Japan's mistaken solutions: lessons on how not to respond to a financial crisis.

• Author: Nakamae, Tadashi

Looking for a country that has "survived" a financial meltdown? Well, some would say that country is Japan, which went through a banking crisis from the mid-1990s until the mid-2000s, and has been cited as an example that America and Europe, currently going through their own financial catastrophes, should emulate. Yet officials, such as U.S. Treasury Secretary Henry Paulson, as well as dozens of analysts, continue to waver over whether Japan is an example of how or how not to deal with a banking crisis.

The answer is simple. Japan's method of dealing with its banking crisis was a failure, and thus is a blueprint for how not to solve a financial crisis. The current mess that America and Europe face is similar in that their financial institutions, like Japan's, are seeing the value of their assets deteriorate rapidly. Shareholders' equity is disappearing, leading to a shortage of capital among financial institutions, obstructing their ability to make fresh loans.

The difference between what is happening now and what happened more a decade ago is that Japan's crisis was relatively simple. Banks had accumulated bad loans, which were backed by bad collateral, mainly in a real estate market that was collapsing in value. In contrast, the current banking crisis in America and Europe has been caused by bad investments in securitized products. Not only are these losing value, they pose a further problem in that their complicated structure and lack of transparency makes them almost impossible to value. Even top officials cannot put a number on how much money has been lost. No wonder Mr. Paulson was forced to pluck a number--$700 billion--out of thin air.

The flip side of the balance sheet also favored Japan, just as it is hurting the West today. Japan's banks could at least be fairly sure that they would not have funding difficulties, as they relied on household deposits in a country that likes to put its savings in banks. In America and Europe, however, troubled financial institutions have an additional problem in that they raised funds in the short-term money market, a source that is, and has been, quick to dry up. This means that the balance sheets of American investment banks such as Lehman Brothers and Bear Steams and European commercial banks such as Deutsche Bank and UBS, to name but a few, are hugely leveraged.

As a result, the problems now facing America and Europe are far bigger that those of Japan a decade ago. And, given that Japan fell into an economic downturn that has lasted some eighteen years, using Japan's so-called solution to its banking crisis would be extremely dangerous for the global economy.

LESSONS FROM JAPAN

The West needs to do three things simultaneously. First, it needs to enable banks to obtain funds easily. Second, it needs to force banks to write down their assets, no matter how painful this may be. Third, it should recapitalize the banks so that they can make fresh loans. Doing these things one by one is not enough.

These three issues are so closely linked that it is foolish to assume that they can be taken care of separately. American officials have failed to see this, even though the markets have responded, temporarily, to each piecemeal attempt by the Federal Reserve and the government. The failure of America and Europe to take care of the third problem of recapitalizing their banks...