Alex Liccketto, Mikita
Meshchorokou & Patrick Stycos
Professor Allin Cottrell
Economics of the Financial
Crisis
16 November 2010
Economic recessions present major burdens to the nations who face
them. During these downturns
unemployment rises, household incomes fall, and gross domestic product (GDP) is
reduced. Investment spending and
corporate profits drop and the price level begins to fall, sometimes bringing
forth a threat of deflation. Typically
recessions last for only a short period of time, but sometimes the collapse is
so devastating the effects are widespread and persist for many years.
While Japan’s asset collapse in the late 1980’s and early 1990’s
draws many parallels with the United States Financial Crisis in 2008, the two
calamities also had many stark differences. It is important to note that most
literature discussing Japan’s asset bubble comes from a pre-2008 perspective.
As a result, policy decisions made in Japan are often compared to those in the
United States. These comparisons assume the United States was not headed toward
a housing bubble of its own. This distinction is crucial because financial
liberalization itself is seldom blamed for the asset bubble in Japan.
The recent financial crisis led to
an eighteen-month long recession dating from December 2007 to June 2009,
the
longest recession in the United States since the Great Depression (Business). This “Great Recession” as much of the media
and populace like to term it, brought about massive unemployment, a continual
reduction of the United States GDP, and general panic about the future of the
country’s economy. Although national
output has since rebounded from the mid-2009 trough, the unemployment rate remains
at a relatively high 9.6% (Labor).
The Lost Decade in Japan was a ten
to fifteen year period of economic decline or stagnation that occurred during
the 1990s, and into the early years of the new millennium. Poor policy decisions following massive growth
throughout the 1980s led to a stunted economy, faced with minimal corporate
expansion and a large credit crunch.
Also, as Japanese citizens began to save the majority of their income,
limited cash flow only amplified the corporate struggle of securing funds.
The Great Recession and the Lost
Decade were both ignited by the expansion and bursting of large speculative
bubbles. Leading up to the downturns in
both economies, the United States and Japan experienced strong economic growth
fueled by increasingly liberal lending practices. Largely due to competition between lenders,
creditors began to extend loans to riskier borrowers which led to
unsubstantiated purchases in their respective economies. While occurring in a different time period,
the speculative rise of housing prices in the United States greatly reflects
that of land and asset prices that occurred in Japan in the mid-to-late 1980s.
At the end of the Clinton
administration the United States was experiencing vast economic growth and
prosperity. Not only did the nation
witness massive growth of its GDP, but the government also ran a budget surplus
for a few years. Household income was rising and people began to invest their
earnings into safe, long-term markets such as that for housing. Beginning in 1998, house prices began to rise
due to increasing activity in the market.
In a speech made earlier this year current Chairman of the Federal
Reserve Ben Bernanke stated, “Prices grew at a 7 to 8 percent annual rate in 1998 and
1999, and in the 9 to 11 percent range from 2000 to 2003… the most rapid price gains
were in 2004 and 2005, when the annual rate of house price appreciation was
between 15 and 17 percent” (Bernanke). During
that period, the rapid growth of the housing market was often justified as a
product of the prosperous times, however many experts now claim the inflated
prices were a byproduct of subprime lending and poor regulation.
As
property values rose in the United States, so did the attractiveness of
securing a mortgage to purchase a home.
Houses were considered to be a safe investment with the potential for
significantly high rates of return due to the ever-increasing prices. From a homeowner’s
perspective, renting seemed illogical because one could always sell a house for
a return on investment if times got tough.
Simultaneously, in an effort to capitalize on profit maximization, banks
began to extend loans to less-qualified individuals with houses being
collateral for repayment. This practice
continued to thrive especially as new devices were invented to offer banks loan
security against these borrowers and spread the threat of loan defaults to
third-party investors. As John Cassidy
states Keynes’s view, “In the short run, prices may move further out of line
with fundamentals, causing them (investors) to make even bigger losses. Following the herd, even when you believe
prices have become disconnected from reality, cannot be described as
‘wrong-headed’” (172). Few believed house
prices would collapse, and even investors who believed prices were inflated did
not want to sit out while others profited on the bubble. Banks continued to lend to risky borrowers
and investors continued to buy mortgage-backed securities, all for the purpose
of increasing profits and not lagging behind competitors. When a bubble is on the upswing nobody can
lose, but the effects of a collapse can be devastating.
Like
in the United States during the late-1990s to early-2000s, Japan’s growth in
the 1980s was largely due to increased land and asset values. According to the Land Price Index, Japanese
land values reached their peak in 1990; also, the Tokyo Stock Price Index shows
a peak in the aggregate
numbers for all stock-exchange-listed firms arriving in 1989 (Goyal & Yamada 179). Many experts attribute the proximity of peaks
in land and stock values to a cycle of corporate borrowing, which was driven by
easy monetary policy. Vidhan
Goyal and Takeshi Yamada note, “The beginning of the asset inflation period
coincided with the Bank of Japan adopting an easier monetary policy. The official discount rate fell from 5% in
1986 to 2.5% in February 1987” (180).
The lower interest rate encouraged corporate borrowing from banks in an
attempt to expand production capabilities.
Upon obtaining these loans corporations bought up large quantities of
land, raising both property values and the prices of their stocks due to
expectations of higher future earnings (Bordo & Jeanne 7). With the corporations now highly
collateralized, the rate of lending continued to increase and the economy’s
growth rate followed.
Japanese lending in the
late-1980s was similar to the United States during the early-to-mid-2000s. Initial borrowing was limited to strong
corporations and wealthy individuals with high expectations of repayment. The rise in stock prices brought about by
increased land values led to the extension of loans to riskier borrowers,
however. Soon, much of Japan’s growth
was based on the speculative escalation of land and stock values. Also, much of
the collateral backing new loans in the late 1980s was funded by
previously borrowed money; this fact increased the risk of default and fed the
speculative boom in various sectors of the Japanese economy. The increased value of corporations, despite
coming from borrowed funds, enhanced their creditworthiness to banks that then
approved higher-value loans. This practically ensured a bubble. Japan’s
economic success during the bubble can be attributed to euphoria and
unsubstantiated expectations for the future (Okina & Shiratsuka 37).
Just as corporations were able to use borrowed funds to enhance
collateral, Japanese banks were similarly given the right to use outstanding
mortgage receipts as part of their capital requirements. In 1988, the world’s
foremost economic leading countries met in Basel, Switzerland to determine, for
the first time, an international standard for capital asset requirements. These
standards would be binding for the top 10 economic countries (G-10) and many
smaller countries would follow them voluntarily. The members of the Bank of International
Settlements (BIS) agreed to let Japanese banks use part of their hidden assets
as capital for their lending. As stated by Thomas Cargill, “The final
requirement permitted Japanese banks to meet the 8 percent risk-adjusted
capital requirements by including 45 percent of hidden reserves in tier 2
capital” (88). Including this 45% as
part of their capital requirements allowed Japanese banks to have substantially
higher leverage ratios.
In addition to these perverse
incentives, Japan also lacked many of the regulatory institutions to police
bank activities. The Deposit Insurance Corporation (DIC), the Japanese
equivalent of the FDIC, played no substantive role in the regulation of banks.
The DIC, which had a total staff of about ten people, had a limited amount of
cash reserves that would be erased by the failure of even one regional bank and
implicitly stated that it would insure all deposits regardless of the amount (Cargill
86).
In the United States, the interconnectedness of large financial institutions
magnified the size of the collapse. Derivatives allowed companies to hedge
their risky investments, but the firms who issued derivatives, like AIG, were
not required to hold capital in reserve to cover those derivatives. So when the
risky investments depreciate below a given value, the issuers had an
insufficient amount of capital to fulfill their contractual obligations. In addition, these derivatives were not traded
publicly, which prevented stock holders from fully understanding the true
financial state of their companies. The lack of transparency in both the United
States and Japan is probably what connects the two crises the most. In Japan,
the actual capital was kept secret while in the United States it was a
different form of insurance that was secret.
At the consumer level, there existed similarities as well. Instead
of using teaser rates and subprime loans as the United States did “Japan had
its own versions of [risky] loans, including the so-called three-generation
loan, a 90- or even 100-year mortgage that permitted buyers to spread payments
out over their lifetimes and those of their children and grandchildren”
(Fackler). In hindsight this type of loan seems unreasonable, but in a country
that was accustomed to an unemployment rate below 3% the credit worthiness of the
next generation seemed high.
Leading up to the collapse, Japan’s housing bubble grew
significantly faster than the United States bubble did. In 1991 all the land in
Japan, which is about the size of California, was worth around 18 trillion US
dollars. At the time, all the property in the United States was worth around 5
trillion dollars (Fackler). When the Japanese government realized they were in
a full blown bubble the central bank significantly raised the interest rate in
order to discourage lending. This promptly burst the housing bubble, and
property and stock values plummeted. As of 2005, land prices in Japan were
worth half as much as their 1991 peak values. Meanwhile, the value of real
estate in the United States tripled. As seen in the graph below, the effect in
cities was even greater. During that 14 year period Japan’s six largest cities
experienced a 64 percent drop in residential housing prices (Fackler).
Housing prices in the United States have yet to stabilize. Although
their decline has been softened by tax incentives and low interest rates, the
surplus of foreclosures currently on the market is proof enough that the plunge
is far from over. Japanese housing prices did not fully reach bottom until 15
years later in 2005 but they turned down again in 2008. If the decline in
prices lasts a similar length of time in the United States housing prices won’t
consistently rise again until after 2020.
Unlike Japan’s government, the United States did not burst its own
bubble with a large increase in interest rates. Instead the United States’
bubble began with the homeowners being unable to pay their mortgage obligations.
While housing prices had skyrocketed, median income in the United States barely
moved from 2000 to 2007. As a result, homeowners were unable to repay their
loans.
During the boom, financial institutions used mortgage securities as
collateral for short term lending. In turn, they used this short term lending
to finance everything from payrolls to long term investments like car loans.
When the short term lenders (money market funds), realized that the securities
were riskier than previously thought, they demanded much more collateral for
short term lending. What ensued was a sudden lack of short term credit that
forced companies to lay off workers in order to balance their budgets.
In contrast to Japan, the United States quickly lowered interest
rates to try and free up credit. Early on the Federal Reserve saved Bear
Stearns from bankruptcy because it was the first institution to go to the brink
of failure overnight. Lowering interest rates to near zero was hardly enough to
compensate for the sudden lack of credit. Soon Leman Brothers approached
bankruptcy and when efforts to negotiate a buyout failed, the large firm filed
for bankruptcy. A Domino effect quickly ensued. The collapse was driven by both
the debts of Leman Brothers to multiple firms, including a money market fund
that also declared bankruptcy, and by the sudden lack of confidence that results
when a major firms declares bankruptcy.
At the peak of Japan’s crisis, the government had just raised
interest rates. It took the government about 5 years to get the discount rate
and the interbank rate to almost zero from 6% and 8% respectively (Cargill 96).
While the United States quickly lowered their interest rate to zero, neither
countries’ monetary policies solved the ensuing recession.
Recessions are largely defined by the unemployment rate. While GDP growth
is the technical determinant of a recession, the unemployment rate is the
standard by which the public judges the health of the economy. For this reason
it is important to examine the unemployment rates of Japan and the United
States in their post asset bubble economies. The unemployment rate in Japan has
historically been very low, usually remaining under 3 percent. Economists
believe there are two major reasons for this: methodical and definitional
differences and Japan’s employment system as compared to that of the United
States.
Some critics argue that Japan
does not follow international standards as it calculates its unemployment rate
based on different principles. Uwe Vollmer states a few differences between how
unemployment is characterized in the two countries under study:
Their concepts differ mainly in the definition of the unemployed
vis-à-vis persons outside the labor force. Excluded from the unemployed in
Japan but included in the United States are persons who have sought jobs in the
previous four weeks but did not take active steps to find work during the
survey week, and persons who are currently without a job but are waiting to
report to a new job within 30 days. (297)
On the other hand United States’ unemployment statistics
record a person outside of the labor force if they made their last job search over
a month ago while in Japan they are considered unemployed members of the labor
force. It is essential to note that many economists believe these differences in
calculations are not the main cause in the varying levels of unemployment in
the United States and Japan.
Commonly, the more important cause of Japan’s low
unemployment rate is thought to be the structure of the labor
market itself. The Japanese labor market is more stable than that in the United
States because many companies offer their employees long-term employment,
sometimes guaranteed to retirement. Therefore job changes are less likely to
occur in Japan than in the United States. Japanese workers tend to have the same job for
an average of 12 years while the average tenure for workers in the United
States is only 7 years. Furthermore, 50% of the Japanese workforce tends
to hold a job for longer than 10 years while the majority of workers in the
United States hold their jobs for an average of less than 5 years (Vollmer 299).
Another factor that plays an
important role to the low unemployment rate in Japan is its rigid real wage and
bonus system. The amount of a worker’s bonus depends on the success of the last
six months of the company’s activity; worker compensation based heavily on bonuses
prevents major deviations in the real wage. For instance, if there is an
increase or decrease in productivity then workers will receive respectively
more or less in bonuses while the real wage stays at the same level. This
system allows Japan to handle external economic shocks without a rise in unit
labor costs and unemployment. Conversely in the United States wage is
adjusted annually so when facing cases of adverse shocks the unemployment rate
goes up because companies start to lay off their workers.
Prior to the collapse of the asset bubble the Japanese
labor market was working extremely well, with the unemployment rate below 3%
for a period longer than 30 years. However, in the early 1990s the unemployment
rate started to rise. The Japanese economy experienced stagnation for
approximately the next 10 years and its unemployment rate remained
higher than normal, around 5%. In comparison, the United States’ unemployment
rate historically averages between 5-6%, but due to the recession
experienced rates over 10% at times (Cargill 6). The financial crisis in the United States
unfolded much quicker than Japan’s crash in the 1990s, and brought harsher
results to the labor force as well as national output.
Recently China surpassed Japan and became the second largest economy
in the world. Up until then, Japan and the United States had been the two
largest economies in the world for decades. In that light, it is perhaps not
that surprising that both countries succumbed to irrational optimism about
their housing markets. While the lead up to and the collapses themselves are
unmistakably similar, ultimately the similarities of the crises will be judged
by the speed at which the United States recovers. Unfortunately, if Japan’s
struggle gives us any insight to the future, the United States will not
experience a substantial recovery for a long time.
Works Cited
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