Deciphering Japan's 1990s Financial Problem

Junichi NAITO (Deputy Director-General, Minister's Secretariat, Ministry of Finance)

Unique phenomena never seen after WWII were observed in Japan's economy following the collapse of the bubble in the early 90s. These include significant and persistent decrease of land and stock prices, excessive debt of corporations and deterioration of banks' assets, and a contraction of credit typified by reluctance of banks to extend loans. Although there were depressions after WWII, the magnitude of the problems incurred upon Japan's economy since the 1990s is unprecedented. Whereas depressions until then were caused by imbalance of supply and demand in the real economy, the current slump is a result of the invalidation of the economic growth pattern based upon indirect financing. Such a change in the basis of an economy occurs rarely, perhaps once in several decades.

Since the collapse of the bubble, every time bad asset problems and bank failures were reported the government was accused of lags and flaws in its financial administration. As depression and deflation deepened, economists argued the necessity of further economic stimulus and monetary relaxation. In October 2002, the Koizumi administration decided to establish the Industrial Revitalization Corporation in order to take care of the industry aspect of the economy along with the financial side, but the new institution does not seem to be highly appreciated.

The question as to why the present problem is so complicated and cumbersome needs to be revisited and clarified from the root. While I was engaged in government and academism, it kept recurring to my mind that the core of the problem might be something nobody yet had pointed out.

Japan experienced a severe financial crisis in 1927 (the "Showa Financial Crisis"), which led to the creation of a financial system called the "1930s model." It could be that the real cause of the present economic difficulties is the collapse of this system, representing a termination of a regime to support the traditional financial system.

Japan's financial system after the Meiji Restoration was surprisingly liberal and Anglo-Saxon. As such, fraud and failures were common. This was until about the end of WWI. Then the prolonged depression after the Great Kanto Earthquake of 1923 and the Showa Financial Crisis that brought about a chain reaction of bank failures changed the scene.

The era of laissez faire ended, and came the age of regulations; severe restrictions on competition and entry into financial businesses were imposed, and the stabilization of the financial system was sought through powerful supervision. This was later dubbed the "1930s model" of financial regime. In fact, the symptoms and the prescriptions adopted for the financial system were very similar to those of the US after the Great Depression.

The 1990s of Japan could be considered the period when this "1930s model" of heavy regulation collapsed. Liberalization began with high inflation in the US during the 1970s. Japan had faced demands from foreign governments to open its market in the 1980s, but the decisive factor was the collapse of the bubble leading to an upheaval in Japan's economic and financial structure. Failures of major banks made people realize the meaning of self-responsibility, which really triggered the fall of the 1930s model. Whereas in the US the liberalization resulted in massive failures of small financial institutions, in Japan the falls of major banks were perceived as a sign of true liberalization. Japan's financial deregulation had been carried out in small incremental steps very cautiously by the authorities during the 1980s, but the actual failures of the banks may have been the decisive stroke to complete the process.

But the overwhelming share of indirect financing in Japan's corporate financing made the impact of the bank failures devastating. Credits were squeezed and companies' debts soared. And as the asset deflation and credit contraction still currently going on is a realignment phase of the huge imbalance so caused, this large-scale stock adjustment process could not be reversed by tackling the issue from the flow aspect, either through fiscal or monetary measures. What could be done is limited to relieving some of the pain inevitable to the process. An important policy objective is to strengthen the capital bases of banks impaired by asset deflation, and revive profitability. This is where, along with infusion of public capital, restructuring of the banking industry and introduction of an Asset Backed Securities (ABS) Market is called for, in order to relieve the state of excessive number of banks and to squeeze their assets. Removal of the full guarantee for demand deposit scheduled after April 2005 is also an important policy measure to expedite the restructuring process.

I have recently, with my colleague, translated a book into Japanese titled "Towards a New Paradigm in Monetary Economics" by E. Stiglitz and B. Greenwald, which was published October 2003 simultaneously in Japan and the US. In it there is an explanation of the banks' behaviors where, because of such factors as assymetricity of information, banks tend to simply decrease the volume of credit extended in order to avoid risks rather than to adjust interest levels according to changes in risk portfolio. This provides theoretical support for the Japanese banks' reluctance to lend, which has been a target of criticism.

This assertion indeed has important implications. Stiglitz and Greenwald explain in general terms that the anxieties of banks to avoid their failures induces credit rationing that leads to overall credit contraction provided by banks as a whole. But in the case of Japan, where the 1930s model was destroyed by sudden collapse of major institutions, the tendency of the banks to avoid risks should become stronger. And the effect would be more severe because of the structure of the economy's heavy dependence on indirect financing; i.e. bank loans.

The issue of prime importance at present is to break out of asset deflation quickly and expedite the integrated revitalization process of financial and industrial sectors. Then, what should be done next--contrary to what many liberal economists advocate--is to recognize the importance of revisiting and seeking the real causes as to why financial liberalization failed to bring about a stable economy. Upon these findings a new system could be established to realize a solid economy, a new financial regime for the 21st century.

(Opinions expressed or implied here are solely those of the author, and not those of the Ministry of Finance.)