Is US entering Japan's nightmare?

By Jim Jubak

Ben Bernanke's Federal Reserve increasingly looks like it's headed toward a repeat of the errors that took Japan into a decade-long banking crisis and economic slump, beginning in the early 1990s.

Welcome to the United States of Japan, where growth slows to a crawl, the stock market goes nowhere and savings earn nothing. Just in time for the retirement of the baby-boom generation, too.

Japan's crisis, like the recent one in the United States, began with an extraordinary real-estate boom. In 1987, the price of land in Japan's three biggest metropolitan areas climbed 44%. Prices went up 12% more in 1988 and then 22% in 1989.

And like the U.S. real-estate boom, the Japanese boom was fueled by cheap money. The Bank of Japan, that country's Federal Reserve, had lowered the discount rate -- the rate it charges other banks -- to a post-World War II low of 2.5% from 5% in 1984-87. In those same years, the money supply grew by better than 10% a year.

And even those official numbers don't capture the full size of the flood of cheap money. Japanese companies, including banks, were able to sell bonds in the European market with an interest rate of 1.5%. When those loans were swapped back into yen, the profits from the swap reduced the cost of money to zero.

As happened in the U.S. real-estate boom, lending standards in Japan collapsed. At the height of the boom, banks regularly made loans for more than 100% of property values. To keep real-estate loans off their books, banks lent through nonbank entities that made the actual loans.

Regulatory oversight took a vacation, too. Japan's Ministry of Finance allowed companies to include the profits from real-estate speculation in reported earnings. By 1987, Japanese companies made half of their profits from speculative investments in real estate -- and the stock market.

As you'd expect in this environment, the Japanese stock market was soaring. The benchmark Nikkei 225 ($N225) index hit 20,000 in 1987, up from 9,000 in 1983, and kept on going. It doubled again over the next two years.

The bursting of Japan's bubble

And then the Bank of Japan pulled the plug over worries about rising inflation and a fear that asset prices were out of control. Starting in December 1989, the central bank raised interest rates three times in 12 months, to 6%. And the bank's new chairman, Yasushi Mieno, began talking about his hopes for a gradual 20% reduction in real-estate values over the course of several years.

But when the speculative fires are burning that hot, there's no way to lower the temperature gradually. In nine months, the Nikkei dropped 48%. Average land prices tumbled 5% by mid-1992, 14% by mid-1994 and 33% by 2000. And they just kept on falling. Japan's real-estate market didn't bottom until 2006 -- after values had crumbled 70%.

Well before that, Japan's government and the Bank of Japan panicked. It's one thing to take the air out of a bubble, and it's something else to destroy a nation's financial sector. And that's what, very quickly, the Bank of Japan believed it was facing.

Because banks had invested so heavily in real estate and the stock market, losses in those two sectors quickly undermined the health of the entire banking system. By the early 1990s, Japanese banks were scrambling to raise enough capital to meet the 8% minimum capital ratio of the Bank of International Settlement.

Propping up the financial firms

The Bank of Japan and the Ministry of Finance decided they had to prop up this house of cards if they could. In June 1990, the ministry gave banks permission to sell junk bonds to raise capital. Some of the money to buy the bank bonds came from the financial subsidiaries of companies that belonged to a bank's keiretsu, a network of interlocking companies. In this arrangement, it was typical for banks to lend money to these customers at cheap rates and for these companies to then lend the money back to the bank at a slightly higher rate. That bolstered bank balance sheets and generated profits for other members of the keiretsu.

The big banks returned the favor, propping up affiliated financial institutions long past insolvency. In 1994, for example, Mitsubishi Bank first wrote off the interest on money owed to it from two affiliated finance companies, Diamond Mortgage and Diamond Factors, to keep the two companies in business. And later in the year, Mitsubishi bailed out the two affiliates by buying loans from them at face value and then selling off the loans at a loss to its own bottom line.

Continued: A decade of pain

 1 | 2 | 3 | next >