Spike and Crash Syndrome (Lessons from Japan in 51 Quotes)

"I’ve been telling my patients for years that sugar acts like a drug in the brain. It causes blood sugar levels to spike and then crash, leaving you feeling tired, irritable, foggy, and stupid. Eating too much sugar impairs cognitive function, which may explain why Odom doesn’t always make the smartest decisions on the court."1


Another symptom of a sugar spike is the hunger in the crash. The effects of economic stimulations are similar. It certainly succeeds in stimulating an economic spike but in its wake comes the crash leaving the economy “tired, irritable, foggy and stupid”… and hungry. So a cycle of spike and crash is initiated.

The roaring twenties, the stock market crash of 1929 and its aftermath; the Japanese miracle and lost decades (yes, its almost 20 years from that fateful December 29th, 1989); the go-go years of the 1960’s and the stagnation years of the 1970’s; the LTCM, Y2K and the 2000 Tech Bubble combo are all examples of the spike and crash syndrome.

The stimulations can be phased over many years or force fed to the economy in monetary policies of the zero bound and quantitative easing and fiscal policies steeped in Keynesian deficit spending traditions. Instability in a downward spiral ensues.

It is no secret that I find the Japanese experiment with spike and crash policies as the best hunting ground for research insights. The Japanese kept feeding their economy candy and has been living with an economy in spike and crash mode for the past (almost) twenty years.

A tremendous body of research material is available on the Japanese experience. Gathering the research evidence to tell the story of Japan will guide us into informed decisions regarding the unfolding of the current global economic crisis which by no means is contained or resolved. These are the findings as reported by insiders who have unsuccessfully been trying to bend the markets to their will. They lament the spike and crash outcomes of endless stimulations.

“In light of Japan’s experience, it seems to be a characteristic that effects of a bubble are asymmetrically larger in the bursting period than in the expansion period.”2


Candy rush one – Zero bound interest rates, a monetary policy debt trap.

Every monetary stimulation feeding liquidity into the market has the effect of reducing interest rates (all else being equal). These stimulations accumulate and compound in the economy over time. Removal of stimulations are preached but seldom practiced. Only when serious structural defects impede economic control objectives would attention turn to slowing the accumulation of stimulations in the economy. Inflation pressure is one such structural defect. Channelling inflation into assets allows stimulations to approach the zero bound interest rate structure.

Manipulated low interest rates encourage investment into productive assets under a false economic signal of an overabundance of savings. In this case there is no true savings, only the imposter of Central Bank liquidity provision.

Central Bank liquidity supplements income through the availability of cheap debt particularly against collateral of assets. Reaching the zero bound is an inevitable outcome of the monetary policy trap of stimulating liquidity for debt formation. A stasis trap for a dysfunctional economy.


Candy crash one – Empty shelves and long term banking distress.

The constant candy of low interest rates caused a fundamental change in conservative bank lending practice. The economic signal of such a low interest rate convinced otherwise prudent bankers that lending risk, particularly against collateral which is rising in price, is insignificant. It never is and the candy crash arrives in the form of debt defaults.

The now crystal clear structural mismatch in interest rates and risk leaves banks in the impossible position of producing loan products in a high risk environment while pricing (with zero bound interest rates) is as if near zero risk exist. The result is very restricted debt formation, even very peculiar debt formation as can be seen later. Debt saturation prevails.

A fundamental and often much maligned source of income to banks is the income derived from borrowing short and lending long – trading on the transformation gap. Interest rates at the zero bound is not compatible with transformation gap profits.

This is how researchers found the structural disconnect in Japan:-

“In retrospect, such aggressive lending at low interest rates seems to have been pursued by financial institutions taking excessive risks compared with their profit outlook.”3

“Constraints on the expansion of bank loans include such problems as (1) the decline in the risk-taking ability of banks resulting from the erosion of their capital due to nonperforming assets; (2) the lack of profitable projects; and (3) the inability of many firms to borrow money because of the debt incurred on previous projects. Even if firms can borrow money for a profitable project, they have to first repay the debt on other projects. Unless such problems are solved through appropriate measures corresponding to the respective constraints, the provision of funds will not result in the expansion of bank lending.”4

“In the meantime, some note the channel whereby, as the QEP flattens the yield curve, financial institutions that conduct short-term funding and long-term investment can make little profit out of maturity transformation, thereby exerting side effects on the banking system (IMF [2003]).”5


Candy rush two – Unlimited Central Bank liquidity.

The candy rush of low interest rates is but a derivative of the only power that a Central Bank has; that of providing money supply. The increase in money supply through debt formation is not measured due the argument that ultimately debt must be repaid with money. This is correct when the debt in fact gets repaid but fails once debt formation is pushed past the barriers of prudence. Then debt use becomes hard core and debt default becomes endemic.

The increase in “debt driven money supply” is not measured or managed but the decline in “debt driven money supply” imposes reality in debt default and requires economic structural adjustment. No structural adjustment takes place since increases in “debt driven money supply” does not exist in official monetary policy. Central Bankers become perplexed at the distress staying power of structurally mispriced debt formation, engineered and maintained by them, when debt driven money supply crash after the stimulatory spike.

The Japanese unveiled the policies of Quantitative Easing at a zero interest rate in March 2001 as “unprecedented worldwide”. Quantitative Easing failed Japan as proven by the persistence of Japanese structural problems into 2009. The argument that the BOJ did not do it aggressive enough seems a bit threadbare given the experience with Quantitative Easing in the USA thus far.

“Japan’s economy experienced prolonged stagnation following the burst of the asset price bubble in the early 1990s, despite several short-lived recovery phases. During this period, general prices measured by the consumer price index (CPI) gradually reduced their growth rate, followed by a continuous and modest decline from 1998 to the autumn of 2005. Over this period, the CPI dropped by a total of about 3 percentage points (Figure 1). In addition, the broad-based influence of the generation and bursting of the bubble spread to firms and financial institutions. In this economic environment and as Japan’s economy headed toward recession triggered by the bursting of the global IT bubble, on March 19, 2001 the Bank of Japan (BOJ) adopted a new monetary easing framework, the so-called quantitative easing policy (QEP), with a view to stemming the continuous price decline and setting the basis for sustainable economic growth. The QEP under a zero interest rate, a policy unprecedented worldwide, consisted mainly of three pillars: (1) to change the main operating target for money market operations from the uncollateralized overnight call rate to the outstanding current account balances (CABs) held by financial institutions at the BOJ, and provide ample liquidity to realize a CAB target substantially in excess of the required reserves; (2) to make the commitment that the above ample liquidity provision would continue to stay in place until the CPI (excluding perishables, hereafter “core CPI”) registered stably at zero percent or an increase year on year; and (3) to increase the amount of outright purchases of long-term Japanese government bonds (JGBs), up to a ceiling of the outstanding balance of banknotes issued, should the BOJ consider such an increase to be necessary for providing liquidity smoothly.”6


Candy crash two – Liquidity speculations, displaced hope and a state of “fallacious stability”.

The liquidity provisions go hand in hand with debt driven demand for asset speculations. Banks being at the epicentre of the liquidity provisions channel the debt formation to the asset classes. A notable favourite due to its relative liquidity is channelling money into equities. Proprietary speculation is not necessarily the only means for this channel includes activity such as financing restructures, mergers, acquisitions, derivatives such as stock futures and options, and margin accounts. Real estate is (was) another favourite due to its perceived “risk free” status.

The Japanese experience is described thus by researchers and it holds a lot of very useful hints on the outcomes for the present global economic crisis:-

“Large Japanese banks had capital ratios of barely above 8% at the start of the 1990s, with about half of the 8% accounted for by unrealised capital gains on their equity positions. Since then, banks have been writing off bad loans by basically using operating profits and realising latent gains on equity positions. This meant that every time equity prices plunged, banks faced the risk of not being able to meet the Basel standards or having to slow down the pace of bad loan write-offs. As of March 1998, latent gains stood at 2.7 trillion yen for the top 20 banks, only 15% of what they were in 1993, almost a negligible portion of their capital base. What has filled the gap is a sharp increase in other components of Tier II capital, mostly subordinate bonds and loans.”7

The ultimate effect of unlimited liquidity and zero or near zero interest rates is to trap the economy in a loss making stance that is cheap to carry. The normal market mechanisms of forced liquidation are suspended but it also suspends the economic recovery. Policy makers and economic participants foster a hope of escape “when the economy recovers”, thus one only needs to carry the structural defects cheaply for long enough. Japan has been carrying for 20 years.

“However, if interest rates are close to zero percent, financing costs of the above excesses will become quite small. When the economy recovers, nonperforming loans could become collectable, excess inventories could be sold, and excess equipment could become operational. In anticipation of such developments, the current situation of extremely low interest rates gives an incentive for corporate management to postpone the resolution of these excesses.”8

“Okina and Shiratsuka (2004) conclude that the QEP did not have the effect of reversing the financial market’s expectations that deflation would persist. They say this is because the transmission mechanism from lender to borrower was blocked and the monetary easing effect did not spill over to outside the financial system.”9

“From these results, Sadahiro (2005) concludes that the effectiveness of the increase in the monetary base was lost during the period when interest rates were zero.”10

“In this context, a historical example that made a strong impression on me is the financial depression in Japan in 1927, when at the peak of financial uncertainty banknotes increased by an amazing 38 percent compared with the previous day and the BOJ was forced to issue ¥200 banknotes that had been printed on only one side. Even as recently as 1997, when financial system uncertainty increased following the collapse of the Hokkaido Takushoku Bank and Yamaichi Securities, the growth rate of the balance of banknotes (end month, year-on-year basis) increased rapidly from 6.5 percent in September, to 8.3 percent in October, and 13.6 percent in November.”11

“Since financial institutions were able to maintain their operations as far as they were managing to meet their funding needs, what was then predominant was something like a state of fallacious stability. Without sufficient information, there existed no strong criticism of this situation. This fallacious state of stability made it possible to prevent systemic crisis. At the same time, however, it considerably weakened the momentum needed for establishing bankruptcy procedures for institutions in trouble and for constructing a comprehensive safety net. It was the very success of buying time that forced the authorities to buy more time, and thus the whole process of handling the nonperforming-asset problem was prolonged.”12

“Disclosure practices among industry participants complemented this norm- and reputation-based approach to bank failure. With MOF support, troubled financial institutions traditionally minimized disclosures of nonperforming assets, often while liquidating portfolio assets in order to show a profit. These measures helped to maintain an aura of financial soundness while mergers and other financial assistance were arranged behind the scenes”13 (MOF is the Ministry of Finance)


Candy rush three – Forbearance lending and loan restructures

The hunger in the bust after the spike asserts itself in renewed efforts to stimulate. The argument is made that the solution to the structural distress is another stimulatory spike. Out comes the stimulatory candy for another spike and crash cycle. Restructure and refinance; roll-and-hope strategies of not collecting debt while not disclosing non performing status (Non Performing Loans or NPL’s). Note that Forbearance Lending is sometimes called “Evergreening”.

“After the collapse of the asset price bubble, Japanese banks are said to refinance firms, even in cases where there is little prospect of firms repaying the loans extended. This phenomenon is known as “forbearance lending.” We find the evidence which is consistent with the view that forbearance lending certainly took place, and that it suppressed the profitability of inefficient nonmanufacturing firms.”14

“This suggests that forbearance loans were mainly provided by rolling over short-term loans, since banks hesitated to provide long-term loans to heavily indebted firms.”15

“It is quite likely that when a bank engages in forbearance lending, (1) that bank behaves as a risk-lover because it effectively becomes a dominant shareholder; (2) at the same time, it wants to put off disposal of NPLs due to insufficient loan-loss provisioning; (3) it thinks that the liquidation of the firm would not pay, since the price of land collateral has plummeted; and (4) it still harbors wishful thinking that the land price will recover in the future.”16

“In short, even after the bursting of the bubble, banks continued to provide loans to the real estate industry at interest rates that did not reflect the firms’ credit risks. This finding seems to suggest that banks engaged in forbearance lending as Hoshi (2000) discusses.”17


Candy crash three – Endless stream of bad debts and economic inefficiencies

The carries and the management of expectations, funded and controlled by the Central Bank petrified the economic inefficiencies for long term economic decay.

“However, this paper shows in addition that, even in the absence of this crisis, the NPL problem was stifling Japanese economic growth through the practice of forbearance lending. Forbearance lending not only props up inefficient firms, it also encourages inefficient firms to avoid making the efforts necessary to raise their profitability.”18

The endless stream of bad debts eliminated any liquidity driven acceleration of inflation because the owners of the money lost their future spending ability. The liquidity helps to carry any inherently doubtful debts until it becomes a default. The “carry” becomes a systemic default when the bank fails. Not allowing the banks to default or fail gave rise to the zombie bank phenomenon.

Follow for example the “jusen” companies of Japan involved in facilitating the last phase of the Real Estate Bubble in Japan. These entities received Central Bank and Central Government support after the collapse of the Real Estate bubble in 1991. Jusen non performing loans were almost 40% of portfolio and in spite of the support were all insolvent by 1995. These are the bailout lessons from Japan.

“In Japan, regulatory forbearance began when the first Ministry of Finance inspection of the jusen, in 1991, showed 40 percent of all loans on the books to be nonperforming and the response was a 10-year regulatory restructuring window. (By 1995, 75 percent of all jusen assets were nonperforming, and this part of the industry had to be shut down.) Since then, the equivalent of regulatory forbearance in Japan has largely taken the form of weak supervision standards, which continually allowed banks to resist classifying as nonperforming their dubious or even underwater credits. As a result, most observers of the Japanese banking industry in time came to dismiss each successive private or official announcement of the scale of the ‘‘bad loan’’ problem as a gross understatement, and correspondingly to regard all banks’ capital positions as overstated. By the late 1990s, it had become commonplace for private analysts to conclude that in aggregate the entire Japanese banking industry was insolvent, or even that each of the 21 large banks was individually insolvent.”19

“The ratio of publicly disclosed bad loans to total loans in the banking sector stood at 3.6% as of March 1998. Based on the self-assessment by banks, problem loans amount to 11.0% of total loans.”20

“The bad loans based on the official definition stood at 19.5 trillion yen for the top 19 and regional banks as of March 1998, while the problem loans based on the self-assessment totalled 71.8 trillion yen.”21

“It is not easy to grasp the extent of the bad-loan problem in Japanese banking. As Hoshi and Kashyap (1999) explain in detail, there are several different definitions of bad loans, and moreover the definitions have changed over time.”22

“The reality was that up to a certain point both the financial supervisory authority and management of financial institutions seemed to have expected the economy and land prices to recover before long. If that were the case, the nonperforming-asset problem would have been fixed without any special treatment. In particular, land price was the key element that decided the volume of nonperforming assets, since small and medium-sized enterprises and non-bank financial institutions had heavily invested in real estate with the money borrowed from banks during the speculative bubble years.”23

“The NPL problem for banks and the debt-overhang problem for firms are different sides of the same coin. The change in the distribution indicates that Japanese firms suffered from an increasingly serious debt-overhang problem in that not only did average firms face higher debt-asset ratios, but also firms with high debt-asset ratios ended up with more severe debt-overhangs.”24


Candy rush four – Debt driven demand

The economic justification for stimulations is based on the concept of unutilised or under utilised factors of production, particularly the availability of employable labour. Thus, in summary, the economy must be stimulated to absorb such labour which absorption would provide the necessary demand for the increased production. The stimulation takes form in increased liquidity provision which, as expected would lower interest rates.

A cycle of fallacious business decisions based on a manipulated price for the use of money supported by easy credit for consumers heralds in the candy rush of debt driven demand.

“First, it was not correctly recognized that “while debts always remain, assets may become lost.” This was partly because the vast majority of people, including policy makers, believed, up to a certain point in time, that “asset prices, even if they decline now, will recover in due course.” Second, it was not correctly understood what kind of mechanism might be triggered when asset prices decline while the nominal value of debt is held constant. A possible explanation of this lack of understanding may have been something that could be called tacit dominance of the “zero-sum fallacy,” i.e., that capital gain and loss should offset each other, and thus be neutral with regard to economic activity as a whole. A capital gain, even if it is unrealized, corresponds to an increase in net worth. However, once such capital gain has stimulated expenditure—via the wealth effect on consumption—or has been used for aggressive capital investment with debt-financing, and these expenditures turn out to be “excessive” ex post, or in plain words, wasted, the subsequent decline in asset prices will end up as “negative-sum,” not “zero-sum.” This comes close to what happened in Japan in the last two decades.”25


Candy crash four – Excess capacity, oversupply, unemployment and disappearing “wealth effects” (asset bubbles).

Then came the time when debt driven demand could no longer be sustained and the ills of a leper economy became exposed. Bits and pieces just kept falling off. Stimulations would bring short term spikes followed by deeper and deeper crashes. Stimulation and hope took the place of structural reform and austerity. Asset bubbles collapsed under the weight of unsustainable debt formation. Aggressive inflationary policies and inflation targeting did not work.

Unemployment became structurally ingrained and themes of restricted access for youth and senior citizen employment emerged together with falling salaries and wages.

Here’s what the researchers found.

“This decline in final demand intensified inventory adjustment pressure, and production activity shrank significantly. The economy was thus caught in a vicious cycle (decline in demand →decline in production activity →decline in corporate profits and labor income →further decline in business fixed investment and private consumption), with real GDP recording negative growth for five consecutive quarters from the fourth quarter of 1997 onward (for the first time since the start of GDP statistics in 1955).26

“In response, the jusen companies turned aggressively to real estate lending. This move coincided with the speculative excesses of the “bubble” era, and the flow of a torrent of cash into the jusen companies from the agricultural cooperatives. Agricultural cooperative lending was spurred in part by the exemption of the jusen companies from MOF administrative guidance that imposed limitations on real estate lending in the banking sector. MOF inspections of the jusen companies in 1991—the first ever—revealed that almost 40 percent of their loans were nonperforming. Under MOF guidance, 10-year restructuring plans were undertaken for each of the jusen companies. Concessionary interest rates and longer repayment schedules were negotiated on loans to the jusen companies, on the assumption that improved land values would eliminate the problem. Consistent with the implicit norms outlined above, the founding banks took the biggest loss on their loans (by eliminating all interest), and the MOF circulated an ambiguous memo suggesting that the founding banks and perhaps even the MOF itself would guarantee repayment of the principal of all loans made by the agricultural cooperatives, which were generally perceived to be the weakest institutions involved, other than the jusen companies themselves.”27

“Moreover, the possibility that the effectiveness of inflation targeting in achieving sustainable growth may depend on such factors as property prices seems to present particular difficulties in setting a target, since most of today’s problems in the Japanese economy were triggered by asset inflation including the rise in property prices.”28

“…, during the bubble period, debt-asset ratios were so low on average that they were not likely to exceed the threshold level. It is also because banks took credit risks aggressively during the period, as evidenced by the increase in the land collateral ratio. The threshold itself was therefore likely to be higher. At that time, the euphoric sentiment prevailing in the economy led people to anticipate further rises in asset prices. By contrast, in the second half of the sample period, as firms’ debt-overhang problem became serious, average debt-asset ratios increased and the threshold declined so that forbearance lending became pervasive.”29

“One of the significant characteristics of the bubble period is that the expansion of capital stock appeared particularly in investment in structures (Bank of Japan [1997b]). A typical example is the large increase of floor space in the Tokyo metropolitan area, triggered by the increase in demand for high-quality office buildings that took place in the late 1980s. Construction of a number of large office buildings with long building periods was begun in 1990–91, the very last years of the Heisei boom, prolonging the capital stock adjustment process that followed.10
10. Relating to this point, Yoshikawa and Ohara (1997) reported that construction in process in fixed assets, as a proxy for a large-scale fixed investment such as factory construction and other large building projects, increased remarkably in 1990–91. Based on such findings, they argued that complete adjustment of capital stock took a long time, since the lives of factories and buildings are longer than those of equipment.”30

“First, during the period soon after the bursting of the bubble economy, the initial stage of adjustment began with adjustments to overtime pay, followed later by adjustments to bonuses. Nevertheless, regular salaries were growing during this period, and it was not until 1998 that nominal wage adjustments making an overall negative contribution occurred. Around 1998, reflecting an increase in the number of firms that suspended pay raises in response to the deepening economic recession, the growth of regular salaries dropped to nearly zero. Then in 1999 and 2000, with the economy slowing further, the firms that had already made adjustments using overtime pay and bonuses began to eliminate annual wage hikes and reduce regular salaries, to the extent that even the average growth rate in regular salaries turned negative. In contrast, looking at employment adjustments shown in Figure 8, it was not until 1997 that the contribution from employment changes adjusted for population factors turned negative for all age groups in total. During this period, growth in the number of younger employees aged 24 and under turned negative in the mid-1990s, suggesting that firms began restricting the hiring of younger workers. Around 1996, the rate of growth in employment of older workers aged 55 and above turned negative, suggesting that older workers were encouraged to take early retirement (or were simply laid off).”31

“Our analysis has shown that nominal wages in Japan are not permanently downwardly rigid, and that nominal wage cuts do occur after a certain amount of time passes.”32


Candy rush five – Fiscal debt spending

Monetary stimulations failed and Japan reverted to Keynesian fiscal stimulation spending. Japanese National Government debt grew by an astonishing 400% from 1990 to 2007 and has since stagnated around 2007 levels.

”as a result of the successive implementation of fiscal stimulus measures, the fiscal deficit became the largest among major industrial countries”33


Candy crash five – Moral hazard, loss of fiscal discipline, regulatory self-preservation with exploding taxation and relative international currency weakness.

Keynesian fiscal stimulations also failed the people of Japan as they rush towards the end of a second lost decade. Central Bank independence is a mirage in these circumstances.

The extension of monetary policy to utilise exchange rate policies to achieve monetary objectives are particularly short-sighted. Massive Yen interventions to depreciate the yen and stimulate GDP through export expansion were frequently proposed as part of monetary policy.

This type of economic psychotic behaviour allows one country to transfer GDP from other countries to itself in the short to medium term. Eventually yen balances so distributed to the rest of the world will be swapped for Japanese Central Government Bonds though bonds, particularly Treasury Bills are near substitutes for cash at the zero bound. Again it is the proposition of leading Central Bankers to use any conceivable means to achieve short sighted monetary objectives. Using exchange rate policy as part of monetary policy to fund long term Central Government debt is a significant temptation in 2009. These policies would only transfer misery in a global economy in crisis.

Central Bank secrecy and opaque behaviour becomes firmly grounded in regulatory self-preservation. Critical questions must be answered, “How many of the stimulations and bailout policies are driven by regulatory self-preservation and when will the crushing tax burden appear?”

“Japan’s financial problems in the 1990s find obvious parallels in the bank and savings and loans crises experienced by the United States in the previous decade. For a time, banks in both systems managed to function well under quite distinct, politically contrived safety nets with deep roots in regulatory self-preservation. Eventually, however, both systems succumbed to an identical economic logic rooted in moral hazard”34

“In both cases, a non-institutionalized reputational system hinging on the MOF’s policy dominance gave way to greater institutionalization as political competition increased and politicians began to assert control over the policymaking process.”35 (MOF is the Ministry of Finance)

“…it is close to impossible to obtain public support for closing banks without the disclosure of the whole picture of the true state of the nonperforming-asset problem and banks’ business conditions. On the other hand, given that a huge amount of nonperforming assets already existed and bankruptcy procedures against troubled institutions and comprehensive safety net were not established, disclosing information on the problem might have aroused serious concern over the financial system, and may thus have triggered a systemic crisis.” “During this process, information on the magnitude of the nonperforming-asset problem and the soundness of individual banks and the banking sector as a whole was kept within limited circles, including the financial supervisory authority and the Bank of Japan; disclosure to the public occurred only gradually.”36

“To such a criticism [outright purchases of Government Bonds], the BOJ has pointed out that (1) in the end it would essentially be the same as underwriting, which is prohibited by the Fiscal Law; (2) most central banks in industrialized countries mainly conduct the outright purchase of short-term government bills for monetary operation purposes; (3) it would impair fiscal discipline; and (4) it might increase long-term interest rates. For example, the BOJ contends that, based on its historical experience, once outright purchase by a central bank is built-in as an automatic funding source for the government, it would become extremely difficult for both the government and the central bank to exit from it. Against this, there is the following counterargument regarding the loss of fiscal discipline: as long as the BOJ is an independent central bank, it can suspend outright purchase or conduct open market selling operations at its own discretion. Hence, the BOJ’s outright purchase at the present juncture may not necessarily put future fiscal discipline at risk.”37

“This recognition brought again to the fore the importance of injecting public funds into financial institutions so as to correct their undercapitalized status, thus revitalizing their financial intermediation function. In March 1998 some ¥1.8 trillion in public funds was injected into 21 major banks. In October, public funds appropriated for financial system stabilization, based on the Financial Reconstruction Law and the Financial Function Early Strengthening Law, were increased to ¥60 trillion and an additional ¥7.5 trillion was injected into 15 major banks, followed by a ¥2.6 billion injection into four regional banks. In the meantime, the Long-Term Credit Bank of Japan and Nippon Credit Bank, both suffering from huge nonperforming assets, were placed under special public administration in accordance with the Financial Reconstruction Law in October and December 1998, respectively.”38

“A second package of legislation passed in late 1998 provides a framework for the recapitalization of distressed banks. The legislation replaced a ¥13 trillion recapitalization fund that was eliminated at the insistence of opposition parties. The law provides for the RCO to purchase the common stock, preferred stock, or subordinated bonds issued by, and to extend subordinated loans to, banks whose capital is below various prescribed levels. The capital will be supplied upon application by a bank, provided that various conditions are met. These conditions, also largely the product of opposition party demands, are designed to reduce moral hazard stemming from the use of public funds to prop up weak institutions. Together, the two sets of legislation contemplate the use of ¥60 trillion (US$550 billion), or approximately 12 percent of Japan’s GDP, to protect depositors and restore the health of the banking sector”39

“I believe that a policy of aggressive depreciation of the yen would by itself probably suffice to get the Japanese economy moving again.”40

“I agree with the recommendations of Meltzer (1999) and McCallum (1999) that the BOJ should attempt to achieve substantial depreciation of the yen, ideally through large open-market sales of yen. Through its effects on import-price inflation (which has been sharply negative in recent years), on the demand for Japanese goods, and on expectations, a significant yen depreciation would go a long way toward jump-starting the reflationary process in Japan.”41

“If the yen did not depreciate as a result, and if there were no reciprocal demand for Japanese goods or assets (which would drive up domestic prices), what in principle would prevent the BOJ from acquiring infinite quantities of foreign assets, leaving foreigners nothing to hold but idle yen balances?”42

“In the 1940s, U.S. monetary policy was geared to containing long-term interest rates, but resulted in the collapse of the government bond market due to inevitable pressure for a rise in interest rates. Because of this, in the 1950s the Federal Reserve Board (FRB) concluded an Accord with the Treasury which stated that the FRB was not responsible for the movement of long-term interest rates.”43


Candy rush six – Coupons and vouchers.

The suggestions of restricted stimulations aimed specifically at achieving spending objectives often find its way into proposals for the issue of coupons. Coupons to purchase a specified item distributed by Government aimed at forced stimulation of aggregate demand. Japan embraced the coupon experiment for a candy rush.

“At one point the Japanese government did attempt to stimulate spending through “consumption vouchers”,47 but there was no way to ensure that vouchers would have been used for spending that would not have taken place anyway.
47 These vouchers, known as “Regional Promotion Coupons,” were part of the Emergency
Economic measures proposed in November 1998 and implemented in early 1999.”44

Candy crash six – Sending displacement and coupon barter.

The Japanese recipient of the coupons used them in place of normal spending and saved the money which they would otherwise have spent. Just another failed experiment. Barter with coupons and outright discounted sales of the coupon or the product will take care of a situation where a recipient has a coupon but no need to use the coupon. Again an inherent “waste” is built into the suggestion resulting in a candy crash deeper than the initiating candy rush.


Candy rush seven – Banking restructures.

Many of the above quotes have dealt with banking restructures as part of the macro environment. Banking restructures are lauded as having saved the economy from “systemic failure” but the price paid in long term economic stagnation far exceeded the systemic cost of a short term economic cleansing, even though it may have been a brutal adjustment. Consider the price paid by Japan carefully and judge its relative value.


Candy crash seven – Survival of the weakest

Central Government and Central Bank interventions looked at size and regulatory self-preservation to create an economic, business and banking paradox which haunted the Japanese economy for two decades with no end in sight. Researchers describe this as a “no exit” policy to promote the survival of the weakest in an environment of information monopoly distributed on a “need to know” basis. These policies are a licence to rip-off consumers of banking products while locking up the economy in “carry” mode.

“The financial regulators were able to avoid systemic problems by playing the leading role in the formation and enforcement of the following well-developed set of informal norms governing bank distress: (1) Survival of the weakest: Interest rates and other regulations were set to permit the survival of the weakest member of the banking industry, whose numbers were kept manageable by high barriers to entry. In addition to enhancing the durability of the industry as a whole, the survival of the weakest norm supported pricing arrangements that allowed the weakest member to stay in business, while allowing more efficient producers to earn super-competitive profits. These economic rents were used to compensate for the monitoring and rescue operations undertaken by the stronger firms. (2) No exit (no failure): Almost a corollary of the principle of survival of the weakest was that of no exit—no member of the banking industry was allowed to exit (fail), other than through merger with a stronger member. This enhanced stability both by preventing the failure of weaker members and by increasing public confidence in supervisory capabilities. (3) Responsibility and equitable subordination: When the danger of financial failure grew, the parent or principal source of funding for the failing entity was expected to take responsibility by extending financial assistance and by subordinating its claims to those of other creditors, even if not legally required to do so. This norm encouraged monitoring by stronger firms, by imposing both monetary and reputational costs on stronger players who allowed smaller institutions to fall into difficulty. (4) Implicit government insurance: The preceding norms led naturally to a norm of implicit insurance provided by the government. If strong members were expected to assist weaker members and if no member of the industry were allowed to fail, some entity had to backstop the strong members. Thus, an implicit grant of government insurance was inherent in the operation of the other norms. Put differently, the responsibility norm extended even to the government.”45

“Competition must be limited and entry barriers must be high to channel a stream of rents to the banking sector. Regulators must maintain a near monopoly on information serving as the basis for prudential policy. Similarly, disclosure of problems in the industry must be limited in order to protect regulatory reputation and avoid stresses on an underdeveloped institutional framework. Competition-distorting incentives may be needed to encourage informal resolutions of bank distress.”46


Candy rush eight – Deposit Insurance and bank safety nets.

Transferring banking risks to government supported entities and often implicitly to Central Government enabled the unimpeded flow of stimulations to the economy. A processed sugar intake for a near instantaneous sugar spike. The economy developed an addiction to the sugar spikes. Obese, too-big-to-fail entities emerged.

Candy crash eight – Arrival of the too-big-to-fail banks posing significant systemic risk (economic domino effect of failures).

Governments and Central Banks believed that by aggressively posturing as the alpha dog they can dominate the economy into submissive acceptance of flimsy, thinly funded and hopelessly overexposed to risk, safety nets. The safety nets failed at the first sign of trouble and those relying on the safety nets fell right through into the arms of Central Government. The obese too-big-to-fail left only tatters in its wake when weak safety nets gave way to Central Bank and Central Government bailouts.

“In this capacity as “institutional designer,” few governments in the past decade have made policy choices more controversial and costly than those relating to deposit insurance and other components of the bank safety net. As recent events in world financial markets have demonstrated, on this central issue of institutional design the stakes are high; the results may best be described as dismal. While governments have expended enormous resources to promote bank stability, systemic banking insolvencies in the last two decades have been commonplace.”47

“Arguably, the most serious problems in the United States were caused, not by the explicit portions of the safety net, but by the development of the “too-big-to-fail” norm and the FDIC’s selection of resolution techniques for failed banks that protected virtually all uninsured depositors”48

In the past decade [1989-1999], however, changes in the economic, political, and regulatory environments following the collapse of the “bubble” economy caused the implicit safety net to fail spectacularly, leaving a gaping hole in Japan’s bank regulatory infrastructure.”49

“Thus, while government safety nets are designed to promote bank stability, they simultaneously provide incentives to increase bank risk, making bank failure mores likely. This necessitates a panoply of additional regulatory structures, including bank examinations, capital requirements, and portfolio restrictions, to limit excessive risk taking.”50

“The complete demise of the implicit safety net might accurately be dated to 1997. Autumn of that year witnessed the collapse of Japan’s 10th-largest bank and its fourth-largest securities firm, as well as the failure of a major life insurance company and a second-tier securities house. Significantly, major shareholders and firms affiliated with these failing institutions refused to come to their aid. Moreover, stronger, unaffiliated institutions resisted the MOF’s attempts to broker rescue mergers. This episode represents a watershed in regulatory approaches to failing banks in Japan, indicating that the ground rules for the operation of the safety net were open to complete revision. Although MOF officials scrambled to reassert the “no failure” norm through public statements that no other major banks would be allowed to fail, credibility in the financial structure fell to an all-time low. Events of the past several years, therefore, exposed a legal and policy vacuum of considerable dimensions. For decades, while operating under a comprehensive, implicit safety net, there was little need for a highly developed institutional structure to govern deposit protection and bank closure. Post-“bubble” economic, political, and regulatory conditions rendered the “no failure” norm inoperable, yet no coherent substitute was in place to address the serious problems facing Japanese banks.”51


Déjà vu

Extracting these quotes from highly regarded sources gave me a heightened sense of déjà vu. Compare for instance a global picture of “witnessed the collapse of Japan’s 10th-largest bank [vis-à-vis Northern Rock in the UK] and its fourth-largest securities firm [vis-à-vis Bear Stearns], as well as the failure of a major life insurance company [alternatively AIG as an underwriter of financial risk] and a second-tier securities house [vis-à-vis Lehman Brothers]”. It is in fact almost impossible not to stumble for one parallel to another. The forbearance philosophy inherent to the jusen companies and the political pressures which resulted in a change in the accounting practice to no longer price debt assets on a mark-to-market basis is a parallel and its potential warning for Freddie Mac and Fannie Mae that I find most depressing.

Observe the Japanese outcomes when you contemplate your immediate and longer term financial future. Any investment in prudence and austerity would probably outperform risk hugging behaviour at this stage of an unfolding economic drama. I leave you with one last quote:-

“Even as the economy stalled in 1992 and 1993, following the largely unanticipated bursting of Japan’s asset bubble in the early 1990s, forecasters appear to have remained optimistic about Japan’s medium-run prospects, with most observers predicting a bounce-back to high growth rates within a couple of years. Exhibit III.1 presents forecasts of Japanese GDP growth made by Federal Reserve Board staff, private economists surveyed by Consensus Economics, and IMF staff. For each year, actual growth, the red bars, is compared with forecasts of growth in that year made one year earlier, the blue bars, and forecasts made two years earlier, the black bars. The exhibit makes clear that forecasts fell off much more slowly than actual growth rates, and only in the latter half of the decade did a fundamental reassessment of the outlook for Japan appear to take place.”52

Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
29 June 2009

Ps. The 1st quote is not a lesson from Japan. A special thank you to each of the authors quoted for enriching us with their insights and creative phrases like “regulatory self-interest”, “survival of the weakest”, “evergreening” and many more.


© Sarel Oberholster

Your comments are always welcome. Please email me at ccpt@iafrica.com with any views or observations. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .


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