By Richard Katz
As the United States sinks deeper into recession, many observers fear the country could reprise Japan's "lost decade," the decade of stagnation that followed its mammoth property bubble in the late 1980s.
But this fear is unawarranted.
Japan suffered from chronic dysfunction in the general economy, one of whose symptoms was a banking crisis. The converse is true in the United States. It is the financial sector's pervasive dysfunction that is now causing deep recession in an otherwise sound economy. In Japan, the flaws were structural.
Even if policymakers had responded properly, the country was still doomed to years of malaise. In the United States, by contrast, the culprit is a series of correctable policy errors brought on by the interaction of a "market fundamentalist" ideology and financial industry lobbying.
Reversing the errors, applying sufficient stimulus and calming panicky financial markets will keep the United States from suffering anything worse than a very deep, but temporary, recession.
The first mistake was refusal to regulate subprime mortgages.
Traditional regulations forbid banks from lending to people with no down payment or proof of ability to repay the loan. However, the Federal Reserve refused to apply these rules to the nonbank lenders who came to dominate mortgages. These new mortgage originators had little incentive to ensure repayment, since they quickly sold these so-called liar loans to investment banks, who packaged them into derivatives. By the third quarter of 2008, 22 percent of subprime, adjustable-rate mortgages were in foreclosure.
By contrast, the foreclosure rate for mortgages guaranteed by Fannie Mae -- most of which have requirements for downpayment and documentation -- was only 0.4 percent.
The second blunder was refusal to regulate compensation of corporate executives.
When executives are paid primarily in stock options, they have an incentive to take outrageous risks with other people's money. If their gambles succeed, they can gain enormous bonuses; if they fail, they merely get a smaller reward. Merrill Lynch's Stan O'Neal presided over his firm's collapse, but still walked away with a $140 million severance package.
Perverse incentives are why so many financial executives made decisions disastrous for everyone but themselves.
The third error was refusal to regulate the derivatives market.
Unlike stocks or corn futures, most financial derivatives are traded not on exchanges but in bilateral deals. If an investor's trading partner (counterparty) fails, he takes the loss.
The collapse of the investment bank Lehman Brothers caused the insurance company AIG to lose big in so-called credit default swaps, undermining trust in all counterparties and causing a run on the entire derivatives and securitization markets. This panic is the real cause of the severe post-September credit crunch that denied money even to healthy firms and households.
That is what suddenly transformed a mild recession into something far worse.
Because the cause of the U.S. crisis differs from that in Japan, so does the scale and scope. In Japan, nonperforming bank loans added up to nearly 20 percent of GDP.
Behind each bad loan was a "bad borrower," a company whose products were not worth what they cost to make.
In the US, most nonfinancial companies are still healthy. Hence, the International Monetary Fund estimates that nonperforming loans, including mortgages, will end up at around 4--4.5 percent of GDP.
The real losses in the current crisis--estimated at 12 percent of U.S. GDP by the IMF --will stem from "mark-to-market" write-owns of derivatives and other securities. Pure panic has caused many of these securities to lose most of their market value even when the underlying asset is healthy and the debt is being paid on time.
Despite the differences, policymakers can draw valuable lessons from Japan's experience.
First, it is far better to do too much than too little, to move too soon rather than too late.
Second, since even a sound economy can be thrashed by panicky financial markets, the Fed and Treasury need to act aggressively and massively to unfreeze financial markets.
Third, while Japan needed thorough institutional reform, the United States simply needs aggressive reform of its financial architecture and executive compensation system.
Markets need to be undergirded by proper market institutions and regulations; better rules make it safe to have freer markets.
Fourth, fiscal policy works, but only in connection with other measures. When Tokyo stepped on the fiscal gas, the Japanese economy did better. When it took its foot off the pedal or, worse yet, applied the brakes, the economy faltered. Equally important, it is hard for fiscal and monetary stimuli to be effective when the financial system is broken.
Getting through today's recession will be neither quick nor easy.
But there is absolutely no need for fatalistic talk of a "lost decade" in the United States. This crisis is not a once-in-a-century unforeseeable disaster.
Bad policies created this mess. Better policies can fix it.
Richard Katz is Editor in Chief of The Oriental Economist Alert and the author of "Japanese Phoenix: The Long Road to Economic Revival."
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