© 2008 Michael Smitka 1 Japan’s Bubble Economics 102 Winter 2008 Michael Smitka Professor of Economics Washington and Lee University

© 2008 Michael Smitka 2 Two Three key causes Management geared for high growth Interacting with Macroeconomic policy mistakes –Including failure to improve regulation in the face of innovation in the financial sector Savings imbalance generated large shifts in flow-of-funds, swamping capability of financial system

© 2008 Michael Smitka 3 As a result... Management had no need for financial controls –project selection was easy –failure was hard / recessions were few & far between Real interest rates were 0% (or less!) –Financial innovation allowed firms to borrow cheap! Firms overborrowed Projects that earned a mere 0% passed muster Mindset still seemed to reflect growth expectations Banks overlent Collateral or track records were enough Asset prices proved unrealistic Projects didn’t earn 0% ex post Banks couldn’t collect on their loans

© 2008 Michael Smitka 4 Confounding factor Pricing long-lived assets is hard –Real estate grew faster than economy –Stock prices grew faster than economy –Growth industries grew very fast indeed!! Real growth averaged 9.3% during Unrealistic price expectations dominated –Prices on real estate were distorted No relation to rents, only expected price appreciation –Prices on stocks were distorted Little relation to dividend levels, rather assets and past growth

© 2008 Michael Smitka 5 Why the “bubble”? - the lending side - Change undermines rules of thumb for banks –Change in types of industry / borrowers –Change in strategic environment / flow of funds –Change in regulatory environment Mistakes are made … –… and a shock produces crisis

© 2008 Michael Smitka 6 Primary shock slower growth after 1971 Industry no longer needs funds 1970s: 10% of GDP drop in corporate funding needs!! But households keep saving Past savings were when incomes were low So accumulated wealth was modest So people needed to keep saving to fund old age Who then will borrow this funds? Paradox of Thrift!! –No discipline by banks…

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10 Shifts in Japanese Savings Flows

© 2008 Michael Smitka 11 Reactions to slowdown High “S” so “C” did not rise to offset “I” –“paradox of thrift” Reactions: –In the 1970s, fiscal stimulus From helped by trade –From 1980 monetary policy kicked in Trade dominated as fiscal stimulus ended Especially during –From the “bubble” took over I rose, S fell (C rose) … but the bubble popped –Thereafter massive fiscal stimulus

© 2008 Michael Smitka 12 Interregnum Japanese fiscal deficits created a new borrower for banks MOF policy stopped that by 1982 Reaganomics: US consumption boom Export-led growth in Japan from 1982 ¥ rise (Plaza Accord) ended that from 1986 So how adapt? Easy money!!! But in the interim financial markets evolved…

© 2008 Michael Smitka 13 Secondary Shock Bad monetary policy –with hindsight –Easy money from 1986, following Plaza Accord Kept low after Oct 19, 1987 US stock market crash –Only hiked interest rates from May 1989 Low rates for 3-1/2 years –Then overdid it: repeated boosts thru Aug 1990 Didn’t cut until July 1991, with both stock and real estate markets plummeting

© 2008 Michael Smitka 14 Financial evolution & deregulation Starting point regulated deposit rates segmented markets ( cf. Glass-Steagal ) Deficits led to bond markets Deposit rates gradually liberalized –Other rules as well (international flows) Large firms became multinational –Could borrow directly in London Disintermediation resulted –dikes broke –Banks had to scramble

© 2008 Michael Smitka 15 Contemporary Financing Sources (% of total assets, large manufacturing firms) Source: MOF, Financial Statements Statistics of Corporations

© 2008 Michael Smitka 16 Bank Lending: Total & Ratio to GDP

© 2008 Michael Smitka 17 Bubble psychology “Japan as Number One” psychology Growth and profits will remain high But slow growth meant historic debt levels suicidal! Just as banks sought new borrowers Real estate … and more real estate! –Small business –Also international loans Sectors where banks had little or no experience… Collateral & reputation as basis for loans –cash flow-based credit analysis not done (or done poorly).

© 2008 Michael Smitka 18 Impact “Bubble” economy –Stock prices doubled –Urban real estate prices rose even more Example: Onoue –Only $2 billion in a $5 trillion economy But repeated many, many times over –pencil buildings, golf, stocks Fiscal policy mistakes accentuated On-again, off-again policy built up debt Created fear of using fiscal policy aggressively Regulatory policy errors accentuated Banks allowed to make more bad loans

© 2008 Michael Smitka 19 Lending and Asset Prices 1980=100

© 2008 Michael Smitka 20 In the end… Lots of poor-quality investments got funded Projects didn’t even earn 0% ex post Lots of poor-quality borrowers got money Banks’ inexperience led to disastrous lending Asset prices proved unrealistic Collateral proved inadequate or even worthless Banks’ equity (including unrealized capital gains on investments in companies) shrank rapidly Major recession 2nd bout of negative growth since 1955

© 2008 Michael Smitka 21 Fiscal policy Can fiscal policy overcome the bubble??? –But spend on what? constituents want politicians to bring home bacon, and they obliged But low multiplier –Done poorly, lost credibility 11+ timid packages full of “smoke & mirrors” Saved not spent as most explicitly one-time –Even if in reality “pork” projects took years to complete Net effect is a “bond bubble” –Debt % of GDP Current interest rate under 1.5% pa –Interest due ≈2% of GDP But what happens if interest rates “normalize” to (say) 3%? –Interest eventually ≈5.5% of GDP [ current bonds long average maturity ] –Meanwhile, bond holders [ banks! ] face capital losses if they need to sell

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© 2008 Michael Smitka 23 Monetary Policy if FP didn’t work, how about MP? Banks had lots of “zombie” borrowers But little capital as value of stock holdings collapsed –So reluctant to push dud firms into bankruptcy Plus few lawyers or workout specialists How pump up capital ratio? –Stop making new loans! Shrinks denominator, as long as don’t have to write down for bad loans “Credit crunch” Visible in many sectors in

© 2008 Michael Smitka 24 Bank panic Gradual write-downs by large banks –US$300 billion between 1992 & 1998 –Japan’s GDP is about $5 trillion –Several failures of specialized banks in 1995 –Mishandled, made regulators slow to support large banks –Series of dramatic bank failures in 1997 –4 major banks –1 major life insurer –#2 stock broker –¥6 trillion capital injection by govt in March 1999 –Helped offset continued writedown of bad loans –Mergers from 2000 left 3 large nationwide banking groups

© 2008 Michael Smitka 25 LargeRegional BanksBanksTotal Value End of Period(% of all loans)(% of all loans)(trillion ¥) March September March September March September March September March September March September March September March September March Nonperforming Loans

© 2008 Michael Smitka 26 Impotent monetary policy “credit crunch” Particularly small firms? Hard to distinguish from reluctance to borrow Average real estate prices continued to fall until 2006 –At local level still falling in many places Growth slow –Good firms don’t need loans –Indeed, overall firms actually repaying debt!! So aggressive “ZIRP” ( zero interest rate policy ) Deflation continued so real rates remained high Who wants to borrow with falling real estate prices?

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© 2008 Michael Smitka 30 Today’s Dilemmas Monetary policy doesn’t work Interest rates can’t be pushed below 0% But prices are falling ==> real rates are positive Banks (rightly) fear bad assets Outstanding loans are shrinking! Money growth is of cash… “Liquidity Trap” If monetary policy doesn’t work, how about fiscal?? Labor markets still have slack “Lost Generation”? - participation rates drop…

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© 2008 Michael Smitka 33 Future of the Economy Some financial sector problems remain –Low profitability so vulnerable to shocks Working age population is shrinking –Supply-side potential growth is thus 1-1.5% pa Population shrinking, so higher per capita! Aging population structure –Will need to boost taxes / transfers But starting point is high deficit and high debt!

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© 2008 Michael Smitka 35 OECD Comparison Of Multiple Bubble Experiences ::: Impact of Equity vs Housing Bubbles –– GDP & C

© 2008 Michael Smitka 36 OECD Comparison Of Multiple Bubble Experiences ::: Impact of Equity vs Housing Bubbles –– Bank Loans & Equity