Peterson Institute publications
The Peterson Institute for International Economics is a private, nonprofit, nonpartisan
research institution devoted to the study of international economic policy. More › ›
RSS News Feed Search

News Release

Resolving the Japan Financial Crisis

October 25, 2000

Contact:    Adam S. Posen    (202) 328-9000

Washington, DC—Japan's financial crisis is far from over. This new study on Japan's Financial Crisis and Its Parallels to U.S. Experience, which conveys the views of leading economists and former officials from the two countries, concludes that Japan must still take four major steps to resolve the crisis and restore a foundation for sustainable economic growth:

  • Inject additional capital into and/or close down smaller banks. The large banks have been addressed in these ways but eroded capital bases still undermine vast sectors of the Japanese financial system.
  • Actively loosen monetary policy. The Bank of Japan should buy Japanese government bonds and other assets to improve the economic outlook and help resolve bad debt.
  • Put distressed real estate and other foreclosed collateral on the market. Uncertainty and illiquidity will continue to pervade the entire Japanese financial system until these steps are taken.
  • Complete the "Big Bang" financial deregulation as soon as possible.

Financial crises have been endemic in advanced industrial democracies as well as in emerging markets in the last 15 years. Most OECD economies, including the United States, have suffered recessions and major public clean-up costs as a direct result of financial crises. The largest crisis of all is the Japanese financial problem of the last decade: the estimated direct cost of cleaning up the Japanese banking system has run to 12 to 15 percent of GDP while the ongoing financial fragility prolonged and deepened Japan's recession. The United States may also now face the prospect of renewed financial fragility, as the stock market run-up has stalled and reversed, and must prepare to avoid repeating Japan's mistakes (and its own from the 1980s).

Comparing the Japanese financial crisis of the 1990s to the American experience of the 1980s reveals common features and policy challenges: a consistent underlying dynamic between imperfect information in financial markets, politically motivated weakness in regulation, and unaccountable monetary policy. This dynamic is both easily understandable and readily, though not easily, surmountable. The authors in Japan's Financial Crisis and Its Parallels with U.S. Experience (edited by Ryoichi Mikitani of Kobe Gaikuin University in Japan and Institute Senior Fellow Adam Posen) including "Mr. Yen," former Japanese Vice Minister of Finance Eisuke Sakakibara, and former Under Secretaries of the US Treasury, Robert R. Glauber and Jeffrey R. Shafer, converge on several key conclusions and recommendations:

Where financial crisis came from in Japan (and elsewhere):

  • Slow partial deregulation and long regulatory forbearance combined to erode financial stability. In Japan, financial deregulation beginning in 1984 and technical progress led to diminishing margins and market share for Japan's banks in corporate finance. This led to Japanese banks increasing land-collateralized lending to riskier borrowers since they could neither diversify their activities nor go out of business. Once the economy turned down, and bad loans had to be called in and written off, regulators were reluctant to strictly supervise weakened banks, hoping a return to economic growth would restore balance sheets. This reluctance to supervise increased the problem manyfold by encouraging banks to roll over risky or failed loans while their capital declined. The same story played out for a shorter time in the US savings and loan crisis.
  • The collapse of an asset price bubble accelerated a debt-deflation cycle. Asset price bubbles have generally produced credit booms of lending based on inflated stock and property values. The collapse in stock prices then hurts firms' balance sheets, making it harder for them to service their debt and transferring more distressed assets (like real estate) into banks. This decline in the value of outstanding loans and collateral erodes banks' balance sheets, making them less willing to engage in new or low-margin lending and more willing to perpetuate bad loans so they do not show up as losses. In the 1990s, this increasingly adverse selection by banks in Japan worsened the macroeconomic situation, increased uncertainty about the banking system, and further dragged down the stock market, which perpetuated the credit contraction cycle.
  • Excessive reliance on bank loans in corporate finance, and tight ties between banks and firms, increased the cost. Japan's main banking system and partial deregulation meant that, except for the very best and largest corporations, there were few alternative sources of corporate financing to bank loans. There also were significant stakes for banks in avoiding bankruptcies among clients, which would also hit their stock portfolios. This feedback effect amplified the cycle between asset price declines, lending contraction, and accumulation of bad loans beyond that seen in the United States, where securitization of lending and lack of bank holdings of equity in nonfinancial firms limited the damage.
  • Deflation was allowed to persist and made the problem worse. Declines in the general price level do terrible things to financial systems that lend in nominal terms: borrowers find the real burden of their outstanding debt rising; households increasingly shift out of bank accounts into cash and save rather than consume; banks are hit by declining asset values, diminishing growth prospects, rising bad loans, and mounting inability to secure loanable funds. The Bank of Japan was the first postwar central bank in an advanced economy to allow deflation to persist for more than a quarter—in fact, deflation has gone on for more than three years. The last time such a debt-deflation cycle was allowed to occur (on a much larger scale) was during the Great Depression.
  • Lack of transparency in both financial and monetary policy prevented resolution. When large amounts of money are lost, and the public is left with the bill, few officials or politicians can be expected to promptly acknowledge the situation. Yet lack of disclosure by government officials deepened the crisis in Japan to an extreme degree. Opaque accounting and repeated overly optimistic assessments of the banking crisis meant that distressed assets like foreclosed real estate were not—and largely still have not been—put up for sale. This overhang kept real estate markets illiquid and depressed, weighing down investment in the entire economy. Minimal disclosure by the Bank of Japan of its monetary policy goals and forecasts, particularly after it was granted independence in April 1998, confused markets and the public about the ability of policy to resolve the crisis and hid the Bank's accountability.

What Japan should do now to resolve its financial crisis:

  • Inject conditional capital into and/or close down the smaller banks (as was already done for the major banks). The Obuchi government's financial reform package of October 1998 was successful as far as it was implemented in the Japanese banking system. By nationalizing the Long Term Credit Bank and the Nippon Credit Bank, encouraging mergers between or departure from international lending by the remaining major commercial banks, and recapitalizing them with preferred shares that revert control to the government if capital is squandered, those banks were put back in business. Savers returned money to them, the interbank "Japan premium" on overnight lending disappeared, rollovers of bad loans noticeably decreased, and their stock prices firmed. These steps relied on aggressive supervision and more accurate accounting by the Financial Supervision Agency and must now be extended to those vast sectors of the Japanese banking system where eroded capital still induces the moral hazard of rolling over bad loans.
  • Actively loosen monetary policy. There is no risk of inflation in Japan today; in fact, it is debatable whether deflation is finally ending or whether oil price rises are hiding broader price declines. The Bank of Japan retains the power to expand liquidity in the economy through purchases of Japanese government bonds, US dollars, and other assets despite nominal interest rates of 0.25 percent (zero until a mistaken increase in August 2000) and despite the banking system being reluctant to lend. Under these conditions, a given monetary expansion will not be as predictable or as large as under normal circumstances but expansionary monetary policy by the BOJ would still counter deflation, and thereby improve the macroeconomic outlook and ease the resolution of bad debt.
  • Put the distressed real estate and other foreclosed collateral on the market. Size is no excuse for holding back. So long as the Japanese real estate market knows there is a vast number of unevaluated properties waiting to come onto the market, no one will be willing to buy or sell. So long as businesses and individuals cannot take their losses and get out of old positions, uncertainty and illiquidity will hang over the entire Japanese financial system. The Japanese government should encourage securitization and sale of distressed assets through the resolution arm of the Financial Reconstruction Commission, which has not yet been used extensively.
  • Complete the ‘Big Bang' financial deregulation as soon as possible. As noted above, in Japan in the 1990s as in the United States in the 1980s, partial deregulation destabilized the financial system by drawing good investments out of the banking system while maintaining lending capacity there. The Japanese economy, like all economies, must move toward a world in which traditional bank loans play a significantly smaller role in capital allocation and traditional bank accounts play a smaller role in households' savings. In Japan, this must include the implementation of the long-promised limitations on deposit insurance as well as a reduction of the role of the government-backed postal savings system.

Lessons for the United States and others seeking a soft landing:

  • Zero tolerance yes, forbearance no. The disastrous Japanese experience with regulators giving banks time for their balance sheets to be restored by economic growth replicates what occurred in the FSLIC and other US bank regulators in the 1980s. Bank supervisors must foreswear forbearance and intervene quickly when banks accumulate sufficient problem loans to outweigh capital. In the short run this will lead to more bank closures and government intervention as well as some distortion of accounting as banks on the edge of capital inadequacy try to hide their precarious balance sheets. In the long run, however, a zero-tolerance approach to supervision will significantly limit the accumulation of bad loans and bank weakness before a widespread problem can occur. An upfront declaration to this effect, while times are good in terms of macroeconomic growth, will remove the temptation to delay when growth slows.
  • Encourage securitization and discourage tight relationship banking. Securitized loans can lose money for lenders just like traditional lending. When a securitized loan is sold at a loss, however, there is no collateral left to dispose of; no hard decision of whether to roll over debt; and no implicit or explicit government guarantee that distorts incentives. Meanwhile, when a bank holds stock in a non-financial firm to which it makes loans, there is both a feedback effect on its incentives to maintain the loan long after it would normally foreclose and a direct hit on its capital as well as the portfolio loss from the loan when the loan fails (as seen in Japan in the 1990s). The repeal of Glass-Steagall and other regulatory changes to banking in the United States will only enhance efficiency to the extent they increase arms-length financing rather than allow for new forms of relationship investing by banks.
  • Monetary policy must anchor inflation expectations above zero. There is no easy answer to whether central banks should try to pre-empt or prick asset price bubbles by tightening policy (in fact, this volume's authors are split on whether the BOJ should or should not have tried to do so in 1989-90). What is clear from the Japanese experience as well as history, however, is that deflation dangerously amplifies the effects of financial crises and is more difficult to reverse once it takes hold in a fragile financial system. Central banks must commit to oppose deflation long before it arises by publicly committing to a nominal anchor, such as an inflation target, or at a minimum by explicitly stating that deflation will be countered. This not only diminishes the likelihood of deflation occurring but it reduces the moral hazard in financial markets from expansionary monetary policy. Such policy is a necessary response to a financial crisis but, if it is seen as supporting asset prices specifically rather than targeting the rate of inflation and financial liquidity, it may induce the very asset price bubble that is to be avoided (a concern in the United States today).
  • Central banks must be transparent about their goals and not overstep them. A large part of monetary policy works through expectations, both in the limited sense of what economic aggregates will do and in the broader sense of what central banks are considered capable of. A central bank, which during a crisis either takes on tasks the public does not expect of it (such as promoting structural reform) or obscures the economic situation so as to avoid taking undesired risks (such as claiming ineffectiveness of policy when policy can in fact work), erodes its credibility and support at a time when its activities are irreplaceable. It also limits the ability of financial and fiscal policies to pursue their mandated goals as they must offset the mistakes of monetary policy. Only through clear statements of goals, subject to public oversight and debate at regular intervals, will a central bank align the public's expectations of monetary policy with what can and should be achieved. As the BOJ demonstrated in the late 1990s, a nontransparent and therefore unaccountable central bank can pursue policies vastly at odds with best practice or democratic decisions.