The Subprime Financial Crisis: A comparison with the financial crisis and 'lost decade' in Japan during the early 1990s

MA-Thesis / Master von Stefan Di Bitonto

Introduction:

It seems useful to me, due to the currentness of the situation and the potential similarities with other financial crises, especially the Japanese financial crisis during the early 1990s, to choose this topic for my Master Thesis in International Economics. Furthermore, the upcoming research concerning this topic also serves my personal interest.

In this paper different theoretic approaches, such as Boom and Bust cycles and the anatomy of bubbles will firstly be addressed. Afterwards, the financial crisis in Japan during the early 1990s will be analyzed and commented on; subsequently the Subprime Financial Crisis in the United States, which was initiated by the falling real estate prices since summer 2006 will be explained and examined. Afterwards an analysis will follow, if governments and central banks have - observed - and learned from other countries past mistakes and will be able to prevent a depression in their regions or countries similar to the lost decade in Japan, or eventually lack the instruments, the conviction, and willingness to do so. To substantiate different assertions, among others, a utilization of the suggestions of well-known economists will take place to narrow down the statements that have been made. Afterwards, a comparison of both financial crises will take place. Subsequently, an illustration of similarities and differences between the current Subprime Mortgage Crisis and the financial crisis in Japan during the early 1990s will be displayed; consequently conclusions and a possible outlook will follow. In order to provide an idea on what this paper will be about and how it should be understood, there will at first be an introduction of some basic thoughts and historical examples about speculations in the financial world over time, followed by theoretical explanations of useful economical framework in the given context.

Table of Contents:

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Chapter 3, Financial crisis in Japan in the early 1990s:

In order to understand how the Japanese crisis proceeded, there will be a brief review of the financial system in Japan during its time of rapid growth, namely from 1950 until 1973. During this time the Japanese government’s predominant goal was to promote economic development. The average growth rates during that time amounted to 8 percent per year. In order to understand how such growth rates could have been accomplished, further material is owed.

Background to the Forge of the Financial Bubble:

One major way for the Ministry of Finance (MOF) to foster such an economic development was to change existing policies. One major tool was to redirect funds from depositors to so-called chosen industries. This initiated a so-called policy-conforming bank behavior. Shoichi Royama argues that the financial organization during this period was characterized by four important features. The first is the dominance of the banks with regulated interest rates. During the mentioned time, approximately 60 percent of the total funds supplied by the financial markets were supplied by banks, 10 percent by non bank intermediaries, and 20 percent by public financial institutions e.g. Insurance Companies and only 10 percent of the funds were raised by the stock or bond market. This had further influence on the creation of Keiretsu structures. Secondly, the segmentation and strict demarcation of business areas took place. Here, corporations were the largest borrowers until the mid 1970s in Japan. For instance compared to the United States - during that time - the high borrowing rate would have been considered much too high and hence too risky. The third and fourth feature is the banking sector (indirect financing and window guidance and administrative guidance). Royama argues that, there were two groups of banks that operated in extremely different ways. One group consisting of the so-called city banks and other big banks that have steadily borrowed in the short-term money market, so-called call money and the interbank discount market. The other group consisted of a mixture of medium-size and smaller banks. This other group lent funds to the so-called city banks and big banks over the two mentioned channels. The fact that the BoJ only gave credit to the big banks and the fact the smaller banks did so as well, resulted in the situation in which these big banks were ‘overloand’. In order for these just mentioned four factors to develop, two aspects were necessary. Royama argues that the first cause can be found in the high rate of economic growth, led by corporate investments and exports. The second factor can be found in the rules and regulations by the MOF and the BoJ. A combination of all these issues, and also the fact of not knowing who would be responsible for failures in an environment with guidance of the financial authorities, lowered the need for strategic management decisions and other precautions measures for the commercial banks (this will be further explained later in the paper by the terminology: moral hazard). Due to the above mentioned process, Japan evolved to a country with a continuing prosperous development during the timeframe of 1950 until 1973.

The Process of Deregulations:

In Japan, just like in many other OECD-countries the average growth rate decreased after the year 1973. From 1973 until 1991 the growth rate halved. However, Japan still displayed an average growth rate of 4 percent during this time period, more than many other OECD-countries. Due to the extraordinary growth rates, Japan’s production per capita (measured in purchasing power parity per unit) emerged from 17 percent in 1950 to 80 percent in 1990, compared to the United States. After the first oil price shock in the 1970s, the government of Japan untangled basic structural features. At first the government issued deficit-financing bonds, which generated the development of the bond market by lowering restrictions on dealing in these bonds. This measure indirectly led to a change in the flow of funds. Corporations started to invest their funds at security firms which offered them Gensaki (the Japanese term for a bond sale incorporating a repurchase agreement at a later date), hence, increasingly rejecting the loans available from the commercial banks. At this point the city banks were offset to a competition situation and lobbied for a free-interest instrument themselves. Between 1979 and 1987, the open market emerged and grew quickly. Also other factors have been affected by this measure. Due to the fact that the Foreign Trade Law had been revised in the year 1980, Japanese corporations increased the issuing of Bonds in Europe. Finally this led to the occurrence of the so-called disintermediation, meaning the movement of corporations away from bank based financing, towards direct means of financing. The deregulation led to competition and deteriorating profit margins for banks, therefore, new business portfolios were developed. In order to recuperate further arising costs, loans with higher risks have been developed and assigned. This led to a long term issue, namely the Nonperforming Loan Problem (NLP). Schaede argues that, the trouble with the progress of deregulations was that the regulators allowed basic features, such as indirect finance, window guidance, segmentation of business areas and interest rate regulations to vanish without preparing the system for an open competition situation.