The 1988 Basle Accord - destroyer of Japan's finance system

Peter Myers. Date: just prior to September 6, 2001; update September 9, 2008.

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Prior to the Basle Accord of 1988, Japan had about 9 of the world's 10 biggest banks. But, I recall, Japan's banks had a Capital Adequacy Ratio of 6%; a central banker told me they had been about 3%. The British and Americans told the Japanese that if they wanted to continue to do business in the West, they would have to agree to an 'international standard' of Capital Adequacy.

(1) David Grover on the Basle Capital Adequacy accord (2) Geoffrey Gardiner on how the Basle Accord of 1988 affected Japan's banks (3) In 1990, nine of the top ten banks were Japanese (4) Richard A. Werner on Japan's buying spree (of foreign assets) in the 1980s-90s (5) Western bankers imposed Basle Accord as a protective measure, causing Japan's crash (6) Japan's Lessons for Tackling the Subprime Dilemma

(1) David Grover on the Basle Capital Adequacy accord

If Japan's financial power peaked in the late 1980s, why was its negotiating position in the Basle Capital Adequacy accord so weak? by David Grover

{originally at, but this link is now dead}

In answering a question such as this, framing the issue is of utmost importance. First, it is necessary to define the significance of the 1988 Basle Capital Adequacy accord for its participants. What made the accord so special? Second, it is essential to provide a synopsis of the major events leading to the signing of the accord. In particular, who was behind creating a multilateral agreement on an international standard for international bank capital reserves, what were their motives, and what were the bargaining positions of the major parties involved? Third, when several aspects of the source and scope of Japan's financial power in the late 1980s are examined in greater depth, it will become apparent that its ability wield financial influence over the United States was actually quite limited. The U.S. still had the structural power to "set the menu" of international banking. Fourth, it is necessary to evaluate the effect that inflated Japanese equity prices had on the Japanese bargaining stance. The high valuation of the equity market made it easier for Japan's banks to adhere to the more stringent capital standards required by the Basle Accord. Finally, from a realist perspective emphasizing relational power, not only was Japan 'weaker', but, in this instance, a unique set of events made the U.S. 'stronger'.

When signed on July 15, 1988, central bankers from the G-10 countries announced that they had reached an agreement that would result in "international convergence of supervisory regulations governing the capital adequacy of international banks" (Kapstein 105). Named for the meeting location of the Bank of International Settlements (BIS), the Basle Accord called for banks to retain capital equal to 8 percent or more of their "risk-weighted" assets (i.e. loans). A bank's capital reserves are used to protect it from 'credit risk': the risk that an institution owing them money will go bust (Economist). The more capital available to absorb losses, the greater the protection for the bank's assets. For banks below the 8 percent level, they would have to raise equity (capital) and/or shed assets (Kapstein 124). "The accord obliged many countries to strengthen regulation and to close their weakest banks. Partly because of that, most big banks are much better capitalized today than they were in 1988" (Economist). In general, U.S. banks were better capitalized (as the U.S. defined it) than Japanese banks, requiring that the Japanese bear the burden of the adjustment.

Observers of the negotiations have hailed the accord for two prominent reasons. First, central bankers entered the multilateral negotiations with conflicting definitions of what actually constituted bank capital, and how much capital banks should be required to hold. Second, national differences in capital adequacy requirements were being exploited by banks as a source of competitive advantage in the financial marketplace (Kapstein 105). For the U.S., one objective of the accord would be to level the competitive playing field in the interest in the competitiveness of U.S. banks. However, In 1990, the secretary of the Basle committee, Peter Hayward, claimed that the Basle Accord was "created not to ensure fair play, but to ensure the safety and soundness of national banking systems and to protect the interests of depositors" (Kapstein 114). Thus, a rather unconvincing attempt to cloak mercantilist motives in the form of an international public good was apparent.

For all the talk of level playing fields, the Basle Accord had protectionist, rather than prudential motives. Further pressure to pass the Basle Accord, for example, came from American and British bankers who claimed 'under-capitalized' Japanese banks were pinching their business unfairly. The underlying cause of the distortion was that Japanese banks are coddled by a plethora of regulations. In fact, not one has been allowed to fail since the Second World War (Economist). Most of the G-10 central bank governors were less than enthusiastic about entering discussions on convergence of capital standards when the issue was first raised by Federal Reserve Board chairman Paul Volcker in 1984. The demand for regulatory convergence grew out of domestic politics in the United States, as public officials fashioned a response to the international debt crisis that took into account the views of both regulators and bankers. Members of Congress did not wish to be seen as bailing out the banks, but neither were they prepared to weaken banks vis-à-vis their international competitors. The solution to their dilemma was to promote international convergence in banking regulations, particularly in the area of capital adequacy.

The problem facing the U.S. was to devise a strategy for placing the issue high on other states' agendas. A bilateral agreement on capital standards with Britain served this purpose nicely, as Britain shared many of the same concerns about its international bank competitiveness. Now, Japan and other countries were facing the possibility of a "zone of exclusion" disadvantageous to their international banks. Japan was now facing a unified Britain and U.S., and they were forced to come to the negotiating table. Much like a shotgun wedding, they really had no choice. This was hardly the beginning of benign multilateral coordination ­ it was pure international power politics, and the story of the Basle accord thus illustrates the enduring strength of the U.S. in shaping and advancing policies in international economic relations.

However, Japan's financial power in the late 1980s cannot simply be dismissed. Most strikingly, by 1985, it had emerged as the world's largest creditor. Helleiner cites this feature as characteristic of previous financial hegemons. However, it is increasingly recognized that Japan's creditor status has not in fact brought an enormous increase in power to the Japanese State. The biggest limitation on translating this creditor status into power is that the majority of funds have been lent to a country ­ the United States ­ on which Japan is heavily dependent, both militarily and economically (Helleiner 422-3). Thus, the normal creditor/ debtor relationship did not apply ­ the Japanese were unable to transfer their creditor status into power at the negotiating table.

Furthermore, the underdeveloped and overregulated nature of Japanese financial markets had (and still does today) inhibited Japan's exercise of financial power by preventing the yen from becoming a global currency ­ another characteristic of financial power cited by Helleiner. The weak position of the yen within the international monetary and financial system had severely inhibited Japan's financial power. Not only does the U.S. continue to derive seigniorage benefits from being in the position of issuing the world's currency, but it also benefited greatly in the 1980s from being able to borrow from Japan in its own currency ­ a situation quite without precedent between the world's largest debtor and creditor. Moreover, because Japanese financial institutions remained highly dependent on dollar borrowings to finance Japanese trade and investments, they remained vulnerable to developments in American financial markets (Helleiner 429-30).

Lester Thurow's characterization of Japan as a 'producer economy' is applicable here (Thurow 119-20). In a producer economy, the goal is market-share maximization (as opposed to Anglo-American profit maximization), and this goal is largely achieved through an emphasis on exports. As an export-oriented economy, Japan's economic welfare was vitally dependent on a continual flow of goods, financed with dollars, to the United States. Although Japan has succeed somewhat in diversifying its exports (especially to Southeast Asia), the dollar still occupies the high ground. Thus, Japan always runs the long-term risk of stirring up protectionist sentiment in the U.S. if it is seen as uncooperative. In sum, although Japan has acquired considerable financial influence, it has clearly not assumed the kind of hegemonic position in global finance held by the Netherlands, Britain, and the U.S. at the height of their power (Helleiner 429-30).

Yet, despite Japan's lack of influence, the U.S.-U.K. agreement was not simply forced upon the other G-10 countries. It was obviously in the interest of the Bank of England and the Federal Reserve to shape a standard that every G-10 member could agree upon and, just as important, live up to by domestic enforcement. For the Japanese, the major concern was accounting for the hidden reserves held by banks, including real estate and corporate equities (Kapstein 115). At the time, Japan thought it had won a major concession by shaping the regulation that reserves would be based partly on the market value of equity assets, rather than entirely on their historical value. For the Japanese, the agreement was not difficult to accept at the time. The Tokyo stock exchange was booming in late 1987, making an increase in bank capital relatively painless, especially in light of the provision regarding valuation of hidden reserves in the form of Tier Two capital (Kapstein 116). Only later, after the meltdown of the Tokyo stock market crash in 1990 did the new capital adequacy requirements begin to bind. By then, an international banking regime, largely shaped by U.S. domestic interests, and with formal principles, norms, rules, and decision-making procedures, was in place. Once again, U.S. structural power ruled the day.

Not only was Japan's weak financial position due to American structural power, but in the case of Basle, it was due to good old fashioned American relational power as well. The Fed provided the 'autonomous, cohesive, state-like bureaucratic apparatus' needed to exert this type of power. In true realist fashion, Cerny emphasizes that unless there is a 'cumulative and simultaneous mobilization of different states' perceptions of their national interests,' in an essentially additive process, rather than a hierarchically organized one, even well-established transnational regimes are likely not only to lack authority but also to be rudderless and fragile in practice (175). Remarkably, this statement characterizes the Basle negotiations, and Japan's weak financial position was compounded by conditions that enabled the U.S. to turn up the heat.

Cerny identifies the four conditions that were in place that allowed the Basle negotiators, influenced by U.S. leadership, to take the necessary concrete multilateral regulatory steps. First, an effective international coalition must be formed, in such a way that no major state can impose a blocking veto. The 1997 U.S./Britain bilateral agreement on capital adequacy satisfied this condition. Second, the subject matter of the agreement must be fairly limited in scope. Compared to degree of negotiation required for the Bretton Woods regime, the Basle Accord was child's play. Third, state actors charged with undertaking (a) the negotiation and (b) the implementation of such a regulatory agreement need to have the legal and political autonomy and discretion to carry out these tasks without having to engage in turf battles or competitive politicking at a party or interest group level. This requirement was met by the Federal Reserve, through the deference of the American bureaucrats and politicians, taking the leading role in the negotiations. Fourth, the form of regulation agreed upon must be effectively enforceable: that is, it must not be overly vulnerable to being undermined by normal market activities or by the standard avoidance tactics which the private sector will inevitably apply (Cerny 174-7). The Basle Committee, despite lacking a stringent enforcement mechanism, is responsible for the standard's enforcement. However, the marketplace is assisting the committee a great deal in upholding the accord. Banks have found a distinct advantage in being able to satisfy the rating agencies and the market that their capital was adequate in terms of the final Basle standard (Kapstein 126). According to Cerny, the remarkable aspect of the Basle Accord is that an apparently workable intergovernmental agreement was reached on a significant aspect of prudential regulation, and that it is actually being implemented (176).

The nature of the limited goal of the accord, combined with limited Japanese financial power in the face of U.S. structural and relational power, provided the cohesion needed for multilateral 'coordination'. The use of state power by the U.S. (and Great Britain) to reach an international agreement does not imply that the objectives of the accord were illegitimate; in fact, all central bankers now agree that the standards adopted at Basle provide a useful starting point for assessing the ability of international banks to withstand loan losses. Furthermore, having reached a capital adequacy standard, bank supervisors are currently pursuing other areas for cooperation. The story of the Basle Accord may therefore shed light not just on financial regulation, but more broadly on the politics of rule creation in the international economy (Kapstein 106).

The Basle Accord provides just one example of how governments can use international cooperation as a re-regulatory counterweight to the pressures of competitive reform (Holt Dwyer 215). The accord represents the most significant step taken to date by bank supervisors in advancing policy convergence and creating an international banking regime. With the accord, central bankers had demonstrated their ability to structure agreements that met the demands of safety and soundness, as well as international competitiveness (Kapstein 119).

While there is legitimate room for debate over the means employed to advance the Basle Accord (basically, threats of market closure by the U.S. and Great Britain), there is little argument over the importance of the end ­ namely, the creation of a supervisory framework for global banking. A smoothly running international payments system has something of the quality of a public good, and each country which enjoys its use also has a responsibility to contribute to its maintenance Kapstein 126). However, without the exercise of American power, a capital adequacy accord might not have been reached. The gap between talk and action was bridged only when the U.S. provided the planks. This suggests that a leadership by a great power will be vitally important if international policy coordination is to occur (Kapstein 128).

WORKS CITED/CONSULTED "Banking Regulation: A Brush with Basle." Economist 16 Sep. 1995. Calder, Kent E. "Assault on the Bankers' Kingdom: Politics, Markets, and the Liberalization of Japanese Industrial Finance." Capital Ungoverned: Liberalizing Finance in Interventionist States. Ed. M. Loriaux. 1995. 17-56. Cerny, Philip G. "American Decline and the Emergence of Embedded Financial Orthodoxy." Finance and World Politics. 1993. 155-85. Kapstein, Ethan B. Governing the Global Economy. Cambridge: Harvard University, 1994. 103-28. Helleiner, Eric. "Japan and the Changing Global Financial Order." International Journal XLVII (Spring 92): 420-44. Henning, C.R. Currencies and Politics in the United States, Germany, and Japan. 1994. 121-75. Holt Dwyer, Jennifer. "The Dynamics of Financial Reform in Japan, 1975-95." The New World Order in International Finance. Ed. G. Underhill. 1997. 195-221. "Hooked on Financial Red Tape: Financial Regulation." Economist 22 July 1995. Inoguchi, Takashi. "Japan: Reassessing the Relationship Between Power and Wealth." Explaining International Relations Since 1945. Ed. N. Woods. 1996. 241-58. Leyshon, Andrew. "Under Pressure: Finance, Geo-economic Competition and the Rise and Fall of Japan's Postwar Growth Economy." Money, Power and Space. Ed. S. Corbridge. 1994. 116-45. "The Real Risk in Banking." Economist 28 Feb. 1998. Rosenbluth, Frances McCall. "Financial Deregulation and Interest Intermediation." Political Dynamics in Contemporary Japan. Eds. G.P. Allinson and Y. Sone. 1993. 107-29. Thurow, Lester. Head to Head. London: Nicholas Brealey, 1992. 113-51. Turner, Louis, and Michael Hodges. Global Shakeout. London: Century Business, 1992. 75-99. Article posted October 14, 1999.

(2) Geoffrey Gardiner on how the Basle Accord of 1988 affected Japan's banks

Subject: Re: capital adequacy ratio Date: Wed, 17 Apr 2002 10:34:07 +0100 From: Geoffrey Gardiner <>

020417 Gardiner to Myers

... The Basel Accord of 1988 was an agreement by the twelve countries who comprise the Bank for International Settlements (BIS) at Basel that the minumum capital adequacy ratio should be 8 per cent of weighted loans, of which not less than 4 per cent should be provided by shareholders funds. Shareholders' funds are referred to as tier one capital and subordinated loans as tier two.

The weightings are a means of recognising that some loans are safer than others. For instance mortgages on houses can be weighted 50 per cent, which means that house loans need to be backed by only a 4 per cent capital adequacy ratio. Some loans to governments may be given a rating between nil and 10 per cent.

Full details of the Accord are on the website of BIS - Individual governments are given some discretion with regard to the setting of weightings. How individual central banks implement the agreement is usually secret.

At the time the agreement was made the Japanese banks were grossly under capitalised. Because their capital bases had been less than others they were able to lend at a lower rate of interest for as their shareholders funds were smaller they needed less profit to achieve the same earnings per share as a better captialised bank. (See Prof David Llewellyn in Jan 1992 edition of "Bankers' World.") They had cornered the market in good industrial lending as a result.

The agreement was fully implemented in Jan 1993. The Japanese banks had been faced with the choice of raising more capital or of cutting back on lending. Not being particularly profitable at the time, a requirement for a successful capital issue, I believe they chose the latter course, cutting back on overseas lending first, and then at home. Of course the cut back produced a recession, helped along by the fact that British banks, led by Barclays, had expanded their capitall bases to increase their business and had made many bad lendings. In 1988 Barclays raised £920 million of new capital. It lost the lot according to a handwritten letter I have from the later Chief Executive who put things right..

When the Japanese banks cut back lending in Japan, it was lending on real estate which was hit particularly badly. Property prices fell, eventually by 60 per cent, and many loans went bad as the security for them faded away. The Japanese bankers had tried to be clever. They had invested their shareholders' funds not in loans but in the common shares of the companies to which they were lending, on the basis that if the companies used the loans wisely, the bank's shareholders would benefit. When lending was reduced, the shares they held went down, and that automatically cut the lending capacity of the banks. A downward spiral followed, ending with the total bankruptcy of the banks. They were kept in business by huge support from the government. In effect the banking system was nationalised, but it was not called that, probably in order to avoid irritating American sentiment.


(3) In 1990, nine of the top ten banks were Japanese

Why Indian banks don't figure

Janmejaya Sinha

January 08, 2008

Chief executives of financial institutions with high market capitalisations sit on an uneasy perch. The market is very irreverent of their past achievements. If you were to review the worldÕs top ten banks by market capitalisation in 1990, 1998 and 2007, you will find this in spates. Every seven to eight years, the pecking order changes almost completely. Who would remember that back in 1990 there were no US banks in the top ten? Nine of the top ten banks in 1990 were Japanese. By 1998, the Japanese banks disappeared, and eight of the top ten banks by market capitalisation were US banks. But the league tables have changed again, and dramatically at that. In 2007, there is an even representation of European, US and Chinese banks. There are three US banks (BankAm, Citibank and Chase), three European banks (HSBC, UBS and Royal Bank of Scotland), three Chinese banks (ICBC, Bank of China and China Construction Bank) and one Japanese bank which has reappeared (Mitsubishi Financial Group). The largest one is ICBC from China.

(4) Richard A. Werner on Japan's buying spree (of foreign assets) in the 1980s-90s

Werner is Professor and Chair of International Banking at the University of Southampton. Previously he was Assistant Professor of Economics at Sophia University in Tokyo. He spent over a decade working in Asia, including at the Bank of Japan, the Japanese Ministry of Finance, Jardine Fleming Securities (Asia) Ltd, the Asian Development Bank and as asset allocator of a major pension fund.

Richard A. Werner, Princes of the Yen (M. E. Sharpe, Armonk, New York, 2003)

{p. 83} From the mid-1980s until the end of the decade, Japanese foreign investment all but dominated international capital flows. ... Outbidding or swallowing rivals, Japanese money bought financial and real assets all over the world. ...

{p. 84} Despite the staggering sums, the actual extent of Japanese foreign acquisitions in the 1980s is still understated by the official figures. The true figures will probably never be known. The gap between data and reality did not open accidentally. Faced with criticism of both the trade surpluses and the large foreign acquisitions, the International Finance Bureau of the Ministry of Finance concocted a clever way of reducing both figures. The trick was to count capital outflows as imports of goods. ...

{p. 85} None of these capital outflows was listed in the capital account. Instead, they lowered the trade surplus by that much.

{p. 86} In the 1980s ... Long-term capital outflows preceded the current account surplus in timing and by far exceeded it in size. Japan was purchasing far more assets abroad than it could afford due to its exports. ...

Reversal of the Tide

Economic models of Japanese foreign investment focused on the period of rapidly rising foreign investment. They failed to explain them and were even more helpless in explaining the events of the 1990s. In 1991, as the Japanese current account was heading for new record surpluses, topping $90 billion, net long-term capital outflows had suddenly vanished. Japan recorded $40 billion worth of net inflows of long-term capital, the first in more than a decade. Japanese investors became net sellers of foreign securities in record figures.26 Japan remained a net seller of foreign assets throughout 1991. From manufacturers to banks and real estate firms, Japanese money was suddenly retreating on all fronts.27

{p. 89} Between January 1985 and December 1989, stocks rose 240 percent and land prices 245 percent. ... By that time, real estate prices had reached unprecedented levels. Using market values, one could calculate that the value of the garden surrounding the Imperial Palace in central Tokyo was worth as much as all the land of the entire state of California. Although Japan is only 1/26th of the size of the United States, its land was valued four times as high. The market value of a single one of Tokyo's twenty-three districts, the central Chiyoda ward, exceeded the value of the whole of Canada.

Such figures should have told us that something was wrong. But economists are trained to believe in "market outcomes." So they tried to justify the extraordinarily high land prices. ...

{p. 90} The answer to the puzzle could be found by asking one of those involved in the land-buying binge of the late 1980s. One would have soon found that they did not acquire land to earn money from renting out office space. Their main aim was to make a quick buck by selling the land soon after. To them, land was simply an asset - one that was about to appreciate further.

The same forces seemed to be propelling stock prices to dizzying levels. ...

{p. 92} It should have worried observers that economists failed to explain any of the unusual developments of the 1980s in Japan. Economists were puzzled to find that they could not even explain Japanese GDP growth. Until then, economists had believed they had a good grip on what determines GDP growth. Although there are many theories in modern macroeconomics about the economy (classical/neoclassical, Keynesian, monetarist, and fiscalist, to name the most important ones), they are all based on the fundamental relationship between money and the economy. They all assume that the money supply is proportional to nominal GDP. Economist Milton Friedman even called this relationship the most stable in economics with its reliability approaching that of a law of the physical sciences. 10

That science was in trouble. In the Japan of the 1980s, the links between the so-called money supply measures, such as M1 or M2, and economic activity had broken down. GDP and money supply did not grow in line with each other. Money supply growth exceeded GDP growth.

{p. 93} However, the "Goldilocks" "new economy" did not last. Economists were startled again when asset prices tumbled from 1990 onward. Between January 1990 and December 1994, stock and land prices halved. Many companies and individuals who had borrowed money to purchase land speculatively found themselves unable to service their debts, let alone repay the principal. Corporate and individual bankruptcies soared to postwar highs. Japanese investors pulled out of their overseas investments in a stampede. Previously unheard of, several Japanese banks and securities firms became insolvent. The boom of the 1980s turned into the bust of the l990s, the biggest economic slump since the 1930s.

Some economists seemed relieved. The downturn was evidence that, after all, Japan's economic system was not so successful. What had previously been praised about Japan - the close ties between the government and the private sector, the monitoring by main banks, the family-style corporate system - were suddenly nothing but cronyism, corruption, and lack of transparency. The system was quickly blamed for the recession. Both inside and outside Japan, voices began to call for a reformation of the Japanese economic structure, as already happened in the 1970s. However, this time the voices did not recede for a decade.

Money Is the Answer

Japan's structure is not responsible for the bubble of the 1980s or the slump of the 1990s. Traditional theories could not explain Japanese asset prices, because they neglected the role of credit creation. From about 1986 onward, banks increased credit creation aggressively. Loan growth of the city banks averaged about 15 percent in the late 1980s, and total loan growth remained above 12 percent most of the time. Meanwhile, the ability of the economy to service these loans - national income - only grew about half as fast.12 It was a classic case of unproductive excess credit creation: money was produced by the banking system but not used productively. Instead, it was used for speculation or conspicuous consumption.

As more money was created out of nothing and injected into the real estate market to buy land, demand for land rose. Since the supply of land is fixed, land prices had to rise. This created capital gains for the speculators. And that attracted even more speculation.13 ... ...

The experts, who had studied finance and economics at university, knew that market prices were always right and therefore land prices were justified.

{p. 97} The ordinary man in the street turned out to be wiser than the experts. ...

Loan growth in excess of GDP growth is one approximation of unproductive credit creation. ... All it takes to burst a credit-driven asset bubble is for loan growth to slow. ... When the bubble bursts, all the speculative lending must turn into bad debts.

{p. 98} Bust: The Story of the 1990s

This, of course, is precisely what happened in the 1990s in Japan. In mid-1989 banks suddenly restricted loan growth. Half a year later, stock prices peaked. Then land prices stopped rising. As no more newly created money entered the asset markets, asset prices could not rise further. Speculators had to cover their positions and started to sell. In 1990 alone, the stock market, as measured by the Nikkei 225 index, dropped a precipitous 32 percent. Land prices also started their sharp decline. Some highly speculative plots of land in commercial districts saw their "market value" drop by 80 percent or more. More and more real estate speculators became "distressed." As they went bankrupt, banks got their first taste of bad debts in decades. They realized that the problem could easily escalate. So they became cautious. Very cautious. They drastically reduced the amount of new loans to real estate, construction, and nonbank financial firms. This, however, had to push asset prices further down, because less and less new money was coming into the market. So bankruptcies rose.

As banks began to realize the enormous scale of potential bad debt - the majority of the 99 trillion in "bubble" loans were likely to turn sour - they became so fearful that they not only stopped lending to speculators, but also began to restrict loans to manufacturing firms that had nothing to do with the bubble. ... So in the early 1990s, when banks became burdened with bad debts and more averse to risk of default, they reduced their lending to small firms. From 1992 onward, small firms suffered trom a credit crunch.3

The implications for the economy were enormous: Small firms are Japan's number one employer, accounting for 70 percent of total employment. The impact was immediate, because small firms never had the luxury of lifetime employment and seniority pay. These structures had been reserved by the war economy bureaucrats for the larger firms. In recessions the small firms quickly reduce bonuses and pay, and they lay off staff. Since they are the main employer in Japan, actual unemployment started to rise from 1992 and disposable incomes dropped. As employees of small firms quite rightly started to worry about their jobs, they spent less and saved more. As consumption slumped, companies could sell fewer of their products. Yet

{p. 99} they had just finished new factories and expanded their production capacities. Inventories of unsold goods piled up. Prices were driven down. Even the large firms had to start cost-cutting measures. Labor markets worsened further. In short, Japan was in a full-blown recession. ...

Again, most economists were puzzled. They had not predicted an economic slump. To the contrary, as the official discount rate was reduced (nine times altogether since 1991), they predicted an economic recovery, believing that interest rates were a good predictor of economic growth. When this author warned in late 1991 that Japanese banks would be driven to the brink of bankruptcy and a massive credit crunch would produce a major recession, the established experts dismissed the prediction.4 How could Japan, which was seemingly taking over the world, whose exports had conquered global market shares, and whose money was buying up assets around the earth, suddenly fall into a full-blown recession?

The recession also lasted longer than expected, for the simple reason that economic growth takes place only when there is more credit creation. Falling interest rates did not help as long as credit creation remained small. Yet as late as 1993 and 1994, most economists in Tokyo denied that there was a credit crunch. Their theories simply did not include credit creation, the very process that is at the heart of every economy. ...

{p. 101} While it is illegal for individuals to print money and go on a shopping spree, central banks have a license to print as much as they wish. Yet it is not easy for a country to just print money and then go shopping all over the world. To buy foreign assets, domestic currency must be converted. Under flexible exchanges, foreign exchange dealers would observe unusually strong demand for the foreign currency - say, the U.S. dollar - and a large supply of the currency of the country concerned. This would immediately affect exchange rates. In addition, foreign exchange dealers keep an eye on key economic indicators of the countries whose currency they deal in. If there was high inflation in a country, this would be seen as evidence that the central bank was printing too much money. So the value of that currency would fall.

There is a snag. The currency of the country that is printing too much money does not weaken automatically. Foreign exchange dealers act on information they receive, and this affects exchange rates. So if the traditional indicators that the dealers watch do not pick up the excess money creation in the country concerned, and if the country has a current account surplus, so that there is demand for its currency (because it is selling its products successfully to the world), then printing a lot of extra money and trying to exchange it for U.S. dollars might work. A neat financial trick could be pulled off: The country can just print money and buy foreign assets. Economists call the phenomenon in which prices do not reflect monetary changes "money illusion." ...

Most of the excess money went into financial transactions, producing asset price inflation. Thus the CPI remained stable ...

Any suggestion that the soaring capital outflows were connected to the Japanese bubble was dismissed by leading economists. ...

{p. 102} Japan had pulled off the same trick that the United States had used in the 1950s and 1960s, when U.S. banks excessively created dollars. Corporate America used this hot money to buy up European companies. While the United States had the cover of the dollar standard, Japan's cover was its significant trade surpluses, which convinced observers that the yen had to be strong. As the yen did not weaken, the world suffered from the biggest bout of money illusion on record - the Great Yen Illusion.


(5) Western bankers imposed Basle Accord as a protective measure, causing Japan's crash

Patrick S. J. Cormack and Bill Still write, in their book The Money Masters: How International Bankers Gained Control of America (Royalty Production Company, 1998, pp. 73-4):

{p. 73} Regulations put into effect in 1988 by the BIS {the Bank of International Settlements}, called the Basle Capital Adequacy Accord, required the world's bankers to raise their capital and reserves to 8% of liabilities by 1992. ... those nations with the lowest bank reserves in their systems have already felt the terrible effects of this credit contraction as

{p. 74} their banks scrambled to raise money to increase their reserves to 8%. To raise the money, they had to sell stocks which depressed their stock markets and began the depression first in their countries. Japan, which in 1988 had among the lowest capital and reserve requirements, and thus was the most effected by the regulation - has experienced a financial crash which began almost immediately, in 1989, which has wiped out a staggering 50% of the value of its stock market since 1990, and 60% of the value of its commercial real estate. The Bank of Japan has lowered its interest rates to one-half of a percent - practically giving money away to resurrect the economy, but still the depression worsens.

{end} More at money-masters.html.

(6) Japan's Lessons for Tackling the Subprime Dilemma

RIETI Report No. 093: April 16, 2008

The turmoil facing the U.S. financial system is, in some regards, coming to resemble Japan's banking system crisis of the late-1990s and early-2000s. This suggests that some lessons may be drawn from Japan's handling of the situation. RIETI Senior Fellow KOBAYASHI Keiichiro has drawn some parallels. Since he published his book Nihon keizai no wana [Trap of the Japanese Economy] (with Sota Kato, in Japanese) in 2001, Dr. Kobayashi has had numerous commentaries published in the Japanese media on Japan's financial crisis, while continuing his theoretical research in macroeconomics. This month RIETI Report shares his analysis of the subprime loan problem and his policy recommendations.

Subprime Loan Crisis - Lessons from Japan's Decade of Deception


Senior Fellow, RIETI

March 2008


Housing prices in the United States could continue to fall for many years to come. Losses could grow and eventually lead to bank insolvencies. Once the fear of prospective insolvencies in U.S. financial institutions spreads in the market, ordinary monetary policy becomes powerless since liquidity provision works only if all financial institutions in the payment network are solvent. With the problem being in the payment system, fiscal policy to save mortgage borrowers cannot restore market confidence. Capital augmentations by banks themselves only buy time but cannot stabilize the financial system if the market feels that bank insolvencies are inevitable. A payment system facing insolvencies becomes caught up in a game of musical chairs, in which each party tries to push the prospective losses on the others. To stabilize the payment system, the U.S. government should eliminate fear in the market. One promising policy plan is to set up a scheme and a sufficient public fund for capital injection into banks in the case of insolvencies. This scheme would stabilize the market by eliminating fear, and public funds would not actually be injected into banks.

1. Financial turmoil could continue

The financial problem associated with U.S. subprime loans is becoming a global economic problem. Arguments are increasing from Europe and Japan that this is the beginning of the end of the U.S. globalization system and may become a serious international political problem if it persists over a long period. We may recall that political support of fascism and communism grew in certain parts of the world 80 years ago because the international great depressions in the 1930s invoked serious feelings that global capitalism was collapsing. Therefore, resolving today's financial crisis quickly may not merely be a problem of U.S. economic policy but should be considered an urgent action point for stability of the international community as a whole.

How far will housing prices in the U.S. fall? If we base our projections on the trend line during the 1990s, they will pick up by 2012 at the latest. But this reasoning reminds me of a similar mindset in early-1990s Japan. When Japan's real estate bubble burst in 1991, the trend line indicated that land prices would bottom out around 1995, when in fact they continued to decline steadily for 12 more years, until 2007.

Figure 1. Land prices in Japan, housing prices in U.S.

Enduring wishful thinking that land prices would soon recover, and the subsequent disappointments, paralyzed Japanese banks and policy-makers and brought on a full-fledged banking crisis in 1997-1999.

At the beginning of the 1990s, Japanese policy-makers and banks believed that the problem was perfectly under control and that the banks then holding huge unrealized capital gains could easily overcome losses from disposals of bad loans, just as their U.S. counterparts believe so today. We may recall that all of the world top-10 banks (measured by amount of deposits) in 1989 were Japanese.


It appears that the 1988 Basle Accord, which bankrupted Japan's banks, in effect applied retrospectively.

This is because it seems to have applied to existing loans, made at a lower Capital Adequacy ratio.

Why didn't the Japanese negotiators insist that the changes only apply to new loans?

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