Will This Be America's 'Lost Decade'?

Posted October 13, 2008

Japanese Finance Minister Shoichi Nakagawa reportedly went to the G-7 meeting over the weekend with an eye to giving advice based on Japan’s experience from a decade ago on how to contain the current financial crisis. It is hard to know whether people listened to this advice.

One cannot, however, escape the feeling that such a dialogue is taking place too late. Surely, policy makers will be coming up with even bolder measures than we have seen so far; asset prices will reverse the recent declines at some point. But the world economy will not be able to avoid serious negative effects stemming from the current financial calamity. In a sense, the U.S. has failed to learn from Japan’s so-called Lost Decade. It may have been a captive of “this time is different” psychology.

Under uncertainties as to the health of others, financial institutions face difficulty in raising term funds (funds with maturities of a few weeks to a few months), not to speak of more long-term funds. Even with central banks’ attempts to keep the overnight rate at very low levels, interest rates on term funds remain at elevated levels in reflection of risk premiums, sometimes forcing financial institutions to tap other sources of liquidity; for example, fire sales of assets they hold. This only aggravates the situation.

Japan went through such a period in the 1990s. To contain the rise in term rates, the Bank of Japan supplied huge amounts of term funds, withdrawing some of them at shorter horizons. (Otherwise, the overnight policy rate falls to zero.) The Fed is certainly carrying out similar operations. But I was surprised to see the Fed not starting such operations back in August last year at the outbreak of the crisis. Instead, it waited until the year-end to start the operations. In the meantime, liquidity problems quickly turned to solvency problems.

With the solvency of many large financial institutions in question, policy makers need to establish a scheme to inject capital to them. Due to political problems Japan was not able to move swiftly in this direction and paid the price. One may say that the U.S. authorities have been responding much faster to the crisis than Japan did in the ’90s.

One needs, however, to evaluate the recent U.S. response in the context of the environment where losses are quickly reflected in prices and balance sheets are marked to market. The U.S. seems to have decided in principle to inject capital to banks following the weekend G-7 meetings. But then, the obvious question is why a capital injection scheme was not included explicitly in the Troubled Asset Relief Program, or Tarp, the U.S. Congress passed just 10 days ago. Such delays are costing the authorities and the world economy dearly.

In a serious financial crisis, the question of too-big-to-fail gives headaches to policy makers. A rough rule of thumb seems to be you either don’t let large financial institutions go under or you make clear the basic principle as to who is allowed to go bankrupt and who is not. In the fall of 1997, a medium-sized Japanese security broker, Sanyo Securities, went under. The associated defaults in the money market generated a panic across the financial system and led to the failure of many other large financial institutions.

Whether or not the U.S. authorities’ decision to let Lehman Brothers go was justifiable would require a careful analysis. It is, however, abundantly clear that Lehman’s failure and the lack of transparency as to the guiding principle on who is to be rescued have been the proximate cause of many of the financial stresses we have witnessed since then.

Such an unfortunate chain of events has led to a sharp fall in the market’s confidence in policy makers’ ability to handle the situation properly. As a result, policy makers are forced to come up with extremely bold measures to turn the market sentiment around.

There are some more bold measures left. If capital injection is not enough, policy makers can decide to protect all bank debt, not just deposits—the measure Japan adopted during her crisis. Of course, these stronger measures come with stronger side-effects. But we could be just a few steps away from such extreme policy intervention in markets.

Even this was not enough in the Japanese case. The Bank of Japan adopted the so-called zero interest-rate policy whereby it promised to keep the overnight policy rate at zero until deflation ended. The policy target is usually the average of all rates paid by borrowers. So, a zero rate meant everyone raising funds at a zero rate. Credit premiums disappeared in the overnight funds market. The promise to continue such a zero rate indefinitely led to the near disappearance of term premiums. This had the intended effect, but it was accompanied by a significant deterioration of the market mechanism.

To embark on such a policy, U.S. and European policy makers, unlike in the Japanese case, might also have to compromise on the objective of maintaining price stability.

It would again be a tough decision to make.

Kazuo Ueda, professor of economics at Tokyo University, is a former Bank of Japan policy-board member.