Inside Investment: Japanese lessons

The drop-out rate from Japanese courses at UK universities is extremely high. Most students take it up from scratch and it proves a challenge too far for all but the most linguistically gifted. Japanese economic history can at least be studied in translation, although it still makes for difficult reading. Vacillation, combined with policy missteps following the pricking of the housing and stock market bubbles in the early 1990s, condemned Japan to a debt deflation cycle not seen in a developed economy since the Great Depression. The country is only now beginning to recover.

Central bankers looking for a guide of what not to do in the present credit crunch and economic slowdown could do worse than turn their attention to what unfolded in Japan. Fortunately for the US and the rest of the world, Federal Reserve chairman Ben Bernanke appears to be a keen student. The lessons are many and varied. The biggest single mistake the Japanese authorities made was to stay within a traditional monetary mindset for far too long. This lack of imagination was compounded by the catastrophic decision to raise interest rates in 1998, tipping the economy into a vicious deflationary spiral.

Deflation means that not only do prices fall but also nominal wages. Debt increases. Consumers and businesses (even if they are fortunate enough not to be saddled with increasing debt service) put off paying for something they can buy at a lower cost in the future. The downward spiral becomes self-reinforcing. Although Japanese banks were being crushed under the weight of non-performing loans, arcane book-value accounting allowed them to stagger on zombie-fashion, neither alive nor dead. The authorities turned a blind eye.

Two policy shifts finally changed the fortunes of the Japanese economy. In 2000, the zero interest rate policy was introduced. This alone did not prove enough. However, the appointment of Toshihiko Fukui as governor of the Bank of Japan in March 2003 was a turning point. He increased the account balance repeatedly to boost liquidity. He also increased by ¥1 trillion the BoJ’s programme of buying shares from banks and began work on a plan to buy asset-backed securities.

Most crucially of all, in May 2003 Japan’s fifth-biggest bank, Resona, was rescued by the government with $17.2 billion of public money. It sent a clear message that the government would not allow the banks to fail. The actions of Fukui and Heizo Takenaka, head of Japan’s Financial Services Agency, were vindicated in March 2006 when deflation was finally consigned to history and the zero interest rate policy was abandoned.

Turning point

Bear Stearns is (or, rather, was) the fifth-biggest investment bank in the US. Will the Fed’s $30 billion of support mark a Resona-like turning point? The Fed has a headstart. The Bank of Japan only gained independence in 1998 and was still fighting internecine turf wars with the finance ministry into the 21st century. The Fed’s responsibilities are clear. But, most important of all, from the outset Bernanke has been doing all of the things the Japanese failed to do. He has been bold, decisive and unconventional and seems ready to do more.

When massive injections of liquidity failed to bring interbank and policy rates in line, the Fed announced the term auction facility on December 12 2007. On March 7, it increased the amounts outstanding in this facility by 40%. It also offered one-month term repo against a broad range of collateral. On March 11 it introduced the term securities lending facility. On the same day as the Bear Stearns bail-out (March 16), the Federal Reserve Bank of New York was authorized to create a temporary lending facility for 20 broker dealers. This in effect gives non-banks access to the discount window for the first time since the 1930s.

The Fed funds and discount rates have been slashed to the point that the Fed is now pursuing a zero (real) interest rate policy of its own only eight months into the crisis – it took the Japanese a decade. Finally, the rescue of Bear Stearns shows that the Fed is acutely aware of the dangers of systemic risk and it taught the Bank of England a thing or two about managing in a crisis.

Intriguingly, Bernanke gave a speech in Tokyo on May 31 2003, just 12 days after the Resona nationalization. It is worth re-reading.¹ He suggested that the Japanese were still not being radical enough and called on the BoJ to "consider adopting a price-level target, which would imply a period of reflation to offset the effect on prices of the recent period of deflation".

This shows just how creative the Fed chairman is prepared to be and offers a foretaste of his present policy. The Nikkei 225 index soared more than 40% between April and the end of 2003. It rose a further 50% in the next two years. It would take a brave soul to conclude that the US stock market will see a similar rally after the bail-out of Bear Stearns. After all, the Dow Jones has fallen less than 20% from its peak, whereas the Nikkei at the start of 2003 was down almost 80% from its record highs. However, Ben Bernanke should be heartily congratulated for paying attention to Japanese lessons.