From: Rakesh Bhandari (rakeshb@stanford.edu)
Date: Tue Oct 29 2002 - 17:28:18 EST
About three years ago in discussion with Fred, I mentioned Susan Strange's warning of the consequences of a Japanese repatriation of capital from the US. There was an article in Business Week sometime in the last year which downplayed the threat. The threat is considered seriously at the end of this analysis. If I remember correctly, Strange drew heavily from Taggart Murphy, co author of this piece. rb Would Reform Ruin Japan? October 29, 2002 By AKIO MIKUNI and R. TAGGART MURPHY TOKYO It is an old routine that goes back half a century: a sudden show of resolve in Tokyo to do whatever it takes to fix whatever problem worries the United States - complete with "reformist" ministers and bold policy pronouncements. In time, both the policy and the minister are forgotten, and Japan returns to business and politics as usual. In this case, Heizo Takenaka, Japan's economics minister and chief financial regulator, was set last week to announce a bold plan to restructure Japan's banking system, which has more than $400 billion in bad debt. With the support and approval of the United States, Mr. Takenaka acknowledged that the banks will be unable to recover on their own, and that fixing them will result in the failure of scores of companies. But at home Mr. Takenaka's reform proposals received withering criticism even from members of his own party, and his support from Prime Minister Junichiro Koizumi may not last. Moreover, it is not entirely clear that the Bush administration realizes the consequences of Mr. Takenaka's solution. None of this is to say that Mr. Takenaka is not sincere, or that Japan's financial system doesn't face a huge crisis. He is, and it does. But the problem has been widely misunderstood. "Bad loans" only mean something in an environment where a borrower's ability to generate cash flow to service debt is the criterion of whether a loan is good or bad. That was not always true in Japan. Most loans were secured by land and rolled over perpetually. The criterion for loans in Japan was not corporate profitability but bureaucrats' ability to drive up real estate prices. Japanese finance has, to Western eyes, been an "Alice in Wonderland" affair now for 50 years. Banks once lent far more money than they had in deposits. Then, in the 1980's, Japanese government officials directed banks to lend well in excess of real economic requirements. Much of that lending fueled a surge in land prices that saw the theoretical value of Tokyo's Imperial Palace grounds exceed that of the whole of California. Bizarre as it may appear to outsiders, Japanese banking nonetheless was driven by two rational objectives: the goal was to finance an industrial plant that would secure Japan's economic autonomy and ensure its political stability. It worked. Four decades after war had left Japan in ruins, the country boasted the world's most formidable industrial machine. And a constant flow of subsidies to politically powerful groups - farmers, small shopkeepers, half a million construction companies - has bought 50 years of political peace. In recent decades, however, the system has changed. Credit now goes increasingly to protect politically well-connected companies from failing rather than to the kinds of firms that built the fabled Japanese economic miracle. These credit policies, combined with falling land prices, brought economic growth in Japan to a halt a decade ago. One of the results of this collapse is more than $400 billion in unrecoverable loans. But recovering those loans is not simply a matter of closing certain banks, recapitalizing others and allowing some big companies to fail. For starters, any questioning of the banks' integrity could lead to economic disaster domestically. If the banks are seen as corrupt, individual depositors could pull their money out of them. Japan's household savings overwhelmingly take the form of bank deposits that carry either explicit or implied government guarantees. The Japanese government, already heavily in debt itself, can ill afford to honor these guarantees during a wave of failures brought on by a run on the banks. Closing the banks could also cause a political crisis. The flow of cash - from household to bank to well-connected borrower employing retired bureaucrats and voters for the ruling Liberal Democratic Party - fuels the very engine of the Japanese political economy. Turning off this flow is tantamount to revolution. The notion that Mr. Takenaka is going to do that, even with the full support of Prime Minister Koizumi and the off-stage applause of the United States Treasury Department, is preposterous. Indeed, last week members of his own party and even a fellow cabinet minister criticized Mr. Takenaka openly. Any Japanese reform, political or economic, must eventually face this reality: Japan has no central government able to override the quasi-sovereign fiefdoms that constitute the Japanese political order. Those fiefdoms - the more powerful ministries together with their protÈgÈs and the various factions of the L.D.P. that provide political protection for them - can and will sabotage any policy initiative that threatens their autonomy. This lack of any institutional mechanism for overriding the claims of special interests helps explain the policy trap in which Japan now finds itself. During the decades when the economy grew rapidly, this institutional failing did not matter so much. But just as the Japanese military leadership in World War II never allowed for the possibility of retreat and didn't know how to conduct one, Japan's current economic leadership has no accepted means of distributing the pain that would inevitably accompany Mr. Takenaka's reforms. That is why, like all other such initiatives of the past decade, they will be allowed to proceed only when they have been gutted. An upheaval in Japanese finance, bringing with it a complete restructuring, is not impossible. But such a restructuring would produce shocks that would reverberate around the world. Japan as a nation holds nearly $3 trillion in dollar-denominated assets, many of them ultimately supported by the very deposits that would be withdrawn in a wholesale reorganization of Japanese banking. Those dollars have played an indispensable role in permitting the United States to swell its trade deficits far beyond the levels of most nations. That so many foreigners are willing to keep their earnings from trade inside the United States banking system - what "holding dollars" literally means - helps the United States tolerate its deficits. But this situation is precisely what restructuring in Japan threatens. If banks were forced to call in loans to pay off depositors, and if those loans financed their customers' dollar holdings, Japanese companies would be forced to sell their dollars for yen. Real money and purchasing power would then leave the United States as the conversion weakened the dollar, forcing a rise in interest rates and import prices and further raising the risk of recession. That is what usually happens to countries that run excessive trade deficits - foreigners lose confidence in these countries' currencies, interest rates rise, the economy goes into recession and, as people can't afford to buy so many imports, the trade deficit begins to close. The United States has escaped this fate largely because of the very problems with Japanese finance that Mr. Takenaka promises to attack. Washington ought to be careful what it wishes for. Akio Mikuni and R. Taggart Murphy are the authors of "Japan's Policy Trap: Dollars, Deflation and the Crisis of Japanese Finance.'' http://www.nytimes.com/2002/10/29/opinion/29MURP.html?ex=1036929764&ei=1&en=7d71b17991401536
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