Over the past few days, the idea that the Obama Administration’s failure to nationalize the banks may very well doom the U.S. economy to the kind of Lost Decade that Japan endured has become ubiquitous. (Here are Paul Krugman, Joseph Stiglitz, Mark Thoma, and Atrios on the danger of turning Japanese.) In the wake of the stress-test results, it’s become obvious to everyone that the Administration is counting on banks to earn their way out of trouble—recapitalizing themselves over the next couple of years via profits. But the skeptics suggest that this is a recipe for disaster, because this didn’t work in Japan, where banks that had been propped up by the government were never able to earn their way back to health, eventually requiring the government to step in and take more decisive action. A Bloomberg story today made the comparison explicit in the first graf:
Treasury Secretary Timothy Geithner is betting that U.S. banks can do something their Japanese counterparts were unable to accomplish in that country’s “lost decade” of the 1990s: earn their way out of trouble.
As I’ve said before, there’s something peculiar about the repeated insistence that Japan’s experience demonstrates that the Obama approach can’t work. Japanese banks may not have been able to earn their way out of trouble in the nineteen-nineties, but American banks did, in both the early nineteen-eighties and the early nineteen-nineties. In that sense, the first graf of that Bloomberg story would have been more accurate if it had read:
Treasury Secretary Timothy Geithner is betting that U.S. banks can do something they’ve done twice before in recent decades: earn their way out of trouble.
The assumption behind the invocations of Japan is that the problem with the Japanese economy in the nineteen-nineties was that because the banks were zombies, they weren’t able to lend enough to get the economy moving again, and so it stayed stuck in neutral. Now, as Ryan Avent points out, Paul Krugman himself has cast doubt on the idea that Japan’s real problems had anything to do with its banks (even if that didn’t stop Krugman from invoking Japan in his column today). But let’s accept for the sake of argument that if Japan’s banks had been healthier, the economy would have been significantly stronger. The question, then, is: Why did Japan’s banks stay so weak? In other words, why weren’t they able, as U.S. banks have been, to earn their way out of trouble?
The conventional answer to that question is the zombie explanation. The real answer is that Japan’s banks kept rolling over bad loans to weak borrowers. As this paper by Joe Peek and Eric Rosengreen shows, during the nineteen-nineties, Japanese banks constantly “evergreened”—they kept extending additional credit to companies that already had loans with them. By extending credit, the banks enabled weak corporate borrowers to keep making their interest payments, and to put off bankruptcy. That made the banks’ balance sheets look better, and also kept companies afloat. The economists Ricardo Caballero, Takeo Hoshi, and Anil Kashyap, in fact, found that thirty per cent of publicly-traded firms were “on life support from banks in the early 2000s.”
Evergreening had two effects. First, because the borrowers had little chance of ever actually paying off their debts (because their underlying businesses were so weak), it kept Japan’s economy from making the adjustments necessary to start growing again. Caballero, et al, conclude that the practice led to lower investment, job creation, and productivity for the economy as a whole. Second, it limited Japanese banks’ profitability, because it effectively meant that, instead of making good new loans, they were constantly throwing good money after bad. As a result, they were never able to earn their way back to health. (It’s true, of course, that not taking over the banks could be seen as itself a form of evergreening. The difference is that big banks, at least in the U.S. experience, have shown that they can earn their way back to health.)
In thinking about the relevance of the Japanese experience to our own, what’s important to note is that Japanese banks did not engage in evergreening solely because it temporarily improved their balance sheets. Rather, they did so because social norms and explicit government pressure encouraged them to do so. (As Peek and Rosengren put it, in Japan, “many lending decisions are strongly influenced by a perceived duty to support troubled firms.”) In fact, Peek and Rosengren point out that government-controlled banks were more likely, not less, to keep extending credit to weak firms.
While U.S. banks have come under political attack at various times for being too tough on borrowers, there’s been no concerted attempt to force them to evergreen. And, in contrast to Japanese banks, U.S. banks have proved more than willing in the past to be tough on old borrowers even while extending new loans. The result has been that at times like now—when net profit margins on loans are high—they have been able to become tremendously profitable, and to, in fact, earn their way out of trouble,as the Obama Administration is counting on. Unless you think that this is going to change—that U.S. banks are going to start evergreening their loans, and continuing to pile up new bad debts—then it seems unlikely that we’re really heading down the road that Japan took.