Credit crunch: JapanÆs lessons for the US

JapanÆs experience in the 1990s shows that a credit crunch can destroy wealth and dampen growth in the real economy for years. The US won't be immune.
There has been a great deal of speculation in the Western press about what lessons the US can learn from JapanÆs credit crisis in the 1990s. Generally, the comparison ends on a note of self-congratulation, with the author pointing out the speed at which US firms have moved to reveal losses, re-capitalising via sovereign wealth funds in some cases, and how quickly the Federal Reserve has cut interest rates.

By contrast, it took many years before the Japanese, under the radical leadership of Prime Minister Junichiro Koizumi, finally forced the banks to recognise their losses and recapitalised the system under the 2003 Takenaka Plan - 13 years after the Nikkei started its collapse.

But tackling the problem speedily may be irrelevant. Some analysts, notably Richard Koo, chief economist at the Nomura Research Institute in Tokyo, have written that credit crises can only be tackled slowly. If the recognition of losses is too abrupt, you simply blow away the financial industry, since your biggest banks go bust, dragging down other lenders and corporate borrowers in their wake. Recapitalising in those conditions might well be impossible as the size of the problem loans would dwarf the ability of the government to solve it.

The reason a credit shock is so dangerous is that debts are especially sensitive to broader market conditions. Perfectly good debts can sour when the shock is serious enough, meaning good companies start failing along with the bad.

JapanÆs experience shows the sheer trauma of a credit crisis once the debt cycle goes in reverse. The arithmetic of debt is simple. If banks are lending out $8 for every dollar they hold, it means that for every dollar they lose in equity, they need to recall roughly $12 dollars. And if the person who borrowed those $12 leveraged up to the same extent, then he has to call in $88 as well û from investors who also leveraged up. And so it goes on.

The fact that the US government has recognised the problem doesn't mean it has found the solution. Like in Japan, credit is going to leave the economy, and this will destroy equity û since the equity has over the years become far too small to support the debt pyramid it underpins. The equity will be eaten up by margin calls and that means the real wealth, as well as the debt wealth, will disappear. Basically, itÆs quite difficult to pay back $12 dollars of debt if you only have $1 in your pocket.

The moral is that until the government starts creating new equity - or new wealth - to balance the ongoing destruction, the crisis is not over. Figures currently being bandied about the cost of the credit crunch have reached the trillion dollar range û up from $150 billion just a few months ago. Nobody really knows. Paul Krugman, the Princeton economist, has suggested a programme of public works worth $25 billion per year. That could be a drop in the ocean, given that the US sold debt all over the world, not just in its own backyard.

While preventing a 1930s-style depression, the effect on the Japanese equity markets from the government's strategy has been terrible. Japanese institutional investors are having government bonds forced down their throats, thus tying up capital that could have been used to buoy the stockmarket.

Other distortions have also emerged: many Japanese companies today prefer to finance expansion out of retained earnings, or to keep large piles of cash on hand. In other words, they are inflating their equity cushion with negative consequences for growth and earnings û both of which benefit immensely from debt. Foreign shareholder activists say such companies are stupid and greedy and should give the money back to shareholders, or invest it.

But these investors could be acting in exactly the same way next year, or perhaps for the next 10 years if the US enters its own "lost decade". If it does, it's difficult to see how Western countries can reach equity-based targets for their pensions and social welfare systems. An intrusion of the public sector into the areas left devastated by the private sector might occur. So we'd end up more socialistic, just as Japan is becoming more market-oriented.

In the 1980s, drunken salarymen in Japan used to flag down taxis by waving handfuls of high denomination notes at them. These days, they take the subway. David Rubenstein, co-founder of Carlyle, came back to Wall Street last Thursday from the Deer Valley ski resort by Gulfstream jet to face the news that Carlyle Capital was receiving escalating margin calls. Maybe next year he will be on a commercial flight û or perhaps even the train.
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