Adam Posen: A Financial Lesson From Japan's 'Lost Decade' Is Lost On Obama

Japan endured a painful 10-year economic slump after its stock-and-real-estate bubble burst in 1989. Today, experts are saying that what happened in Japan could never happen in the U.S. Or could it? I put that question to Adam Posen, who wrote the book on the policy mistakes made during Japan's lost decade. Posen is deputy director of the Peterson Institute for International Economics. We spoke yesterday on the eve of the G-20 economic summit in London.

Is this financial crisis unprecedented? You told PBS "the data is getting away from us because no one ever expected things to get this bad."

Adam Posen: Almost all countries suffer bursting bubbles and banking crises at some point in their history. Japan's lost decade has much in common with the U.S. savings and loan crisis of the 1980s, for example, as well as with the Nordic crisis of the early 1990s. Banks with insufficient supervision and insufficient capital misbehave in much the same way. However, more often than not political pressure from the banks and the general public delays a swift policy response by the government. The current U.S. financial crisis is caused by this same basic dynamic.

But aren't there some genuine differences this time -- the global spread, the toxicity of some of the bad assets, the relative speed of the response?

Yes, that's true. But basically this financial crisis is following a standard script.

The Japanese made financial policy mistakes in the 1990s. Could President Obama learn from them?

Japanese policy makers made three big mistakes. Or rather, three mistakes turned what should have been a two-year slump into a 10-year recession. The Japanese were very passive in their response to the crisis. That was their first mistake. It's better to be aggressively activist. The Obama team grasps this point.

The second mistake Japan made was to raise taxes during a recession, while worrying too much about loose monetary policy causing inflation. A better approach would have been to push monetary and fiscal stimulus very hard. The Obama team and the Federal Reserve got this right, although I think household tax cuts enacted by Republicans in Congress will diminish the fiscal impact.

And Japan's third big mistake?

Japanese policy makers weren't tough enough with their banks, especially when injecting capital. Obama has failed to learn this lesson.

Should Obama change leadership at the major banks, like he did at General Motors?

Yes, because these people messed up and there should be a clear message that messing up has costs. I haven't seen any evidence that Treasury Secretary Tim Geithner is going to be tough on bank executives, except when a firm melts down overnight -- as did Bear Stearns and Lehman Brothers. Of course it takes a huge effort not to be tough in cases like that.

What else would you do to stabilize the U.S. financial system and put banks on the right path?

Ultimately what matters is convincing the general public, the financial-system stakeholders, and particularly the regulators and supervisors that the environment has changed. Yes, there is a limited risk of bankers strapping themselves to the bombs of financial positions that have to be unwound -- which seemed to have happened with AIG Financial Products. But the U.S. has laws to deal with this, if the government is willing.

Here is what I would recommend:

I'd mark assets to market -- or price bad assets conservatively close to zero -- and then bolster the banks balance sheets for those losses, as necessary, with the injection of more capital.

I wouldn't wait around for "right" prices to evolve slowly from an arcane set of tests.

I'd resist the temptation to subsidize viable financial firms, even if I wanted those companies to buy things.

When taxpayers put a lot of money into an insolvent institution, I'd put voting and managerial control temporarily in the hands of the government, as the taxpayers' agent.

I'd make sales of government stakes and assets clean, full sales -- no public-private partnerships.

I'd set-up a publicly controlled "bad bank" on the RTC model. In so doing, I'd keep most of the upside on resale of currently distressed assets for the taxpayer.

I'd push Congress to consolidate systemic regulations quickly.

I'd impose stricter oversight of banking supervisors, and allow less room for discretion.

I'd listen to European proposals for additional financial regulation with a more open mind, and let them lead on some of those issues so long as the transatlantic playing field is kept level.

Almost every member of the House Financial Services Committee received large contributions from troubled banks last year. Do we need a new watchdog?

The entire U.S. Congressional system is beset by this kind of problem. I think the relevant committees can retain some desire to do the right thing without bias, especially if the public mood forces them to do so. But yes, it would be better to have public financing of campaigns, and none of this contribution nonsense.

Many pundits say the U.S. will pull out of this recession in 2010. But Obama said we may lose a decade. What is your best guess?

My best guess is that the U.S. economy will stop contracting before the end of this calendar year. The massive stimulus, along with subsidizing banks via the Geithner plan, will provide a temporary boost to the economy. Another lesson learned from Japan is that if you don't mess things up by raising taxes and interest rates during a recession, it is difficult to keep a modern market economy down.

However, the recovery will likely be strong for just three to six months, and then fall off again. The stimulus measures will not create a sustainable recovery unless the private sector is ready to pick up investing, and that will not happen unless the banking problems are really fixed and interest rates stay low.

So you don't believe our banking problems will be fixed any time soon?

I fear that by late 2010 or 2011, the banks will be back in trouble because the Obama team was not tough enough on them. In addition, maybe the Fed will have to ease up on the stimulus because the public debt will have expanded too rapidly. I hope I'm wrong on both counts, and the recovery is sustained beyond mid-2010.

What are the early indicators of a sustained economic recovery?

Look for a narrowing of spreads between interest rates on private-sector and U.S. government debt, while the average interest rate creeps up. Look for an increase in new home building and auto production, but not an increase in housing prices or in auto company shares. And look for a willingness of people to invest in more risky assets, while putting less in savings accounts and treasuries. Unemployment may continue to rise and housing prices may continue to fall during this period, but only for a short while.

Comments

[TheMadHedgeFundTrader]

Japan’s closely watched tankan report was released today, a quarterly report of business sentiment, showing its sharpest drop in history, cliff diving from -24 to -58. Japan is the one nation that has profited the most from globalization, and is therefore the most severely punished now that it is in retreat. Exports have dropped by half, industrial production plunged 9% in a month, and unemployment is soaring. Q4 GDP shrunk an unimaginable 3.2%, double the fall seen in the US. The last time the numbers were this bad, two atomic bombs had just been dropped on Japan and it lost WWII. Prime Minister Taro Aso’s government is embroiled in multiple scandals, taking his approval rating down to 23%, so the ruling Liberal Democratic Party’s half century long hold on power is in doubt. Elections are due in September. Perversely, a hurried unwind of a decade long accumulation of yen carry trades has pushed the yen up just short of a 20 year high of ¥87 in January, making the country’s essential exports even less competitive, and vaporizing the foreign earnings of Japanese companies. Toyota Motors (TM) has been reduced to begging for bail out money from the government, GM style. The government has passed four bailout packages in the past year totaling 13% of GPD, none of which have so far been spent. Japan has little choice but to wait for a US economic recovery, and then grab hold of its coat tails for dear life. www.madhedgefundtrader.com.

[Diane Tucker - Huffpost Blogger]

"Toyota Motors has been reduced to begging for bail-out money from the government­."

That surprised me when I first heard it, in more ways than one. Were you surprised? It seems to me that in the U.S., a double standard is at work. When GM and Ford need a bail-out, it's due to "bad management­." But when Toyota needs a bail-out, it's due to "market forces beyond their control."

I'm not saying GM and Ford have made the best choices -- and having worked on many international auto shows, I'm in a position to know. But if role model Toyota needs government assistance, something larger than executive screw-ups is also part of the domestic auto crisis.

Thanks for your comment.

[Kache]

"Look for an increase in new home building"

That cannot happen if all homes are arbitrarily devalued by 40%. That is what a forced, across the board mark-to-market would do. A contractor can not magically build a 300K home for 180K just because it looks good on an economist's speadsheet.

The problem was not that homes were priced too high, it was that 7% of buyers were buying homes they couldn't afford. But mark-to-market, when there is no market, devalues all homes, even the 93% of home buyers who bought what they could afford and continue to afford with each month's payment..

[KillTheMessenger]

Contractors do not spend $300k on even a million dollar home. And one can build apartment buildings for little over $100k per unit. That is what the country really needs to get back on its feet: densely populated inner cities which are affordable to all, not just the rich or those folks who are willing to spend 80% of their income on rent.

[RobinSeattle]

There was one likely pressure on the Japanese government that made them slow to act when the real estate bubble of the 1980's burst: many members of the ruling LDP as well as the corporations that own those politicians in the Diet were using Yakuza to get homeowners to sell their property (so-called "jiageya," or, literally, "land lifters") to their patrons so that those patrons could then flip the property for a hefty profit. Also, the Yakuza control almost all the freelance construction labor in Japan and new projects on seized land mightily benefited organized crime as a result.

So you had an unholy alliance between organized crime, government and business and when things went bad, the Japanese preference for slow deliberation and indirection as well as fear of being blackmailed by the Yakuza impeded the ability to come up with swift, workable solutions and all that was complicated by exploding scandals in the papers and weekly magazines surrounding what led up to the bubble.

The main difference, then, with the U.S. situation is that we haven't seen any indication that the Mafia or street gangs were used as muscle for real estate speculators here. But the greed, myopia, dishonesty and incompetence are the same as what Japan has and continues to endure.

[Beowolf741]

Perhaps if you explained that the Yakuza are the Japanese mafia that would be a little more helpful.

[Bob4]

Alarmed by rampant speculation in real estate and stocks, the Bank of Japan deliberately burst their bubble in 1989 by raising interest rates sharply. More than can be said about our FED. Didn't Greenspan warn about irrational exuberance years ago? No one wants to be responsible for the severe consequences that always follow. After the 1929 crash many said the FED caused the bubble with easy policy, but most agreed they were at least responsible for not having stopped the excess.

Bubbles always happen - were the Egyptian Pyramids a bubble gone wild? Was it a bubble aftermath that brought down the Roman Empire? Modern times differ, and leaders of central banks are supposed to have integrity, learning, shrewdness, intelligence and prudence. Does it not mean that those very people have to be overcome in order for a bubble to happen in the first place?

Hapless central bankers will always be guilty before knowing it. Like the science fiction movie in which people are convicted of crimes before they are committed, central bankers will be guilty of not having stopped the bubble, and of compounding mistakes in the wake. Deflation was a problem in the 1930s because bankers were worried about inflation? This time they are worried about deflation, and are thus flooding the system with liquidity and making sure major bankruptcy is orderly. Does this mean our mistake is going to be triggering rampant inflation? Only time will tell, but guilty of something we always are.

[Bob4]

i.e., the regulations should have come before the bubble, not after. Once a bubble happens, the aftermath - one human generation - is unavoidable.

That's why the Japanese are having their lost decade nearing the two-decade mark now. Everybody knows brokers and finance people can't be trusted, money can go poof, and that leverage in reverse can never ever ever be repaid no matter what. What was the size of the CDO market? $64 trillion? More than 5x bigger than the US GDP, bigger than the entire GDP of the planet? Oh oh....

What did Warren Buffet say? "Beware of geeks bearing formulas."

[Bob4]

The lost Japanese decade is said to be caused by a lack of timely or aggressive enough measures, this or that. Tim Giethner and Barack Obama have made references. But I wonder if that's true? In the history of all major bubble collapses, the time to recovery in every single case takes an entire generation - without fail, and regardless of economic system, circumstances, or policy. That doesn't mean we can't ameliorate the situation, but is there a natural law of gravity at play here?

The reason is simple. The rabbit is out of the hat and everyone suddenly knows firsthand that stock prices, tulip prices, real estate, South Sea ventures. Louisiana gold, dogfood.com, fancy Florida condos, and AAA rated subprime mortgage CDOs can become worthless quite quickly. It's awfully hard to convince someone otherwise once he has seen it with his own eyes, lost all his money, job, or home. You have to wait until everyone dies off, and their children, or grand children are in charge and think they know better. Then you can convince them all over again of anything - the more absurd the better.

Regulations, measures, and stimulus always follow - some quite worthwhile, but regulations are always about 10 or 15 years too late.

The other reality is that life goes on, and we'll all manage somehow.

[KillTheMessenger]

I can give a counterexample to your "learning hypothesis" about bubbles. The dot-com bubble is hardly ten years old and I beg you to find anyone but Warren Buffet who hasn't lost money on it. Yet, people did not learn because they have this desperate need to find "a better investment" for their money. Whenever the need to beat the market dominates, bubbles are the only outlet. Technology disappointed, so the most conservative investment possible, real estate, had to be the right solution!

Of course, it wasn't. All we did was to create another Ponzi scheme where the dumb money follows the smart money (which is just as dumb, except that is happens to be dumb early).

[Henry]

Diane,
The reason for the lost decade of Japan was simple. They refused to let their banks "fail" and permit the pain of market pricing. Along with refusing to let their banks fail, the bloated asset prices that were collateral for bank loans were also prevented from market priced salvage pricing. It is the stunning difference between the Resolution Trust of Americ's savings and loan crisis and the lost Japanese decade. In America the failed savings and loan were permitted to fail and their assets sold at discount prices to hawks in the market place. Had this not been done there would not have been the Clinton boom.
If all the subprime mortgage securities been purchased at Par 3/10/08 for approx $2-3 trillion by a new Resolution Trust Corp and liquidated at government loss (of approx $1 trillion) then we would not have had to bail AIG eh? The loss is going to be the loss and it will eventually flow to the taxpayer. Why not recognize, deal with it , and be done with it? This is not rocket science.

[Kache]

"failed savings and loan were permitted to fail and their assets sold at discount prices to hawks in the market place."

The Geithner plan does that in effect. It instead lets banks attempt to sell off their bad assets to the hawkers. Those banks that can sell enough to reach solvency survive, those that cannot sell off enough fail. It's doubtfull Citi can sell off enough because their bad asset to good asset ratio is too high. But this way the market decides who fails and who survives instead of the government. More importantly, the market decides which loans are toxic and how toxic. Not all subprimes are in default and not all defaults are subprimes. Only 4% of homes are in default, another 3% are behind on payments but still making payments. 93% of mortgages are sound.