What the US Can (and Can't) Learn from Japan's Financial Fiasco

Yesterday Japan's opposition party (DPJ) refused the proposal of the ruling party (LDP) for the deputy governor of the Bank of Japan (BOJ), because he had been a high official of the Ministry of Finance (MOF). It seems that Ichiro Ozawa, the Chief of DPJ, has not correctly learned the lesson of Japan's lost decade, of which he was partly responsible.

Many economists, including Ben Bernanke, former Professor of Princeton, condemned BOJ's "poor monetary policy". Indeed it was poor, but it isn't enough to attack them to learn from their failure. You must understand why the best and the brightest of Japan failed so miserably.

First, you should recognize that BOJ had been regarded as a device of MOF for fifty years after WW2. The BOJ Law, enacted in 1941, manifested that BOJ must mobilize all the national forces to win the war. It meant that BOJ should print money to buy the government bonds. So BOJ financed the war and made the inflation after the war. It was the trauma of BOJ after the war, so it tends to avoid buying the government bond to keep the budget discipline.

And BOJ failed to prevent the asset inflation in the late 1980s, because MOF tightened the budget to reduce the deficit and forced BOJ to ease money, which fueled the bubble. In 1989, when BOJ tried to raise the discount rate, the Minister of Finance, Ryutaro Hashimoto, threatened to fire the governor of BOJ. So BOJ were too afraid of asset inflation rather than deflation.

As a result, BOJ was too cautious in lowering the discount rate and increasing money supply by buying the government bond even after 1991, when they started to ease money. I was surprised at hearing Yoshio Suzuki, former Chief Economist of BOJ, said "BOJ should be cautious to lower the rate because, if it should raise it again, it would hurt banks" in a program of NHK in 1991.

It's true that BOJ was inclined to tighten money because it would help restructuring of banks and firms. Masaru Hayami, a governor of BOJ, raised the discount rate from zero in 2000 because it would "help structural reform". It turned out to be wrong , but his view was based on the tradition of BOJ that regard the role of monetary policy as passive and the essential problem of Japanese economy as "structural".

It's a consensus among many economists that the main bank system that was born in the wartime and endured after the war, which centralized the economic control to MOF and banks, is no longer efficient because the financial engineering made financial industries more decentralized and global. The bank reform was inevitable.

However, if BOJ wanted to help the reform, the banks didn't want it. And MOF suppressed the disclosure of the banks' loss, most of which were in fact insolvent. So the tragedy of the lost decade was the lack of coordination between the monetary policy by BOJ and the (lack of) structural reform by MOF. Many economists naturally blame BOJ's poor policy, but the essential problem was MOF that covered up the collapse of highly centralized economic system inherited from the wartime.

So Japan's lost decade is more similar to the Great Depression than the Subprime Crisis. In the 1930, the US financial systems changed from bank-based to equity-based. Japan should have done it, too. But it meant the demise of the state-socialistic system born in the wartime led by MOF and bureaucrats. They avoided it with the huge cost, $1 trillion, burdened to tax-payers and consumers.

The true lesson is that the lack of communication between BOJ and MOF would be more harmful than amakudari (descent of bureaucrats to private companies) and that the essential problem, the obsolete and inefficient financial structure, has scarcely changed.

In contrast, the US has done the reform in the 1970s and, learning from Japan's tragedy, FRB supplied liquidity promptly and encouraged full disclosure of loss. It took Japan almost eight years to face its true problem by the bust of Yamaichi in November 1997, but FRB has done it in a year. The size of loss might be $1 trillion, but it's far smaller per GDP.

It's impressive that FRB faces the problem and tells the truth. It's the most important lesson from the lost decade that uncertainty is more dangerous than the exposure of loss, because uncertainty induces people to hoard money (liquidity preference) rather than investment, as Keynes stressed in the 1930. If the loss is fixed, the problem is half over. So I think the US economy has passed the most dangerous stage and it would recover in this year.