A Brief History of Doom

by Richard Vague

  Concern on the part of the international lending community regarding Japan’s banks became such that a “Japan premium” emerged on the offshore borrowings of these banks.35 This was “particularly galling to major Japanese banks,” which were still penalized regardless of their financial strength, and was “intensely embarrassing to the Japanese government and its economic agencies.”36

  Some would suggest that this protracted process and pervasive denial was an intentional strategy rather than an ad hoc process, one that dealt with the financial crisis only to the extent that the government could admit and afford. Could Japan have even planned a fifteen-year process if it had full awareness of the problem in 1991? Perhaps. Paul Volcker pulled off a similar trick in 1982 in the Latin American debt crisis, where a few very large New York money-center banks had losses in excess of their capital. He offered quiet forbearance by letting these banks write off loans against earnings gradually without forcing them to write off the full amount against capital while doing so. But that was just a few banks and one very powerful regulator.

  Whatever the case, Japanese actions during these years showed elements of great tolerance and restraint. That would be tested when Japan’s Asian neighbors, and the source of much demand for its goods, began to unravel in the Asian financial crisis of 1997.

  In the 1990s, a number of the smaller Asian countries—including South Korea, Thailand, Indonesia, Hong Kong, Laos, Malaysia, and the Philippines—were experiencing rapid GDP growth and economic miracles of their own, but it all was abruptly interrupted when their currencies and stock markets came tumbling down, beginning in July 1997.

  Figure 3.3. Japan: Reserves for Possible Loan Losses and Number of Failed Lending Institutions, 1992–2005

  Although stock and real estate prices had dropped by 1991, banks delayed fully providing reserves for those losses for a number of years.

  Figure 3.4. South Korea: Private Debt as a Percentage of GDP, 1990–2000

  Though it has often been characterized as primarily a currency crisis or even a government debt crisis, the Asian crisis was, like almost all financial crises, foremost a runaway private debt crisis. By 1997, at the start of the crisis, the ratio of South Korea’s private debt to GDP had grown 28 percent in five years, and its overall ratio of private debt to GDP had reached 164 percent (see Figure 3.4). Its government debt was a mere 12 percent of GDP. The South Korean currency, the won, had been trading in the same general range for several years. Then, after years and years of rampant lending, investors, depositors, and traders were beginning to hear and see fragmented evidence that corporate borrowers were overleveraged and would be unable to pay their debts, putting the banks that lent to them in jeopardy. Foreign investors and lenders withdrew their funds where they could and moved those funds out of the country. As that happened, South Korea’s currency collapsed and a fiscal rout began, but only well after years of rampant lending.

  Figure 3.5. Thailand: Private Debt as a Percentage of GDP, 1990–2000

  The concern that banks had lent too much and corporate borrowers were overleveraged was amply justified. Private debt in South Korea, Thailand, and Indonesia had exploded between 1992 and 1997, creating overcapacity and a bevy of bad loans in all three countries. Corporate debt, as much or more than real estate debt, was the culprit in South Korea. Some of these loans were to corporations that supported Japan’s industries and were thus exposed to Japan’s slowdown. Figure 3.6 shows the debt buildup in five of South Korea’s largest chaebol, the large industrial conglomerates in South Korea that were historically family controlled: Samsung, Daewoo, Hyundai, SsangYong, and LG. All became increasingly leveraged and suffered significant reversals. One, Daewoo, was forced into bankruptcy and emerged from that process a much smaller and different company.

  Some blamed it on a currency crisis, but the rampage in private lending had fully occurred before the currency drop. Financial crises have occurred in situations when currencies drop, when they rise, and when they are stable. From 1927 to 1930, the U.S. dollar was flat relative to the pound, the German mark, and the French franc. The euro grew 32 percent against the U.S. dollar in the two years leading into the 2008 crisis, before finally dropping midway into 2008. There is limited correlation between currency swings and financial crises.

  Table 3.2. South Korea Crisis Matrix: 1990s

  In the five years leading to 1997, South Korea’s private debt grew by 148 percent.

  The currency crisis was a result rather than a cause of the Asian crisis, but that currency drop did indeed exacerbate the problem. In countries where a meaningful percentage of businesses or households borrow in a foreign currency, a currency drop effectively increases the amount they owe. If the currency drops by half relative to that lenders’ currency, then the borrower’s debt doubles. Koreans had already borrowed too much, many of their loans were already in trouble, and the currency devaluation worsened the situation significantly.

  The story was similar in Thailand, Indonesia, and beyond. The financial collapses in these countries affected Japan. The combined 1996 GDP of Thailand, South Korea, and Indonesia was $1 trillion. That was only about 22 percent of Japan’s GDP that year, but large enough to worsen the environment for Japan in three key ways. First, it adversely affected Japan’s GDP growth since businesses and households in these countries were customers of Japanese companies. Second, it further weakened Japan’s lenders because they lent to companies in these countries. Third, it added to general market turbulence, which prodded the Japanese government toward recognition that it needed to intervene with its own domestic banks. After the Asian crisis, it became more difficult for Japan to project an imminent recovery of its stock and real estate markets.

  Figure 3.6. South Korea: Chaebol Debt, 1994–2000

  Private debt grew rapidly up to 1997 in major chaebol.

  Table 3.3. China Crisis Matrix: 1990s and 2000s

  China’s private debt grew more than threefold in the five years leading to 1995, which brought loan losses estimated as high as 30 to 40 percent of total loans.

  Figure 3.7. China: Private Debt as a Percentage of GDP, 1991–2000

  The emerging giant China had a reckoning in this era as well. By 1999, loans in the then-nascent capitalist nation had nearly doubled in a mere four years (Figure 3.7) and had risen from 84 percent to 111 percent of GDP. Problem loans in the banks reportedly reached over 30 percent of total loans, an unfathomable percentage that greatly exceeded the level in Japan.37 In the China of that era, as occurs in many countries as they first industrialize, it was almost as if lenders didn’t yet know how to make a loan and were learning to be lenders as they went along. That certainly seemed true in the United States in the 1830s, given the extraordinary losses lenders incurred as we will see in the next chapter. It appeared that Japan reached those same extraordinary loss levels in 1882, its first financial crisis brought on by its rush to industrialization, though the data is even murkier for Japan in that year than for the United States in 1837.

  But as maladroit as it was at lending, China was a wizard at whitewashing its financial crisis. In the early 2000s, China pulled off two astonishing tricks that made credit problems totaling 20 percent of loans (or 16 percent of GDP) effectively disappear from those banks and allowed China’s lending and GDP growth to continue. First, China’s banks lent ¥270 billion to the government, which promptly injected those same funds back into the banks as equity. It was almost magic. Where did the banks get the money to lend? The government simply lowered their reserve requirement from 13 percent to 9 percent. In other words, they used funds already on deposit at the People’s Bank of China, China’s central bank—and with just a few paper entries, the capital of those banks was doubled.38 The government then set up four asset management companies (AMCs), and the banks transferred roughly ¥1.4 trillion in bad debt (which was “20 percent of the total loan balance at that time”) to those AMCs—at face value. The banks took back AMC bonds and People’s Bank credit in payment.39r />
  This was more magic on China’s part and a clever way to achieve a government recapitalization and shift the burden to taxpayers.40 With a large dose of new equity added from overseas, one of the largest bad debt problems in banking history had instantly been dealt with. As circumstance would have it, at this moment, the West started its debt-fueled mid-2000s importing binge, much of which was from China, and China’s net exports surged from 2 percent to 8 percent of GDP, supercharging that country’s economy. With that, China’s banks were soon back. This was supplemented shortly afterward and in the years beyond through additional government capital, additional nonperforming loan transfers, and foreign investment.41

  China’s legerdemain was breathtaking but ruthlessly logical. Unlike the governments of the United States or even Japan, the Chinese government had absolute ownership or control of all the entities involved: banks, borrowers, regulators, and AMCs. China’s deftness and creativity in financial problem-solving made Japan in the 1990s and the United States in 1987 and 2009 look positively clumsy in comparison.

  Turning back to Japan, for seven years, through a combination of denial and delay, Japan had managed to avoid facing up to its vast bad debt crisis. But with its own mounting problems and a backdrop of the Asian crisis, the day of reckoning was at hand. On November 4, 1997, Japan’s Sanyo Securities filed bankruptcy, making it the “first failure of a publicly listed security company since the war.” On November 17, Hokkaido Takushoku Bank “asked the Bank of Japan for an emergency loan,” likewise another first: the “first failure of a ‘city bank’ since the war.” Then on November 22, 1997, “Yamaichi Securities started voluntary liquidation,”42 which stunned the markets since, unlike Sanyo, it was one of Japan’s four largest securities companies.43

  Japan then entered phase three of financial crisis, the recapitalization and long climb back. From 1997 to 2003, Japan’s government spent huge sums to rescue and recapitalize some of the largest banks and securities firms in Japan. In March 1998 the government finally began a large-scale intervention in the crumbling banking system by injecting ¥1.8 trillion of funds into twenty-one banks.44 But that amount was far “too small to stabilize the [funding] market,”45 given that the problem was at that moment perhaps still ¥100 trillion to ¥200 trillion in size even after the banks had already charged off ¥50 trillion of that against earnings. So in October, the Japanese National Diet passed more effective bankruptcy (Financial Revitalization Act) and public capital injection laws (Bank Recapitalization Act), which gave it a more straightforward path to deal with problem banks.46 It took this path almost immediately, when it nationalized the Nippon Credit Bank in December.47

  In March 1999, the Japanese government injected another ¥7.7 trillion into fifteen banks, which stabilized the financial and funding market,48 though some further deterioration of loan quality remained and the problem lingered.49 With this recapitalization in 1998 and 1999, Japan’s banks finally began to take actions to restructure and charge off loans, and they finally began to contract their overall loan totals. Thus began a private debt deleveraging that saw an almost unbroken private debt–to–GDP decline for an incredible twenty years—offset by even greater levels of public debt growth. Private debt deleveraging is difficult. It is hard for an economy to grow if the ratio of private debt to GDP is contracting because private debt growth is a primary engine of economic growth. This protracted deleveraging was the main cause of Japan’s stagnant economic performance during this time, sometimes called the Lost Decade, but ultimately so long that it should more appropriately be thought of as the Lost Generation.

  In 1999, the Nikkei rallied but quickly fell again, and remained trapped in a desultory trading range for over a decade. Audits in 2001 by the Financial Services Agency showed that banks had still not fully acknowledged the problems in their portfolios. Regulators, who were now more willing to address the problem, assessed bad debt on banks’ books to be significantly higher than the banks’ estimates of the same.50 By 2003 bank capital was almost depleted again owing to newly recognized problem loans.51 Clearly, banks had still not fully acknowledged or addressed the extent of their loan quality problems.

  In 2003, “many weakened banks were allowed to operate by showing massive deferred tax asset” gains, and regulators continued to show forbearance since there were simply “too many bad banks for government to nationalize.” In May of the same year, the government injected ¥2 trillion into an insolvent Risona Bank, even though it had been represented as sound. In November, Ashikaga Bank, “a big regional bank, was nationalized.”52 The government-led recapitalization continued piecemeal through 2003, and related bank failures dragged on until 2005.

  Japan had strung out its massive 1990 overcapacity and bad debt problem for almost fifteen years. Its three years of lending profligacy, from 1987 to 1989, had brought fifteen years of penance. Some mark the long-deferred end of the crisis as 2005, when loan losses for major banks, which had been as high as ¥13.5 trillion in 1998, declined to ¥2 trillion.53

  Between 1992 and 2004, Japanese banks lost ¥96 trillion. Some observers estimate that the crisis ultimately cost between ¥100 trillion and ¥150 trillion, or 20 percent to 30 percent of Japan’s GDP.54 Estimates of this cost vary. Nomura’s esteemed economist Richard Koo calculates certain gains realized by Japan’s government and concludes that in the final analysis the cost was far smaller, at ¥11.5 trillion. The European Commission estimates the cost was ¥70 trillion and the IMF estimates that it was ¥21.8 trillion. Estimates vary widely for the cost of every financial crises economists and historians examine.

  Yet the most enduring cost was an economy that posted zero nominal growth from 1997 to 2016 and remained laden with, and stunted by, one of the world’s highest private debt–to–GDP ratios. Japan’s businesses were deleveraging but were nevertheless still highly leveraged, and thus found it hard to increase borrowing no matter how attractive the rate and terms. As a result, the factor that could have been pushing Japan’s economy forward—growth in private debt to GDP—was absent.

  The fact that Japan showed so much forbearance for so long, and then rescued its banks, meant that companies that would have otherwise gone bankrupt continued to operate thereby keeping unemployment comparatively low.55 The Japanese have always assigned very high value to social cohesion, and this was very much a factor in the 1990s. There was little social disruption. Unemployment at the height of the crisis reached an unusually high figure for Japan but it was still low by the standards of other major crises.

  In Japan’s slump, the government’s tax revenues declined and its expenses increased, and since that time, Japan’s postcrisis government debt–to–GDP ratio had climbed to 236 percent, more than double the ratio in the United States. Japan’s huge government deficits constituted, in some sense, the greatest Keynesian experiment of all time—which is to say the use of government expenditures to increase demand. And while GDP growth responded, it did not respond at the hoped-for level given the magnitude of the increased government spending.56

  Some prominent Japanese economists have more recently argued that Japan’s approach to rescuing its banking industry was a success compared with the U.S. approach in 2008. The United States dealt with its problem in a much more compressed time frame, yet experienced both more GDP contraction and higher unemployment.

  Whether Japan’s approach came from default or design is still debated. Though it did result in less disruption and unemployment, it left Japan’s economy struggling with very high levels of private debt. The better policy, as always, would have been to have curbed or moderated the runaway lending of the late 1980s to begin with.

  The crises described thus far occurred at times when reliable data on private debt were more or less available, albeit neglected. But it is my contention that private debt played the same pivotal role in more distant historical crises and was the core factor in nineteenth-century financial crises. To examine this view, we will take a tour in the next two chapters of ma
jor crises that occurred before the Great Depression, with a focus on the same six countries with the largest economies during that time.

  In these first Industrial Age financial crises, vast amounts of private debt—incurred to buy land, to build on that land, to grow cotton, and to build railroads and canals—led to overcapacity, troubled loans, and bank failures.

  CHAPTER 4

  The Dawn of the Industrial Age Banking Crisis

  1819–1840

  Though financial crises date back to the dawn of lending, the crises in the United States in 1819 and Britain in 1825 can be considered the first major crises of the Industrial Age.

  The Crisis of 1819

  In 1816, the Second Bank of the United States had been chartered by Congress in large part because the absence of such a bank had made the War of 1812 difficult to finance. It was chartered with a mandate to make conventional loans, and make them it did, with loans skyrocketing from $13.5 million in 1817, its first year of business, to $41.2 million by 1818. By all appearances, the bank did not know how to judge risk, as is often true in a newly industrializing country, and almost immediately had made enough bad and fraudulent loans to bring the nineteenth century its first truly major financial crisis. Its losses spanned all regions of the country, especially the South and West, and “were so enormous that the bank was crippled in its dealings for six or seven years.”1 In just one facet of the aftermath, the property it had been forced to accept in liquidation of its debts resulted in its owning “a large part of Cincinnati: hotels, coffee-houses, warehouses, stores, stables, iron foundries, residences, [and] vacant lots.”2 When Andrew Jackson blamed the Second Bank for this crisis, it was with good reason. The contention between soon-to-be-president Jackson and the Second Bank would figure prominently in a much larger crisis less than two decades later.