Following the demise of Lehman Brothers, Merrill Lynch and the giant insurer AIG, pundits have been quick to compare today's turmoil to Wall Street's great crash 79 years ago. This has now been billed the worst financial crisis since the great depression. This may be true for Britain and the US. But a more recent parallel may be drawn with Japan's so-called "lost decade."
Unlike the events of 1929, the Japanese debacle occurred very much within living memory, and its causes remain the subject of heated debate. But the facts are broadly these: the Nikkei index of leading Japanese shares peaked at 38,916 on 29th December 1989 at the end of a five-year long orgy of debt-fuelled speculation, centred largely on the real estate market. During the fat years, banks lent against property in the confident expectation that prices would never fall. For a while, they were amply rewarded: share and real estate values rose fourfold between 1984 and 1989. It took time for the crisis to bite hard, but from 1990 share prices started a 13-year decline, punctuated by sharp rallies. Over that period they gave up all their bull market gains, and by 2002, the stock market was back where it had been in 1984. Property values also crashed. In total, the long decline wiped out ¥1,500 trillion ($14.2 trillion) of national wealth, equivalent to three years of Japanese GDP. It was the largest such loss experienced by a nation in peacetime.
The demon the Japanese confronted during the lost decade was that of "de-leveraging." This arose initially because banks were reluctant to lend, and then because too many borrowers paid down debt at the same time—a toxic combination that crushed asset prices. It is this fear that is now stalking financial markets. A rerun of what happened in Japan is possible, although with luck not in as savage a form.
Doubts about collateral have also made it harder to raise new capital to replenish the losses. Banks have raised some $352bn since the credit crunch began. Strategic investors from the middle east and Asia have taken substantial stakes in some of the largest institutions in the City and Wall Street. But even this enormous sum has been insufficient to fill the vast losses that are being racked up in the financial system ($500bn to date, and rising). Moreover, investors have taken some punishing losses. Of the $6bn invested only three months ago by shareholders in Lehman, two thirds have been wiped out and the last third looks extremely doubtful. When two British banks, HBOS and Bradford & Bingley, raised capital in the autumn, most of the shares had to be sold to the underwriters. (As Prospect went to press, HBOS had accepted a rescue bid from Lloyds TSB.)
The nasty thing about deleveraging is that once started, it can feed on itself. It is the reverse of leverage—an agreeable phenomenon we have been going through in recent years. When debt levels are rising, I pay more for a house because the bank is willing to lend me more money to buy it. The value of the house rises, giving the bank the confidence to lend me more. I use this to buy a car, or do up my house. This may sound like small beer, but multiply it across the financial system and it has a big impact. Asset prices rise and GDP growth is high. Moreover, leveraging generates its own momentum. Everyone becomes addicted to borrowing a little bit—and sometimes a lot—more. Banks look for cunning ways to extend more credit. They set up off-balance sheet vehicles. They lend more not only to consumers, but also to private equity firms and hedge funds investing in financial assets.
In a deleveraging world, this whole upward spiral goes into reverse. Assume a bank has made losses on some duff property loans. Its bosses may call for it to increase its capital ratios, meaning it can make fewer loans to customers for the same amount of capital. So it has to call in some loans. This in turn forces some borrowers to sell assets, and asset prices fall. That undermines the value of collateral banks are holding. More loans are called in, leading more borrowers to sell assets, and so on.
The way any banking crisis plays out depends to a great extent on whether demand for credit holds up. If it does, the banking system can be revived by the expedient of cutting short-term interest rates and creating an upward-sloping "yield curve" (meaning short-term rates are lower than longer term rates). This allows banks to rebuild their profits by exploiting the difference between the low short-term cost of money, at which they can borrow, and the higher longer term interest rates at which they lend. The continued supply of credit also cushions any fall in asset prices. This is essentially how the US and British banks dug themselves out of their last financial hole in the early 1990s.
But in a debt-averse world, things run a different course. When everyone is saving, the demand for credit declines. Reductions in the short-term interest rate do not therefore generate the hoped-for upwardly sloping yield curve. Banks struggle to make money. This was what happened in Japan.
How did the Japanese slip into their deleveraging malaise? A recent book by Richard Koo, one-time chief economist at Nomura—In the Holy Grail of Macroeconomics: Lessons from Japan's Great Recession—suggests that when asset prices tumble, highly leveraged borrowers reassess the way they finance themselves. After 1990, many heavily indebted Japanese firms were technically bankrupt. To restore their solvency, they started to repay what they owed. It became rational for companies to prioritise debt reduction over making profits. Ultimately, this caused a liquidity trap, in which the Bank of Japan became impotent. Interest rates fell to zero, without stimulating the economy.
Of course, the Japanese bust wouldn't have been so savage had the preceding boom not been so extreme. Japanese indebtedness grew at an extraordinary pace in the 1980s—a full 5 percentage points faster than GDP each year. This was considerably faster even than America's recent experience. During the easy money period that followed 2000, US debt only expanded 2.4 per cent faster than GDP. That said, the finishing points aren't so far apart. In 1990, the ratio of total Japanese debt to GDP stood at 250 per cent. Last year the comparable figure for the US was 221 per cent.
There is one other big difference between the US and Europe now and Japan then. Japanese companies went into the downturn highly leveraged. But now, companies are relatively free of debt. It is consumers that are up to their eyeballs in it.
Japan's balance-sheet recession was pretty unpleasant. While the private sector was absorbing the financial losses, the economy became highly dependent on exports and prone to recession. It was also an extremely boring time for capitalists after the go-go decade that preceded it, but it was a necessary adjustment to the system.
The US and Europe will have to go through a similar sort of adjustment. True, debt levels are not as high now, partly because American and British property returns were not as rocket-fuelled as they were in late-1980s Japan. But they are not that far off. Japanese property values peaked at 300 per cent of GDP in 1990. In the US they have topped out at 160 per cent (more worrying than it looks, given that America is land-rich rather than a crowded island). Britain's figure is a definitely worrying 260 per cent.
There are reasons to hope that we won't experience the sort of savage debt-aversion that Japan experienced. The west is more open, more flexible and its politics arguably less corrupt. Politicians and central bankers have the baleful example of Japan before them, and will strive to stave off asset price inflation spreading to the whole economy. But this worrying possibility can no longer be wholly discounted.
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