Economist Draws Parallels Between U.S., Japan Banking Crises

The main lesson from 1990s Japan: A bailout of banks is politically unpopular but ultimately necessary to save the economy

by Dan Slater

Richard Koo, chief economist at the Nomura Research Institute in Tokyo, discusses the grim parallels between the US and Japan, including the need for unconditional capital injections.

Do you see any parallels between the US now, and Japan in the 1990s?

It's looking like a replay of many of the events that happened in Japan. Take the example a few weeks ago, during the G-7 meeting in Tokyo, when the Japanese finance minister advised the US treasury secretary to carry out immediate capital injections to the US banks. Paulson couldn't commit himself—similar to Japan in the 1990s, when public opinion was very strongly against bailing out highly-paid bankers and irresponsible banks. Recall also that in 1992, then-Prime Minister Miyazawa wanted to help the banking system with public funds, but was slammed by the public. As a result, it became taboo for the government to talk about bailing out the banks for the next six years.

This being an election year in the US, something similar is happening. Everyone is talking about a borrower rescue, not a lender rescue. In Japan, the public's perception towards the banks only changed when the Japanese credit crunch hit home. And that was in 1997, many years after the bubble had burst. That's because Japan was different to the US in one important respect—Japan, until 1997, had funds to lend but nobody wanted to borrow. The Japanese corporate sector was rebuilding its balance sheets. Until 1997, the average Japanese did not feel much pain. If he wanted to take out a loan, the banks were falling over themselves to make him one. But after 1997, the combination of a weak yen and a sagging stock market hit the banks. They realised that they were no longer meeting the 8% capital ratio mandated by the Bank for International Settlements, and desperately needed to reduce lending.

To make things worse, then-Prime Minister Ryutaro Hashimoto was trying to reduce the government fiscal deficit—at the most inopportune time. It was clear that the economy was kept going only by the government fiscal stimulus, yet here was Hashimoto talking of raising the consumption tax and other tightening measures. As soon as he came out with those ideas in January 1997, the stock market collapsed and everybody sold yen. That really hurt the capital cushion of the Japanese banks and they had to cut lending.

So the Asian financial crisis of 1997 affected Japan?

Yes, even though, in a way, the Asian crisis was actually caused by Japan. While the yen was very strong against the dollar, in the 80-90 range, having factories in Southeast Asia made sense. But when the yen weakened to 140, it made no sense to have those factories, so the Japanese started closing them down. But as the Japanese were pulling out, Western money was pouring in, even into countries which were no longer competitive. They were becoming uncompetitive because they were linked to the US dollar, which was gaining strongly in those years and was amongst the strongest currencies in the world. But the yen was going the other way. So the Southeast Asian business model was not sustainable, and not surprisingly, the dollar pegs were attacked by the likes of George Soros.

What was the next step in Japan after the credit crunch you just mentioned?

After the credit crunch, there were finally capital injections in March of 1998 and 1999. The second capital injection basically ended the crunch. This is what we have to see happen in the US. The problem is there are 8,500 banks in the US (there used to be more). These local banks have no access to sovereign wealth funds or other bailout money—if the big banks were ok, then they could help, but the big banks are not ok and Warren Buffett can't solve the banking problem on his own! So the small banks have no choice but to reduce their lending. And that will create a major credit crunch in the US.

What do you think will the US public's reaction to a bailout?

This is the problem. The Japanese government listened to the US advisers from the Treasury, who insisted on 'conditionality.