Those Who Forget the Regulatory Successes of the Past…End Up Like Japan

My first column showed why the theoclassical attack on regulation is the leading reason why we suffer recurrent, intensifying financial crises. This column explains why the attack on regulation impairs our recovery from these crises by contrasting two polar cases: the U.S. response to the S&L debacle and Japan’s response to the collapse of the twin bubbles (real estate and stock). At the end of the 1980s when it became necessary to resolve the S&L debacle, Congress created an authority, the Resolution Trust Corporation (RTC) and budgeted funds for the resolution. The regulators knew that the losses were overwhelmingly due to bad assets and fraud and would be borne primarily by the public—with a final accounting in the neighborhood of $150 billion ($1993). The RTC strategy had three key features that were praised by senior Treasury officials of both Republican and Democratic administrations. First, the regulators required S&Ls to recognize their losses instead of covering them up. Failed S&Ls were placed in receivership. The RTC was run in a generally transparent manner. Second, the regulators hired experienced managers from the private sector with good reputations to manage the assets. The books and records of failed S&Ls often proved unreliable. The managers cleaned up the records, found the full inventory of bad assets, and made criminal referrals where that was appropriate (more than one thousand top S&L managers and their co-conspirators were convicted of felonies). The managers stopped the failed S&Ls from growing, began to shrink them, and got the S&Ls in shape to be sold. “Bureaucrats” did not make business decisions. Third, the government promptly liquidated (rare) or sold the failed S&L with federal assistance (typical). It did not cover up the failures and provide opaque subsidies to failed S&Ls. The shareholders and subordinated debt holders (which are both supposed to serve as “risk capital”) were wiped out in these deals. The RTC strategy was deliberately the opposite of what became the Japanese strategy of covering up the banking and real estate losses and providing opaque subsidies through the central bank. The RTC strategy was designed to allow markets to “clear” rapidly. The RTC strategy succeeded. Real estate markets cleared and stabilized fairly promptly. Losses to the public were minimized because bad managers were removed and growth in asset categories already beset by bubbles ended. The correct incentive structures were maintained by requiring risk capital to be wiped out and by bringing thousands of regulatory enforcement actions, civil suits, and criminal prosecutions against the senior managers and co-conspirators where appropriate. The Japanese strategy produced the “lost decade” (which was followed by the mediocre decade). Banks were allowed to hide their losses. They often loaned more funds to bad borrowers so that the borrowers would have the cash to make interest payments and stave off loss recognition. Even though Japan had a tremendous bubble in commercial real estate, the number of construction workers surged after the bubble burst. The change in productivity in the construction sector became sharply negative. Banks, and their troubled debtors, twisted slowly in the wind. Lending for productive purposes was weak. Property values in parts of Tokyo fell for ten straight years. The real estate markets took a full decade to clear. The NIKKEI remains, even on a nominal price basis, at 25% of its peak value. The Japanese strategy was to cover up the banks’ losses, to treat most of the massive “main” banks as too big to fail, and to provide opaque subsidies through the zero interest rate policy primarily to the main banks. The result was recurrent recessions and periods of weak recovery. The U.S. repeatedly suggested that Japan follow the RTC model and it was only after a decade of covering up bank losses that Japan finally did begin to require greater loss recognition and achieved moderate growth. Having seen the disaster that Japan’s strategy produced and the enormous success of the RTC strategy, it is the height of insanity that both the Bush and Obama administrations adopted the Japanese approach. Neither administration sought advice from the real regulators that cleaned up the S&L debacle. Neither administration appointed any senior regulator who contained and cleaned up the S&L debacle to a leadership position. As a result, both administrations failed to learn from both the mistakes and successes of the past. My next column will discuss why the modern anti-regulators’ adoption of the Japanese-style cover up and subsidize strategy (led by Bernanke, but with the tacit support of the Bush and Obama administrations) explains much of what is so bizarre about U.S. real estate markets (e.g., the shadow inventory) and large U.S. banks’ reluctance to lend. These two perverse regulatory actions have eviscerated the recovery.