10/22/2008 06:07 pm ET Updated May 25, 2011

Does This Sad Tale Sound Familiar?

Fueled by low-interest mortgages, real estate prices in Japan had risen so
high by the end of the 1980s that just the land under the Imperial Palace in
Tokyo was nominally worth more than all the real estate in California.
Then, in late 1989, the bubble burst and real estate prices plummeted,
leaving Japan's financial institutions saddled with toxic mortgages and
facing bankruptcy.

Enter the government. In 1990, the Japanese Central Bank began cutting
interest rates, and continued cutting until they reached absolute zero.
So money was free for banks to borrow. Nevertheless the Japanese stock
continued its fall, with the Nikkei index going from a high of 40,000 in
1989 to a low of 12,000 in 2001. So did real estate, which lost 80 percent
of its value during this period.

The government next tried more classic Keynesian tactics, spending and tax
cuts. Between 1991 and 1998, it pumped 100 trillion yen into the economy
through public works programs and, to further stimulate spending. cut taxes
by 2 trillion yen. All these measures succeeded in accomplishing was
raising Japan's public debt to 100 percent of its GDP.

To deal with the ever more ominous threat of bank insolvency, the
Japanese government injected public funds directly into Japanese banks,
investing first in 1996 $100 billion and then in 1998, under the Obuchi
Plan, another $500 billion to pay for bank loan losses, bank
recapitalizations and depositor protection. The bail-out, which amounted
to over 12 percent of GDP, resuscitated the individual banks but not the
financial system . The banks, although on government life support,
resisted lending out their new found capital. Paralyzed by the fear of
losing their new found capital, many banks became, in Japanese terminology,
"zombies," since they were neither dead nor alive (at least in fulfilling
their function of extending credit.) As a result, the money Japan pumped
into its banks did not thaw the frozen system. Indeed, it was not until
2002 that the Japanese economy, buoyed by the boom in China and other of its
export markets, showed positive growth. The moral of this financial Kabuki
play is that government intervention does not always work immediately, or,
in this case, for a decade.

America of course is not Japan. The differences, when it comes to
restoring financial confidence, cut both ways. On the bright side,
American financial institutions, unlike their Japanese counterparts, quickly
moved to recognize their losses from their toxic debts and find ways to
recapitalize themselves. The US government also intervened much earlier in
the process than did Japan. In the first year of the crisis, it committed
about $800 billion (about 7% of GDP) of taxpayers's funds to
re-capitalizing the banks and guaranteed depositors against loss. That is
the good news. On darker side of the equation, unlike in Japan, there is a
multi-trillion dollar casino dealing in credit default contracts
overhanging, like a Sword of Damocles, the financial system. Through
buying or selling these contracts, American banks, hedge funds, insurers,
and other players have wagered at least $47 trillion on the fate of a wide
range debt instruments. Like any other punter, the buyer or seller of one
of these contract need not own the debt that is being wagered on, so
pay-offs made in the event of a default of a bond can be vastly higher than
its face value. Indeed, a default can result in such huge losses on these
contracts that it triggers a chain reaction of other defaults. Witness, for
example, the near-bankruptcy of AIG from the credit default contracts it
held. Worse. there is no central registry that lists obligations undertaken
in this casino activity. This lack of transparency makes it exceedingly
difficult to figure out the exposure of financial institutions to
catastrophic loss. In this environment, banks, even if they don't become
zombiefied, may not rush to lend their money out. So the Japanese experience
may yet prove instructive