Japan and Sweden Have Been Down This Economic Road

CU360
April 23, 2008 | COMMENTS

From Japan to Sweden, other nations have traveled from real estate busts to financial crises in recent years, notes The Christian Science Monitor. From those experiences, a simple lesson has emerged: Effective policy makes the difference between a long or a slow recovery.

For U.S. policymakers, Japan is the case study in what not to do when a credit bubble is followed by a real estate bust. Regulatory delay resulted in a "lost decade" of economic stagnation there. Sweden faced similar challenges but now serves as a model for how decisive action can mend a banking system.

So far this year, the Federal Reserve has already moved in creative ways in a bid to contain what may be America 's worst financial crisis since the Great Depression. Its most recent actions brought a measure of calm to Wall Street.

But finance experts say the fundamental problem—the burden of bad loans on financial firms—still needs to be worked through. Future steps will determine whether America follows the Japanese or the Swedish path.

While the scale and scope of U.S. losses are as yet unknown, the Federal Reserve and other U.S. policymakers are aware of the Japanese precedent and want to avoid it. And the scale of the problem is larger and more complex than the challenges faced by Sweden and other Scandinavian nations nearly two decades ago.

That doesn't mean the outcome will be catastrophic—thanks in part to the lessons policymakers have learned.

The common progression begins with a housing boom, money flowing in from overseas, and rising government debt. Then economic growth cools and banks see a rise in delinquent loans. Lenders tighten up on credit, further squeezing the economy. Often the result is a severe recession.

"The Japanese example is a terrific model of how not to do it," says David Beim, a former banker now at Columbia University 's business school. "They had huge problems in their banks and they didn't face up to them."

For too long, experts say, Japanese regulators coddled ailing banks, hoping the problem would go away. The government tried to pump money into the system, but without demanding better management. Credit became largely unavailable to firms that could have used it productively.

"If the government must bail the bank out, it should basically wipe out the management and wipe out the shareholders," says Beim.

It sounds tough, but that's the point. It sends a signal that bad management won't be rewarded. And it conserves the bank's remaining resources—and taxpayer money—to restore sound lending for the economy.

The U.S. did a decent job along these lines, Beim says, when many banks failed in the late 1980s and early 1990s. By contrast, earlier in the 1980s, U.S. policymakers tried to help ailing savings and loans by altering regulations, and the eventual mop-up became much more costly for taxpayers.

Is a wave of bank implosions coming in the U.S.? "There probably will be some bank failures," Federal Reserve Chairman Ben Bernanke told Congress in February. Much depends on whether a recession makes it harder for firms and consumers to keep paying off their loans, notes the Monitor.

Risks are already rising. The percentage of bank loans that are noncurrent is 1.39%--a six-year high, according to Yardeni Research. And banks' return on assets was only 0.18% in the most recent quarter—the lowest since 1990.

A key concern for banks now is uncertainty over the real value of mortgage loans and the structured investments that contain those loans. "There are losses buried everywhere on balance sheets," Beim says. "It's all over the globe."

Faced with a comparable problem, Sweden had board-of-valuation experts go in and value the assets—the loans at banks—according to David Rosenberg, chief economist at Merrill Lynch. And when a bank failed, the Swedish regulators reorganized the institution with "good" loans and "bad" loans under separate managements.

"Such a restructuring," Rosenberg writes in a new report, "can be an effective way to dispose of nonperforming loans and return the financial sector to health."