Analysis of the Lost Decade - Essay Example

?Running Head: THE LOST DECADE Topic: The Lost Decade Lecturer: Presentation: The Lost Decade Japan experienced a boom and burst in the equity and real estate market in early 1990s often referred as the “the lost decade” as it resulted in stagnation of the economy. According to Saxonhouse and Stern (2004), Japan had experienced a period of increased economic growth which was attributed to good economic management at government and firm level for the last 25years before the asset bubble. Japan had a culture of savings and the government wanted to stimulate spending hence it lowered its interest rates and introduced tariffs to discourage imports and foster domestic market. As a result, there was trade surplus and increased liquidity for banks thus making credit easily available and cheap. There was also increase in asset prices such as; real estates, stocks and land. Banks used excess liquidity to lend loans backed by real estates or land as collateral and when eventually the ministry of finance raised interest rates in 1989, the asset bubble burst resulting in the collapse of the financial markets and economic growth stagnation. There are several factors which can be attributed to the recession. Some scholars like Ito believe that the situation could have been avoided if only the government had taken measures urgently. The Bank of Japan (BOJ) and ministry of finance(MOF) and Japanese banks took a long time to acknowledge the existence of the problem hence took long to respond and this led to worsening of the problem (Saxonhouse & Stern, 2004). Increased speculation is also viewed as a contributing factor to the lost decade. Due to high prices of land, stock and real estate, banks thought that the prices would continue to rise thus instead of reinvesting the excess liquidity, they loaned it with real estate as a collateral without foreseeing any risks. As prices continued to increase, the companies continued to acquire more loans backed by assets and invested in stocks and securities and the banks offered loans without considering creditworthiness of the loanee. By the time the bubble bust, most banks had little or capital reserves (Callen & Ostry, 2003). Callen and Ostry (2003) observe that the economic slowdown was a result of massive savings due to demographics of aging population. This resulted in over reliance on traditional bank loans as opposed to issue of stocks and bonds in the capital market to acquire additional financing. The relationship of banks and corporations led to lowering of lending standards leading to increased risks. The shareholders of commercial banks were mutual life insurance companies which were managed by representatives selected by the management hence there was no regulations to operate efficiently. The banks therefore were lending money without a profit maximization motive thus increased lending risks. The MOF had also undergone deregulation hence was not providing the banks with regulatory rents hence they turned to small and micro enterprises and gave the loans against real estate collateral at low interest rates (Syed et al. 2009). The government institutions were getting annual subsidies and hence were not keen on making profits hence lack of control in lending activities. The government response policy in 1997 of increasing consumption tax is the reason for continued crisis which had already began to ease (Syed et al. 2009). The government underestimated the depth of the crisis and began strategies to reduce budget deficits by increasing consumption tax. This resulted in increased consumption of durable goods by consumers as they speculated the increase leading to inflation (Nanto, 2009). The community banking model of Japan also prolonged the crisis since the banks were reluctant to write-off non-performing loans and instead opted to continue lending to defaulters. The increase in interest rates in 1989 by the MOF led to the bursting of the bubble. The impact was felt not only by the banking system and other financial institutions but also in the whole economy of Japan. The price of assets declined; by the year 1992, equity prices had fallen by 60% and so did stock and land prices and the economy came to a halt (Shigenori, 2003). The corporations and firms were unable to repay the loans advanced due to high interest rates hence increased non performing loans by the banks. The banks had no liquidity hence could not lend out loans for further investments to corporations; the banks tightened their lending leading to debt crisis and credit crunch. According to Saxonhouse and Stern (2004 p. 1), the equity market fell by 75% and land prices fell by 80% in 2002. The growth rate for real estate fell from 32% to 8%. The bank turned to bailing out the financial institutions hence incurring massive debts leading to budget deficits. Due to increased spending and constant tax revenues, the government debt rose to 60% of GDP between 1993 and 2000 (Syed et al. 2009). The Japanese Government Bonds (JGB) also declined. Due to lack of funds from banks, corporations could not engage in further investments hence began to cut down jobs leading to high unemployment. The government emphasis on saving combined with increased competition from Taiwan and South Korean firms changed the face of the labor market. Permanent labor was replaced by temporary jobs which have no security and no benefits (Krugman, 2009). Due to low rate of return on investments, the corporations experienced slow progress in recovery. There were also mergers and consolidations of large financial institutions and small ones and some collapsed; only four banks remained in Japan. According to Nanto (2009), the government had to use various strategies in order to exit from the recessionary period. It undertook a combination of monetary policy, fiscal stimulus packages and direct intervention to overcome the crisis although at some point, the government underestimated the crisis and introduced a negative policy which worsened the situation. The strategies aimed at ensuring the banks remained in operation and were conducted through the Deposit Insurance Corporation of Japan (DCIJ). The government did not acknowledge the situation but later asked the banks to disclose non performing loans and protected depositors by strengthening deposit protection emergency liquidity. It encouraged the banks to assist each other hence assisted them in forming mergers. The government then formed the cooperative credit purchasing company to dispose off non performing loans (NPL). The government also offered stimulus packages and increased its spending. It monetary policy was operating at zero interest rates to enable the banks to make profits. In 1996, it started injecting capital in the banks by purchasing assets of housing lenders. The government also began bailing out banks through the DCIJ; injected nearly 47 Trillion Yens and bought two bankrupt banks which it later privatized (Nanto, 2009). The role of DCIJ was to ensure none of the banks failed although some did fail. The BOJ also purchased corporate bonds, commercial papers, and asset backed securities to help in recovery (Syed et al. 2009). Through open market operations, the BOJ was able to reduce inflationary pressures; it withdrew liquidity without sale of government bonds or issuing bonds hence holding them to maturity. Japan’s situation was almost similar to the US financial crisis with only some slight differences in how the situation emerged and how the government responded. Both crises were as a result of a boom and burst of asset prices; Japan’s crisis arose as a result of increased prices of land, equity and stocks while the US crisis was as a result of increased housing prices. Both were also a result of relaxed monetary policy whereby interest are low to encourage local markets in Japan as a result of appreciating Yen and to encourage the poor to own homes in the case of US. Due to low interest rates, prices of commodities especially assets usually tend to rise making real estate business profitable. The Japanese banks borrowed money from BOJ and loaned at higher interest hence earning easy money. They would give out loans backed by land as collateral due to speculation in future price increases (Syed et al. 2009). The US case was complicated since it involved subprime mortgage being sold to banks by agents who would then compound the mortgages into a complex product, rate the complex mortgage by credit rating agencies and then buy mortgage backed securities (Taylor, 2009). The credit rating companies gave good ratings as they were unable to rate the complex mortgages. Financial institutions and insurance companies entered the industry and borrowed more money for buying mortgages. In both cases there lacked proper risk management to avert the crisis; creditworthiness was not considered when lending. When the interest rate rose, the housing bubble burst. Mortgage owners were unable to repay loans due to high interest rates and the banks repossessed the houses but it was difficult to sell due to mass repossessions and reduced housing prices. The financial sector and the stock market collapsed and a credit crunch was experienced; banks could not lend any more. The Japanese banks continued lending to defaulters in the hope that continued operations would lead to profits hence repayment of loans. This was also due to the close relationship between the banks and the corporations which made it difficult to write-off NPL (Nanto, 2009). The crisis in US also involved credit default swaps which activated the crisis as the insurance companies were unable to honor their obligations and some collapsed while others were bailed out by the government. The situation in US involved many banks as compared to Japan which after mergers and consolidation was left with only four banks. The response by US Federal Reserve was faster than Japan which opted to remain patient before requiring banks to disclose their NPLs. Both banks had a rescue strategy for the failing banks. The BOJ bailed out banks indirectly through DCIJ whose role was to ensure no bank collapsed but were to remain operational. For the US, the Federal Reserve Bank bailed out some financial institutions and left others to collapse. For example, the Lehman Brothers was not bailed out while AIG was bailed out (Taylor, 2009). This resulted in lack of confidence due to lack of clarity in the bailing out procedure. The US government spent $700 billion as rescue package while Japan used $ 500 billion. Both states also purchased the assets of affected banks; Federal Reserve purchased mortgage based securities. The US and Japan governments undertook open market operations to recapitalize the banks and ensure liquidity. The BOJ withdrew liquidity without sale of government bonds or issuing bills which enabled the bank to reduce inflationary pressures and allow bonds to mature (Syed et al. 2009). Large holdings also bought short-dated government paper. The US collateralized short term loans by use of its securities but charged low interest rates to member banks (Taylor, 2009). The U.S government undertook various measures to deal with the subprime mortgage crisis which was threatening to take the economy to a depression. Some of these measures are effective while others have not been effective in achieving the set objectives. I would therefore not fully agree with those measures since there were better policies which would have been taken and some measures ended up worsening the situation. Some of the measures taken include; bailing out the financial institutions, rescue or stimulus packages, increased government spending, lowering of interest rates, and homeowner assistance among others (Shah, 2010). The aim of these policies was to support market liquidity and to stimulate economic growth. The first response undertaken by the American government was to bail out the failing financial institutions especially large institutions such as Goldman Sachs. Many banks did not have liquidity as funds were tied up in mortgage backed securities and loans hence had no funds to lend to potential investors leading to a credit crisis. According to Shah (2010), by February 2009 the government had spent a total of $9.7 trillion to bail out banks and other financial institutions. These bailouts were not clear to the public as some institutions like American international Group (AIG) were bailed out while others like Lehman brothers were left to collapse. This led to a lot of speculation and loss of confidence in the credit market thus worsening the crisis. Besides, the idea of bailing out large financial institutions did go well with the public as they felt that the funds would have been given to homeowners to repay their mortgages hence stimulate the economy and that the institutions were the cause of the crisis to start with. The banks were being bailed out so as to increase their lending capacity but instead, they used the funds for other purposes thus not easing the credit crisis. Moreover, they lacked transparency as to how the funds were being allocated and used. However, the strategy was effective in ensuring the institutions remained operational and in easing the credit crunch. The government also increased its spending on infrastructure in order to stimulate demand. However, the response by individuals and businesses has been slow due to constrained resources. For example, businesses need credit in order to fund demand which is not readily available and individuals need income for consumption. Although the government spending has enabled the creation of employment, it is small scale hence income for spending is low leading to slow growth in aggregate demand. The strategy also has the left the government with very high deficit since there is no increase in tax revenue and this will need increments in taxes in future to finance the deficit and this may lead to reduction in aggregate demand and slow economic growth. Shah (2010) notes that despite the massive deficit spending by the government, the economy continues to contract. This he reasons is due to the fact that deficit spending only changes the composition of demand and not total demand and that it denies the private sector purchasing power. The homeowner assistance and regulatory action are effective in that they deal with the root cause of the problem. The borrowers are offered better terms of repaying their loans thus avoiding foreclosures which lead to low housing prices. The banks should be regulated so as to avoid abnormal risk taking behavior and fraudulent activities such as what happened with the rating of complex mortgage securities and credit default swaps which can lead to another crisis. Low tax rates are effective in stimulating demand by individuals and businesses hence the economy. References Callen, T., Ostry, J. (Eds). (2003). Japan’s Lost Decade: Policies for Economic Revival. Washington, DC: IMF. Krugman, P (2009). The Return of Depression Economics and the Crisis of 2008. Norton Company. Nanto, D. (2009). The Global Financial Crisis: Lessons from Japan’s Lost Decade of the 1990s. Congressional Research Service. Saxonhouse, G., Stern, R. (Eds). (2004). Japan’s Lost Decade: Origins, Consequences, and Prospects for Recovery. UK: Blackwell. Shigenori, S. (2003). Asset Price Bubble in Japan in the 1980s: Lessons for Financial and Macroeconomic Stability. Institute for Monetary and Economic Studies Discussion Paper no. 2003-E-15. Syed, M., Kang, K., Tokuoka, K. (2009). “Lost Decade” in Translation: What Japan’s Crisis Could Portend about Recovery from the Great Recession. Washington, DC: IMF. Taylor, John (2009). ‘The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong’. Working Paper 14631 National Bureau of Economic Research. Read More