The Bubble Economy: The Japanese Economic Collapse, by Christopher Woods.

Can China learn from Japan''s banking experience? Yes, but it could learn even more about not giving in to US revaluation demands.

Like China, Japan has a tradition of state-controlled bank lending for fuelling the economy. Both countries have seen corruption problems in a system where capital is allocated by government banks, instead of through free market mechanisms such as the stock and bond markets.

Woods, a writer for the Economist, writes with a pen dipped in acid about the glaring ethical and business deficiencies he saw in Japan in the early 1990s.

Woods is an early version of the school of writers who emerged after the Asian Financial Crisis in the late 1990s. Essentially, they argue that Asia's 'miracle' was actually based far more on underworld connections, crony capitalism, corruption and a lack of democratic transparency than had hitherto been appreciated.

Thus Woods spends a great deal of the book poking through the numerous scandals that have dogged Japan - the fairly clear implication being that it is not surprising such a system eventually had its come-uppance - and indeed that such an outcome is both deserved and desirable.

Woods writes with great intelligence and verve. But his two premises, that Japan was solely responsible for its troubles, and that a painful cleansing of the system was necessary and ultimately positive, are profoundly unsatisfactory.

It is extraordinary that Woods does not mention the macro-economic and international situation surrounding the birth of the Japanese bubble.

In fact, the reason why the bubble emerged in Japan gives a huge amount of credence to the Chinese government's refusal to be browbeaten by the US into amending its exchange rate in order to diminish the US trade deficit.

Recall that in many ways the state of the US economy then was similar to now. The country was living beyond its means and racking up huge trade deficits with Germany and Japan.

Given their crushing loss in the Second World War and their dependence on US economic assistance, the two countries had little choice but to listen when the US convened the Plaza Accord in 1986 and the follow-up Louvre Accord in 1987. The US told its main economic partners to carry out policies which would lessen the trade deficit. This could be achieved through stimulating domestic demand for US good with lower interest rates, or by letting their currencies strengthen against the Dollar to make their exports more expensive, or any combination thereof.

Japan's answer was to stimulate consumption. The central bank cut the discount interest rates five times, down to 2.5%, between 1986 and 1987, while money supply continued to grow at 10% per year, almost twice as fast as GDP.

The results were spectacular. The Nikkei 225 index shot through the roof, from 20,000 in 1987 points to 30,000 points in 1988. The index would top out at 38,000 in 1989. It's currently around 12,000.

The after-effects of the Japanese bubble, after the government over-tightened interest rates, are well-known: A massive loss of confidence leading to a downward deflationary spiral from which, 15 years later, the economy has still not yet recovered.

Having a corrupt banking system is clearly a bad thing, but not sticking up for your own economic interest would appear to be an even worse alternative.

Wood's second point concerning the inevitability and desirability of a quasi-moral 'reckoning' is more complex. But it reflects a common perception that greed and love of wealth and need to be punished.

How such concepts fit into economic modeling is a tricky question, however.

In economic terms an investment cannot be 'corrupt'. Rather, it usually revolves around mis-pricing. Thus, a boom-time investment typically involves excessively cheap capital. That capital may have been obtained through shady government connections, or it may be inherent to the system, as in China, or it may be conscious government policy.

What's clear is that that in all these cases cheap capital drives down the necessary returns, or 'hurdle rate' for investments.

When capital becomes scarce, these investments turn out to unviable because the cost of capital rises to above the returns of the investment.

US economist Paul Krugman discusses the question in several of his books. He sees the traditional 'booms and bust' business cycle as technical questions. Thus he explains a bust as involving a catastrophic loss of confidence leading to a higher savings rate, decreased consumption and loan growth and ultimately deflation. Essentially, he argues that a bust is just as irrational as a boom. Some event will trigger off a panic which will lead to economic collapse. In Japan's case that event seems to have been the first Gulf War in 1990, since it affected oil, a commodity of existential importance to Japan.

"There is no obvious reason why bad investments made in the past require an actual slump in output in the present," he argues.

Hence, instead of embarking on a witch hunt for culprits, the government need simply restore confidence by flooding the economy with money. That this so far hasn't worked in Japan shows just how psychotic and irrational the loss of confidence is.

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