Washington’s Dangerous New Consensus on China
Don’t Start Another Cold War
In periods of crisis, pundits and policymakers tend to scramble for historical analogies. This time, many have seized on Japan's notorious "lost decade," the decade of stagnation that followed a mammoth property bubble in the late 1980s. But this comparison is wrong. In Japan, the primary problem was pervasive dysfunction in the economy, which caused a banking crisis. In the United States, pervasive dysfunction in the financial sector has caused a deep recession in the economy as a whole. This financial dysfunction is not the result of structural flaws, as in Japan, but of grave policy mistakes. It is now being compounded by widespread investor panic.
The consequences of the 2008 U.S. financial crisis will be different from Japan's slump in the 1990s for three reasons: the cause of the current crisis is fundamentally different, its scope is far smaller, and the response of policymakers has been quicker and more effective.
Japan's malaise was woven into the very fabric of its political economy. The country has a thin social safety net, and so in order to protect jobs, weak domestic firms and industries were sheltered from competition by a host of regulations and collusion among companies. Ultimately, that system limited productivity and potential growth. The problem was compounded by built-in economic anorexia. Personal consumption lagged, not because people refused to spend but because the same structural flaws caused real household income to keep falling as a share of real GDP. To make up for the shortfall in demand, the government used low interest rates as a steroid to pump up business investment. The result was a mountain of money-losing capital stock and bad debt.
Japan's crisis pervaded virtually its entire corporate world. In sector after sector, debt levels and excess capacity ballooned and profitability remained low. White-elephant projects, from office buildings to auto plants, were built on borrowed money under the assumption that if times got tough, the government and banks would bail out the debtors. But the banks were too poorly capitalized to write off bad loans. And for every bad loan, there was a bad borrower whose products were not worth the cost to make them. The cumulative total of bank losses on bad debt between 1993 and 2005 added up to nearly 20 percent of GDP.
Policy mistakes -- from Japan's mismanaged fiscal and monetary policy to the government's failure to address the loan crisis -- made a bad situation even worse. But even if policymakers had done everything right, Japan's economy still would have stagnated until Tokyo addressed its more fundamental flaws.
The United States' subprime mortgage fiasco of 2007-8, in contrast, was primarily the result of discrete, correctable mistakes brought on by ideological excess and the power of financial-industry lobbyists rather than intractable structural problems.
The first mistake was the U.S. government's refusal to regulate subprime mortgages. Traditional banking regulations forbid banks from lending to people with no down payment or proof that they can repay a loan. However, no such rule applied to nonbank lenders, even after they became the country's biggest mortgage originators. That left new mortgage institutions with little incentive to ensure that their loans could be repaid; no sooner had they issued these so-called liar loans than they resold them to investment banks for a profit. The investment banks then sliced and diced the loans into securities embossed with AAA ratings despite the dubious creditworthiness of the original borrowers. A single statistic makes clear how damaging this lack of regulation was: by the third quarter of 2008, 22 percent of subprime, adjustable-rate mortgages were in foreclosure; by contrast, the foreclosure rate for prime, fixed-rate mortgages -- 60 percent of all mortgages -- was still less than one percent.
There were plenty of warnings. In 1994, a bipartisan coalition in Congress passed the Home Ownership and Equity Protection Act, which enabled the Federal Reserve to force all mortgage lenders to follow traditional banking standards. But Federal Reserve Chair Alan Greenspan refused to use these powers, claiming that the financial markets were self-correcting. When Democrats and Republicans in the next Congress tried to require that the Fed enforce these rules, House Majority Leader Tom DeLay (R-Tex.) quashed the effort.
The second policy blunder was the U.S. government's failure to regulate the compensation of chief executive officers (CEOs) -- a system that in its current form gives executives incentives to take outrageous risks with other people's money. When CEOs are paid primarily in stock options, as is the case today at many firms, they suffer little punishment for failure. If CEOs gamble big with the company's money and succeed, they can gain hundreds of millions of dollars in bonuses; if their gambling fails, they do not suffer losses, just a smaller reward. Even CEOs who have caused their firms to collapse, such as Merrill Lynch's Stan O'Neal, have still walked away with enormous severance packages. This system is a critical factor in the behavior that led to today's crisis. Studies show that extraordinary losses are much more common at firms where the majority of CEO compensation comes from stock options, rather than cash or outright stock.
The third error was the virtual nonregulation of the derivatives market. Derivatives should serve as a kind of insurance to lessen risk. Corn futures, for example, stabilize farmers' incomes, inducing them to plant more, which gives consumers more food at cheaper prices. Today's financial derivatives often turn the insurance principle on its head, causing shocks to be amplified and transforming derivatives into what the investor Warren Buffett has called "financial weapons of mass destruction." If an investor buys a share of General Electric from Merrill Lynch, that share retains its value even if Merrill goes bankrupt. But unlike corn futures or stocks, most financial derivatives are traded not on exchanges but in bilateral deals. If an investor's trading partner (counterparty) fails, the investor takes the loss. The collapse of the investment bank Lehman Brothers caused the insurance company AIG to lose big in so-called credit default swaps, undermining trust in all counterparties and causing a run on the entire derivatives and securitization markets. Rather than frightened depositors banging on bank doors, the result was investors furiously clicking away at their keyboards as their money disappeared. In the end, the impact was the same: perfectly solid companies suddenly found themselves unable to issue commercial paper, and creditworthy homeowners found it hard to get car or student loans. It took an intervention by the Federal Reserve to forestall a more serious meltdown.
This run on the shadow banking system is the real cause of the severe post-September credit crunch that transformed a mild recession into something far worse. Banks have actually increased their extension of credit by six percent since September, but they are having a hard time securitizing those loans in the capital markets. That means that they can no longer use the proceeds to make further loans, which would allow them to use the initial dollar over and over again.
If powerful financial lobbyists waving the banner of faith in markets had not thwarted commonsense regulation, much of this would never have occurred. Democratic and Republican policymakers alike, from Treasury Secretaries Robert Rubin and Lawrence Summers to Federal Reserve Chair Greenspan, blocked attempts at reform in 1998. Then, in 2000, Senator Phil Gramm (R-Tex.) went so far as to virtually outlaw the monitoring and regulation of many types of derivatives by initiating the Commodity Futures Modernization Act. Just as deposit insurance now prevents massive runs on banks, the regulation of derivatives could have made this crisis less severe.
A TALE OF TWO BUBBLES
The scope of the Japanese crisis and the scope of the U.S. crisis are also fundamentally different. From 1981 to 1991, commercial land prices in Japan's six biggest cities rose by 500 percent. The subsequent bust brought prices down to a level well below that of 1981; as of 2007, they were still 83 percent below the 1991 peak. In the United States, the real estate bubble was not as inflated, and the bust has been less severe. From 1996 through the 2006 peak, housing prices in the 20 biggest U.S. cities rose by 200 percent. Most forecasters think prices will drop by 30-40 percent from the peak levels before bottoming out in 2009 or 2010. No one is suggesting that prices will fall below the level of 1996.
Most of the United States' nonfinancial corporations are still healthy. Whereas the debt of Japanese corporations was several times their net worth, in the United States, corporate debt amounts to only half of companies' net worth, the same level that has prevailed for decades. The ratio of nonperforming loans among nonfinancial companies is only 1.6 percent, and productivity growth remains solid.
In October 2008, the International Monetary Fund's Global Financial Stability Report predicted that the losses on all U.S.-originated unsecuritized loans (including home mortgages) would amount to $425 billion, about three percent of U.S. GDP. This estimate will likely rise, but even then it would not come close to the 20 percent ratio that Japan experienced.
The biggest financial losses are coming not in loans taken out by household or business borrowers but in the shadow banking system. Because of the leverage inherent in financial derivatives -- which are designed so that a one percent hike in real estate prices can create a much larger gain in asset-backed securities -- a small loss in the value of the underlying assets can be multiplied several times over. Far more significant is the psychological factor: by mid-December 2008, pure panic had pushed the value of AAA-rated commercial-mortgage-backed securities (CMBS) down to 68 percent of their face value, despite a commercial-mortgage delinquency rate of only one percent.
That 32 percent loss has reverberated throughout the financial system due to mark-to-market accounting rules, which require securities to be valued at their current market price, even in markets where there is little trading and prices fluctuate wildly. As a result of these rules, all investors holding CMBS have had to write down their holdings by 32 percent, even if the underlying mortgages are being paid on time. That, in turn, has led prices to decline even more and investors to write off more capital, further tightening the credit crunch.
The International Monetary Fund predicts that this vicious cycle will cause $1 trillion in mark-to-market losses, as much as seven percent of U.S. GDP. If this is correct, most financial losses suffered since the onset of the crisis will have come not from genuine defaults in the real economy but from problems generated within the shadow banking system. Applying normally beneficial mark-to-market rules in today's abnormal markets without any adjustment is doing more harm than good. By the time the economy recovers and those marked-down securities are marked back up, the credit crunch will have led to a host of corporate bankruptcies, millions of layoffs, and countless families losing their homes.
A PROGRAM OF ACTION
The Japanese and U.S. crises differ in many ways, but the starkest contrast is in the response of policymakers. Denial, dithering, and delay were the hallmarks in Tokyo. It took the Bank of Japan nearly nine years to bring the overnight interest rate from its 1991 peak of eight percent down to zero. The U.S. Federal Reserve did that within 16 months of declaring a financial emergency, which it did in August 2007. It has also applied all sorts of unconventional measures to keep credit from drying up.
It took Tokyo eight years to use public money to recapitalize the banks; Washington began to do so in less than a year. Worse yet, Tokyo used government money to help the banks keep lending to insolvent borrowers; U.S. banks have been rapidly writing off their bad debt. Although Tokyo did eventually apply many fiscal stimulus measures, it did so too late and too erratically to have a sufficient impact. The U.S. government, by contrast, has already applied fiscal stimulus, and the Obama administration is proposing a multiyear program totaling as much as five to six percent of U.S. GDP. When it comes to crisis management, it is far better to do too much than too little.
Policymakers can draw many lessons from this comparison. First, the current U.S. crisis -- like the Asian financial crisis of 1997-98 -- has proved that even an economy with sound fundamentals can be thrashed when financial markets go haywire. However, the Asian crisis provides a more promising message: once financial markets are calmed and policy mistakes are reversed, economies recover.
Second, whereas Japan needed a thorough overhaul of its political and economic institutions and practices, a process that continues today, the United States simply needs aggressive reform of its financial architecture and CEO compensation system. President Barack Obama clearly understands the need for better regulation, and there is reason to hope that his economic advisers, many of whom are alumni of the Clinton administration, have learned from their mistakes. In October, former Treasury Secretary Summers, now director of the National Economic Council, wrote in the Financial Times, "The pendulum will swing -- and should swing -- towards an enhanced role for government in saving the market system from its excesses and inadequacies."
Third, fiscal policy works, but only in connection with other measures. Many commentators believe that Japan's lost decade proves the uselessness of fiscal stimulus. They are wrong. When Tokyo stepped on the fiscal gas, the Japanese economy did better. When it took its foot off the pedal or, worse yet, applied the brakes -- such as when it raised taxes in 1997 -- the economy faltered. Equally important, it is hard for fiscal and monetary stimuli to be effective when the financial system is broken.
Finally, markets only work when undergirded by proper regulatory institutions that enforce genuine checks and balances on corporate executives, corporate boards, financiers, accountants, rating agencies, and regulators. Better rules make it safe to have freer markets.
There is, of course, one way in which the United States' crisis is much worse than Japan's: its global ripple effects. Getting through today's recession will be neither quick nor easy. But there is absolutely no need for fatalism or talk of an upcoming "lost decade" in the United States. The first step is to recognize, as Obama has repeatedly stressed, that this crisis is not a once-in-a-century unforeseeable disaster. Bad policies created this mess. Better policies can fix it.