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Don’t Repeat Japan’s Mistakes

Friday, January 9, 2009

On financial market reform, Obama should adopt the successful Swedish model rather than the failed Japanese one.

Karl Marx famously observed that history repeats itself, first as tragedy and then as farce. It appears that U.S. policymakers are trying to prove Marx correct. Over the past 18 months, they have grossly mishandled the mortgage meltdown and subsequent financial crisis. Now they seem intent to repeat many of the mistakes that Japanese authorities made in mishandling their own financial crisis during the early 1990s. Those mistakes led to Japan’s “lost decade” of economic stagnation.

Heightening the element of farce in the present crisis is the fact that U.S. policymakers spent much of the 1990s lecturing their Japanese counterparts on the need for a clear strategy to quickly recognize bank losses and adequately recapitalize their banks. They also repeatedly warned the Japanese about the dangers of keeping insolvent, non-lending financial institutions and non-investing “zombie” companies on life support. Sadly, America’s advice to the Japanese fell on deaf ears until around 1998. The result for Japan was a decade characterized by dismal economic performance. Not only did overall Japanese output virtually stagnate, but Japan also suffered the ravages of sustained deflationary pressures.

Seemingly oblivious to the lessons of Japan’s lost decade, U.S. policymakers are repeating the very same mistakes that they warned Tokyo to avoid.

Now, seemingly oblivious to the lessons of Japan’s lost decade, U.S. policymakers are repeating the very same errors that they warned Tokyo to avoid. At the most basic level, 18 months into the worst financial meltdown since the Great Depression, U.S. policymakers have yet to offer a clear vision or well-articulated strategy for resolving the crisis. Instead, they have been extinguishing fires without rhyme or reason, first at Bear Stearns, then at Fannie Mae and Freddie Mac, then at AIG, and most recently at Citibank. Worse still, U.S. policymakers are repeating the Japanese mistake of infusing capital into insolvent institutions that are in no position to lend.

The clearest indication that they lack any coherent strategy is the twisted history of Treasury Secretary Henry Paulson’s $700 billion Troubled Asset Relief Program (TARP). Presented to Congress in September 2008 in the vaguest of terms in a three-page proposal, the TARP was sold to lawmakers as a desperately needed asset purchase plan designed to remove illiquid assets from banks’ balance sheets. Yet no sooner had Congress approved this proposal than it quickly morphed into a program aimed at infusing capital in an ad hoc manner, first into the banking system and then into AIG, the troubled insurance giant. Worse still, the TARP funds may now be used to bail out the automobile industry, which would move the program even further from its original objective of restoring financial market stability and also spur other struggling industries to demand their own share of the $700 billion.

Despite the hundreds of billions of dollars in liquidity injections by the Federal Reserve, and despite the disbursement of almost $300 billion in TARP funds, the U.S. financial system remains deeply dysfunctional. The banks are not lending, the securitization process has all but dried up, and the spreads that even the best-rated corporations are paying have widened to onerous levels.

One of the very first priorities of the incoming Obama administration should be a radical rethinking of the TARP in an effort to restore the U.S. financial system to a semblance of normality. In the absence of a properly functioning financial system that makes credit more readily available, efforts to revive the American economy through a fiscal stimulus package and unorthodox monetary policy measures will prove fruitless.

In rethinking the TARP, the Obama administration should review the successful Swedish financial relief program of the early 1990s, which swiftly restored the Swedish banking system to normality. In contrast to the Japanese approach, the Swedish program made the vital distinction between solvent and insolvent financial institutions. It also used a “good bank/ bad bank” approach to rehabilitate insolvent institutions so that they could quickly resume lending. Hopefully, if history has to repeat itself, the Obama administration will adopt the successful Swedish model rather than the failed Japanese one.

Desmond Lachman is a resident fellow at the American Enterprise Institute.


Image by Darren Wamboldt/Bergman Group.


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