Searching for a Cure: Financial Sector lessons from Japan

As the meltdown of the U.S. financial system continues apace, building on the already considerable losses from earlier in the year, the looming questions are “what went wrong?” and “ how do we fix it?” Each day the magnitude of the crisis seems to be getting worse. The tally reached a benchmark of $379 billion in July of this year, and is now estimated to have losses easily surpassing the trillions of dollars. In short, this is the worst financial crisis the U.S. has faced since the stock market crash of 1929. We now have to reevaluate what the real purpose of the U.S. financial system is, and what degree of regulation is necessary to achieve that vision.

Since the Japanese economic model was dismissed in 1989, the U.S. has been the predominant economic and financial model: advocating free markets and even greater liberalization of capital markets. The U.S. vision for the financial markets was one in which government played little to no regulatory role, where the markets would ultimately decide the direction of capital flows. In contrast to the U.S. model, Japan long advocated controlled use of capital through coordination between the government, banking, and industrial sectors. However, while Japan’s economy has quietly grown at a modest pace of 1-2% over the past 17 years, it has been outpaced by the stellar growth that the U.S. economy registered during the same period. In fact, when one takes a deeper look at the existing data a much different picture emerges as to which economy was better serviced by their respective financial systems.

With the gradual deregulation of the U.S. financial system, the economy adjusted to increasingly plentiful lines of credit by beginning a binge of borrowing. Not only did the U.S. government accrue debt at an alarming rate, the average American household used easy credit by borrowing against the value of their house, to fund a 15 year spending spree. At the same time, despite high economic growth, there has been a steep rise in income disparities , and due to rising prices, an actual decrease in living standards for the majority of Americans after 2001. This created an American economy that relied too heavily on credit borrowed from abroad and one too heavily focused around financial services as a basis of the economy.

Although often criticized for growth rates that were considered too sluggish, during the same 17 year period Japan's economy managed to increase its trade surplus, household savings rates, and standard of living. Notably, such developments occurred in tandem with a reformation of the banking sector. The Japanese financial system is based on managed and cooperative use of capital. This involves cooperation between the government, large banks, and large companies to direct capital to towards areas of the economy that need capital. In a word, the Japanese financial sector still functions as a market, as the big banks still function in respect to profit, however the use of their money and speculation is more closely monitored than in the deregulated American system. The goal of the financial sector is not simply to make a profit, but also to direct capital toward developing industry for the purpose of international trade. Additionally, instead of using primarily foreign capital, the Japanese system relies primarily on domestic capital created through household savings. This means the individual savings of Japanese families are put towards developing the national economy in contrast to the American system where foreign money fueled consumer spending.

The Japanese system can hardly be called perfect, and has suffered its own serious downturns such as in 1989. However, the United States has suffered no more than three serious financial crises in the same period, with the current one being by far the worst. Alan Greenspan, the former head of the Federal Reserve Bank called it, " A once in a half century, probably once in a century, type of event." A financial system that is highly unregulated poses just as much of a danger to our society as a source of capital to help our economy grow. In particular, in the age of globalization, where the internet provides lightning fast communication, a deregulated financial system can too easily be misled by incorrect information and speculation.

Last week, the negative effects of speculation were clearly evidenced when short selling nearly forced several large investment banks such as Morgan Stanley into bankruptcy, despite their performance not being quite that bleak. In a deregulated system, we are more likely to see financial crises driven by greed, such as the current sub-prime mortgage crisis. They are more likely to spiral out of control as speculation forces even financially sound companies to their knees. The proponents of this system point to the vast amounts of capital it can make available for use, however, the use of that capital make a profit has negated the benefits it offered. In short, this system of finance is not one that has served our nation well: it has led to a massive accumulation of household debt, the erosion of industry, and a destructive wave of defaults that threaten the very foundation of our nation's economy.

In order to return the American economy to health, the instability of the financial system must be resolved by a degree of re-regulation by the government. When the Japanese Finance Minister, Eisuke Sakakibara predicted the current crisis in American financial markets he stated the reasons as being, "that the global capitalism we now have is inherently unstable, and... We don't have the international mechanism to really prevent a crisis or to manage them when they occur." Therefore, the U.S. government, particularly the Federal Reserve Bank, must take a leading role, akin to Japan's Ministry of Finance and the Bank of Japan, in the regulation and direction of the finance industry. It is of profound importance that the financial tools available to raise capital for the economy are regulated and establish specific rules for the trading of such equity. Primarily the dependence of the U.S. economy on large investment banks should be broken, and those companies should be strictly regulated. Additionally, that system where over-consumption is encouraged through artificially low interest rates and excess capital is put to an end. Instead a policy the encourages savings by limiting access to easy credit such as mortgages, credit cards, and other forms of commercial borrowing for consumption. With higher savings the U.S. will have a decreased need on foreign capital to both finance our debt and to provide capital for business. Increased savings will also provide a considerable bulwark of funds both nationally and within the banking system itself with which to protect against further financial crises. Although there may be little we can do to correct the current crisis and the impending economic recession, through smarter regulation and coordination between the government, banking sector, and industry we might just be able to secure a better and healthier American economy for generations to come.