How Japan's Banking System
Let the Economy Down

Michael Hudson, Ph.D.

[June 1997]

INTRODUCTION BY BILL TOTTEN (from Japan): In this continuation of the second installment of a three-part essay analyzing the roots of modern banking, economist Michael Hudson describes the unfortunate consequences of hasty deregulation on the U.S. banking and thrift sector in the 1980's. His analysis warns of repercussions for Japan, which appears to be blindly emulating the same expedient U.S. policies.

IV. Some contrasts between Japanese and U.S. banking

Today's Cold War victory of privatization and economic deregulation aims less at financing new industrial investment than at generating capital gains on assets already in place by inflating stock market and real estate bubbles. Toward this end governments are being turned into armies commanded by financial speculators who have neither the time nor the foresight to make their gains in ways that expand society's horizons. The politicians who staff these armies have become mercenaries, paid in economic booty divided among loyal officials in the form of campaign contributions. The more financial gains the new laws create in the hands of the wealthy, the larger these contributions grow. The first government payoff to campaign backers (headed by the real estate, banking and insurance industries) has been a fiscal reward. The tax burden is being shifted away from holders of real estate, stocks and bonds, onto industrial capital and wage- earners. Yet no one seems to be analyzing how credit is being steered into the capital and debt markets to inflate asset prices, creating economic bubbles. Even as Japan discusses its banking and financial reforms, no public official is explaining how this may help - or hinder - the nation's recovery of employment and direct investment in key technologies.

It is as if economics is discussing a just-pretend world of science fiction, not the real world around us. Japan's case is by no means unique. Nobel Economics Prizes continue to be awarded for theories of equilibrium even as the economic environment is suffering debt pollution and a polarization of wealth and income between rich and poor. People have come to recognize how the earth's atmosphere and biosphere are entering an epoch of extreme disequilibrium, but to many observers society's own widening economic imbalances seem still to be invisible. So thorough a victory for the financial and real estate industries hardly seemed likely eighty years ago. By the time World War I drew to a close, it seemed that the epoch of laissez faire had passed. After Russia's October Revolution even Europe's political right wing endorsed the principle of centralised government planning. Italy's fascists advocated a "corporate state," while Germany's national socialists sponsored heavy industry and employment on a military footing. National power seemed likely to be a function of economic planning and technological innovation, not financial and real estate gains for rentiers. John Maynard Keynes wrote a famous essay on "The End of Laissez Faire," and called for "euthanasia of the rentier." His General Theory contained a devastating critique of rentier capitalism. The essence of his theory of government planning was to show how unearned income from financial speculation and the debts it created was deflating purchasing power for the rest of the economy, deterring new tangible real investment and employment.

The situation began to change after the Second World War. Free- trade economists attributed the German miracle to free enterprise, a slogan Chancellor Ludwig Erhardt used later. But the real reason for the turning point occurred in 1947. The Allies canceled Germany's internal debts (save for the wages that employers owed their workers for their last few weeks' pay). The guiding logic was that most business debts were owed to former Nazi businessmen. The Allies also refrained from exacting reparations. Germany thus emerged from the war with almost no burden of taxes needed to defray interest charges on public debts, and almost no debt-servicing costs on private debts. Germany's government budget also benefited - as did that of Japan - by having no army to support. No wonder these two economies were able to compete so well in the international economy!

But the Allies' beneficence was not without political strings. Both Germany and Japan felt obliged to reimburse the United States for providing the Cold War umbrella. Both countries contributed heavily to American initiatives throughout the world. Their central bankers let the World Bank and its associated regional banks serve as vehicles to shift D-marks and yen into U.S. dollars, mobilizing the German and Japanese balance of payments to support America's own political programs and affluence. In the end, Japan's fiscal solvency was sacrificed to the United States, most notoriously under the Plaza Accord. With hindsight, it seems that Japan's economy was put in order mainly to serve the United States as a financial colony.

Recently, a thoughtful study of financial philosophy as it pertains to Japanese banking has been published. This best-seller, "The State We're In," by English economist Will Hutton, recommends that the solution to "the British disease" is to reform England's banking system along lines practiced for many years in Japan. Hutton analyzes British banks as having a short-term rentier mentality that has not changed much since the days of Foxwell. By contrast, he writes, from the late 1930s through the 1980s Japan mobilized its savings to fund industry. While its post office network collected long-term savings, the large public investment banks lent money in partnership with Japan's commercial banks to fund industries targeted by MITI as being in the national interest.

Is Mr. Hutton pining for a lost world? Besides the problems of corrupt bank officers being reported in recent news articles, haven't Japan's own banks become more "English" in their patterns of lending which, during the Bubble, was largely for real estate speculation? If they were enlightened industrial banks, what has gotten them into the trouble in which they find themselves today?

Placing the analysis of Japanese banking in historical perspective, Hutton describes how Japan's financial system adopted the Anglo-American model's short-term horizon in the 1930s, even as the rest of the world was centralising government economic and political control in the aftermath of World War I. At the time Japanese banks did not yet offer long-term loans, and the zaibatsu represented "only ten of the top sixty manufacturing and mining companies. In the non-zaibatsu firms quoted on the stock market, R&D and investment took second place to immediate profits." Workers were fired as business conditions fluctuated, and "senior management insisted on bonus and share option schemes as incentives to further effort." All this sounds very Anglo-American and un-Japanese indeed!

As Japan prepared for World War II, however, "the government moved to a 'New Economic System' which recast the financial and labour system along broadly contemporary lines. Stockholders' rights were limited, dividends were curtailed and individual firms were induced to become 'an organisation whereby employers and employees are bound together in their respective functions.'" The objective was to increase production, and financial institutions were directed to provide the needed credit. Some Japanese urged a more British-type free-for-all market system. It was perhaps fortuitous, however, that "after Japan's defeat the U.S. was too distracted by opposing communist trade unions and Japanese socialism to follow through in its attempts to change the system, and the underlying institutional structure [of war planning] survived." The result was that Japan's "regulated financial system is the least market- based, most traditional, above all most committed to its customers, of all the three principal capitalist variants" (England, Germany and Japan). Shareholdings represent long-term commitments to companies, not mere vehicles for short-term trading profits.

Japan's banks are linked to the rest of the financial system by a system of cross-shareholdings. "Mitsubishi, Mitsui, Sumitomo, Fuyo, Sanwa, and Daiichi Kangyo Bank are each City banks which, along with a trust bank, life insurance company and trading company, sit at the centre of a constellation of cross-shareholdings. The banks act as presidents of each group, channeling long-term loans, chairing negotiations over joint ventures and generally sharing information and business advice." The mutual shareholdings that cement inter- relationships among the kigyo shudan (industrial groups) represent some 40 per cent of the equities traded on Tokyo's stock exchange. An additional 30 per cent are held by the keiretsu, or sub-contractors that work for the major industrial companies.

This "relational market" accounts for some 70 per cent of Japanese stocks, constituting a system of mutual long-term commitments, Hutton concludes (p. 272). "The group companies, because of the dense network of cross-shareholdings, in effect own each other and are impregnable to takeover," while group pressures serve to monitor and improve company performance. Corporate raiders are thus alien to the Japanese spirit, while "other features of the Anglo-Saxon system like executive share options are banned."

Most notably, "in the event of bankruptcy the banks rank after the employees and subcontractors in having a claim on the company's assets." This leads Japan's banks to save their customers from insolvency rather than withdrawing financial support when business conditions turn down. This support helps the banks avoid being left holding the financial bag. "Japanese banks will lend up to four times more in relation to a firm's assets than British banks," Hutton finds; "the respective fortunes of the two countries' car and consumer electronics industries are a stark illustration of the competitive advantage that such abundant working capital and stability of ownership give the Japanese." (Likewise, he finds that Korea's chaebol incorporate within single conglomerates "a vast cluster of related enterprises that are given overt state support by the South Korean government and state banks.")

Finance and commerce are thus linked. In the process, their long- term relationships block foreigners from penetrating Japanese (and Korean) markets "even when they have saleable products. They are not part of the relationship network."

In the United States the three-pronged link is between banking, government, and the real estate sector. Manufacturing gets short shrift as over 70 percent of loans to businesses are real estate loans. New credit creation thus is based mainly on mortgage banking. This inflates the real estate bubble (and stock market gains) without funding new direct industrial investment. This bias is reinforced by a fiscal system that taxes capital gains at much lower rates than earned income. American investors accordingly aim at achieving capital gains (above all, land-value gains) rather than industrial earnings.

V. The Impact of Deregulation

For many years the U.S. financial system separated commercial banking from long-term mortgage lending to home-buyers and businesses. By World War II, mortgage banking consisted mainly of two specialized types of institutions. Mutual savings banks, created in the 1800's, were formed to benefit local depositors by mobilizing their petty savings (hence, names for savings banks such as Dime, Dollar, Emigrant's, Seaman's, and Bowery), and to lend out these deposits to small-scale borrowers. Savings and loan associations (S&Ls), created in the 1930's, were "share companies" to provide home-buyers with longer credit than the three-year renewable mortgages extended by commercial banks. The S&Ls were privately owned and run for the profit of their owners. Continuing their organization as joint stock companies until the 1980's, S&Ls accepted money as "shares." They were insured by the Federal S&L Deposit Insurance Corp.(FSLIC) rather than by the Federal Deposit Insurance Corp (FDIC), which insured commercial and savings banks. The names for most S&Ls concealed this non-bank character by calling themselves "First Federal" (or "First Federal Savings") in big letters, only disclosing in the small print that they were S&Ls rather than savings banks.

Japanese may compare U.S. savings banks to their own credit unions, and the S&Ls to their jusen. Unlike Japan's jusen, however, America's commercial banks did not hold stock in the S&Ls. Under U.S. law there was a strict separation of function. S&Ls were allowed to pay higher rates of interest, the costs of which they covered by taking more risks. Their fortunes were buoyed by America's postwar inflation of land prices. This enabled even badly conceived projects to be profitable, thanks in large part to the special tax breaks the real estate lobby won from Congress.

Most of the rise in interest rates occurred after 1964, when America escalated the war in Vietnam and pushed the nation's balance of payments deeply into deficit. Interest rates had to be increased to attract enough dollars to offset military spending. Rising interest rates curtailed the stock market run-up and slowed new construction until war-induced inflation led to a flight into property.

The problem for S&Ls and other mortgage lenders was that while interest rates were being buoyed by inflation (and inflation adjustments), market values of the financial community's long-term mortgage loans were declining against this real estate. Each rise in interest rates made the financial structure more shaky.

By the end of the 1970s the S&Ls were in trouble because they had reinvested their deposits into mortgage loans whose interest rates were fixed over periods of twenty or even thirty years. When market interest rates soared during the post-Vietnam years of Pres. Carter's administration (1977-80), depositors began to withdraw their funds from S&Ls. S&L portfolios of mortgage loans fell in value, just as prices of bonds and other securities yielding fixed income fell in value as interest rates rose.

The real estate loan problem faced by America in the late 1970s thus was different from that confronting Japan today. In the latter case, there is real estate overvaluation. But the problem in America was financial. Interest rates were rising, which reduced market value of long-term MORTGAGE LOANS against this real estate. Property holders with older, low-interest mortgages were in a favored position relative to new borrowers. Asset values of mortgage lenders, S&Ls and savings banks fell below their deposit liabilities. This threatened their net worth positions.

The S&Ls turned to the government to bail them out of their balance sheet problem. The FSLIC had been established as a source of emergency credit for just such circumstances. But already by the mid- 1960s, California's aggressive S&Ls had borrowed fully 25 percent of their liabilities from the FSLIC. They had used what was supposed to be emergency credit as a low-cost source of capital. The value of their mortgage loans fell and their dilemma became: how could they repay both their depositors and the FSLIC under such circumstances?

The S&Ls were able to get into this dilemma in the first place because their industry was assumed to be self-regulating. So much money was being made in real estate development that heavy mortgage origination fees could be paid. Mortgage lenders were even given some equity incentives such as shares in the real estate being financed. S&Ls indulged in real estate debt pyramiding. Their depositors were insured by the government. The Reagan Administration sharply increased government guarantees. Thus, S&Ls that made shaky loans could attract all the deposit money they needed in order to cover their losses and bad loans. In this way, all risk was transferred to the public sector, not to depositors. This was the true meaning of "privatization" under the Reagan-Bush administration: a free transfer of assets to benefit the private sector while the public sector received all the risk.

The real estate and financial industries joined forces to support this policy. More than enough money was available to buy Congressional support for deregulation in the early 1980s. Academic wisdom contributed, by depicting all market economies as being self-regulating. This was, after all, the laissez faire "equilibrium economics" for which Nobel Prizes were given out each year.

Reagan administration ideologues (known in Washington as "the crazies") were eager to believe that all economic problems were self- curing. To more hard-headed Republican politicians, every government policy, every pork barrel project, every tax break was put up for sale in exchange for campaign contributions or other favors. Financial deregulation thus went hand in hand with the environmental deregulation sponsored by James Watt, the parallel dismantling of the anti-trust law, and the decriminalization of much white collar looting of pension funds, gutting of companies, establishment of offshore tax havens and, in the banking sphere, holding companies. What formerly had been deemed criminal activity was rechristened "modern business management." Japanese who wish to know what their future might look like under the current "big bang" proposals might therefore benefit from studying the American experience that followed similar deregulation programs in the 1980s.

Part of the financial deregulatory process was abolishment of the historical separation of functions between savings banks and S&Ls, and between commercial banks, investment underwriters and stock-brokers. All these types of institutions had diversified to "follow the market place" and to break free of the designated functions for which they originally had been founded. Savings banks, for instance, campaigned successfully to change local banking laws to allow them to shift their deposits out of state, especially to large Florida real estate developments. A single such loan could absorb millions of deposit dollars that otherwise would have financed dozens of loans to the banks' local constituents. The parallel for Japan today is obvious. An increasing amount of Japan's savings will be lent to the United States and other foreign economies rather than be used to fund new investment within Japan. The nation's firms will be thrown into a bidding contest against borrowers in all other countries. Distress borrowing by, say, the Russian government to repay its bad debts may thus pull savings out of Japan, slowing Japan's investment or even creating a financial crisis. There are no international rules to encourage international lending in a productive way to finance new direct investment.

Reagan's policy makers rationalized financial deregulation on the grounds that it would let the S&Ls and savings banks "earn their way out of debt." Higher earnings were assumed to be freely available by taking bigger risks. Such speculation was supposed to enable the S&Ls to offer depositors higher rates to keep their money in these institutions. S&Ls were permitted to buy stocks and junk bonds, and even to undertake their own real estate development. Financial institutions thus became direct investors. In fact, deregulation of the S&Ls enabled real estate developers to create (or take over) their own institutions. These institutions then were given broad lending and investment privileges, along with higher federal deposit guarantees (FSLIC). Deregulation particularly benefited swindlers because it loosened constraints on their activities and legalized what hitherto was illegal.

Republicans assured doubters that deregulation would save the government from having to bail the S&Ls out of their low-interest mortgage portfolios. The S&Ls used the new rules to bid for new deposits on a vast scale, attracting large institutions that fully knew the risks, but understood that the government had re-classified what formerly had been "shares" in S&Ls as bona fide bank "deposits." The government was the ultimate underwriter, even for the most dangerous institutions which were obliged to offer the highest rates. Yet S&L examiners were not allowed to rein in self-dealing by operators, including many who subsequently were convicted as felons - men such as Charles Keating Jr., with his Lincoln S&L in Irvine, California; Donald Dixon with his Vernon S&L in Dallas; and David Paul with the Centrust Bank in Miami. These crooks (who claimed to be public benefactors and even heroic risk-takers) hindered government regulators by using deposits in their institutions as a fund from which to contribute generously to the election campaigns of the leading members of Congressional banking committees. This is how the notorious "Keating Five" members of the Senate banking committee shepherded Mr. Keating's criminal operations through government, calling Mr. Keating's activities free enterprise and virtually hailing him as a hero fighting the federal regulatory bureaucracy!

What is so striking, and so instructive for Japan today, is how relatively small contributions are able to produce such vast frauds. Charles Keating's case cost the government over $3 billion to clean up, and his criminal conviction was followed by a $1.6 billion civil judgment to compensate his victims for about three-quarters of their original capital investment. When Mr. Keating claimed to lack the funds to pay, two of his accounting firms -- Ernst & Young, and Arthur Andersen -- were found to be guilty of gross negligence (if not outright complicity), and were directed to share the blame for having lent unwarranted credibility to his financial malfeasance. This experience shows that politicians have been bought by major financial and real estate operators. Most of this political buying and selling is done legally, by lobbying Congressmen to pass laws legalizing practices that formerly were deemed illegal or immoral. Of course, economic and legal theorists in academic institutions have jumped on the bandwagon, led by the University of Chicago's business and law schools, which have become public relations advocates for the ideology of decriminalization in the name of "free markets." The new libertarians in fact consider putting any social objectives ahead of money-making as dereliction of administrative duty!

The effect of such deregulation for savings banks and S&Ls stands as an object lesson: They lost any social role beyond an obligation to their shareholders to make as much money as quickly as possible. In the case of the savings banks, deregulation let executives "go private." The result was similar to what occurred in Russia. The executives of these traditionally sleepy small institutions sold banks to themselves for virtually nothing. In effect, they registered the banks' accumulated reserves in their own names, giving the stock to themselves rather than distributing it to the depositors as a special dividend. They thus got rich by privatizing bank assets that were supposed to serve a public function. This private looting of public or social wealth and assets has been the essence of deregulation since 1980. The epoch of "value-free" economics had arrived with a vengeance.

As America's post-Vietnam inflation pushed up interest rates to double-digit levels, depositors found they could earn higher returns by shifting their deposits elsewhere. To meet these withdrawals, the S&Ls had to either raise the rates they paid depositors - and thus run an operating loss - or else sell off their mortgage portfolios at a substantial loss to their balance sheets.

While this financial restructuring was occurring, direct industrial investment was starved for funds. To ward off raiders searching for companies to buy cheaply, the entire industrial sector had to live for current earnings - rather than invest in long-term projects. Companies were obliged to support their stock prices in order to avoid being raided. One strategy was to pay out a higher proportion of their earnings as dividends. Another was to spend their revenue to buy up their own stock. Both policies were employed at the expense of funding R&D and other long-term investment.

Yet a third strategy against corporate raiding was for companies to load themselves down with debt (so-called "poison pills"). They would borrow so much money that no raider would be able to borrow enough money to break up a company, raid its treasury, its pension fund and its real estate. In such cases their earnings were used to pay interest rather than to finance new direct investment.

Japanese companies did not have to confront this kind of raiding during the 1980s because they were not run for the benefit of outside stockholders, raiders or investors whose main objective was to obtain as quick and high a rentier income as possible. Under normal conditions the objective of Japanese firms was to optimize their operations, benefit their own work force and their customers (who often, in Japan's case, were also major stockholders). Thus, when T. Boone Pickens came to Japan, his American-style financial methods were rebuffed. The "value-free" principle described above has become the foundation of Western banking systems. Instead of financing industry, the banks and S&Ls lent to its raiders. Instead of financing new direct investment, the financial game turned to asset stripping. In this way U.S. banking, and the "anything goes" economic philosophy prompting its deregulation, represents the antithesis of Japan's postwar financial philosophy.

The U.S. banking system's attitude toward depositors is well indicated in a training document that exhorted Mr. Keating's salesmen to "always remember [that] the weak, meek and ignorant are always good targets." The meek got separated from their money quickly by financial deregulation benefiting predatory insiders at the public's expense. What was funded by deregulation was not productive investment, but the economy's overhead of crooks and rentiers. This is the system that American advisors are now urging Japan to adopt. The drive to generate financial returns willy-nilly, even at the cost of cannibalizing manufacturing industry, downsizing the labor force, cutting pensions, minimizing taxes on real estate and stock market speculation, and making up the fiscal shortfall by raising consumption taxes first to 5 percent and then to higher levels - all this has become part of the new fundamentalist economic religion being foisted on Japan.

VI. The role of banking philosophy and the politics of its laws

To a large extent America's banking patterns, like those of Japan, are a product of historical accident. After the Panic of 1907, a National Monetary Commission was convened to decide what sort of banking system the United States should have. The Republicans were in power, and had been dominant in national politics since the Civil War. Supported by big business, they were federalist and protectionist in their economic philosophy, and hence opposed to English free trade doctrines. This led them to favor a financial system modeled on Germany's industrial investment banking.

The Democrats based their electoral support on the indebted Midwestern, Western and poor Southern states, and on the large east coast cities among immigrant workers and real estate interests. They favored a decentralized merchant banking system along English lines. Matters took a fateful turn when the former Republican president Teddy Roosevelt split the Republican vote in the 1912 presidential election by running on a third-party Bullmoose ticket. This enabled Woodrow Wilson to win. Under his Democratic administration the Federal Reserve system was created in a decentralized manner that reflected the country's widespread mistrust of large banks, and of strong federal banking power in general.

The Federal Reserve system divided the United States into twelve regional districts, each with a relatively high degree of autonomy. The old state banks continued to exist alongside those that chose federal charters (and which were subject to local state authorities). For many years, state laws, especially in the Midwest, blocked banks from having more than one office, and did not permit branching across state lines.

The result was a decentralized financial system with over 20,000 banks, subject to diverse regulatory systems. The Glass-Steagel bank reform prevented banks from investing their reserves in common stocks, either of their customers or other firms, much less from taking a controlling equity position. Banks could have trust departments to manage the estates of their customers, but their lending and trust operations were strictly segregated by laws that were tightly enforced. The guiding idea was to prevent bank control of industry, not to recycle financial savings into direct industrial investment. The proper function of banking was held to be mainly a monetary function, providing the means of payment "to oil the wheels of commerce."

Many smaller banks outside of New York kept their deposits in the large money-center banks in New York or Chicago. In effect, they acted as local branches for these larger banks, passing their deposits on to Citibank, Chase and other New York City or Chicago giants. By the 1980s these money- center banks were earning large commissions by shoveling their correspondent-bank deposits (that is, deposits by smaller banks) into the quickest and largest loan packages they could find. Much of the money was invested in loans to third world central banks, until Mexico triggered the Latin American debt bomb in 1982 by announcing that it lacked the money to pay even the interest on the loans that had gone mainly to enrich its small clique of ruling families. Even the largest banks did not conduct research to foresee this problem. Instead they simply printed out reports showing monetary amounts due on specific dates.

By the mid-1960s, banks could not find any reasonable way for third world debtors to pay, short of the U.S. government lending them the money as "foreign aid." One reason for this short-sightedness was a legal problem. Most third world loans had a clause stating that if any dispute arose, the suit would be settled according to the laws of New York. But from colonial American times (when most colonists owed money to British creditors, and looked for ways not to pay), New York had a pro-debtor law on its books: Debtors would have their obligations cancelled, if the creditor could not show that he knew just HOW the debtor would pay him back, at the time the loan was made. Thus, if New York and Chicago banks could not explain how Latin American countries and other third world debtors could repay the loans, these countries could ask that their debts to the American banks be cancelled. Banks worried that these debtors might subpoena the records of the country-risk analysts, and get their debts annulled.

To protect themselves from third world lawyers annulling billions of dollars worth of debts by using this legal loophole, banks found it easier to simply abolish their economic research departments (or, what was the same thing, merged them into their public relations and publications departments). Thus, nobody could PROVE that they had done a credit analysis and shown that there was no reasonable and foreseeable way for debtor countries to pay WITHOUT liquidating their public assets to do so. Of course, this absence of economic analysis hardly enabled the banks to operate with an informed long-term plan. Still, in the 1980s most correspondent banks imagined that the large money-center banks knew what they were doing. This assumption proved to be ill-grounded as the demise of third world lending was followed by yet another unhealthy absorber of surplus bank deposits: takeover loans to corporate raiders, and huge credits to real estate developers. When the asset inflation of the 1980s burst, these sectors went the way of third world debt. Loans to third world countries traded at just 30% or even just 20% of their face value - pennies on the dollar - as annual interest rates soared to over 40 percent for Argentina, Brazil and other developing economies.

Junk bond interest rates meanwhile rose from 15 percent to over 25 percent for many companies whose bloom had worn off. Real estate developers discarded properties from 1986, leaving the Federal Savings and Loan Insurance Corporation (FSLIC) to reimburse depositors for the hundreds of billions of dollars that had been funneled into these risky investments in search of federally guaranteed high interest premiums. Depositors thus obtained high interest rates as "compensation for risk" without actually having to take any risk!

What the large banks wanted was larger commissions on correspondent-bank funds and other money deposited with them, no matter how recklessly. And what depositors at banks and S&Ls wanted was the highest-yielding ventures available, as long as the government was taking the risk. When market prices for third world debt participations fell drastically, the New York City banks began to buy back these loans on the secondary market (often from their own correspondent banks). The banks then made a capital gain by convincing Treasury Secretary James Brady to convert these debts into "Brady bonds" whose value was internationally guaranteed. Although large banks were libertarian in demanding free rein from government regulations, they also sought public bailouts of any losses they might incur as their loan activities became more speculative.

During the 1980s the U.S. money management business was a guaranteed money-maker, in spite of short-sighted policies. After all, management fees would be based solely on the raw volume of assets under management. Rapid capital gains may serve to attract more business and thus generate yet more fees, but they do not directly remunerate fund managers more. They may earn money largely by inertia, for once a trust fund has been placed with a trustee, the customer is obliged to hire a lawyer to make a formal legal motion to shift money out of the trustee's hands. This tends to take the pressure off having to adjust to new developments.

Still, money managers for companies such as Fidelity or Scudder Stevens and Clark, with their arrays of specialized funds - and also labor-union, bank and insurance-company trust managers - have come under pressure to outperform rival managers in a financial game whose scores are posted on a quarter by quarter basis. Fund managers thus are obliged to aim their investment strategy at short-term performance, buying securities wherever immediate returns are highest. Under such circumstances, investment requiring long research and development periods with extended payout horizons tends to fall by the wayside.

Living the proverbial "one day at a time" is normally most appropriate for those with little time left to live. Such a short frame best characterizes moribund economies that expect to be dead by the time capital-intensive technology comes to fruition. But large American money-market banks have long known a secret that enables them to indulge in short-term opportunism and greed without paying a long-term price. They have convinced the government that they are too large to fail, using the logic that their collapse would drag down the rest of the economy too. The government should therefore bail out the largest banks, rather than risk their depositors losing savings.

And indeed, during the financial storms of the 1980's when Citibank, Chase and Chemical were left alone by regulators to fend for themselves, those banks did in fact remain intact despite the warnings of pessimists. Behind their recovery, however, were usurious practices which hardly benefited average consumers who had succumbed to the credit card mentality actively promoted earlier by those very banks. While interest rates had peaked at over 20 percent during the Carter administration inflation era, even when the regular interest rate had receded from the 1980 highs, banks were permitted to keep their interest charges high for credit cards and other consumer loans, squeezing out of small borrowers what the banks had lost on third world, real estate and corporate takeover lending. It was primarily in this way--with tacit non-regulation by the American agencies involved--that the banks recovered. One wonders if such usurious non-regulation is in the offing for Japanese banks as they struggle to recover.

Some lessons for Japan

For the past six years the Bank of Japan has been following the American model by leaving things alone in the hope that the banks might "earn their way" out of debt. But to date they have not recovered.

Why not? How did it happen that a system seeming to be so well suited to long-term industrial lending ended up inflating the world's largest real estate and stock market bubble? It is axiomatic that an economy's strengths are also potential points of weakness. One reason Japan's banking system could traditionally take the long-term perspective has been the willingness of frugal Japanese depositors themselves to take a long-term social view. Many deposits are made for a five-year term. This takes the pressure off banks to recycle the money into loans or investments of the type that can be liquidated most quickly.

Still, a bubble is a bubble, and the banks certainly made little effort to resist speculation during 1985-91. Real estate borrowers were willing to pay high interest rates on bank loans, in the hope of reaping capital gains in the rising loan market. Lower interest rates resulting from the Plaza Accords lowered mortgage costs, providing lucrative opportunities to ride the asset-inflation wave and its associated real estate speculation and overbuilding. Japanese banks were eager to finance the jusen to extend high- yielding real estate loans. Many such loans were extended irresponsibly, and often in a criminal manner, as subsequent investigations have shown. Even more serious, the effect of recycling Japan's savings into mortgage credit inflated its land prices, and hence its housing and office-rental overhead. As the bubble gained momentum, Japan's bank deposits were directed less and less into long-term industrial investment.

Prior to the Plaza Accords of 1985, Japan's capital markets pursued a cohesive national savings strategy. Insurance companies, pension funds and banks received savings and recycled them within the domestic economy. The effect was to bloat the national real estate and stock markets far above levels of other economies, as measured by price/earnings ratios. Stated another way, Japan's demand for assets was biased heavily in favor of the nation's own asset markets, rather than on foreign markets.

In 1985, however (as explained in OW64 & OW65), Ministry of Finance officials responded to U.S. pressures by deregulating the economy. The "encouragement" was for insurance companies and other financial institutions to invest their money in U.S. Treasury bonds. This boosted American bond prices and held down U.S. interest rates, while slowing the yen's rise in international value. American bonds, real estate or stock fell in yen-value as the dollar's exchange rate declined. The Ministry of Finance tried to hide the situation by ruling that Japan's insurance companies no longer needed to report currency losses on their investments in excess of 15 percent. The companies still lost money, of course. But now, with relaxed reporting requirements, the speculators lawfully could avoid telling the world (including their own policy holders) the extent to which their support for the U.S. dollar was eroding their reserves and hence impairing their ability to responsibly invest the savings that Japanese individuals and companies continued to pour into them.

The effect has been that Japan's own domestic savings have been mobilized to finance about a third of America's huge federal budget deficit in recent years. This support has arisen from banks, insurance companies and other firms investing their reserves not in Japanese capital markets, but by speculating on those of the United States.

The important point is that putting Japan's savings in U.S. Treasury bonds and related dollar-support operations has not helped finance Japanese industry or technology. Nor has it been financially remunerative. David Hale of Kemper (a US money manager and investment advising firm) observed last year (in his August 15, 1995 report), that during the decade spanning 1985-95 "Japanese investment firms have lost over $500 billion on their foreign assets. In the late 1980s, those losses were offset by a booming Tokyo stock market. In the early 1990s, the slump in [the] Tokyo stock market depressed Japanese capital outflows by reducing the hidden reserves which had been used to offset exchange rate losses."

Japan's banks own about a quarter of the nation's corporate equities. This fact helps explain why the Ministry of Finance has sought to support the Nikkei above the 16000 level as it plunged down from nearly 4000 at the end of the 1980s. The objective of this support is not to fund a new bubble, to be sure, but to prevent insolvency, because a level of 14000 is said to be the limit below which the banking system's cumulative stock-market gains would be lost entirely.

Despite the collapse of Japan's real estate bubble, the banks have been able to satisfy the Bank for International Settlements' capital adequacy requirements by refraining from downscaling the market value of their mortgage loans, and by pointing to their unrealized gains in the stock market. This equity investment forms the banking system's ultimate buttress, unlike the case in the United States and England, where bank reserves are invested in government debt rather than stocks. However, Japan's shaky stock market poses the danger of wiping out these "hidden reserves," forcing banks into positions of negative net worth.

To be sure, bond prices have risen since 1991 as their yields have fallen from 9 percent to a trough of 2.5 percent in recent months. These low interest rates make stocks appear relatively desirable by comparison. But if bond yields should recover to the normal range of 3.5 to 4 percent, the bond market will draw money out of the stock market and the Nikkei will fall, shrinking reserve positions of representative members of Japan's banking system all the more. Japan thus seems to be in a quandary. It seems whatever path it chooses will only make things worse. (Curiously, economists call this an "optimum" position, one from which it is impossible to move to a better one. But non-economists simply call this "being stuck.") As with any quandary, the solution must come from outside the problem's parameters as formulated. In Japan's case, the context--being the political system and its regulatory philosophy--must be changed in order to provide relief.

Japan's present government, its Ministry of Finance and the Bank of Japan have not placed the present reforms in any long-term perspective, except to reflate the balance sheets of Japanese banks. But it is axiomatic that the expedient solution to any given problem tends to create new, unforeseen problems. The danger is that by merely rebuilding bank balance sheets and stock-market prices through reflating land values, Japan will create a system diverting future savings AWAY from needed industrial investment.

How the United States deflated its real-estate bubble, and implications of such a policy for Japan, will form the subject of the concluding section (VII) of this essay.

VII. How America deflated its real estate bubble - and helped its stock market recover

Prime Minister Hashimoto and the Ministry of Finance appear to believe that the way to help Japan's stock market is to re-inflate the real estate market by steering more savings into it. They seem to believe that this policy will make Japan more like the United States, and hence conform to international "good practice." Yet the U.S. stock market was re-inflated in precisely the opposite way from that which the Japanese government is now proposing. U.S. savings were NOT channeled into real estate.

Indeed, since around 1991 most U.S. savers in fact have given up on the U.S. banking system as the main repository of American saving. This was largely a voluntary choice by U.S. banks. Because of the structure of U.S. bank laws, there was little the banks could have done with more deposits, except recycle them (that is, speculate) to fund a new real estate bubble. But the banks did not want to see this happen again. Accordingly, they discouraged new deposit inflows by reducing interest rates offered to depositors. (Increasingly, bank earnings are being made by keeping interest rates high on their credit cards and related consumer lending.)

By 1991, as Japan's real estate bubble was in the process of collapsing, the U.S. real estate bubble had already collapsed. U.S. bank deposits no longer were being directed primarily into the real estate market. S&Ls, where problem loans involving real estate were most serious, were not given a chance to earn their way out of debt. Bank regulators in the United States chose to let the most troubled S&Ls go under, thereby wiping out many S&L stockholders (who were by no means blameless) but saving the depositors, including even large institutional money-brokers who had known full well what was going on. In this way the government paid for the S&L industry's gambling in Texas, California and a few other western states whose regulations had been weak. Non-performing real estate investments were packaged and sold off to interested buyers - many of whom subsequently made millions of dollars on properties which have since recovered their value.

A key point is that the stock market picked up precisely because less money was going into mortgage lending! The Dow Jones Industrial average soared from 4000 in 1993 to over 6000 by the November 1996 presidential elections, and is now at 7000. What has been behind this dramatic stock market increase if a major element of the net worth of U.S. industrial companies is the value of their land and other real estate?

The collapse of the real estate market set in motion a kind of teeter-totter movement. Finding the real estate market dead after 1991, banks lowered interest rates they offered their depositors, as described above. Having grown accustomed to higher returns on their savings, depositors began to shift their money out of banks and savings banks into mutual funds and money-market funds. Investment managers of these funds in turn have been channeling the savings inflows into the stock and bond markets, fueling the boom on U.S. stock prices from 1993 onward. The funds involved have been mainly money market funds, bond funds and stock market funds, specializing in every major industry.

While America seems, in a sense, to have been adopting the former Japanese and German (traditional) system of recycling its savings into industrial stock-holdings, it is important to understand that relatively little of this money has gone to fund new direct investment. Most of it has been used to bid up the price of seasoned securities. This has created capital gains for rentiers (including mutual funds and pension funds). The result has been that while Wall Street has prospered, Main Street (that is, needed infrastructure investment) has been languishing, as has been the U.S. construction industry. The situation for average American workers' wages--especially in contrast to salaries of corporate executives--also reflects this speculative investment policy. While price-adjusted wage levels of most American workers have fallen, corporate chief executives have been receiving record-high wages, thanks largely to the system of stock-option compensation which has enabled executives to buy stocks in their companies at fixed prices over time. As more private savings have been recycled into the stock market through the mutual and money-market funds described above, prices of these stocks have been bidded up and corporate executives with stock-option holdings have benefited handsomely. Several well-known executives have crowed that it has been their brilliant policies which have created the rising values of their stock, yet it seems only a few have had the modesty to acknowledge that they have merely been lucky to ride a new stock-market inflation wave. Indeed, that wave is being fueled primarily by diversion into stocks of savings which previously had gone into inflating the real estate bubble.

With this as background, we can see why Japan has not been able to emulate the American response to the real estate collapse. In this regard the two economies fundamentally are different. First, Japan's banks have held up to a quarter of its stock market's securities. Liquidating these equities would obviously have crashed the Nikkei and reserves of Japan's healthy banks as well as reserves of insurance companies and other major institutional holders would be wiped out. Second, many individual companies held bank stocks, a practice which has been the very essence of Japan's system of crossholdings. Such interlocking was not permitted in the United States, so no such problem had developed. A third concern has been how Japan could raise public money (that is, government revenues) to bail out depositors and policy-holders at insolvent banks and insurance companies. Of course Japanese politicians could attempt to tax the wealthy more, especially large real-estate investors. But such investors have the reputation of being "pillars of the economy," and have certainly been considered by the LDP as pillars of the party's campaign contribution system!

No wonder Ministry of Finance officials preferred to delay their response, hoping that Japan's financial institutions somehow could ride out the storm, as their U.S. counterparts were doing. But simply riding out the storm has not happened because the assets backing Japan's banking system fell too sharply in value when the Bubble economy collapsed. Falling real estate values have made it uneconomic for mortgage borrowers (whose mortgages typically exceed property value) to repay the loans into which Japanese banks had been recycling most of their deposits. And stocks of Japanese companies (mainly the banks' major customers) which banks had bought with money supposedly set aside as reserves, also have declined in price. Although at first glance Japan's banks in 1991 seemed to face much the same problem as that which confronted America's S&Ls, the problem differed and Japan's response could not be the same as the U.S. response. Indeed, to acknowledge the fall in real estate and stock market system values would have meant letting more banks with negative net worth to go under, Japan would have to create a new banking system.

Thus the question Japan has faced is can it re-inflate its economy, and if so, what is the best way to do this? How might asset values be restored to at least a semblance of their former heights, so as to rescue the financial system's balance sheets? Should bank depositors be bailed out? Is there sufficient reason to hope that banks and insurance companies might "earn their way out of debt?" If so, at whose expense are they to make their earnings? Should the tax system be changed - and if so, should taxes be raised on consumption, or on real estate and stock market gains?

The most irresponsible advice to Japan would be for it to "inflate its way out of debt," or to inflate the stock market and real estate market so as to restore bank solvency by increasing market value of bank reserves. Such asset inflation would be achieved by steering bank loans back into the real estate and stock markets, and then making real estate speculation more attractive by reducing taxes and having the government enter the market to bid up prices directly.

Such an expedient policy would indeed be a far cry from the traditional (industrial investment) patterns described earlier whereby Japan's savings were skillfully steered into industrial or other loans to fund productive investment, employ workers directly, and finance new technologies needed to maintain Japan's international competitive position.

Considering deregulation

The most prestigious bank-reform advisors have become lobbyists for more of the value-free "live for the moment" banking that got Japan into its Bubble economy in the first place. Their idea is to remove public regulations on companies, and zone restrictions on real estate. Removing their obligation to serve social objectives is supposed to "free" more income to pay bankers and shareholders. In their view, the economic problem is primarily a matter of insolvency by the nation's financial sector, and has no relation to the fact that Japan's financial rentier overhead has been bleeding the economy.

One problem with such deregulation is its indirect (unforeseen) effects. That is, the set of effects which deregulation proponents fail to acknowledge up front which will require heavy public "clean-up" spending in future years. What is added to private-sector revenues in the short run will certainly have to be made up by public expenditures in future years.

Deregulating Japan's economy and letting its banks take desperate risks in an attempt to earn capital gains quickly (by pyramid schemes and other financial paper-manipulation) would likely bring about the same kind of catastrophe that befell the U.S. S&L industry. Rather than renewing the speculative real estate and stock market booms, the solution lies in Japan returning to that successful aspect of its own banking history which industrial advocates in other countries have admired most: the ability to fund long-term, socially responsible industrial investment, and to use such investment as the base of its credit system. The only way to solve Japan's banking problem is to take an economy-wide approach, reviving Japanese banking along with the nation's industrial economy in general.

Conclusion

It should always be remembered that Americans have their own national interest in mind when advising Japan to inflate its way out of debt. The effect would be to float the world's stock and bond markets upward. Much of Japan's surplus liquidity would be recycled into relatively low-yielding U.S. Treasury bonds. This would free American savings for more profitable investments in the "controlling heights" of third world and formerly socialist economies.

The experiences of 1981-96 would not seem to give Japan much reason to trust American advisors who recommend an Anglo-American style banking system for Asia. Such advisors seem to be trying to get other nations to commit economic (and social) suicide at the same rate as that of the United States. But the Anglo-American disease - a rentier economy - is terminal. The cure is blocked by financial, insurance industry and real estate interests converting their economic power into political power. They are using this power to re-write tax laws so as to shift taxes off their own takings to labor and industrial capital, which are the ones which actually produce the nation's wealth.

Future OW essays will suggest an alternative approach, based on taxing Japan's land values (and using the proceeds to free labor income and industrial revenues) rather than freeing them from taxation to promote a new bubble. This approach will be contrasted with Prime Minister Hashimoto's present plans to re-inflate Japan's real estate and stock market bubbles, and to divert the pension funds of Japanese to this cause rather than to invest directly in enhancing the nation's productive powers.