The Long Shadow of a Bubble

At the end of World War II Japan lay in ruins, physically and spiritually. The disastrous war, the American occupation, and several years of dire poverty caused tremendous upheavals in Japanese society. Yet twenty years later, Japan had recovered in commerce and industry, in self-esteem and international recognition. Politically stable and economically affluent, Japan had joined the family of democratic nations. During the 1980s it stood out as the most promising country in the world. Japanese products were highly valued on world markets and Japanese businessmen and investors were prominent nearly everywhere. In quality of workmanship and quiet unpretentious efficiency Japan set admirable standards. The Japanese rate of savings and investment was one of the highest in the world and profits from industrial success were largely reinvested to increase capacity rather than distributed to investors. Pride in work and a rising standard of living served to reassure the Japanese people of their eminent standing in the world community.

To Americans, the Japanese success was clearly visible in millions of Hondas and Toyotas on the road and a flood of Japanese goods in specialty stores. When, during the early 1980s, the U.S. dollar soared in international money markets the U.S. trade deficits soon exceeded a hundred billion dollars a year, more than half of it with Japan. The Japanese dollar earnings in turn precipitated a burst of Japanese investment in American Treasury securities. Indeed, for several years the Japanese were financing the lion's share of the federal deficits. In economic matters the two countries seemed to exchange roles: Japan was becoming the world's largest creditor nation, and the United States the world's largest debtor country.

Searching for the ultimate causes of the Japanese success, many observers point at the Japanese business and management system. They set great store by Japanese zero-based budgeting, participating management, the cooperative relationship between business and government, and many other Japanese characteristics. Many delight in the Japanese notion of extended family—involving not only company executives but also company-oriented unions. Japanese workers seem to be ever mindful that their own interests are bound up with those of their employers and, therefore, tend to refrain from any activity detrimental to their company's future.

The admirers of the Japanese management system conveniently ignore its limitations and drawbacks. Surely we may hold with a company-oriented workforce as opposed to the ever confrontational craft and industry-wide unions in the United States. But we must not ignore the ominous role played by the Japanese government in economic matters. He who gives substantial credit to government for the success of Japan in becoming a major political power must also charge it with the painful recession of the 1990s. He must not ignore the high price the Japanese people were forced to pay for the political intervention throughout the postwar period and especially during the 1990s. After all, government intervention invariably diminishes economic productivity. The huge budget deficits which the Japanese government suffers nearly every year are preponderantly consumptive; they consume savings, prevent the formation of productive capital, and thus keep the levels of living lower than they otherwise would be. Moreover, when the central bank conducts monetary policies for purposes of economic growth and full employment, it gives rise to the business cycle with its booms and busts. During the 1970s and 1980s Japanese authorities sowed the seeds for the painful depression of the 1990s.

In the United States the 1970s were the decade of the Nixon price and wage controls and the Carter energy shortages. The economy stagnated, unemployment soared, and the U.S. dollar lost nearly one- half of its purchasing power. In Japan, as in most parts of the free world, the 1970s were a decade of stubborn recession coinciding with inflation. Yet, unhampered by price controls and energy shortages, the GNP growth rate exceeded 5 percent per annum, and the yen rose from 360 to the U.S. dollar in 1970 to some 225 in 1980.

The 1980s brought economic recovery to the United States but also massive federal budget deficits. Federal revenue during the Reagan and Bush years rose from $517 billion in 1980 to $1.032 trillion in 1990, but expenditures exceeded revenues by hundreds of billions nearly every year, raising the federal debt from some $909 billion in 1980 to $3.206 trillion in 1990. In Japan the government passed a number of "austerity budgets," which marked small increases over previous years, the lowest rates of expansion in more than two decades. Yet, the government regularly relied on borrowing for one- fourth to one-third of revenue, which increased the public debt from some 92 trillion to 160 trillion yen (some $1.2 trillion) during the 1980s. They were years of remarkable growth with startling rises in the valuation of land. As a result, banks near population centers developed multigenerational mortgages, and other financial institutions used them as collateral for pyramids of loans at even higher levels. Guided by the Ministry of Finance's recommendations, some banks grew in size and soon numbered among the world's largest. The yen rose from 225 to 136 to the U.S. dollar.

The decade was marked by continuous strains on the U.S.-Japanese relationship about the chronic U.S. deficits and Japanese surpluses in merchandise exchange. In mercantilistic fashion, the Reagan and Bush administrations exerted great pressure on the Japanese government to reduce exports to the United States, particularly of automobiles and electronic goods. They urged Japan to take more responsibility for guarding its own territory against potential Soviet aggression, to "sharing-of-roles." Japan was enjoying a "free ride" in the area of national security, they were convinced, while its trade policies – specifically, the export of automobiles – were damaging American industry and causing American unemployment.

Although the Japanese government reluctantly increased its defense spending, it clung to its "austerity budgets." Deregulation and privatization, particularly during the administration of Prime Minister Nakasone (1982-1987) eased government deficits and invigorated the private sector. But the government would not just rely on deregulation and privatization. The Ministry of Finance used tax strategies that sought to encourage industries with good prospects for growth and the Bank of Japan always assured an ample flow of funds into such fields. By 1985 Japan became the second- largest trading partner of the United States after Canada. With its GNP reaching $1.6 trillion, Japan became the second-largest economic power in the world and the world's largest creditor nation, with assets exceeding liabilities by some $120 billion.

Few observers of the Japanese miracle could distinguish between genuine economic expansion and the growth of a "bubble" due to inflation and credit expansion. Economic expansion builds on the formation of business capital from savings and profits plowed back; it raises the productivity of labor and lifts standards of living throughout the economy. A financial bubble is a manifestation of inflation and credit creation, insubstantial, groundless, and ephemeral, that comes to nothing. It is a visible symptom of a financial policy that falsifies interest rates and misleads investors and businessmen. It causes economic maladjustments which sooner or later call for readjustments in the form of painful recessions. The difference became visible in Japan only when stock and real estate prices rose rapidly, generating expectations of ever higher prices and attracting new buyers—generally speculators interested in profits from trading assets rather than their earning capacity. From 1985 to 1989 the total value of stocks traded in Tokyo soared from some 240 trillion yen to 890 trillion. The 225-issue Nikkei stock average peaked at an all-time high of 38,915 in December 1989. Real estate prices soared to unprecedented levels.

In the United States more than 500 commercial banks failed during the 1980s, and more than 3,000 thrift institutions suffered insolvencies. Fashioned by legislators and regulated by government officials, enmeshed in countless laws and regulations, the banking cartel was unable to cope with the rampant inflation of the 1970s and with the globalization of capital markets during the 1980s. In August 1989 The Reform and Rescue Act, which in its essentials embodied President Bush's proposals, created the Resolution Trust Corporation which took control of all insolvent Savings & Loans, liquidated or merged them with other institutions, and disposed of their assets. The bailout costs of some $300 billion were placed on the backs of American taxpayers.

In Japan the distortions became clearly visible in 1989 and 1990, which led the Bank of Japan to raise its discount rate five times to deflate "the bubble of speculation." When, in August 1990, the rate was boosted to 6 percent, the stock market finally succumbed, sending the Nikkei index to below 30,000 in just three months. A few months later, when it became known that the leading brokerage firms were compensating their preferred customers for the losses they had suffered, at the expense of their stockholders, the market lost more than one-half of its value. It retreated despite frantic efforts of the authorities to support stock prices with social security trust funds, despite strenuous "price keeping operations" which meant to prevail over the laws of the market. By August 1992 the Nikkei index barely exceeded 14,000. It called an end to the speculative euphoria which had bred and concealed political corruption on a scale unprecedented in postwar Japan. The bursting of the bubble together with the corruption also ended the thirty-eight year rule of the Liberal Democratic Party.

Throughout the decade the Japanese economy suffered several abrupt declines in real GDP and employment, followed by false starts of recovery. Despite feverish efforts by politicians, officials, and central bankers, economic activity continued to stagnate; the contra- cyclical policies proved to be ineffective or even counterproductive. No real attempt was made at a structural reform; after all, the social and economic structure had worked so well until 1990. Instead, the authorities returned again and again to the teachings of John Maynard Keynes which places legislators and administrators in charge of economic recovery.

Economic prosperity and full employment, according to Keynesian instruction, can be achieved only if government deliberately encourages consumer and business spending and, if necessary, engages in deficit spending. Central bankers must maintain an easy money policy throughout the recession. In the footsteps of Professor Keynes, the Japanese government embarked upon massive deficit spending and the Bank of Japan lowered its discount rate to stimulate the economy. By September 1995 the rate reached 0.5 percent, the lowest level ever; it has continued on that floor ever since. Yet, despite busy exports and massive current account surpluses, the Japanese economy continued to linger in stagnation and even decline. With an anemic economy at home and interest rates at minuscule levels, many Japanese investors prefer to place their funds overseas.

Official announcements of imminent recovery throughout the decade proved to disappoint again and again. In 1997 and 1998 Prime Minister Hashimoto (1996-1998) made a valiant effort to initiate genuine reforms. He moved to reduce the Keynesian pump-priming measures such as public works and personal income tax cuts in favor of revival by deregulation and reform. He even dared to raise the consumption tax from 3 to 5 percent and shifted the increased costs of medical insurance to individuals. When economic conditions failed to improve and unemployment rose to record levels, Hashimoto returned to the ways of of the past. A new stimulative plan worth more than 14 trillion yen (some $123 billion), the largest ever adopted in Japan, was to revive the economy. Six months later when the Nikkei index fell to a new low of 12,900, the new Obuchi Administration approved a 22 trillion yen economic stimulus package; it included 7.5 trillion yen for public works and 5.5 trillion for tax cuts.

The Asian economic crisis, which burst to life in July of 1997 when Thailand could not maintain its currency exchange rate, aggravated the Japanese recession. It compounded the difficulties of Japanese banks many of which had become insolvent when the bubble burst in 1990 and 1991. Yet, these institutions had lent more than $100 billion to risky ventures in the Asian region. They assumed correctly that insolvency in Japan rarely has the dire consequences it usually has in the Western world; liquidation and bankruptcy laws are largely unused. The Japanese favor reconstruction and compromise which may stave off insolvency for a long time.

Throughout the long years of stagnation and recession Japan experienced sharp international criticism of its economic performance. At several meetings of the leaders of the advanced industrial democracies, the Japanese delegates came under loud criticism for not taking stronger medicine for its recession. International Monetary Fund economists issued grim estimates of Japan's future and proposed that Japan reduce its consumption tax and accelerate government spending. The prime example of this outside commentary is President Bill Clinton who uses every opportunity in contacts with Tokyo to wax eloquent about American prosperity and prescribe remedies for the economic evils in Japan. Many Japanese view this attitude as "bluntly interventionist," an intrusion into domestic affairs.

In October 1998, finally, the Japanese Diet mustered the courage and support to embark upon some reforms. It passed laws that mandated the nationalization of failed banks and the creation of "bridge banks" making loans to solvent borrowers. The Diet also provided for a Deposit Insurance Corporation with 25 trillion yen of public funds and later approved another 55 trillion yen to rescue the nation's nineteen biggest banks. The legislation was to weave a safety net designed to be a temporary framework with all depositors and creditors fully protected in any bank failure until March 2001. By that time the banks hopefully will have recovered and been returned to private ownership.

Since 1998 a merger movement has reduced the number of banks; the nine biggest commercial banks are expected to merge to just four or five in the coming months. Japan's 144 banks have managed to improve their capital positions although their loan assets continue to contract. The Deposit Insurance Corporation has resolved the difficulties of some 50 institutions but still faces non-performing loans of some 99 trillion yen. Many loans must be written down to 70 percent, others to just 15 percent. When Citibank of New York wanted to buy Tokyo's Sowa Bank, the Finance Ministry rebuffed it, fearing the bank's liquidation. Banks may be nationalized but not liqui- dated; similarly, a large-scale disposal of real estate is to be avoided because it would have a negative impact on land prices.

Driven by the legislative initiative, the restructuring and recovery of many companies, and the boom of the information industry, stock prices at the Tokyo exchange enjoyed a remarkable recovery in 1999. They soared to more than 19,000 of the Nikkei index, or some 50 percent of the bubble top in 1989. Yet, two time bombs expose economic life to grave danger, one threatens the capital market, the other the credit responsibility of the Japanese government.

The Bank of Japan is building a bomb consisting of countless distortions and maladjustments. A reform act of 1997 gave the Bank a measure of independence from the Ministry of Finance and provided for some transparency. It charged the Bank with the task of pursuing price stability and assuring an orderly financial system. Mindful of this mandate, the Bank is laboring to prevent a feared contraction of the credit system and further declines in economic activity by conducting a policy of unprecedented ease, i.e. a zero call rate and a .5 percent discount rate. But such rates are ill-suited to support 99 trillion yen (some $900 billion) of nonperforming loans and untold trillions owed to the Deposit Insurance Corporation. A zero-rate overnight loan does not offset a permanent loss; however, it does allow commercial banks to carry nonperforming loans on their books and thereby pretend to hold assets which no longer exist. In short, the Bank's interest-rate policy creates and maintains a financial world of make-believe. It does not work very well, which the long and painful recession clearly illustrates.

The Japanese taxpayer is the only reliable supporter of the financial structure. If it were not for the taxpayer, the system would crumble and disintegrate -- just as the American S&L cartel would have failed without the Resolution Trust Corporation and some $300 billion of taxpayer funds. But the Federal Reserve Bank did not charge a zero call rate, or a 0.5 discount rate; it held its discount rate at 7 percent throughout those turbulent months, which approximated the market rate at which the demand for and the supply of funds tended to be equal. The market rate forced all financial institutions to face the realities of profit and loss and, above all, use and allocate their resources economically. In contrast, the policies of the Bank of Japan ignore the market which reflects the value judgments and time preferences of all participants. They invite much misuse and misallocation of funds, which will become apparent as soon as interest rates once again are determined by the market. An investment made at a capital cost of 1.375 percent and yielding 2 percent will be profitable as long as interest costs remain below 2 percent; it will inflict grievous losses as soon as they rise to 7 percent or go even higher. Every increase, no matter how small and gradual, will reveal unprofitable investments made in the past. They will keep the economy depressed, which may tempt the Bank to continue its fateful zero-rate policies.

The Bank of Japan may finally succeed in igniting a price inflation which invariably will add its own distortions to the distorted economy. When the commercial banks finally come to life as a result of massive taxpayer-fund injections and the monetarization of government debt, bank credit may rise again and goods prices may resume their upward trend. Price inflation depreciates all debt and thereby defrauds creditors but enriches debtors, especially the biggest debtor of all, the Japanese government.

The Bank of Japan appears to actually favor moderate inflation which would give instant relief to insolvent financial institutions and stimulate business as long as it raises product prices and lowers business costs. It may even depress the exchange rate of the yen versus the dollar and thereby favor the export industry which ever since the 1960s has loomed so important in the full-employment objectives of Japanese authorities. To prevent an unwelcome rise in the yen exchange rate which, in their judgment, would impede the budding recovery, the Bank of Japan has supported the dollar throughout the recession. It increased its foreign exchange reserves, buying U.S. dollars and selling yen, from some $61 billion in 1991 to almost $300 billion at the present. It is by far the biggest creditor of the United States, the biggest buyer of U.S. Government obligations, and unintentionally also the staunchest booster of the American bull market. It is a great benefactor of American consumers who enjoy a great variety of Japanese products which keep American prices lower than they otherwise would be. Japanese businessmen exchange their goods for paper dollars which then are hoarded by the Bank of Japan. Of course, guided by Keynesian prescriptions, the Bank merely means to benefit Japan. And guided by old Mercantilistic notions, American officials, meaning to benefit the American people, frequently restrict the importation of Japanese goods to the United States. In official circles economic knowledge has not advanced much during the last 300 years.

Decades of deficit spending have made the Japanese government the biggest debtor (in terms of a percentage of GDP) ever during peacetime. During the 1990s Japan's national debt soared from some 160 trillion yen to some 340 trillion (some $3.225 trillion). Its public gross debt now amounts to 128 percent of GDP—up from 69 percent in 1990 and compared with the U.S. government GNP debt ratio of 70 percent. While the American government has temporarily weaned itself from its old borrowing habits, the Japanese government continues its deficit spending with fervor and conviction. As late as November 1999 it announced another package of economic stimulants, worth some 19 trillion yen ($174 billion) to increase public works and aid small business. An undisclosed amount of this new debt is to be placed with the Bank of Japan which uses the occasion to expand the stock of money and thus keep interest rates low lest it endanger the desired economic recovery.

The growing burden of government debt constitutes another time bomb that casts a dark shadow on the future of Japan. During the height of the speculation fever, the central government merely suffered budget deficits of some 10 percent of expenditures. During the current fiscal year the deficit is estimated at more than 50 percent, with revenues estimated at 34 trillion yen and the deficit at 38.6 trillion. With the discount rate at 0.5 percent, the prime rate at 1.375 percent, and the government bond rate at 1.69 percent, the burden of this debt may still be bearable. But how will it set when the market rates of interest finally prevail over the central bank rate and soar to 5, 6, or 7 percent? Debt service is the biggest share of government expenditures at the present; at some 25 percent it exceeds government spending on social security, public works, education, and defense. At market rates of interest it will exceed total revenue.

It is difficult to foresee how the Japanese government can service its growing debt at rates several times higher than present rates. Surely it may just add the interest charges to the total debt and cause it to rise ever faster. Or it may want to double and triple the tax burden on the people, which would certainly choke off any economic recovery and aggravate the recession. Or it may even slash its expenditures by constraining the welfare state in all its forms; but the electorate may summarily reject such drastic measures.

If expenditures cannot be reduced drastically and the burden of taxes cannot be multiplied, there is always the possibility of willful inflation, which depreciates and erodes all debt. The Bank of Japan may be the last resort to defuse the debt bomb by inflating and depreciating the yen. At this very moment it is standing by to refinance some $440 billion in Postal Savings deposits that are falling due and may soon be withdrawn seeking higher returns elsewhere. Every fourth government bond presently is held by the Postal Savings system which invested in 10-year savings bonds issued at the beginning of the 1990s at high market rates.

Despite the heavy hand of government, Japan is one of the most advanced industrial countries in the world. And despite the painful depression of the 1990s, the Japanese economy is likely to advance again in efficiency and productivity. Every failure and disappointment spurs reflection and introspection that may correct the errors of the past. But men learn only what their mores and values allow them to learn. Paternalism and authoritarianism stand ever ready to inject their concepts and principles; they do so throughout the world.

Economists may disagree over the similarities between the Japanese bubble economy and the heady run-up of stock prices in Wall Street during the late 1990s. They may even differ on the nature of the run-up, on whether the U.S. stock market is a bubble about to burst or a new technology-driven boom with substantial underpinnings of productivity and profitability. Some place their faith in the new world of high-tech and speak of a "new paradigm." They readily admit that there will be market corrections, but these will not disrupt the trend towards new growth and prosperity.

In contrast, the defenders of the bubble principle point at the similarities and differences between the Japanese bubble of the late 1980s and the American bubble of the late 1990s. They are convinced that the Wall Street euphoria will come to naught just as it did in Tokyo. Their greatest concern is the possibility that, in the footsteps of the Japanese government and guided by the same Keynesian thought and political philosophy, the U.S. government will make matters worse once the bubble bursts. Just like the Japanese government, it will embark upon massive deficit spending in order to revive economic activity and sustain employment, and the Federal Reserve, just like the Bank of Japan, may flood the money market in order to rescue insolvent financial institutions. The consequences are bound to be similar as economic growth and prosperity give way to painful stagnation. Of course, the U.S. government will merely imitate itself, and repeat what it has repeated many times before.

Edwin O. Reischauer and Marius B. Jansen, The Japanese Today,Cambridge, Mass.: The Belknap Press of Harvard University Press, 1995; S. Prakash Sethi, Nobuaki Namiki, Carl L. Swanson, The False Promise of the Japanese Miracle, Boston: Pitman, 1984; Bank of Japan:

Hans F. Sennholz, The Savings and Loan Bailout, Grove City, Pa: Libertarian Press, 1989; http: //; Economic Planning Agency of Japan:; Statistics Bureau and Statistics Center (Japan):

Hans F. Sennholz

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