3: Japan's Trap

There was time when Japan was rolemodel.

All that is gone now.
Still it makes news, but mostly the bad ones.
We've now lost interest in Japan.
Some have concluded, Japan wasn't that tough after all.

This is foolish.
Their failures are as important as its success.
What happened to Japan is both tragedy and an omen.
World 2nd largest economy is still blessed.
Unlike Latin America or Asian economies, it's a creditor nation.

Yet Japan spent most of its time in slump.

Once the growth champion of adv. world, in 1998 Japanese industry produced less than
it had in 1991.
Country like Japan doesn't deserve to be in decade-long slump.
It was an omen: if it could happen to Japan it could happen to anyone.

How did it happen?

Japan as number 1

No country, even Soviet experienced as swift growth as Japan in its high-growth periods
from 1953-1973.
In 2 decades from argicultural economy became world's largest exporter of steel and
automobiles.

Some westerners began to took notice.

Herman Kahn published The Emerging Japenese Superstate, predicting Japan as
world leading economy by 2000.
As japanese product began to flood western markets, people began to wonder about
secret of Japan's success.

Heroic age of Japanese economic growth ended just when westerners began to take it
seriously.
In early 1970s, for mysterious reasons, growth slowed through-out the advanced world.
Japan's also face slowdown. From 9% in 1960 to 4% after 1973.
Although, this rate was still faster than any other country.
Japan's growth was envy for other nations.
Many argued, Japan had figured better way to run its economy.
Not only this but also that its success came at expense of naive Western competitors.

There were two sides.

One side explained growth as the product of good fundamentals, excellent basic
education and a high savings rate and also sociological reasons why Japan was good
at manufacturing high quality at low costs.
Other side argued, Japan had developed supeior form of capitalism.

One element of supposedly superior system was Govt. guidance.

In 50s and 60s, both Ministry of Intl trade and Industry and influential Minstry of finance
played strong role in directing economy.

Another element of distinctive Japenese economic style was insulation of major

companies from short term financial pressures.
Members of Japenese Keirestu- groups of allied firms organized around main bank-
owned substantial quantities of each others share, making management independent of
outside stakeholders.
Nor did Japanese companies worried about stock prices or market confidence, since
they rarely financed them by selling stocks or bonds.
Instead, the main bank lent them money they needed.
So they didn't worry about profitability at all.
One might have thought that financial condition of KEIRETSU bank would in the end
discipline corporate investment.
If the loans to bank's affiliates looked unsound, wouldn't the bank start to lose
depositors?
But in Japan as in most countries, depositors believe govt. won't let that happen.
So they paid little attention to what banks did with their money.
Result of this system, claimed both those admired and feared was a country able to
take long-term view.
One by one Japenese govt would target ''strategic'' industries that could be engines of
growth.
Priv. sector would be guided into those industries, helped along by initial period of
protection from foreign competition, during which industry could hone its skills.
Then there would be great export drive, during which they ignore profitability while
building market share and driving their foreign competitors into ground.
Eventually, its dominance of industry secured, Japan would move onto next one.

Skeptics poked holes in many of details of this account.

But even those who absolved Japan of predatory behaviour, tended to agree distinctive
characterstics of Japenese system must have to do with its success.
Only much later would these distinctive characterstics come to be labeled crony
capitalism and seen as the root of economic malaise

But weakenesses were evident by late 1980s, to anyone willing to see.

Bubble, boil and trouble

At beginning of 1990, market capitalisation of Japan was larger than U.S, which had
twice Japan's population and more than twice its GDP.

Late 1980s represented a time of prosperity for Japan, of fast growth, low
unemployment, and high profits.
Nonetheless, nothing in the underlying economic data justified tripling of both land and
stock prices during that period.
Even at time many observers thought there was something manic and irrational about
financial boom- taht traditional Co. in slowly growing industries should not be valued like
stocks, with price-earnings ratio of 60 or more.

Financial bubbles are nothing new.

From tulip mania to Internet mania, even most sensible investors have found it hard to
resist getting caught up in momentum, to take long view when everyone else is getting
rich.

But given the reputation japan long-term strategic thinking, then common perception
that Japan Inc. is more like planned economy than free market free-for-all, extent of
bubble remains somewhat suprising.

Now Japan's reputation for long-sighted always exaggerated reality.

Real estate investors often getting extra edge by paying off politicans.

Speculative investments in real estate came close to provoking a banking crisis in

1970s.
It was saved only through burst of Inflation.
It reduced real value of speculators debt and turned bad loans good again.
Still, extent of Japan's bubble was astonishing.
Was there some explanation beyond mere crowd psychology?

Its turns out that Japan's bubble was only one of several outbreaks of speculative fever
around world during 1980s.
All of these outbreaks had common feat that they were mainly financed by bank loans.
Bank loans institutions whose image used to defined by all -American earnestness of
Jimmy Stewart's small-town banker in it's Wonderful Life, but which in 1980s became
indentified with high-rolling Texas real estate moguls.
But similar lending of dubious lending occured elsewhere.
And economist have argued that such episodes lies the same economic principle- one,
like basic baby-sitting model of reccession.
This economic principle is known as moral hazard.

Term moral hazard has its origin in insurance industry.

Very early in game providers of fire insurance, in particular, noticed that property owners
who were fully insured against loss had an intersting tendency to have destructive fires-
particularly when changing conditions had reduced probable market value of their
building to less than insurance coverage.

Borrowed money is inherently likely to produce moral hazard.

Suppose that I'm a start guy without any capital, you decide to lend me billion dollars.
If investment prospers, so will I. If it doesn't, I'll declare personal bankruptcy and walk
away.
Heads I win, Tails you lose.

Ofcourse, that's why noboody will lend someone without capital of his own a $billion to
invest.
Creditors normally place restrictions on what borrowers can do with any money they
lend, and borrowers are obliged to put up a substantial amounts of their money, to give
them good reason to avoid losses.

Sometimes lenders forget these rules and lend capital without care, to people who put
good show of knowing what they're doing.
At other times requirement that borrower put up enough of his own money can itself be
source of market instability.
When assest lose value, those who bought them with borrowed money can be faced
with a ''margin call''.
They must either put more of their own money in or repay their creditors by selling
assets, driving prices down still further, a process central to current financial crisis.
There's another reason why rules sometimes get broken: Bcos moral hazard game is
played at taxpayers' expense.

Remember what we said about main banks; Keiretsu.

Their depositors believed they're safe, cos govt. stood behind them.

This sort of carelessness offers a tempting opportunity to businessman.

Just open bank.

It's not that easy.

Infact from 1930 to 1980 this behaviour was rare among bankers cos regulators did
more or less same thing Priv. lender would do.
They restricted what banks could do, restricting excessive risk-taking.
They required owners of banks put substantial amounts of their own money at stake,
through capital requirements.
And in more subtle and unintentional measure, regualtors limited competition, making
banking licence a valuable thing in itself.

But in 1980s, these restraints broke down in many places.

Mainly, cause was deregulation.
Traditional banks were safe, but also conservatives.
Failed to direct capital to most productive uses.
Cure was, said reformers, more competition and freedom.
Somehow, reformers forgot that this would give bankks more freedom to take bad risks
and that by reducing their franchise value, it would give them less incentive to avoid
them.
Changes in marketplace, notably rise of alternative sources of corporate finance, further
eroded profit margins of bankers who clung to safe, old-fashioned ways of doing
businesses.

And so in the 1980s there was sort of global epidemic of moral hazard.
Few countries can be proud of their handling- not U.S, whose mishandling of savings
and loan affair was a classic case of imprudent, short-sighted and occasionally corrupt
policymaking.
But Japan, where all usual lines- between Govt. and business, between banks and their
clients, between what was and what was not subject to Govt. guarantee- were
especially blurry, was peculiarly ill suited to a loosened financial regime.
Japan's banks lent more, with less regard for quality of borrower, than anyone else.
In doing so, they helped inflate bubble economy to grotesque proportions.

Sooner or later bubble always burst.

Bursting of the Japanese Bubble was entirely spontanoeus.
BOJ concerned about speculation, raised interest in 1990.
At first, it was not successful but later it was.

A Stealthy Depression

Unlike Mexico in 1995, South Korea in 1998, and Argentina in 2002, Japan never went
through a year of unmistakable, catastrophic economic decline.
Decade after the bubble burst, Japan experienced only two years in which real GOP
actually fell.
There was one year in the decade after 1991 in which Japan grew as fast as it did in an
average year in the preceding decade.
Economists have one of their famously awkward phrases for what Japan was
experiencing: a "growth recession."
A growth recession is what happens when an economy grows but this growth isn't fast
enough to keep up with the economy's expanding capacity, so that more and more
machines and workers stand idle.
The slowness with which Japan's economy deteriorated was in itself a source of much
confusion.
And at the same time, both Japanese and foreign analysts tended to assume that
because the economy grew so slowly for so long, it couldn't grow any faster.

Japan's Trap

There is nothing mysterious about the onset of Japan's slump in 1991: it was bound to
burst.
The same thing happened in the United States after the U.S. stock market bubble of the
1990s burst, and again after the next decade's housing bubble popped.
Question is: why Japan's policymakers, in particular its central bank, weren't able to get
the economy moving again.

It is time to return to the story of the baby-sitting co-op. Suppose the U.S. stock market
were to crash, undermining consumer confidence. Would this mean a disastrous
recession?
Think of it this way: when consumer confidence declines, it is as if for some reason the
typical member of the co-op had become less willing to go out, more anxious to
accumulate coupons for a rainy day.
This could indeed lead to a slump-but need not, if the management were alert and
responded by simply issuing more coupons.
That is exactly what our head coupon issuer, Alan Greenspan, did in 1987.

Even if the head coupon issuer temporarily gets behind the curve, he can still ordinarily
tum the situation around by issuing more couponsthat is, with a vigorous monetaty
expansion, like the ones that ended the U.S. recessions of 1981-82,1990-91, and 2001.
The Capitol Hill co-op didn't get into trouble because its members were bad.
It had a technical problem- too many people chasing too little scrip.
And so the co-op's story ought to inoculate us that recessions are always, and indeed
easily, curable.

But in that case why didn't Japan pull up its socks after the bubble burst?
if we extend the co-op's story a little bit, it is not hard to generate something that looks a
lot like Japan's problems.

First, imagine a co-op whose members realized that there was an unnecessary
inconvenience in their system: there would be occasions when couple would find
needing to go out several times in row, and would run out of coupons-and so would be
unable to get its babies sat even though it was entirely willing to do lots of
compensatory baby-sitting at a later date.
To resolve this problem, we'll suppose the co-op allowed members to borrow extra
coupons from the management in times of need, repaying with the coupons received
from subsequent baby-sitting.
(We could move the story a bit closer to the way real economies work by imagining that couples could also borrow
coupons from each other; the interest rate in this infant capital market would then play the role the "discount rate" of
the co-op management plays in our parable.) To prevent members from abusing this privilege, however, the
management would need to impose some penalty, requiring borrowers to repay more coupons than they borrowed.

Under this new system, couples would hold smaller reserves of coupons than before,
knowing that they could borrow more if necessary.
The co-op's officers would, however, have acquired a new tool of management.
If members of the co-op reported that it was easy to find baby-sitters, hard to find
opportunities to baby-sit, the terms under which members could borrow coupons could
be made more favorable, encouraging more people to go out.
If baby-sitters were scarce, those terms could be worsened, encouraging people to go
out less.

Imagine that there is a seasonality in the demand and supply for baby-sitting.
During the winter, when it's cold and dark, couples don't want to go out much but are
quite willing to stay home and look after other people's children.
But suppose that the seasonality is very strong indeed.
Then in the winter, even at a zero interest rate, there will be more couples seeking
opportunities to baby-sit than there are couples going out, which means that baby-sitting
opportunities will be hard to find, which means that couples seeking to build up reserves
for summer fun will be even less willing to use those points in the winter, meaning even
fewer opportunities to baby-sit ... and the co-op will slide into a recesion even at a zero
interest rate.
The 1990s were the winter of Japan's discontent.
Because of its aging population, perhaps also because of a general nervousness about
the future.
Japan, say the economists, fell into the dread "liquidity trap." A liquidity trap happens
when even cutting short-term interest rates all the way to zero isn't enough to persuade people to
spend more, either by borrowing or by drawing down their bank deposits.

Japan's Recovery

Japan's economy finally began to show some signs of recovery around 2003.
Real GOP started growing at slightly more than 2 percent a year.
What went right?

The answer, mainly, was exports.

In the middle years of this decade the U.S. ran huge trade deficits, importing vast
quantities of manufactured goods.
Some of these goods came from Japan, biggest was from China.