Asset price inflation and monetary policy.

What action could the authorities have taken to restrain bank lending to the real estate sector? Given the policies that produced the asset boom--the liberalization of the tightly regulated financial system in the first half of the 1980s, and the easy monetary policy of the second half of the 1980-there is a counterfactual that could have deflected the boom's consequences for financial institutions.

Japan could have had in place capital requirements that increased as the ratio of each loan category (for example, real estate loans, loans secured by stocks and bonds, and unsecured loans) to the total loan portfolio rose and the ratio of each category of assets other than loans (for example, equities, bonds) to total assets rose of each subclass of banks. (2) The responsibility of the bank supervisory agency would have been to monitor changes in the ratios quarter by quarter and to ascertain that the institutions held adequate capital.

Banks would have had to sell assets to reduce the ratio when it exceeded the matching capital requirement. They would then have been allowed to continue to operate. Banks that ignored the rule would have been sanctioned. Had such a system been in place, the boom might have been restrained. Japan's financial institutions would have been spared the baleful consequences to their portfolios that still plague them since the bursting of the bubble. Instead of raising interest rates to deter bank lending, the authorities could have relied on rising capital requirements to control changes in the composition of financial institution portfolios.

Another obvious counterfactual would have been conduct by the Bank of Japan of a stable monetary policy instead of the lax policy that was a precondition for the asset boom. Finally, the unforeseen consequences of bank ownership of corporate equities could have been averted only by a change in legislation governing banks and insurance companies. Restriction or prohibition of the right of financial institutions to hold equities would have been desirable.

The United States 1929-22

The Downswing

From the September 1929 peak of 381 the Dow Jones Industrial Index declined to 199 in November, recovered to 294 in April 1930, fell to a low of 158 in December 1930, recovered to 194 in February 1931, fell to 74 in December 1931, recovered to 89 in March 1932, fell to 41 in July 1931, and at the business cycle trough in March 1933 was 55. (3) The annual averages of the S&P 500 composite index fell from 21 in 1930 to 14 in 1931 to 7 in 1932 and stood at 6 in March 1933.

The profound collapse of the economy was mirrored in declines in stock prices, output, national income, consumer prices, short-term interest rates, and the money stock. Bank failures reached historic proportions culminating in a nationwide bank holiday.

Financial Institution Portfolios

It was enough to show the rising proportion of loans backed by securities to highlight the distortion of bank portfolios that asset price inflation produced. It is not enough to report that proportion, which in fact did not change much after 1929, during the ensuing asset price collapse. The true measure of the banks' financial distress once asset price deflation set in was the plunge of the market values of their assets to levels far below book values: not only loans backed by securities but also loans for real estate, commodities, and general business as well as their holdings of corporate and foreign bonds. The root explanation of this result was Federal Reserve failure to respond to the distress.

Response of the Authorities

The Federal Reserve took no responsibility for the failure of banks, member and nonmember banks alike. A new institution, the Reconstruction Finance Corporation, was created in January 1932 with authority to lend $1.5 billion to railroads and banks. It made loans that were publicized for political reasons. Unfortunately, that publicity harmed the banks that borrowed. Moreover, the banks that were salvageable needed infusions of capital more than loans. The RFC lacked authority to do so until the Emergency Banking Act of March 9, 1933, empowered it to invest in the preferred stock or capital notes of commercial banks. There is no comparable example of the devastating portfolio effects the U.S. banking system experienced from 1930 to 1933.

Alternatives to the Authorities Response

Monetary expansion by the Federal Reserve in 1930 and 1931 could have shielded the banks from runs that contracted their reserves and reduced the money supply. Asset prices would not have plunged to the extent that they did, bankrupting industrial corporations, public utilities and railroads. Jobs and consumer purchases would not have suffered the enormous declines they experienced. Depression in the rest of the world would not have been so pronounced. By 1932, when the Fed undertook a $1 billion open market purchase, the program was curtailed prematurely, reversing the upturn in prices and production that it had succeeded in achieving. The banks and the economy tailspinned into their final collapse.

Japan in the 1990s

The Downswing

The Nikkei 225 stock price index began to decline in February 1990 from a high of 39,000, falling below 14,000 in August 1992. By mid-May 1993 the index reached 21,000, but fell back to 16,000 in November 1993. Pump-priming government public works expenditure announcements have led to increases in stock prices, followed by declines as recession has resumed. Stock prices recorded a bottom of 9072 in September 2002. Subsequently the index fell below 9000.

Land prices ceased to rise in mid-1990. At the end of 1993, land prices in the six largest cities were 36 percent below their 1990 peak. Land prices in 1999 were 20 percent lower than in September 1985 and 80 percent lower than in September 1990 [Okina et al. 2000, p. 3]. As of mid-2002 land prices had not stabilized.

Cyclical chronology dates the period February 1991 to October 1993 as a recession, when durable goods output and residential and business fixed investment declined along with a rapid decline in the growth rate of monetary aggregates. A second period of low growth occurred in 1995 when commodity prices fell and the exchange value of the yen appreciated, despite a declining stock market. In both instances the government increased public works spending to stimulate recovery. In 1997 financial institution failures and an increase in the consumption tax triggered a resumption of recession. A redefinition of GDP growth by the government increased what was originally reported as negative growth in 1997 and 1998 to positive 0.1 percent annual growth. In 1999 the government spent $70 million to recapitalize 15 major banks and relaxed fiscal policy. Improvement in the economy that seemed to follow petered out in 2000.

The Japanese economy contracted in each quarter of 2001, but apparently did not decline further in the first quarter of 2002. It emerged from recession in the second quarter, thanks to export-driven growth. The appreciation of the yen in early 2002 led the finance ministry to engage in seven rounds of yen-selling intervention for fear that the exchange rate would abort the recovery. Reliance on budget deficits throughout the post-1990 period that have raised the public debt to 4.6 trillion yen, well over 100 percent of GDP, induced Moody's to downgrade government bonds two notches to A2, much to Japan's shock.

Financial Institution Portfolios

Twelve years after the asset market boom in Japan collapsed financial institutions, both depository and non-depository ones alike, are trying to recover from its aftereffects. Major banks and insurance companies have failed--two banks in 1998, four life insurance companies in 2000, and a regional bank in 2001--but many more are believed to be insolvent. In Japan in 2002 the survivors still bear the scars that asset deflation has inflicted on their portfolios. Each industry has its share of bad debts from loans that went sour when land prices collapsed in the early 1990s, and suffered erosion of its capital base.

The problem for these institutions is that the companies that borrowed from them are delinquent, surviving only because the banks do not foreclose on their loans. The banks in turn have no incentive to lend, given the load of non-performing loans in their portfolios, so bank support for economic activity is anemic. The government has not made a firm decision to compel insolvent companies to file for bankruptcy protection, although periodically it announces reform programs that halfheartedly tackle the problem but do not resolve it. Likewise, the government has been ambivalent about the measures to employ to deal with insolvent financial institutions.

Direct write-offs from fiscal 1992 to end of March 1999 amounted to 53.9 trillion yen at major banks, about 11 percent of nominal GDP, but still more non-performing loans were thereafter recorded on the books of banks. There is no end in sight of write-offs of non-performing loans, officially estimated in 2002 as totaling 52.4 trillion yen ($4.28 trillion). Private estimates are much higher.

In April 2001 banks were required to mark their investment portfolio to market effective a year later. Limits were also imposed on equity ownership. Japan's nine biggest banks have equity investments that are larger than their core capital and for years have been selling shares in an effort to improve their financial health. A falling equity market in 2002 saddled them with significant capital shortfalls. Unlimited insurance of deposits in Japanese banks, originally scheduled to end in March 2003, may not eventuate. Observers believe that, if the change occurs, it will endanger the existence of some banks and smaller financial institutions.

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