Wednesday, October 22, 2008


Regardless of the politics, why is Treasury Secretary Paulson (with the support of Fed Chairman Bernanke) in a hurry to buy up $700 billion in “distressed” debt? Paulson maintained in congressional testimony that it was to take bad loans off banks’ ledgers so that they would be able to lend again. But there is a much more serious reason, and it springs from the “Japanese lesson” of the 1990s.

It was Bernanke—in a little-noticed aside during his testimony—who said we didn’t want to repeat the “Japanese” experience. For those who don’t remember the 1990s, Japan experienced a 10-year deflationary spiral because their real estate and stock market bubbles burst almost simultaneously.

During that period, the interest rates on their cost of funds actually became negative. And that also happened in the past week with the U.S. Treasury’s 1-month bills, raising fears of a “liquidity trap”. This is the specter haunting the U.S. Treasury and Federal Reserve. When interest rates go to 0, it means all lending has ground to a halt, in a word. Investors have decided to park their monies in U.S. Treasury securities instead, the ultimate safe haven.

When this happened in Japan in the 1990s, it resulted not only in lost business and investor profits, but even reduced wages for Japanese workers that brought consumer spending to a screeching halt. And their 10 years of basically no growth made Japan no longer the feared economic competitor it had been in the 1980s.

Secretary Paulson’s rescue package will be helpful if structured correctly. It all depends on the ultimate cost to the Treasury, of course. Bernanke maintained that although $700 billion might be needed to purchase the bad debts—and might include all manner of consumer loans, as well as mortgages—they could hold the debts to maturity and thus be able to sell them for much more.

No one knows the value of the distressed mortgages at present, in part because the values of the underlying homes haven’t stabilized. Also, the amount of distressed mortgage debt could total $1 trillion, out of a total $9 trillion in outstanding mortgage debt. That means a lot more foreclosures could happen. But home prices should still remain above 2000 levels, according to most projections, which means a majority of homeowners might retain some of their equity.

It was because of the Japanese deflation that the Federal Reserve under Alan Greenspan advocated the record low interest rates of 2001-03 that brought us out of the 2001 recession. He (and Bernanke who was Fed Vice Chairman at the time) continually cited the Japanese reluctance to act quickly in writing off bad debts and closing down bankrupt entities.

There were other reasons for the Japanese deflation. The interlocking ownerships of banks-owning real estate-owning stocks made them reluctant to write off bad loans and close down insolvent institutions. They kept putting good money after bad money, in other words, which crowded out credit and capital needed for healthy businesses to grow.

That is the real danger we have now, in the eyes of Paulson and Bernanke. Hence the need for urgency in solving our credit crunch. The collapse of AIG, Lehman Brothers, Bear Stearns, combined with the failures of several banks, has left the government with few other options than to print as much money as is necessary to prevent the D words, the depression and deflation that might surely follow.

© Harlan Green 2008

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