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3 US can fast exit from bad
times By Edward J Lincoln
The recent US experience
of mounting bad loans, unemployment, a housing bubble
that has burst, and a financial bubble, is
reminiscent of Japan in the 1990s. Is the US
repeating Japan's mistakes as it tries to extricate itself from
the mess? Not so, according to Edward J Lincoln,
of New York University Stern School of Business.
The following is an edited transcript of his
address on the issue to the Carnegie
Council's New Leaders Program.
Is the United States
repeating some of Japan's experience? - the basic
answer is no. But to get there, let me start with
a little bit of background on the Japanese
situation. It begins in 1985. In early 1985, the
yen was still rather weak against the dollar. In
April of that year the yen
was at 260 yen per dollar.
As you may
know, in September 1985, over Labor Day weekend,
there was a meeting of the G7 finance ministers at
the Plaza Hotel. They signed the Plaza Accord,
which said, finally: "We all agree that the dollar
is overvalued." Now, the dollar had already begun
falling since that spring, but this reinforced the
trend. It gave investors to believe that the US
government and the other finance ministries were
going to alter monetary policy in a way consistent
with a weaker dollar. Everybody was happy with
that, including the Japanese government.
The problem is the Japanese government had
no clue as to how far the yen was going to go up
against the dollar. They thought it was going to
go from 260 to 200. It went from 260 to 130 in the
space of 18 months. This was a huge negative shock
for the Japanese economy. It made their exports
less price-competitive in global markets -
essentially doubling the price of their exports
abroad - and made imports 50% cheaper.
the government steps in and says: "Oh my God,
we've got to do something." Well, the obvious
thing to do is to say: "Let's stop supporting the
idea of a weaker dollar. We need to start
supporting a weaker yen and cut interest rates."
So they cut interest rates to what was
then a postwar low. And the more important part is
they accompanied the interest rate cuts with
person-to-person advice to the leaders of Japan's
major banks, saying: "Get out there and lend
money. We need you to lend money to prop up the
economy, to keep investment going in this
Well, it worked. They got five
years, 1986 through 1991, of an average growth
rate for the economy of 5%. This was the highest
growth rate among any of the OECD [Organization
for Economic Cooperation and Development] member
This was the period of time in
which Americans looked at Japan and said: "What on
earth is going on? Here we have an advanced,
mature, industrial nation, and it is growing at 5%
and we're growing at 3%. What's going on here? Is
there something magical that they have created?"
So you've got books being published in the
United States about why Japan was better than the
United States and all that. It looked good at the
time, as these things often do, as the subprime
market did in the United States.
little underside of this was that although the
growth rate, the economy, was high, they also had
incredible inflation of real estate prices and the
stock market. It was those asset values going up
that helped to drive a fair amount of what was
happening in the economy.
Over the space
of five years, from the beginning of 1985 to the
end of 1989, the Nikkei average for the Japanese
Stock Market tripled in value. And over a slightly
longer period, to the end of 1990, the value of
urban real estate in the six largest urban areas
of Japan, which probably account for about 60-70%
of the population, also tripled in value.
End of bubble As is the case
with all financial bubbles, this one came to an
end when the government finally decided that this
had gotten out of control, that there was no way
you could justify prices in these two markets
being that high. So the Bank of Japan, number one,
raised interest rates; and, number two, went back
to the banks and said, "Will you please stop
lending money to real estate?" - reversing their
earlier administrative guidance.
that broke the bubble. It broke the bubble so
strongly that today the Nikkei average is about
where it was in 1986, 22 years ago. The real
estate market declined back to where it was around
1985. It bottomed out a couple years ago and then
turned up a little bit, but we're still talking
about urban real estate prices at about 1985
If you're not an economist, let me
just say that taking a hit on asset values that
big, that's a huge blow to the economy. This is
akin to what happened to the United States in 1929
and we got the Great Depression. The Japanese
should probably count themselves lucky that they
got out with a decade of essential stagnation.
From 1992 through 2002, the average annual
growth rate in Japan was 0.9%. It went from being
the most-rapidly growing country in the OECD to
being the slowest-growing country in the OECD,
even slower than Switzerland, which has usually
been at the bottom. And they experienced about
three recessions over the course of the 1990s.
So that's the background.
me talk to you about some similarities. I think
there are a few. The first one is that we seem to
have a case where almost any country where there
is financial deregulation and/or innovation is
often associated with mistakes and problems, at
least in the initial phase.
S&Ls [savings and loans] in the early 1980s,
allowed them to behave in much more risky fashion.
They did, and they got into big trouble. We
created a junk-bond market in the 1980s, an
important innovation. We didn't really understand
what we had created, and we got a huge crisis in
the junk-bond market.
Or, in Japan we had
the government turning the big banks loose on the
real estate market. That was an informal
deregulation. Historically, in the postwar period
in Japan, real estate finance had belonged to
little banks - credit associations and little
regional banks. The big banks in Japan had stuck
to financing large corporate customers.
That changed in the 1980s. The big banks,
when they went to the Ministry of Finance, said:
"You're telling us to go and lend more money. Who
are we going to lend to? Our traditional buyers -
Toyota, Matsushita - they're being beat up in
export markets because of yen appreciation. They
don't need more money right now. Who are we going
to lend to?" The Ministry of Finance said, "Oh, go
lend to real estate." So they did, and they did
not know the real estate market.
So in all
of these cases you've got this
innovation/deregulation and, fairly quickly, you
tend to get mistakes being made. So that's a
certain amount of similarity.
hubris. In both countries, we have had financial
institutions that seem to think that they've got
some new, brilliant insight into how the world
works that nobody understood before and that they
are so brilliant that they can do this without
having any losses. In the case of Japan, you had
this phenomenon of people saying, "Oh yeah, okay,
real estate market. Sure, yeah, I understand that.
It never goes down."
In the 20th century,
up until that point, there had been only two years
in which there was a downturn in the real estate
market in Japan: 1923 in the immediate aftermath
of the Tokyo earthquake, and 1945 at the end of
the war. Other than that, real estate prices had
gone up. And so they said, "Oh yeah, we know this
market. Sure bet. If the price rise is
accelerating, let's get in right away, because
that's how we're going to make lots of money."
In the United States, I think you had an
equal amount of hubris, guys who said: "I've got a
PhD in physics. I understand equations. I know how
to run this stuff. I've discovered something new.
Let me tell you how we can repackage all this
stuff. And, somehow, it's all going to work and
we're going to get high returns and no risk."
The third similarity is greed. It's coming
out of my previous point. Somehow, along the way
in the psychology of these things, you seem to get
people at financial institutions who ought to know
better, to believe that they can generate annual
returns of 20% or higher with no risk.
Now, for those of you who are not
economists, the normal presumption in economics is
that there is an inverse relationship between
financial return and risk. You can have low
return/low risk - that's your savings account in
the bank; it's guaranteed by the government up to
a certain amount of savings deposit. Or you can
have high return and high risk - that means that
over a long period of time, say 20 years, you
ought to anticipate that in fact you'll get a
pretty high return, but along the way you are
going to have years in which you are going to get
hit with big losses.
Well, what seems to
happen in these kinds of financial bubbles is that
people who probably learned this stuff when they
were going through business school or PhD programs
in economics, seemed to think: "I've invented
something new. I can get 20% returns and there is
no risk." That is always a mistake.
Japanese certainly believed it in the real estate
market. "It went up 30% last year? Oh, hey, I'd
better get in because it's going to go up 30%
again this year and next year and next year." The
idea that it is going to come to an end seems to
drift off into Never-Never Land.
thing that seems to be a similarity between the
two countries is a bad underestimation of the
implications of the problem when it finally gets
I remember going and having
conversations with officials at the