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Return of the Living Dead

What the U.S. can learn from Japan's failed experiment with "zombie businesses"

Anthony Randazzo
December 17, 2008

Killing zombies isn't typically the responsibility of America's president or treasury secretary. But if the country is going to get through the current financial crisis, President-elect Barack Obama and his economic team better get out their shotguns and aim for the head.

Today, our economy is plagued by struggling markets, liquidity concerns, and frozen credit. Twenty years ago, Japan faced nearly the exact same problems. Then they fell prey to the zombies.

After Japan's asset bubble burst in the late 1980s, their economy took a sharp downturn, prompting government officials to try bailing out banks and investing in infrastructure, much like the activity and proposals floating around America today. The results were terrible.

With the government propping up poor business models rather than allowing further job losses, firms wound up operating over the long-term without making a profit or adding any value to society. Their utter lack of vitality earned these perpetual money-leaching entities the moniker "zombie businesses." And unless American policymakers understand the failures of the Japanese response, we will suffer the same zombie fate.

Remember that the Japanese asset bubble and the American housing bubble have eerily similar origins. Both were driven by aggressive behavior in financial institutions. Wall Street, which sought new ways to get quality returns on investments, turned to securitizing everything it could and issuing unwise subprime mortgages—all highly valued by the rating agencies, and all highly misunderstood. The Japanese aggressively pursued real property assets to the point where the inflated values were unsustainable.

In both cases, the rapid rise in rates of return led to over confidence. In Japan, it is said that the market experienced a sense of euphoria, and poor investments were driven by excessively optimistic expectations of future economic development.

The Nikkei, Japan's stock index, rose from 18,000 in 1986 to an intraday high of 38,975 by the end of 1989. Similarly in the U.S., the Dow Jones went from 7,591 in July 2002 to an intraday high of 14,115 five years later.

These large growth trends led to inadequate risk management, over-leveraged investments, and depleted capital reserves. In both bubbles, loans were given out like candy, often times to people that the banks knew were high risk.

Government practices during both bubbles share many unfortunate similarities as well. In Japan, increased capital requirements caused many firms to struggle when their assets started to depreciate. Similarly, the inflexible mark-to-market regulations in America forced firms to raise capital quickly, sometimes driving them towards bankruptcy.

In America, Federal Housing Administration policies encouraged the expansion of subprime mortgages, particularly through Fannie Mae and Freddie Mac. The idea was to expand homeownership for low-income families, though the increased demand drove housing up until the market was eventually oversaturated. Japanese regulatory policies and tax codes also caused land prices to unnaturally rise until they ultimately burst.

Given these similarities, U.S. officials should take a careful look at how Japan's response to the crisis lead to the more than ten years of recession and stagnation known as "the lost decade." We do not want to duplicate Japan's mistakes.

First mistake. The Bank of Japan tried to ease economic pains during their downturn through the 1990s by loaning large amounts of money to businesses. However, such attempts to recapitalize the market were counteracted by underlying management problems endemic to the dying firms.

According to Shigenori Shiratsuka, Deputy Director and Senior Economist at the Bank of Japan, even though firms became unprofitable, the government still encouraged lending to them to prevent losses from materializing. There were heavy concerns about a failing firm increasing unemployment.

The intense lobbying from special interest groups representing various sectors of the Japanese economy further perpetuated these ill-fated loans, funneling additional funds to zombie businesses. As Shiratsuka notes, "under such circumstances, loans to unprofitable firms become fixed and funds are not channeled to growing firms, holding down economic activity."

Unfortunately, we're seeing a disturbingly similar trend in America today, as the cost of bailing out AIG continues to rise and Congress moves forward with a bailout for the auto industry. The $8.4 trillion (and growing) cost of "saving" firms deemed too big to fail completely ignores the inefficiency and poor quality of the very businesses the government is trying to save.

Second mistake. With all those loans, the Japanese government was simply too integrated into the market to have adequate incentives to create the right policies. Daniel Okimoto, former director of the Asia-Pacific Research Center, points out that the interests of Japan's economic bureaucracies, such as the Ministry of Finance, became interdependent with the banking industry.

Moreover, government officials suppressed data revealing the intense scope of the economic malaise, all while regulations were developed with government interests in mind. Transparency and public accountability were basically nonexistent.

America now finds itself in the same position. The Treasury has taken equity stakes in many major financial institutions and insurance companies, not to mention the pending partial nationalization of Detroit's Big Three. This has created a myriad of conflicting interests as well as vast potential for fraud.

Consider that while the bulk of what the Treasury, FDIC, and Federal Reserve have spent has been tracked, it's far from clear what the banks and other institutions have done with that money. Without this information, it's difficult to measure whether the $8.4 trillion has been effective. Fighting fraud is equally difficult.

Third mistake. The length of Japan's asset deflation, recession, and liquidity struggles has been blamed largely on the lack of foresighted policies and political leadership. Politicians bent on retaining their power took action that sought to solve the present day concerns, such as infrastructure projects, without regard to their long-term effects. As a result, economic growth was not sustained.

America suffers from a similar vision problem. Intent with avoiding any semblance of economic pain, federal officials have thrown moral hazard and laissez-faire principals to the wind. Creative destruction has been rejected, despite long historical proof that it is the best way for an economy to grow.

Fourth mistake. Japan tried to climb out of its economic mess by raising taxes and cutting interest rates. Okimoto cites a series of policy mistakes in a report on Japan's economic stagnation that includes a consumption tax hike, business taxes, and heavy-handed reliance on interest rate cuts that reduced investment incentives.

President-elect Obama has backed down temporarily on his oil industry windfall profits tax and his promise to end the Bush tax cuts. But he still plans on letting the Bush tax cuts expire in 2010 and has set an arbitrary cap of $80 per barrel as the most profit oil companies can make before a windfall tax.

Neither Obama nor Congress has seriously considered cutting business taxes, cutting capital gains taxes, or creating an investment tax holiday. Any of these would encourage capital investment and the growth of businesses, thereby spurring on an economic recovery. Meanwhile, the Fed continues to slash interest rates with the goal of encouraging lending today, thereby limiting investment rates of return over the long-term.

Fifth mistake. With the Japanese government enabling lending to zombie businesses, taking cash away from productive ventures, and passing tax laws and other regulations that did not promote growth, the private sector was actively discouraged from investing.

Japan's economic growth during the 80s was due in large part to consumption growth and heavy capital investment. However, during the 90s, that money dropped-off as savings increased due to uncertainty, leading to a sharp drop in demand that further hurt prospects for recovery. The same problems contributed to the flight of foreign capital from Japan as well.

To counteract the lack of private investment, the Japanese government turned to large-scale infrastructure programs. They built roads, bridges, and airports, all with the goal of creating jobs and saving the economy. But it didn't work. Public debt skyrocketed (it is now higher than GDP), unemployment doubled, and the economy remained stagnant.

While private sector investment isn't totally stalled in America today, there is great uncertainty about what the government will do next, whether taxes will increase, and what future rates of return will be considering the Fed's rate-slashing binge. Foreign investment dollars are slowing as well, partially due to the global economic dip, but also because of errant policy.

To make matters worse, Obama is planning a Japanese-styled infrastructure investment project, with the goal of restarting the economy and creating 2.5 million jobs. But the plans are unlikely to encourage long-term economic growth, the jobs are not sustainable, and the spending will increase national debt.

And while some of Japan's infrastructure projects have served society, that value must be compared to what the private sector could have created with economic policies in place that encouraged free market activity. In other words, what are the unseen losses?

Still there are reasons to be optimistic. Not only does America have the Japanese lesson to study, we are in a much better position to act than Japan ever was. Despite Wall Street's massive losses, for instance, there is over $100 billion in private capital available now for investing in infrastructure. With a little forward thinking, we can unleash the greatest new wave of investment this country has ever seen-one that originates from the private sector, not from government planners focused on propping up the living dead.

Anthony Randazzo is a research associate at the Reason Foundation. This column first appeared at Reason.com.


Anthony Randazzo is Director of Economic Research


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