Economic Crises and Their Remedies - Center on Pacific Economies

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					             Financial and Economic Crises and Their Remedies




                                                                     Kazuhiko Toyama
                                                CEO, Industrial Growth Platform, Inc.
                      COO, Industrial Revitalization Corporation of Japan (2003-2007)


   Today, I would like to discuss about Japan’s rehabilitation process after the Bubble
   Economy and the phenomena before and after the Lehman Crisis.


1. The Rise and the End of the Economic Bubble in Japan and the US
   Since the Lehman Crisis, there have been many discussions on the causes of the
   Lehman Crisis. Frankly, I have listened to those assessments with some uneasiness.
   First, there is a theory that the Bubble economy and its demise were caused by
   financial engineering and human greed, both of which relate to emotional and moral
   issues.


   The Japanese Bubble occurred in the 1980s, and at the time, the country was full of
   various industry regulations. On the other hand, the most recent bubble that
   occurred in the US happened under weak financial regulation. Hence, it is not
   appropriate to explain the phenomena of the two countries in terms of regulatory
   environment. The only difference between the bubble in Japan and that in the US is
   that the Japanese financial institutions were controlled by the graduates of Tokyo
   University liberal arts departments while the US financial systems were controlled
   by genius “quant” gurus. In the end, both the Tokyo University graduates and the
   quants are both fools in the eyes of God. I say affirmatively that human societies
   will continue to see the rise and fall of the bubble phenomena.


   Economic Bubbles have existed ever since people started to use money as means of
   trade. The only reason why a hundred dollar bill is worth a hundred dollars is that
   people believe this to be the value of that paper bill. As humans are prone to
   expectations and imagination, the Bubble cannot be avoided. In other words,
   regulations can prevent the Bubble from magnifying or control the volatility, but
   this, too, is only to a certain extent. They will not be able to eliminate the Bubble
   from happening again. It is also very dangerous to assume that there will be no
Bubble as long as the financial regulations are in effect.


Another point is that attributing the crisis to human greed does not give solution to
the problem. Do we ask a person whether he/she is greedy before hiring for the
executive position? Besides, would a non-greedy person really be fit as an executive
in a financial institution? There is no doubt that greed is one of the causes of the
current financial crisis, but there is no practical solution to this problem. Today, we
are facing an influenza epidemic worldwide, and the reality is that the only way to
eliminate the virus fundamentally is to eliminate all human beings. We know that
this is not possible. The financial and economic bubble is just the same. Thus, it is
unproductive to continue such argument. We must shift our focus to the way to
avoid a pandemic.


I must also note that the Bubble is not all bad. In fact, the more catastrophic the
situation, the greater opportunities there are for innovation. History tells us that we
have overcome many depressions and crises. When the US faced the Great
Depression, the European economists believed that the US economy had come to an
end. They believed that this new nation could not do anything to overcome the
situation. However, the US economy came out very strong, with the consolidation of
the auto industry and innovations in various industries. Eventually, the US became
the super industrial power to lead the world by the latter half of the 20th century.


I was in Silicon Valley until 1992. In 1992, as you all remember, Silicon Valley was
in a deep recession. The entire computer industry was facing a severe downturn,
and IBM was on a verge of a serious corporate crisis. Silicon Valley companies, up to
that point, had avoided lay-offs and restructuring; however, in 1992, the computer
industry had to take such measures to keep themselves alive.


However, in 1993 and 1994, the computer industry gained new players—Netscape
and Yahoo. It was because of the industry downturn in the late 1980s and early 90s
that the new industry paradigm emerged. In essence, this is similar to the history of
Honda and Sony after World War II.


Thus, the Bubble has not only the negative effects but also destroys the status quo
and provides opportunities for innovation. From thirty to forty years from now, we
would realize that today was the turning point for many countries. The countries
   would be categorized by those that pursued innovation and those that gave up.
   Japan is indeed facing the turning point today. We are tested whether we could
   bring about substantial industrial and social structural changes.




2. Global Environment
   (1) US
   I believe that the US economy will recover fairly quickly if appropriate measures are
   taken on a timely manner. The reason behind the current financial crisis is the bad
   consumer loans the financial institutions provided in the domestic market, as with
   the case in Japan in the 1980s. The difference between the two countries is that the
   credits of the Japanese banks were to specific debtors, whereas in the US, the loans
   were securitized and traded in the market, thus making the problem more
   prominent and widespread.


   Therefore, the remedies that should be taken in the US are similar to those that
   were actually taken in Japan. It took Japan too long to make the assessment and
   take appropriate measures, as it was the first time Japan encountered financial
   crisis of such extent. The US could, however, utilize the experience of Japan and
   take measures quickly.


   In the case of Japan, the government took two steps. The first step was taken in
   1998~1999 in the form of transitional federal financing to avoid deepening crisis,
   and the second step of federal bailouts occurred after extensive asset due diligence.
   The US government has completed the first step, so it needs to take the second step
   as soon as possible. The earlier the second step, the quicker the recovery.


   We must simultaneously look at the problems of the borrowers. The US households
   still carry an excessive amount of debt, which diminishes any incentives for
   investments in areas such as housing and automobile. In order to alleviate this
   problem, it may be necessary for the government to purchase their mortgage loans.
   This was done in the past by RTC, but it is not done today.


   Thus, we must tackle the issues of both the lenders and the borrowers
   simultaneously in order to achieve a quick recovery. Improving the balance sheet of
   the banks alone would not solve the problem. It is misleading to say that the banks
are not providing liquidity to the market because there is currently very little
demand for liquidity among the US households. I believe that if these issues are
dealt with within this year, the US economy will stabilize next year.


(2) EU
   The situation with the EU is that the lender and the borrower are often of
   different nationality, and this is adding complexity to the problem. For example,
   almost all of the borrowers of Iceland financial institutions were of England and
   other EU countries. This makes it difficult to take a unified approach. In
   addition, the loans of the European banks are to specific borrowers, thus the
   problems stay under surface and worsen until they become eminent to the public.
   Moreover, financial activities are done in terms of the European Union, while
   fiscal measures are taken by each country, thus making it difficult to take a
   unified approach to the problem.


   We must also note that the US is still growing in terms of population, and it
   continues to attract many talented people from around the world. Europe, on the
   other hand, is similar to Japan in that it faces aging population and weakening
   growth potential. The financial crisis was an additional blow to the region that
   had already been facing difficulties.


(3) China
   China has the power to revive quickly as it is still in the early stage of economic
   growth. Just as what Japan had experienced in the 1960s and 70s, financial
   policies and Keynesian policies are still effective, and the remedies for troubles
   under this stage of economic growth are well known. China is indeed taking
   such measures and is already showing signs of recovery.


(4) Japan
   Since last fall, Japan has been facing decline in foreign demand, causing
   recession in durable goods industries. The recent recovery of the Asian market
   has allowed final goods and some machinery parts to show some recovery, but
   capital investment continues to be sluggish.


   The important point is that we should no longer consider domestic demand and
   foreign demand separate. Unlike in 1985 when Maekawa Report was released
under Prime Minister Nakasone, foreign demand and domestic demand are
strongly interconnected. Therefore, if foreign demand is stagnant, it will
inevitably have negative effect on domestic demand.


Japan is currently seeing steady decline in domestic demand-related industries.
This is directly affecting unemployment rate and people’s bonuses. Real
unemployment rate, which adds recipients of employment assistance subsidy,
reaches over 9%. In such circumstances, you may not be unemployed, but there
is a great possibility that you know someone who is unemployed, and this kind of
a negative sentiment prevents you from spending. Since 70% of Japan’s economy
consists of domestic demand, Japan is unlikely to see a substantial recovery any
time soon.


As it is no longer appropriate for Japan to divide between domestic and foreign
demands, we must focus our attention on how to raise household income and
assets. In the past, there was an assessment that labor share would not increase
when the economy is good. This was because economic growth at the time was
dependent on the performance of overseas subsidiaries, and the wealth only
went to foreign employees. How, then, could this wealth be driven to domestic
households?    The best way is for Japanese to hold stocks in Japanese
companies that possess these overseas subsidiaries and gain profits through
overseas operations. However, the reality is that a high percentage of the shares
of such global companies are owned by foreign institutional investors, and any
wealth generated would end up outside Japan. It is time that the Japanese
government and the private sector seriously considered the way to increase the
wealth of the Japanese households.


As a result of the current financial crisis, we will be seeing further globalization
which would not have the US as the dominant center-figure. There is no
question that Asia would achieve substantial growth. It is fortunate that Japan
is a part of the Asia-Pacific region. Japan could, for example, pursue a scenario
where it would host the core manufacturing facilities of global companies that
target the Chinese market. Japan is the best country to set an R&D facility, as
there is little liquidity in the labor market, and sensitive information and
know-how could be kept under control.
3. Market Capitalism or Democratic Socialism
   After the end of the Bubble Economy, there have been critics in Japan who state
   that market capitalism and market-oriented economy have come to an end and that
   we should focus on bringing back Democratic Socialism. This, however, is an
   argument that is totally out of the question. Sweden and Demark, for example, are
   not Democratic Socialistic societies that they used to be in the mid 20th century.
   Japan is the only advanced country that still brings such ideological debates into the
   area of economic policy. Sweden, for example, is extremely clear on its
   market-oriented economic policy. Uncompetitive companies naturally go bankrupt,
   and there is no public policy to assist small and midsize companies or to set
   minimum wages. In Sweden and Denmark, there is no restriction on layoffs, so the
   workers face the same kind of severe labor market just as in the US. On the other
   hand, both countries provide system where the federal government gives direct
   assistance to those that have failed in the competitive environment. The two
   countries   have   been   successful   in   balancing   economic   growth   based    on
   market-oriented economy and re-distribution of wealth and social stability.


   Should we explain their system as a Democratic-Socialistic approach or as market
   capitalism? The number of federal bailouts to failed companies is far greater in
   Japan than in Sweden, so this would make Japan as more of a democratic-socialistic
   society than Sweden. In short, Japan is the only country that is engaged in this kind
   of nonsense, and such trend goes counter to the direction of global economy.
   Economists and critics making such arguments do not even know the reality of
   Sweden, and they should leave the scene at once.




4. Governance
   Recently, we hear critics who assert that executive managers became uncontrollably
   over-possessed with profit-oriented mindset because of too much emphasis on
   shareholders’ governance. Such statement of governance goes back to the
   Principal-Agent Theory in the 1980s which states that a corporation is owned by the
   shareholders (principal), and the management is merely an agent. This theory
   received wide recognition partly due to its simplicity, but I believe that it contains
   several flaws. For one thing, how could you explain a situation of a 100%-personally
   owned company? Ownership and management is controlled by an absolute power,
but it could fail severely.


Governance is not a matter that could be discussed so easily. We need to realize that
the issue is about avoiding too much power in the hands of one stakeholder. History
tells us that all mankind is weak and that having too much power would only
misguide a person. The essence of governance is about establishing a mechanism
that would avoid such danger.


There is no need for governance when a company is making profit and everything is
under control. However, no one can guarantee that the good times would last forever.
Governance is a mechanism that prepares you for the bad times. This applies not
only to companies but also to governments. Governance is necessary whether we are
facing the breakdown of the Bubbly Economy or not.


As for the private companies, many shareholders today consider themselves as
short-term investors due to high liquidity of the equity market. Therefore,
companies must consider the appropriate governance that would allow them to
achieve stable and sustainable management under the governance of short-term
shareholders.


They should be especially careful with populist claim, which demands management
to increase dividends or increase debt to re-purchase company’s trade stocks in
order to raise ROE. Obviously, such claim is not governance.


Lehman’s management, for example, was in fact complying with shareholders’
interests. All indicators of shareholders’ interests had been increasing up to the
point of its crisis. But this phenomena, under which all interests of the shareholders
were met, provided the management with the opportunity to justify themselves with
absolute power. Shareholders believed that the management was doing the right
thing. In fact, the Lehman shareholders should have taken a long-term view and
demanded management to take measures to increase capital, even if that would
lead to a drop in ROE in the short term.


Shareholders are sensitive to company profit because their interests in equity stock
are subordinated. Moreover, as Illustration 1 demonstrates, shareholders have the
risk of losing their value when corporate value decreases below 20 billion yens. In
   essence, shareholders are holding an option that have the inflection point at
   negative 10 billion yens.


   The value of an option increases as volatility rises. Therefore, shareholders as well
   as management, their agent, tend to choose strategy with higher risks (see
   Illustration 2). We often see management buying high-risk derivative products
   when the company is not doing very well. This is actually a practical decision, given
   the fact that the management is an agent of the shareholders. Shareholders would
   chose Strategy B with high-risk, high-returns rather than Strategy A, a low-risk,
   low return strategy. Derivatives clearly fall under strategy B.


   One must consider such characteristics when formulating a mechanism of
   governance. Shareholders must exercise appropriate governance, and equity
   analysts must provide appropriate guidance to the shareholders.




5. Final Thoughts
   The current financial crisis has given us many challenges. All parties involved must
   ask themselves whether they are seeing the core of the issues and making
   productive arguments.


   Both equity analysts and management have serious work ahead of them.
   Management has, up to date, often neglected to understand the market fully.
   Investors, on the other hand, have often lacked deep understanding of management,
   business, and the industry.      For example, when Kanebo Cosmetics revealed
   accounting fraud in 2005, most equity analysts stated that the Kanebo brand was so
   tarnished that its business would never recover. This was, in fact, a very shallow
   assessment. The business of Kanebo Cosmetics had not been supported by its brand
   but rather by the marketing power of the sales ladies. 90% of the analysts simply
   referred to an ordinary textbook that said brand supports retail companies. The
   focus of the equity analysts should have been whether the sales ladies would leave
   the company or stick with it and work fearlessly to revive the company. It was the
   latter that happened, and we all know today that Kanebo Cosmetics’ business
   performance achieved a great comeback.


   In the Post-Bubble era, we are challenged whether we have leveled ourselves up
from the past. In twenty or thirty years, we will look back at today and realize that
today was the turning point for the Japanese economy and the financial markets. I
hope that we will be saying that it was a turning point for Japan to move forward.




Based upon the lecture at the annual general assembly of JAPAN security analyst
association held in October 2010

				
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