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Week 8-9 (Oct 29- Nov 3-5). Economic Roller Coaster: Bubble, Collapse, and Institutional Reforms

What Happened to the Japanese Economic Miracle?
Part 1: the Great Bubble

How the Miracle went topsy-turvy

From This (A picture of two Sumo wrestlers fighting) to This? (wrestlers dying)

Opening Questions

• What was the Great Japanese Financial Bubble?

• How much have stocks and land prices fallen between 1990 and 2002?

• How much did the unemployment rate increase?

• What has been Japan growth rate in the 1990s (decade)

Lecture Focus

• Two puzzles:

1. How can we explain the peculiar bubble of 1985-1990?

2. How could a system be  miraculous for so long and fail to deal with a financial crisis for over 10 years?

• One Overall Point: Financial Deregulation put the system off-balance and revealed key political weaknesses: the difficulty to change in Japan.

Lecture Outline

1. The Bubble: Symptoms, Causes, and Consequences: 1985-1990

2. The Collapse of the Bubble: 1990

3. The Weak Government Reaction to the Financial Crisis (Thursday): 1990-1997

4. The politics of reforms and non-reforms in the context of globalization: 1997-2008 (Thursday)

The Definition of the Bubble

• A period of hyper-liquidity in the economy, marked by a speculative rise of both stocks and real estate, fueled by enormous bank lending, and following a frenzied cycle (acceleration)

• Key Components: 1985-1990

  • Huge rise of stock market and real estate
  • Extremely low interest rates
  • Enormous and cheap bank lending

Some Bubble Facts

• 1989: Japan’s stock market = 42% of the world’s stock capitalization

• 1989: Japan’s total land value = 4 times the total US land value

• Tokyo land value alone = total US property value

• Imperial Palace alone = total value of Canada

• In 1990 alone, the stock crash (45%) amounted to a paper loss of US$ 2.25 trillion

Immediate Caveats about Bubbles

• You don’t know one until it bursts!

• Rationale in Japan in the 1980s to justify the rise of stocks and land:

  1. Japan has the strongest economy in the world, huge savings and trade surplus. The rise is fueled by domestic money

  2. Japan has no inflation (no need to raise interest rates)

  3. Japan reached a more advanced economic stage (Zaitech), no need to use usual yardsticks

  4. Land prices are safe loan collaterals. They have never fallen in Japanese history

Larger Context of Other Bubbles in History             

• [See Charles Kindleberger: “Manias, Panics, and Crashes”]

• Great Precedents: Dutch Tulip Mania 1637, South Sea Stock 1720 (UK), Railroad Bubbles mid 19th century…

• 5 phases: a displacement (innovation), a boom (mania, deviation from fundamentals), international spread, sudden stampede (and revulsion), necessity of govt action (lender of last  resort)

Key Components of Japanese Bubble         

1. US concerns with trade deficit and Endaka (rise of the Yen). Key date = Plaza Accord of Sept 22, 1985

2. Lowering of Interest Rates from 5% in 1986 to 2.5% in 1987 + tight fiscal policy

3. Exchange Rate Deregulation after 1979 and Financial Deregulation after 1984 --> Bank innovation, lack of government oversight

4. Exit option by large corporations: reliance on direct financing instead of bank financing.

Selected indicators of the Shift in Bank Lending during the Bubble.

Summing Up the Bubble

• A frenzied period of speculation in stocks and real estate, fueled by cheap money

• Caused by an interaction of 3 kinds of factors:

  • Availability of cheap  money (interest rates, endaka)

  • Financial deregulation

  • Antequated government regulation of finance

--> What would be a possible US conspiracy theory here? [cf Kikkawa in Japan]

Which leads to a key political question…

Why did Japanese leaders Let that happen?

The Answer: Poorly Institutionalized Deregulation

• A combination of forces led to a sub-optimal outcome as the path of least resistance

• US demands for deregulation and solutions for the trade deficit + demands by Japanese corporation for exit option

• Matched by high political costs for the LDP to take direct measures on trade

• Financial deregulation seen as cheap exit.

But the great party...

... came to a great crash in the early days of New Year 1990..

2. Collapse of the Bubble

• Triggered by Overzealous New Governor of Bank of Japan

• May-Oct 1989: BOJ raises interest rates from 2.5% to 3.75% - little impact

• Dec 17, 1989: Governor Mieno (BOJ) replaces Sumita (MOF) as BOJ Governor. Pledges to stop the bubble.

• Dec 25, 1989: BOJ raises inter. rates 4.25%

• Mar 20/90: 1 full % up (5.25%), 6% by Aug

• Nikkei falls from 39,000 to 24,000 in 1990

Mieno Yasushi – the great bubble warrior

The Vicious Cycle Begins

• Scandals Revealed- Security Companies (tokkin)-1990-1991

• Banking Bad Loans appear

• Collapse of Bank Lending and corporate funding in stock market --> eco. Crunch

• Worsened by BIS Ratios agreed 1988

• Scandals of MOF - 1993-1998

• Endaka continues (US-JP trade deficit), accelerating move to recession

• Structural Problems come to the fore, need structural reforms

Nomura Apologies 1991

Government Reaction      

1. MOF Administrative Guidance (Apr 90): ordering financial companies to limit real estate lending

2. PKO: Price-Keeping Operations (interventions into stock market)

3. Coercion to discourage investors from buying stocks further

4. Interest Rates Cut (to 0% by 1998)

5. Massive Economic Stimulus (debt / GDP from 38% in 1989 to 150% in 2002)

The Japanese Puzzle: a Crisis of Political Capacity

Simple life in the post-bubble period (yomiuri)

A Sliding Economy-Political Inaction

Overview of Big Dilemmas in 1990s

• The government has been reeling from the effects of the collapse of the Bubble since 1990. It passed all possible monetary and fiscal measures (with some delay), but showed critical weakness in the 2 areas that matter most:

  1. Reform of Banks (bad loans)

  2. Structural Reforms (corporate governance)

Conclusion:

• Ill-sequence and ill-institutionalized financial deregulation tipped the Japanese miracle into a bubble and then financial collapse

• The aftermath of the bubble revealed the weak reactive capacity of bureaucratic governance (especially while political leaders were distracted by electoral reforms and kabuki politics)

Deepening Crisis and Reform of the Model in the 1990s 

OUTLINE:

1. Collapse of the Bubble and Initial Government Response

2. Some important but limited reforms 1996-2000

3. Big Picture: 3 explanations of the Japanese Crisis of Governance

4. An Argument for Change and non-Change: Crisis of Political Mediation

5. The Restructuring of Japan, 1999-2006

Overview of Big Dilemmas in 1990s

• The government has been reeling from the effects of the collapse of the Bubble since 1990. It passed all possible monetary and fiscal measures (with some delay), but showed critical weakness in the 2 areas that matter most:

  1. Reform of Banks (bad loans)
  2. Structural Reforms (corporate governance)

2. Some Important Reforms

• 1995: Deregulation kicks in

• 1996-97: 6 Big Hashimoto Reforms, especially the Financial Big Bang, Administrative Reforms, and Fiscal Reconstruction; MOF carved out, BOJ independent

• 1998: Financial Revitalization Package: $US 75 Billion injected into banks

Significant Regulatory Change (Enabling)

• Jun 1997: abolition of ban on holding company

• 1997-1999: accounting reforms (consolidation, mark-to-market)

• Aug 1999: commercial code reforms (swaps)

• Aug 1999: industrial revitalization law

• Dec 1999: bankruptcy law reforms + labor (dispatch, interim, part-time)

• 2000-2001: commercial code reforms (spin-offs, stock issuance, e-vote, etc..)

• 2002: commercial code (US-style board option)

Some Policy Mistakes

1. Mysterious Interest Rate Policy (enduring debate)

2. Saga of Jusen bailout in 1995

3. Rise of consumption tax from 3 to 5% in 1997

4. Lack of immediate response to Black November 97 (Yamaichi Collapse)

5. Bank bad loans-still accumulating

6. Lack of thorough reforms of corp. govnce

3. The Big Debate over the Japanese Crisis

1. Natural Maturing of the Japanese Model. Got to its apex and pettered out, must be reformed

2. Domestic Sins:

• a) policy mistakes,

• b) MOF and bureaucracy,

• c) vested interest groups and LDP pbs,

• d) systemic pb

3. Global Forces: a) US, b) Globalization

4. A different Explanation: Crisis of Political Mediation of Global Financial Forces

1. The Bubble and its collapse were caused by  imbalanced financial deregulation. Japan deregulated under US pressure but did not build the necessary supervisory institutions.

2. The government’s response to the crisis has been hampered by political fragmentation: political transition since 1993, bureaucratic fragmentation since 1995, and continued asymmetric interest group structures.

3. Conversely, foreign investors are forcing some structural reforms after 1997

Political Mediation Process

The process of Structural Reforms in a Parliamentary System

Executive Leadership in Flux

• Political Realignment or Dealignment since 1993, changing coalitions, fragmentation within LDP

• Bureaucratic Fragmentation, net weakening, new poles

• New Schizophrenic Front: Cabinet vs Parliamentary Majority

Summing Up So Far

• The sturdy Japanese Economic Ship Ran into a 2-step trouble: bubble followed by financial depression

• Whether this big trouble was caused by a maturing of the model or by global forces, the political system has proved unable to react to the crisis in an effective way

Meanwhile.. Population Decline

5. To Restructure or Not to Restructure

• Large-scale corporate restructuring (risutora) came with a bang on the Japanese policy scene in 1999 (in contrast with 1993).

• There is evidence of large-scale restructuring of firms (Nissan, Sony) and of a large economic and social impact (turnaround, fierce debate on inequality)

• Yet, there is also evidence to the limits in comparison to other countries (banks, small firms, even Toyota).

Arguments: Selective Restructuring

1. Significant institutional change did take place during 1999-2006

2. In contrast to Korea and other countries, slow and gradual process relying on enabling measures. Many sectors left out (Amyx).

3. Dual engine: firms and state (cumulative structural reforms)

4. Multipolarity and diversification of Japanese model, but preservation of key coordination links (some firms broke loose).

Arguments for Restructuring in Japan, late 1990s

• Structural rigidities (labor market, capital transfer)

• Inability to adapt to fast changing technological change (creative destruction)

• Inefficient allocation of capital

• Concerns for competitiveness (including in corporate financing) + pressure of investors

• Restructuring required in bank borrowers to solve bad debt problem

Social Dilemma: the social contract

• At the core of stakeholder systems, such as Japan’s, lies a political bargain involving all social actors and the state as guarantor.

• The so-called social contract refers to a set of formal regulations and informal norms that ensures both economic competitiveness and social stability (life-time employment, stable industrial relations, and a stable financial system).

• --> potential for social backlash, need for parallel construction of safety net

Limits in Restructuring

• Uneven picture within industries (Nissan vs Toyota)

• Uneven picture between industries (steel cartel remains, vs automobiles)

• SMEs less affected, many domestic sectors shielded

• Backlash on takeovers (METI task force, current Horie-Murakami saga)

Corporate Governance battles

New Global Context in the Late 1990s

• Explosion of global equity flows and rise of global standards and norms on corporate governance, ROE

• My interpretation = golden bargain

• Global investors (pension funds) bring abundant capital in exchange for corporate governance reforms and higher capital efficiency (ROE)

Total foreign equity liabilities as percentage of total stock market capitalization in G7 plus Korea

Broad Causal Hypothesis:

• Golden bargain and external change cause uncertainty, fragment coalitions

• In a situation of coalitional stalemate, there is room for political entrepreneurs to craft a novel path: Hashimoto, Obuchi-Yosano-Yamazaki, Koizumi-Takenaka

• Aiming at reaping mid-term benefits, continuing modernization of Japan, enlarging support coalition in center

• Key variables: degrees of strategic political autonomy and capacity for bureaucratic delegation

Conclusion

• Significant institutional change

• Dual path of firm adaptation and government-sponsored regulatory change

• Political choices emphasized access for investors and the creation of options (enabling reforms).

• Leads to diversification, fragmentation of model, but preserves core coordination links.