Lessons from Japan's lost decade: why America's experience may be worse.

• Author: Koo, Richard C.

The ongoing financial and economic difficulties in the United States have not only defied many earlier forecasts of quick recovery, including those from the Federal Reserve, but are also showing signs of stress that many experts are calling the worst since the Great Depression. In spite of the ever-worsening outlook, policy responses from Washington so far have been mostly ad hoc, with the Fed and government officials running with fire extinguishers to Bear Stearns one day and Fannie Mae the next. The debate in Congress has also centered on how to avoid a repeat of the crisis in the future, not how to contain and overcome the ongoing meltdown. Moreover, there seems to be no "Plan B" or "Plan C" in case things get even worse.

This lack of comprehensive approach in the face of such massive danger may be due to the fact that the current administration is already a lame duck and those with policy experience from the 1930s who can tell us what to expect are no longer with us. The lack of a thorough diagnosis of the problem and its possible remedies, in turn, has multiplied the fearfulness of both market participants and the general public, greatly worsening the deflationary pressure in the economy. The fact that European and Chinese real estate bubbles are also bursting is adding to the global gloom.

The United States (and the world) is extremely fortunate, however, to have the recent example of Japan before us. The second-largest economy in the world went through something very similar just fifteen years ago, and its experience can tell us volumes about what to expect in this kind of crisis. Although many Americans may scoff at the idea that the United States has something to learn from Japan, the truth is that the magnitude of the house price bubble in the United States from 1999 to 2006 (a 138 percent increase) was virtually identical to the one Japan experienced between 1984 and 1991 (a 142 percent increase). Furthermore, according to the house price futures listed in Chicago Mercantile Exchange, the magnitude of the decline in house prices (33 percent decline from the peak in four years) is nearly the same as that of the earlier Japanese experience (37 percent decline from the peak in four years).

Similarities do not end there. The largest estimate of losses financial institutions may incur in the current crisis was provided by the International Monetary Fund in its 2008 Global Financial Stability Report, which placed the price tag at $945 billion. This amount is virtually identical to the total non-performing loans Japanese banks wrote off during the post-bubble period, $952 billion at the exchange rate of 105 yen to the dollar.

Although the United States has not experienced a "lost decade" yet, many signs are far worse this time around compared to Japan fifteen years ago. For example, the much-criticized Japanese banking problems in the 1990s never reached the point where the banks distrusted each other in the all-important interbank market and the central bank had to enter the market on the daily basis to make sure banks were able to meet their payment responsibilities. In both the United States and in Europe this time around, however, the lack of trust between the banks is so serious that central banks have been forced to provide liquidity directly for over a year, with no end in sight.

Japanese banks also did not depend much on foreign capital injections, while banks in the United States and some European banks had to beg the sovereign wealth funds of some of the least democratic nations in the Middle East and Asia for capital in order to stay afloat. The credibility of rating agencies and mark-to-market accounting, once heralded as a pillar of transparency and accountability, also collapsed as markets for many highly rated financial assets simply disappeared. It is no wonder that many experts are calling the current crisis the worst since the Great Depression.

The ailment is called a "balance sheet recession."

Although there are many differences between the Japanese and...