Subprime: Is the United States Repeating Japan's Experience?

• Introduction
• Remarks

DEVIN STEWART: Welcome to the Carnegie New Leaders Program. I'm Devin Stewart of the Carnegie Council. Today we have Edward Lincoln from New York University Stern School of Business. We have bad loans, we have unemployment, we have layoffs, we have a housing bubble that has burst, we have a financial bubble that has burst. What I'm describing is Japan. You know, it sounds a lot like today. Actually, Ed Lincoln is quoted in an article a couple of days ago, in the Saturday New York Times Business Section, on this very topic, because I think The New York Times reads Policy Innovationsfor ideas.

Ed is going to give us a talk on looking at the Japanese experience: Are we repeating the same mistakes; what can we learn from the Japanese experience; and what can we expect? And then we will open up to discussion.

ED LINCOLN: The answer is no. Can we go straight to dessert? Devin, thank you for having me here. My background is on Japan and economics. I've been doing this professionally for 30 years, watching Japan and the United States and the interaction between the two of them. Is the United States repeating some of Japan's experience?—the basic answer is no. But to get there, let me start with a little bit of background on the Japanese situation. Now, I think probably you all are well aware of things that are going on in the United States over the last year, but the Japan experience is now somewhat in the past. Let me run through that very quickly. It begins in 1985. In early 1985, the yen was still rather weak against the dollar. In fact, in April of that year the yen was at 260 yen per dollar. As you may know, in September 1985, over Labor Day weekend, there was a meeting of the G7 finance ministers at the Plaza Hotel. They signed the Plaza Accord, which said, finally: "We all agree that the dollar is overvalued." Now, the dollar had already begun falling since that spring, but this reinforced the trend. It gave investors to believe that the U.S. government and the other finance ministries were going to alter monetary policy in a way consistent with a weaker dollar. Everybody was happy with that, including the Japanese government. The problem is the Japanese government had no clue as to how far the yen was going to go up against the dollar. They thought it was going to go from 260 to 200. It went from 260 to 130 in the space of 18 months. This was a huge negative shock for the Japanese economy. It made their exports less price-competitive in global markets—essentially doubling the price of their exports abroad—and made imports 50 percent cheaper. So the government steps in and says: "Oh my God, we've got to do something." Well, the obvious thing to do is to say: "Let's stop supporting the idea of a weaker dollar. We need to start supporting a weaker yen and cut interest rates." So they cut interest rates to what was then a postwar low. And the more important part is they accompanied the interest rate cuts with person-to-person advice to the leaders of Japan's major banks, saying: "Get out there and lend money. We need you to lend money to prop up the economy, to keep investment going in this economy." Well, it worked. They got five years, 1986 through 1991, of an average growth rate for the economy of 5 percent. This was the highest growth rate among any of the OECD [Organization for Economic Cooperation and Development] member countries. This was the period of time in which Americans looked at Japan and said: "What on earth is going on? Here we have an advanced, mature, industrial nation, and it is growing at 5 percent and we're growing at 3 percent. What's going on here? Is there something magical that they have created?" So you've got books being published in the United States about why Japan was better than the United States and all that. It looked good at the time, as these things often do, as the subprime market did in the United States. The dirty little underside of this was that although the growth rate, the economy, was high, they also had incredible inflation of real estate prices and the stock market. It was those asset values going up that helped to drive a fair amount of what was happening in the economy. Over the space of five years, from the beginning of 1985 to the end of 1989, the Nikkei average for the Japanese Stock Market tripled in value. And over a slightly longer period, to the end of 1990, the value of urban real estate in the six largest urban areas of Japan, which probably account for about 60-70 percent of the population, also tripled in value. As is the case with all financial bubbles, this one came to an end when the government finally decided that this had gotten out of control, that there was no way you could justify prices in these two markets being that high. So the Bank of Japan, number one, raised interest rates; and, number two, went back to the banks and said, "Will you please stop lending money to real estate?"—reversing their earlier administrative guidance. Well, that broke the bubble. It broke the bubble so strongly that today the Nikkei average is about where it was in 1986, 22 years ago. The real estate market declined back to where it was around 1985. It bottomed out a couple years ago and then turned up a little bit, but we're still talking about urban real estate prices at about 1985 levels. If you're not an economist, let me just say that taking a hit on asset values that big, that's a huge blow to the economy. This is akin to what happened to the United States in 1929 and we got the Great Depression. The Japanese should probably count themselves lucky that they got out with a decade of essential stagnation. From 1992 through 2002, the average annual growth rate in Japan was 0.9 percent. It went from being the most-rapidly-growing country in the OECD to being the slowest-growing country in the OECD, even slower than Switzerland, which has usually been at the bottom. And they experienced about three recessions over the course of the 1990s. So that's the background. Now, despite my smart-aleck remark at the start, saying "no, there are no similarities," let me talk to you about some similarities. I think there are a few. The first one is that we seem to have a case where almost any country where there is financial deregulation and/or innovation is often associated with mistakes and problems, at least in the initial phase. We deregulated S&Ls [Savings and Loans] in the early 1980s, allowed them to behave in much more risky fashion. They did, and they got into big trouble. We created a junk-bond market in the 1980s, an important innovation. We didn't really understand what we had created, and we got a huge crisis in the junk-bond market. Or, in Japan we had the government turning the big banks loose on the real estate market. That was an informal deregulation. Historically, in the postwar period in Japan, real estate finance had belonged to little banks—credit associations and little regional banks. The big banks in Japan had stuck to financing large corporate customers. That changed in the 1980s. The big banks, when they went to the Ministry of Finance, said: "You're telling us to go and lend more money. Who are we going to lend to? Our traditional buyers—Toyota, Matsushita—they're being beat up in export markets because of yen appreciation. They don't need more money right now. Who are we going to lend to?" The Ministry of Finance said, "Oh, go lend to real estate." So they did, and they did not know the real estate market. So in all of these cases you've got this innovation/deregulation and, fairly quickly, you tend to get mistakes being made. So that's a certain amount of similarity. Second, hubris. In both countries, we have had financial institutions that seem to think that they've got some new, brilliant insight into how the world works that nobody understood before and that they are so brilliant that they can do this without having any losses. In the case of Japan, you had this phenomenon of people saying, "Oh yeah, okay, real estate market. Sure, yeah, I understand that. It never goes down." In the 20th century, up until that point, there had been only two years in which there was a downturn in the real estate market in Japan: 1923 in the immediate aftermath of the Tokyo earthquake, and 1945 at the end of the war. Other than that, real estate prices had gone up. And so they said, "Oh yeah, we know this market. Sure bet. If the price rise is accelerating, let's get in right away, because that's how we're going to make lots of money." In the United States, I think you had an equal amount of hubris, guys who said: "I've got a Ph.D. in physics. I understand equations. I know how to run this stuff. I've discovered something new. Let me tell you how we can repackage all this stuff. And, somehow, it's all going to work and we're going to get high returns and no risk." The third similarity is greed. It's coming out of my previous point. Somehow, along the way in the psychology of these things, you seem to get people at financial institutions who ought to know better, to believe that they can generate annual returns of 20 percent or higher with no risk. Now, for those of you who are not economists, the normal presumption in economics is that there is an inverse relationship between financial return and risk. You can have low return/low risk—that's your savings account in the bank; it's guaranteed by the government up to a certain amount of savings deposit. Or you can have high return and high risk—that means that over a long period of time, say 20 years, you ought to anticipate that in fact you'll get a pretty high return, but along the way you are going to have years in which you are going to get hit with big losses. Well, what seems to happen in these kinds of financial bubbles is that people who probably learned this stuff when they were going through business school or Ph.D. programs in economics, seemed to think: "I've invented something new. I can get 20 percent returns and there is no risk." That is always a mistake. The Japanese certainly believed it in the real estate market. "It went up 30 percent last year? Oh, hey, I'd better get in because it's going to go up 30 percent again this year and next year and next year." The idea that it is going to come to an end seems to drift off into Never-Never Land. A final thing that seems to be a similarity between the two countries is a bad underestimation of the implications of the problem when it finally gets revealed. I remember going and having conversations with officials at the Ministry of Finance in Japan in 1992 and 1993 and asking them: "So what's going on? Are you worried? The stock market seems to be down. The real estate market has turned down." They said: "Not to worry. Yeah, there was a little bubble in the stock market and real estate market, but, you know, that was being fueled by a handful of extremely unethical investors in Japan. Now we've got them. We've raised interest rates. The market has gone down. We're going to get rid of those bad guys. No impact on the real economy. Financial sector, real sector, you know, not that closely connected. This was all a game to begin with. So don't worry. A little slowdown in growth this year and then, man, we're off again." That was 1992, when the growth rate was maybe 1.5 percent. In 1993 it was zero. It bumped between minus-0.5 percent and plus-1.0 percent over the next eight or nine years. So they were badly wrong. In the United States, if you remember what was being said as recently as last summer when the subprime problems were being revealed, a lot of people were saying: "Oh well, that can't be much of a problem. Subprime market? It couldn't be all that big. The losses can't be all that bad. We don't think there's going to be that big a spillover into the rest of the economy." And what did we get? At least temporarily, in the fall, we had other parts of the financial sector seizing up, because the financial sector depends upon trust, that you are engaging in a financial transaction with a counter-party who is not going to go out of business tomorrow. As we realized that we don't know how big this problem is, we don't know how deeply involved particular financial institutions are, a lot of the short-term lending between financial institutions began to dry up, because that trust in the other party temporarily evaporated. So we had a temporary credit crunch in the fall. When you have a credit crunch, that is going to have a pretty immediate impact on the real economy. You know, if General Motors or Ford or Toyota can't borrow money in American credit markets easily, then they can't do the things that they were going to do with that money. That particular problem we've gotten through. But now we seem to be having a much broader fallout on the real estate market. In fact, you probably could argue that the trigger for the subprime market actually was an overdue downturn, overdue correction, in overall real estate prices. We, too, like the Japanese, had a bubble in the real estate market. The air starts going out of that. That begins to pull in the subprime loans that are going to be the first ones to turn bad. And we did not realize how big the downturn in the real estate market would be. And, particularly in the United States, probably more so than in Japan, a downturn in the real estate market has a broad real impact, because if people aren't buying new houses, they're not buying furniture, lawn mowers, and other stuff to put into those houses. So you get an impact on consumer spending as well. So in both countries there was this process that when the bad news finally comes, initially nobody really seems to realize how serious it is going to be. Okay. So those are similarities. But I think the differences are more important. Let me start with disclosure. In Japan, the full scope of the problems at the Japanese banks, which had been lending money for both real estate and stock market speculation—the full scope of the banks' problems was not disclosed until the end of the 1990s. So we are talking about eight-to-nine years of drifting along, in which both the government and the banks continued to say, "Oh, don't worry, the problem's not really big." By 1996-1997, a lot of people realized they were lying, but you don't know what the truth is. So it's not until we get to, maybe, 2000-2001 that the government began to issue figures on bad debts in the banks that outside analysts were beginning to believe were reasonably correct. How could this happen? Because the Japanese happened to have a particularly weak set of rules and regulations and very weak inspection of banks. Just to give you an example, a good friend of mine from grad school, who was from the Japanese Ministry of Finance, got in trouble in the late 1990s when the press revealed that—he was in charge of bank inspections for a couple of years, and they had an example of a bank that his department had gone to inspect. His subordinates were checking through all the numbers and found that he was being fed expensive dinners by the owners of the bank. That's not a wise idea. He is no longer with the Ministry of Finance. Actually, he is with the European Development Bank. He is actually, in my estimation, a very honorable person, and of all the people not to be swayed by having dinner with people in Japan he is probably at the top of my list. But the fact that he did it got him in trouble. Or my other favorite example was a case around 1990 or so. There was a Japanese currency trader with Daiwa Bank and he lost $10 billion. He managed to hide his losses. For quite a while, he was hiding his losses from his own bosses who, he said in a magazine article afterwards, were so dumb and knew so little about currency markets—these are bankers—that it was really easy to dupe them. But then he revealed that and they decided that they were going to try to hide this from both the U.S. government and the Japanese government. The Ministry of Finance had actually come over to do an inspection. Now, exactly what their jurisdiction was I'm not quite sure. But since it was a local branch of a Japanese institution, they came to New York and did an inspection of Daiwa's offices. Again, this guy says that what they did was they took his little currency-trading operation, put a bunch of empty boxes in it, and closed the door and turned the lights off, and told them, "Well, that's just a storage room." And the more important part was the inspectors were there for a grand total of 20 minutes and then spent the next four days in Las Vegas, at Daiwa expense, gambling. So some weaknesses in the inspection process. Contrast this to the United States. Now, granted, we are an imperfect country, we do not always behave ethically ourselves, and yet the rules for the financial sector are relatively tight. This means that financial institutions in the United States are required to reveal bad news relatively quickly. So think about the subprime problem. We're talking about an issue that really began developing, say, a year ago. By last summer, you began to get financial institutions beginning to report that they had losses. We are still in the process, but we're only seven to eight months after that now. My guess is that by the middle of this year we'll have had a pretty complete, honest revelation of all the bad news that there is to be revealed in this process. Now, I should say as a caveat in both countries—again, maybe sort of a similarity—there is an issue of what is the bad news. What happens when you have an asset that has declined in value? How do you re-price it? How do you know what the current real market value is until you've actually tried to sell it? So it's still sitting there on your books. You have not tried to sell it. You don't really know what the market value of that asset is. So there's a little bit of ambiguity here. But still, I would argue that under U.S. rules and regulations we'll pretty much know what this problem is within a few more months. So, altogether, we're talking about a year, a year and a half, where in Japan we were talking about eight or nine years before people really had a grip on what the bad numbers were. The second difference is macroeconomic policy response. Basically, the Japanese government made a series of real blunders in macroeconomic policy throughout this whole period. First of all, you can argue it was their fault that this situation developed in the first place, that cutting interest rates and providing administrative guidance to the banks in the mid-1990s was excessive. They were too slow to recognize what they had done. When they finally recognized it, they raised interest rates too far and they kept interest rates high too long. They brought them down slowly after about 1993; didn't get them down to a really low level until 1997-1998. So they did not recognize the need to take decisive, quick monetary policy action to deal with this issue as it was developing. Similarly, on the fiscal policy side they did some of the right things, although a lot of it was sort of automatic things. When the economy slows down, tax revenues go down; expenditures like unemployment go up. There are automatic stabilizers. If you had Economics 1.01, a fair amount of it was that. But they did cut some taxes. But then they raised taxes in 1997, before the recovery was really getting going, and by raising taxes pushed the economy back into recession. Then, in 2000 the Bank of Japan, in another blunder, decided to raise interest rates at a totally inappropriate time. So there just is a series of mistakes that, frankly, had macroeconomists and central bankers in the United States and Europe shaking their heads and saying: "What is going on? How could they do this? They're supposed to be smart people"—and, in fact, they are smart people. But maybe it's a lesson in how easy it is to get it wrong. In the United States, so far we seem to have had the right response. Perhaps, because we are dealing in different periods of time and the Fed is well aware of what happened to Japan in the 1990s—particularly Ben Bernanke, who actually wrote an academic article about similarities and differences between Japan and the United States, and this was actually the S&L crisis versus Japan's banking crisis in the 1990s. He is well aware of what had happened in Japan. So we are getting rather quick and decisive cuts in interest rates in the United States, which is the right thing to do. That ought to soften the downturn in our economy. So it is unlikely that we are facing a decade of stagnation, like Japan. The next difference is prices, related to the previous point. The Japanese made so many mistakes in monetary and fiscal policy in the 1990s that they ended up having their economy slip into deflation. Deflation means the overall price level, like the Consumer Price Index or the GDP price deflator, is going down. If any of you have been to Japan—some of you I know have been to Japan, or come from Japan—you say: "So what's the problem? In the mid-1990s, prices in Japan seemed bizarrely high. So if prices are coming down in Japan, how could that be a bad thing?" Well, first of all, prices in Japan seemed high for two reasons:

• One, the exchange rate. The Japanese yen was overvalued. So if you look at Japanese prices as a foreigner going to Japan and think about the dollar equivalent of that, a fair amount of it was simply that the exchange rates were out of alignment.

• The second thing is that we tend when we go to a country and see prices are high, we're thinking in microeconomic terms, we're thinking of particular products, right? Everybody knows that musk melons in Japan are ridiculously priced—$50-$100 to buy a perfect melon in the supermarket. Well, that doesn't mean that overall prices in Japan are high. It just means that in particular markets there is bizarre pricing. So changing relative prices, getting down prices of things that seem strangely high, is a very different thing than saying all prices in the economy are coming down.

Economists don't like deflation. They don't like it because all modern economies live on debt. If you own a house, you realize that debt is much easier to repay if you have modest inflation. Modest inflation means that over time all prices are going up, including your income. But the one thing that is not going up in value is your mortgage. It's a fixed amount of money. You borrow $300,000 from the bank and, even if you've got inflation, that's not going up. It's still $300,000, or what's left after you've paid some of it back. And so it's easier and easier and easier for you to repay, to meet your monthly mortgage payments, as time goes by. So that if you get to be old enough as me, you reach the point where you can chuckle and laugh at all the young people. Your mortgage—in fact, my mortgage got paid off two months ago. By the time you pay it off, it looks ridiculously cheap. So that encourages the whole process of debt formation in the economy. In reverse, if you have deflation, that means year by year it gets harder to pay back the money, because your income is going down—or, if it's a corporation, the price of your output is going down—and it gets harder and harder to meet the payments to the bank. So, in general, we don't like deflation. We don't like high inflation either, but moderate inflation of, say, 1 or 2 percent a year, economists love that. Japan allowed its economy to slip into deflation. Once you are in that situation, it turns out it can be difficult to get out. How difficult it is to get out, I think we have learned a lot from the Japanese experience. It has been hard for them. They may be getting out of it this year, after roughly a dozen-to-fifteen years of modest deflation. It's hard to get out partly because monetary policy doesn't work well anymore. Normally we think about raising and lowering interest rates. So let's say you've lowered interest rates to zero, but you've got deflation, and deflation is getting worse, so you've got like 2 percent deflation. That means that real interest rates in your economy are 2 percent. And there's nothing you can do about it. You can't get real interest rates down any lower because you hit the zero bound on nominal interest rates. So we don't like it. And they got stuck with it. I don't think that is likely to happen in the United States, again perhaps because the Fed has learned from observing what happened in Japan and recognizes that it is real important to squash downturns quickly before you get close to deflation. That's what the Fed did in 2001-2002, when we had a recession. They got interest rates down real quick, because we had prices drifting down towards zero inflation in this country. The Fed, I think, was a little concerned about that. At the present time, again, we have cut interest rates very quickly. It should bolster the economy. And frankly, this time around we've got enough upward price pressure that I don't think deflation is really an issue for this economy. In fact, if anything, there is a potential issue of something called stagflation, that we had back in the 1970s, where you've got the economy slowing down but you've still got inflation higher than you want, in both cases driven by commodity prices, the price of oil going up. The next difference is the scale of the problem. In Japan, I told you the stock market had tripled in value in five years and then lost all of those gains so it went back down again. We're talking about a drop in the stock market of 70 percent from its peak at the end of 1989. In the United States, we've had the Dow Jones Industrial Average double in 10 years. Substantial, but it's not like tripling in five years. And on the down-side—of course, none of us know exactly what the future brings, but my guess is we're talking about maybe a correction of 20 percent, not 70 percent. In the real estate market in Japan, we also had a tripling of urban real estate prices in the space of six years and a drop of 70 percent over the next decade. In the United States, in contrast, according to one price index for urban real estate, we've had a price increase of 80 percent in five years. That's less than a doubling. And on the down-side, I'd be surprised if we've had an overall correction of more than 20-25 percent. And I don't think it is going to last very long. We've had occasional downturns—maybe not nationwide, but certainly in particular markets like New York. It tends to shake out in a couple of years and then turns back up. On the real estate side, part of the difference may be simply in both economic growth and in population growth. In terms of economic growth, we're growing at 3.0-3.5 percent a year, on average, over long periods of time. Japan is now down to probably 1.0-2.0 percent a year. As you grow, you have more demand for office buildings and things like that. That demand growth is stronger in the United States, and should be stronger over the next decade in the United States, than in Japan. And similarly with population. We still have a growing population. Japan does not. Japan now has a shrinking population. It is shrinking particularly rapidly at the younger end of the demographic chain, and that means that we are going to see fewer and fewer and fewer new households looking for a place to live. So the longer-term prospects are, I think, for a fairly quick recovery in real estate prices—or at least a turn back up, if not a total recovery—in the United States. There is also a big disparity in terms of the scale of the problem on the financial losses. In Japan, the face value of non-performing loans at Japanese banks was in excess of a trillion dollars. That is in an economy of $5 trillion. So we are talking about bad loans of roughly 20 percent of GDP. Now, we say a "bad" loan. We're talking about, say, a mortgage where the borrower is not repaying the loan, and this is the face value. How much was the mortgage? The real cost in the economy, of course, is what can be recovered from that. Obviously, the value of the mortgage has not gone to zero. The property is still worth something. You don't know that until you have forced the borrower into foreclosure, seized the property, and resold it. The real cost in Japan was probably on the order of $500 billion. That's still 10 percent of GDP in Japan. Again, that's a pretty big asset loss for the economy to absorb. And this is just real estate; we're not talking about the stock market here. In the United States, my colleague at the Stern School, Nouriel Roubini, who is a perennial pessimist on economic issues, has suggested that the losses in the United States in the current subprime/financial sector problems could be a trillion dollars. But that's in a $13 trillion economy, so we're talking 8 percent loss. And again, this is the face value, not the final real cost, which is probably about half of that. So we're talking maybe, in a worst-case scenario, losses equivalent to 4-5 percent of GDP. That's half of the real value of the losses relative to the size of the economy in Japan. So there is really no comparison in the scale of the problem here. Yes, the U.S. economy is going to be hurt by this. Sure, we're probably going to have a recession this year. My guess is that it's going to be a pretty mild recession. We'll be out of it relatively quickly. We'll be getting to work cleaning up the aftermath of the mess in the subprime market over the duration of this year. Personally, I think the U.S. situation is shameful, messy. It does reflect hubris, greed, arrogance—all those bad things that some people associate with Wall Street, that everybody thought were really great until the market turned bad. And there are some similarities with Japan. But the bottom line is I think we will be out of this problem far, far faster than Japan was and that the cost of the losses in the economy will be much smaller than they have been in Japan. American capitalism certainly has lots of problems, lots of things you can criticize if you want, but on the plus side there is a lot of flexibility and an ability to correct mistakes pretty quickly. We are no better than the Japanese or anybody else at getting ourselves into trouble because either of hubris, greed, or simply misunderstanding things, or making even honest mistakes. But it seems to me that one of the positive features of the American system is that when bad things do happen you can correct them relatively quickly. On that positive note, I will come to a conclusion. DEVIN STEWART: Thank you very much.