The Nikkei Financial Daily (Market Eye Column)., 18th December 2007
In the late 1980s, when Japan’s bubble was reaching its peak, the excesses where plain to see, credit was too easy, asset prices were too high and profits were being boosted by financial transactions. Despite general agreement on the nature of the problems and their threat to the economy, neither industrial companies nor banks modified their behaviour. Japan’s companies was the object of international scorn for the financial follies of “zaitec” and its banks for the “convoy system”, which assumed that no individual bank could be blamed for what all did and that banks as a whole could not be allowed to fail.
Today it is clear that Japan was, once again, merely leading the way. Both the convoy system and zaitec have become the international rule rather than an example of one country’s exceptionality.
The current crisis has not come without warning. As Professor Goodhart has written “Almost every central bank which published a Financial Stability Review, and international financial institutions such as the BIS and IMF, which did the same, had been pointing for some time prior to the middle of the 2007 to a serious under-pricing of risk.” Despite all these warnings commercial banks continued their reckless lending. In the notorious words of Chuck Prince, the soon to be fired CEO of Citibank, “We keep on dancing.”
Banks world wide have been moving in convoy. The reason for this apparent blindness to risk is that it pays banks’ management to be myopic. As I explained in my October article, it is an example of what is known to economists as the Principal/Agent problem. No one knows when the good times will end and premature caution damages short term profits. As management remuneration has become increasingly absurd both in its scale and its short term emphasis, the long term problem has become much worse in recent years. Such self-interest would no doubt have created a herd instinct, but it has been reinforced by the belief that if one particular bank got into trouble everybody would, so no one could blamed. In addition, the fact that everyone was behaving in the same way would mean that central banks would have to intervene to prevent the problem harming the economy. As the problem would be general, so would the bale outs.
Alongside this example of the Japan’s bubble behaviour becoming the general norm, we have seen a similar internationalisation of zaitec. There are numerous examples of this. It has for example been claimed in responsible journals, such as the Financial Times, that not only are Chinese shares selling at high multiples of their profits, but that much of the these profits are “made on the stock exchange.”
Increasingly companies’ profits as reported differ from those recorded in national accounts, because the former have financial assets and liabilities “marked to market”, while national accounts generally assume that the fluctuations of financial markets are ephemeral. If assets are valued at market it is logical to do the same with liabilities and this has been done by at least one US investment bank. The result is both logical and bizarre. If a company’s outlook deteriorates to the point when its creditors become concerned about the value of their loans, their value falls and the change is recorded as a profit. It follows that the more clouded the future becomes, the better, at least in this respect, are current profits.
The world has therefore been following the path that Japan pioneered in the late 1980s. The big question is therefore whether the next stage will also be similar to Japan’s subsequent experience. As the credit problems of America and Europe unfold, will their economies fall into torpor even if central banks bring interest rates down to zero, and governments run huge fiscal deficits? So far at least, though there are some signs of concern, the stock market clearly doesn’t think so. While it is clearly a significant risk, we have very little experience of credit squeezes induced by a unwillingness of banks to lend rather than by central bank tightening. Even more than usual, therefore, economic forecasts are liable to error in these conditions.