The Bursting of the Bubble

Madame Nui’s Toad
On arriving at [Madame] Nui’s house, the IBJ [Industrial Bank of Japan] bankers would join elite stockbrokers from Yamaichi Securities and other trading houses in a midnight vigil. First they would pat the head of the toad. Then they would recite prayers in front of a set of Buddhist statues in Nui’s garden. Finally Madame Nui would seat herself in front of the toad, go into a trance, and deliver the oracle—which stocks to buy and which to sell. The financial markets in Tokyo trembled at the verdict. At his peak in 1990, the toad controlled more than $10 billion in financial instruments, making its owner the world’s largest individual stock investor....By 1991, in addition to IBJ, which lent Nui ¥240 billion to buy IBJ bonds, twenty-nine other banks and financial institutions had extended her loans totaling more than ¥2.8 trillion, equal to about $22 billion at the time.
       Onoe Nui was riding the success of the so-called Bubble, when Japanese investors drove stocks and real estate to incredible heights in the late 1980s. In 1989, the capitalization of the Tokyo Stock Exchange (TSE) stood slightly higher than that of the New York Stock Exchange; real-estate assessors reckoned that the grounds of the Imperial Palace in Tokyo were worth more than all of California....Euphoria was in the air. Japan’s unique financial system
—which is based on asset valuation, rather than on cash flow, as is the norm in the rest of the world—had triumphed.

When the crash came, it hit hard. In the first days of January 1990, the stock market began falling, and it lost 60 percent of its value over the next two years....When the stock market collapsed, so did real-estate prices, which fell every year after 1991 and are now about one-fifth of Bubble-era values or lower. [Alex Kerr, Dogs and Demons: Tales from the Dark Side of Japan (New York: Hill and Wang, 2001), 78-79]
Banks, which lent heavily to speculators like Madame Nui to buy stock and land, found themselves saddled with an enormous weight of nonperforming loans....The S&L bailout [during the 1980s in the U.S.], at $160 billion, came to about 2.7 percent of GNP at the time, but the cost of rescuing Japan’s banks could reach as much as 23 percent of GNP, a crushing burden. By the end of the century, despite a decade of rock-bottom interest rates maintained by the government to support banks, and despite a massive ¥7.45 trillion bailout in 1999, Japan’s financial institutions had written off only a fraction—perhaps 20 percent—of the loan overhang. [D&D, 80]
What occurred in Japan is an elegant test case, better even than that of the U.S.S.R., of what happens when controlled markets defy reality. For fifty years, the Ministry of Finance (MOF), the most powerful of Japan’s government agencies, has set levels for stocks, bonds, and interest rates that nobody has dared to disobey. The financial system was designed to enrich Japan’s manufacturing companies by providing cheap capital, and in this it succeeded spectacularly well for thirty years. Money from savings flowed to the big manufacturers at very low rates—in the late 1980s, the cost of capital in Japan was about 0.5 percent. (In contrast, American and European companies paid rates ranging from 5 percent at the lowest to more than 20 percent.) And while in other countries investors and savers expected returns and dividends, in Japan they did not. [D&D, 81]
During much of the past half century, money poured into the Tokyo Stock Exchange, driving stocks relentlessly upward. After decades in this hothouse atmosphere, Japan’s financial community came to believe in the “magic of assets”: assets would always rise in value, especially when calculated by a technique, dear to MOF’s heart, known as “book value accounting.” According to this system, owners of stocks, bonds, and property do not need to assess their holdings at market value. Instead, balance sheets show stock at the price purchased—the stock you bought at 100 seven years ago, though now worth 200, still appears on the books at 100.
       This is a complete fiction, and it spawned a concept know as “latent profits,” which is the difference between purchase value and current value. The concept of “latent losses” did not exist. Investors have ignored dividends and looked exclusively at “asset value” and “latent profits.”
[D&D, 84]
Banks rarely make unfriendly recalls of their debt within keiretsu (industrial groupings), allowing companies within their grouping to borrow safely far more than their counterparts in the rest of the world. It has been in a company’s best interest to borrow as much as it can so as to acquire more and more capital assets and never to sell them. A company would borrow against assets such as land, and then reinvest that money in the stock market. The market would rise, and the company would then have “latent profits” against which to borrow more money, with which to buy land. And on to the next round. [D&D, 86]
The aim of the contraption the Ministry of Finance had rigged up for Japan’s financial world was peace or, rather, stasis. No bank could ever fail; no investor could ever lose by playing the stock market. Everywhere, cartels and monopolies ruled, guided by the firm hand of bureaucrats. This desire for peace, for no surprises, is such a strong factor in traditional Japanese culture that the Law of No Surprises comes first in my personal Ten Laws of Japanese Life. There is no better paradigm for this than the tea ceremony, where detailed rules determine in advance every slight turn of the wrist, the placement of every object, and virtually every spoken word. No society has ever gone to such extreme lengths to rein in spontaneity. In the industrial arena, employees rarely change companies; small start-ups do not challenge established large firms. [D&D, 87-88]
However, there was to be one last mission for MOF’s financial machine to accomplish, albeit a suicide mission. MOF decided that it should expand into Asia, which it considered Japan’s natural sphere of influence. Land prices had been rising in Thailand, Malaysia, and Indonesia for decades—all the old Bubble rules still seemed to apply there. So Japan in effect exported its Bubble to Asia, lending heedlessly to build office towers, shopping centers, and hotels, as was done in Tokyo and Osaka years ago....In the fall of 1997, the Avenging Angel arrived in Southeast Asia waving the flaming sword of “real value.” The Korean, Thai, Malaysian, and Indonesian currencies collapsed overnight....A massive financial meltdown of the sort that had been taking place slowly in Japan over seven years happened within a few months. [D&D, 90-91]
This brings us to a striking feature of Japan’s post-Bubble trauma: paralysis....Banks lent heavily to real-estate companies that own land now valued at a fifth or a tenth of the price they paid for it a decade or two ago. As the real-estate companies go under, these properties become the problem of their lenders, but rather than write down the losses year by year on a present-value basis, the banks have kept these properties on their books at purchase value; the moment they sell, they must suddenly report huge losses. So the market came to a near-complete stop in the 1990s: banks didn’t sell because of “latent losses,” and few bought because not enough transactions occurred to lower the prices to profitable levels. [D&D, 93-94]
There is one important area in which Japan’s financial system may not be globally irrelevant, and this is the nation’s enormous dollar holdings. This brings us to another artificial financial system, one that has perhaps the most far-reaching repercussions of all: Japan never took the dollars earned over decades of trade surpluses and exchanged them back into yen....
For Japan to repatriate all the dollars earned abroad (net holdings came to a colossal $1.3 trillion by the end of 1998) would put pressure on the yen and drive it upward, increasing imports and weakening Japan’s ability to export, and the point of MOF’s financial system was to repress imports and allow Japan to keep exporting at all costs; so manufacturing firms and the government left these dollars abroad, while funding their external balance with “virtual yen”—that is, yen borrowed at almost no interest from domestic lenders. This system worked well for decades, but by the 1990s it had come under huge strain. It is now more difficult than ever for Japan to repatriate its foreign reserves, since if it did, the dollar would drop like a stone, which would drive up inflation in the United States, raise interest rates, and put an end to America’s long economic expansion; at the same time, it would result in a shockingly high yen, bringing Japan’s exports to a crawl. So it is not only Japan that wields power over the United States; it goes both ways. Murphy says, “Japan and the United States have realized the financial equivalent of the nuclear balance of terror—mutually assured destruction.” [D&D, 97-98]