The Magazine

What Japan Did Wrong

And what we can learn from it.

Feb 23, 2009, Vol. 14, No. 22 • By DUNCAN CURRIE
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Japan also attempted to stimulate the economy with infrastructure spending. Throughout the postwar era, Japan had always devoted an exceptionally large share of public spending to its infrastructure. In the early 1990s, this spending mushroomed and led to an explosion of what Lincoln calls "absolutely stupid projects."

The construction binge would have worked better, says Hoshi, if the money had been targeted more prudently. He reckons that most of it was wasted, and that the tax cuts were a better stimulus than the public works schemes.

Others, however, take a more benign view of Japan's infrastructure spending. Economist David Weinstein, a Japan expert at Columbia, believes that Japanese government spending was more important than tax cuts in boosting aggregate demand during the mid-1990s. Japan was an "extreme case," he says, in which massive infrastructure spending made sense. Weinstein also thinks the 1997 tax increases were a major obstacle to Japan's recovery. "They were much too hasty in raising taxes."

Compared with Tokyo in the 1990s, Washington has been fast in its reaction to the financial crisis. The adoption of a zero-interest-rate policy took years in Japan; in America, it took months. Whereas Japanese officials spent years denying or sugarcoating their bank woes, U.S. officials have been much more forthright in tackling the bank credit crunch. Those American lawmakers who wish to see most or all of the Bush tax cuts expire at the end of 2010 should remember that, as Hoshi observes, Tokyo's 1997 tax hikes "put the Japanese economy back into recession."

Japan was not sufficiently aggressive in pressuring banks to sort out their bad loans, or in recapitalizing those banks. Weinstein points out that the U.S. banking system today is much more sophisticated than the Japanese system was in the 1990s, yet the response from Washington has been disappointingly similar.

In their recent paper, Hoshi and Kashyap stress that "the fundamental problem" plaguing U.S. banks is a capital shortage. This was also the basic problem plaguing Japanese banks after the bubble burst. Hoshi and Kashyap show how Japan's use of asset management companies (AMCs) to buy up bad debts had only minimal success, partly because of their limited asset purchases, and that, moreover, the AMCs did not help recapitalize the troubled banks. The Japanese bank saga demonstrates that recapitalization and removing toxic assets are two different challenges, Hoshi and Kashyap write, and that "care should be taken not to waste money propping up financial institutions that will ultimately fail."

So have U.S. policymakers learned the correct lessons from Japan's bank meltdown? Hoshi does not sound terribly confident: "I'm afraid we may be making the same mistake the Japanese government made."

Duncan Currie is the managing editor of the American.