Fueled by low-interest mortgages, real estate prices in Japan had risen sohigh by the end of the 1980s that just the land under the Imperial Palace inTokyo 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 andfacing bankruptcy.
Enter the government. In 1990, the Japanese Central Bank began cuttinginterest rates, and continued cutting until they reached absolute zero.So money was free for banks to borrow. Nevertheless the Japanese stockcontinued its fall, with the Nikkei index going from a high of 40,000 in1989 to a low of 12,000 in 2001. So did real estate, which lost 80 percentof its value during this period.
The government next tried more classic Keynesian tactics, spending and taxcuts. Between 1991 and 1998, it pumped 100 trillion yen into the economythrough public works programs and, to further stimulate spending. cut taxesby 2 trillion yen. All these measures succeeded in accomplishing wasraising Japan's public debt to 100 percent of its GDP.
To deal with the ever more ominous threat of bank insolvency, theJapanese government injected public funds directly into Japanese banks,investing first in 1996 $100 billion and then in 1998, under the ObuchiPlan, another $500 billion to pay for bank loan losses, bankrecapitalizations and depositor protection. The bail-out, which amountedto over 12 percent of GDP, resuscitated the individual banks but not thefinancial system . The banks, although on government life support,resisted lending out their new found capital. Paralyzed by the fear oflosing their new found capital, many banks became, in Japanese terminology,"zombies," since they were neither dead nor alive (at least in fulfillingtheir function of extending credit.) As a result, the money Japan pumpedinto its banks did not thaw the frozen system. Indeed, it was not until2002 that the Japanese economy, buoyed by the boom in China and other of itsexport markets, showed positive growth. The moral of this financial Kabukiplay 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 torestoring financial confidence, cut both ways. On the bright side,American financial institutions, unlike their Japanese counterparts, quicklymoved to recognize their losses from their toxic debts and find ways torecapitalize themselves. The US government also intervened much earlier inthe process than did Japan. In the first year of the crisis, it committedabout $800 billion (about 7% of GDP) of taxpayers's funds tore-capitalizing the banks and guaranteed depositors against loss. That isthe good news. On darker side of the equation, unlike in Japan, there is amulti-trillion dollar casino dealing in credit default contractsoverhanging, like a Sword of Damocles, the financial system. Throughbuying or selling these contracts, American banks, hedge funds, insurers,and other players have wagered at least $47 trillion on the fate of a widerange debt instruments. Like any other punter, the buyer or seller of oneof these contract need not own the debt that is being wagered on, sopay-offs made in the event of a default of a bond can be vastly higher thanits face value. Indeed, a default can result in such huge losses on thesecontracts that it triggers a chain reaction of other defaults. Witness, forexample, the near-bankruptcy of AIG from the credit default contracts itheld. Worse. there is no central registry that lists obligations undertakenin this casino activity. This lack of transparency makes it exceedinglydifficult to figure out the exposure of financial institutions tocatastrophic loss. In this environment, banks, even if they don't becomezombiefied, may not rush to lend their money out. So the Japanese experiencemay yet prove instructive