds available for investing in Japan, nearly $1.75 trillion, are being held by the government-run, postal-savings system which has "invested" funds in infrastructure boondoggles and has "lent" funds to businesses that were too risky for private banks.


This is to say nothing of life-time tenure for workers and government subsidies to companies to maintain employment and protect them from international competition. Nor were today's critics of cronyism pointing to the "Asian Tigers" during their boom for having economies corrupted with political shenanigans. Without the fuel of central-bank monetary inflation, a crony economy would have inefficient production and stagnate or slow-growing standards of living.

Another side-show often mistaken for the main event is bankers' sudden loss of risk aversion. Increasing riskiness of projects and the corresponding risk of loan default, however, is a necessary aspect of central-bank monetary inflation and credit expansion. Without such intervention, bankers properly balance their portfolios of loans, accepting additional risk only at higher interest rates, and extend loans to their most credit-worthy customers for the projects most likely to generate profit. The additional credit created by central-bank monetary inflation and fractional-reserve-bank money multiplication must be extended to less credit-worthy customers, both consumers and entrepreneurs, for projects less likely to be profitable.

Consumers, who could not obtain credit otherwise, are now able to entice entrepreneurs to satisfy their preferences by spending borrowed money. Individuals, who could not enter the ranks of entrepreneurs before, now find bankers willing to lend them start-up money. As a boom matures, bank portfolios are filled with loans that would not have been made, either for too much risk or too little return, in the absence of credit expansion. The longer the boom continues, the greater the errors within and emanating from banks.

Just as the boom builds outward from banks to the rest of the economy, with banks benefiting the most, the bust collapses inward to banks from the rest of the economy, with banks suffering the most. Now the balance sheets of fractional-reserve banks, swollen with loans and checkable deposits during the boom, suddenly collapse. Or rather, the value of their loans collapses initially, as the projects they lent to turn out to be unprofitable, leaving them with negative net worth and then upon bankruptcy, their checkable deposits are liquidated.

Bankruptcy is made much more likely by the policy of fractional reserves. The checkable-deposit liabilities built up during the boom no longer have assets of equal value balancing them out once the crisis hits. Customers who know this have a great incentive to demand redemption of their checking accounts in cash, an obligation which fractional-reserve banks cannot fulfill even when the value of their assets is intact let alone after their loans devalue.

Monetary deflation via bank failures is the other side of the coin of liquidation of bad loans. Liquidating the loans implies realizing the bankruptcy of the businesses that have taken out these loans. The monetary inflation and credit expansion of the boom are now reversed in the bust. The capital build-up of the boom must now be dismantled and factors reallocated into lines of activity made profitable by consumers.

From 1985-1990, the largest six banks in Japan made $215 billion worth of real-estate loans. In the six major Japanese cities, commercial real-estate values have fallen 75% since the bubble burst in 1991. Risky Japanese loans were not confined to real estate. Recently, Moody's Investors Service Inc. downgraded Toyota Motor Corp. debt from triple-A to double-A-1, leaving only nine Japanese companies with the triple-A rating and five of these are being reviewed for downgrading. Mitsubishi Electric Corp., Hitachi Ltd., Nissan Motors Co., and Mitsubishi Motor Co. all recently had their debt downgraded. Moody's is even considering downgrading Japan's triple-A, sovereign-debt rating.

As late as 1993, Japan had the largest eight banks in the world, ranked by assets. Now, Japanese banks have the same share of the world market as they did in the early 1980s. In 1987, bank stock shares constituted 30% of all listed stock in Japan. Japanese banks currently make up only 12% of Japanese equity. One of the largest twenty banks in Japan and the world's 67th largest in 1993, Hokkaido Takushoku Bank Ltd., failed last November. Long-Term Credit Bank, ranked 14th largest in the world in 1993, recently had its debt rating reduced by Moody's. Sumitomo Trust & Banking, number 16 in 1993, is balking at a merger with Long-Term Credit Bank because of the Long-Term's bad debt. Sakura Bank, number 5 in 1993, is now trading a price-to-book value of 0.81, that is, investors think the bank is worth less than the value of its assets. Bad-loan write-offs have forced Sakura to plead for $2 billion in cash from its major shareholders to restore its assets and rebuild its net worth. Several other giant banks have seen their stock prices sink in recent months.

Japanese banks now suffer from carrying, by private estimates, over $1 trillion in bad debt, $600 billion of which is officially admitted. The largest six banks hold $131 billion in bad debt. And according to Japan's Financial Supervisory Agency over one-tenth of all good debt has higher than normal risk of default. $256 billion of this high-risk good-debt is held by Japan's 19 largest banks. For 1997, Japan's top banks made 0.24% return on portfolio assets, making them the least profitable banks of any developed area. In the U.S., banks' return was more than five times greater at 1.33%.

The Japanese debacle has been repeated around the world. Allowing for the unique circumstances that will make the situation play out differently in each country, central banks and fractional-reserve banking systems have flooded their countries with money and credit. The result is a world-wide financial crisis and bust.

Now that central-banks have created an international crisis the best policy is to let the market work, that is, adopt a policy of laissez-faire. Only entrepreneurs operating on an unhampered market can restore economic health. Only they know how to reorganize production, reallocate factors, liquidate malinvestments, and reconstruct the capital structure in the best way. The bad loans should be liquidated, that is, sold at a discount to entrepreneurs who will specialize in their collection. The bankrupt banks and companies should be liquidated, sold to entrepreneurs who best know how to reallocate their assets, and the funds distributed to creditors.

To the charge that a laissez-faire policy means cruel hardship, the answer is twofold. First, a laissez-faire policy would have prevented the boom and thus, the crisis and bust. It should have been adopted before the cycle began and its adoption now will prevent cycles in the future. Second, it is the least-painful way to deal with the government-created bust. The more quickly this is done the sooner the economy can return to normal.

If the government, perversely, tries to forestall liquidation, then the depression will linger on indefinitely. In Japan the government has made liquidation difficult with various regulatory hurdles and unfavorable tax treatment. Almost the entire stock of bad loans remains on the books of banks making them financial zombies, unable to conduct normal business and unable to perform their crucial social function. The result is the paralysis of production.

A central-bank policy of re-inflation only leads to another wave of misallocations and malinvestments. Open market operations is a clumsy tool for repairing existing misallocations and malinvestments. A bank that receives a infusion of funds from the central-bank will not use them to liquidate or re-negotiate existing bad debt, but seek out new borrowers. It will lend to the most credit-worthy customer it can find instead of the least credit-worthy one, i.e., the customer who cannot pay what it already owes the bank.

When the Bank of Japan increased bank reserves in an effort to reinflate, banks, already burdened with loads of bad debt of domestic consumers and entrepreneurs, took the additional reserves and lent them to businesses in Asia, especially South Korea, exacerbating the boom there. The Bank of Japan's reinflation policy has piled foreign bad debt upon domestic bad debt and led to the devaluation of the yen. Banks have responded by further retrenchment; they make fewer loans at home and abroad. In the first quarter of 1998, their overseas lending fell by $244.3 billion.

A policy of bailout, even if it can be tailored to liquidate bad debt, creates moral hazard, making the next boom-bust cycle more extreme. If it goes to bailout distressed and bankrupt businesses, then the money is wasted entirely since these are the very operations that need to be contracted. Japanese banks are right to refuse to extend more loans for real-estate projects or to steelmakers like Toa Steel Co. who has declared bankruptcy under the burden of $1.82 billion of debt. The 30 trillion yen ($207 billion) bailout fund for banks proposed by the Japanese government will be money wasted prolonging and extending malinvestments. Moreover, bailouts are usually financed by more central-bank inflation and thus, result in further malinvestments and misallocations.

Japan will also try a 17 trillion yen ($128 billion) stimulus package. But, fiscal policy leads to more misallocations and malinvestments as the liquidated projects and unemployed factors are, at best, channeled into areas consumers do not value as highly as those selected by entrepreneurs. To favor fiscal policy as a palliative to the bust, one must favor the political expenditures of bureaucrats over the economic expenditures of entrepreneurs since, either in the case of fiscal policy or laissez-faire, the malinvestments must be liquidated and the misallocated factors reallocated.

Increasing government expenditures also means either raising taxes or more monetary inflation and debt neither of which is wise during the bust. To really help, any tax cuts, Japan has proposed a 6 trillion ($42.8 billion) yen cut, should be matched by spending cuts. Budgets should not be balanced by raising taxes since raising taxes punishes production. When Japan increased the consumption tax rate from 3% to 5% in April 1997 its growth rate fell from a positive 6.6% annual rate in the quarter before the increase to a negative 11.2% in the next quarter.

Furthermore, fiscal policy makes consumption expenditures when what is needed to minimize the difficulty of the bust is more saving. During the boom productive factors are mistakenly drawn into the production of the capital structure which must be liquidated in the bust. But the liquidation can be kept to a minimum if people provide more saving to sustain the existing capital structure instead of turning to consumption which would require more factors to be shifted out of capital good's production.

By implication all calls for people to consume more and save less or cries against "oversaving" are counter-productive. The problem in Japan is not "oversaving" or lack of fiscal or monetary stimulus. The problem is that the government refuses to let the market work. By refusing to allow bankrupt institutions to fail, it has forestalled the liquidation process necessary for recovery. Until it permits liquidation, the Japanese economy will remain moribund.

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