Dogs and Demons

Despite the best efforts of Madame Nui's bankers and the toad, her empire crumbled. In August 1991 the police arrested her, and investigators found that she had based her first borrowings on fraudulent deposit vouchers forged by friendly bank managers. Nui's bankruptcy resulted in losses to lenders of almost ¥270 billion, the resignation of the chairman of the Industrial Bank of Japan, and the collapse of two banks. The «Bubble Lady,» as the press called her, spent years in jail, along with her bank-manager patrons.

Banks, which lent heavily to speculators like Madame Nui to buy stock and land, found themselves saddled with an enormous weight of nonperforming loans. For years the Ministry of Finance claimed that bad loans amounted to ¥35 trillion, only grudgingly admitting, in 1999, that they surpass ¥77 trillion. Even so, most analysts believe the figure is much higher-perhaps twice that. Taking the more conservative figure favored by many analysts, ¥120 trillion, Japan's bank fiasco dwarfs the savings-and-loan crisis of the 1980s in the United States. The S amp;L bailout, at $160 billion, came to about 2.7 percent of GNP at the time, but the cost of rescuing Japan's banks could reach as much as 23 percent of GNP, a crushing burden. By the end of the century, despite a decade of rock-bottom interest rates maintained by the government to support banks, and despite a massive ¥7.45 trillion bailout in 1999, Japan's financial institutions had written off only a fraction – perhaps 20 percent – of the loan overhang.

What were the policies that caused a supposedly mature financial market to fall prey to a mania completely askew with economic realities? The answer is simple. It applies not only to this question of finance but to questions in almost every area in which Japan is presently suffering: Japan's financial system rests on bureaucratic fiat, not on something that has intrinsic value. What occurred in Japan is an elegant test case, better even than that of the U.S.S.R., of what happens when controlled markets defy reality. For fifty years, the Ministry of Finance (MOF), the most powerful of Japan's government agencies, has set levels for stocks, bonds, and interest rates that nobody has dared to disobey. The financial system was designed to enrich Japan's manufacturing companies by providing cheap capital, and in this it succeeded spectacularly well for thirty years. Money from savings flowed to the big manufacturers at very low rates-in the late 1980s, the cost of capital in Japan was about 0.5 percent. (In contrast, American and European companies paid rates ranging from 5 percent at the lowest to more than 20 percent.) And while in other countries investors and savers expected returns and dividends, in Japan they did not.

In the West, financial gurus sometimes lament that Wall Street holds corporate earnings captive to shortsighted demands for profit, whereas in Japan, rather than paying dividends to greedy stockholders, companies retain most of their earnings and pour them back into capital investment. Even though they didn't pay dividends, stocks kept climbing throughout the 1970s and 1980s. Thus arose the myth that stocks in Japan were different from those in other countries: they would always rise. When in 1990 Morgan Stanley began issuing an advisory that included warnings of which stocks to sell, MOF viewed this as an ethical lapse out of tune with the moral tradition of the Japanese stock market.

Concentrating only on the benefits to companies that need not pay dividends leaves out several important factors. We all know there are various standard ways to value stock. Most important of these is the price-to-earnings ratio (P/E ratio), which tells you what percent of your investment you can expect a company to make as earnings. A P/E ratio of 20 means that in one year the company will earn one-twentieth, or 5 percent, of the price of the stock, some or all of which it will pay out to you, the shareholder, in the form of dividends. These dividends will be your basic return on investment.

Calculating the true value of a stock gets complicated if you expect the company's earnings to grow dramatically in the future-which is why investors have snapped up Internet stocks in America even though many dot-coms have never made profits and have even suffered losses. But the general principle still applies; that is, the investor expects to be paid dividends, now or in the future, on earnings.

This has not been true in Japan, where the accepted wisdom held that stocks needn't pay out earnings; before the Bubble burst, P/E ratios reached levels undreamed of elsewhere in the world. The Dow Jones average, at its most inflated in early 2000, averaged P/E ratios of about 30, at which point analysts screamed that it was overheated. In contrast, average P/E ratios in depressed Japan reached 106.5 in 1999, more than three times the American level. A P/E ratio of 106.5 means that the average earnings per share of companies listed in the Japanese market is essentially zero.

A situation like this is paradise for industry, because it means that companies can raise money from the public for practically nothing. It works for investors, however, only if stocks always magically rise somehow, despite producing no earnings. That is to say, it works only as long as the stocks continue to find eager buyers. As part of the recovery after World War II, Japan's Ministry of Finance engineered just such a system, and it was a modern miracle. It worked partly because there was then relatively little stock available to the public, given a policy called «stable stockholding,» by which companies bought and held each other's stock, which they never sold. The purpose, as with many of MOF's stratagems, was not economic (which is why Japan's system baffles classical Western theorists) but political, in the sense that it was a means of control. It prevented mergers and acquisitions, which MOF could not allow: the threat of a takeover forces a company's management to manage assets to produce high returns, and this would go against the government policy of building up industrial capacity at any cost.

In order to restrict the stock available to the public, MOF raised high barriers for new companies coming to market. Only long-established firms could ever consider a new listing on the Tokyo Stock Exchange. Even Japan's over-the-counter market (OTC), equivalent to the NASDAQ exchange in the United States, followed this 'bigger and older is better' approach. The average review period for a company to list on the OTC was 5.7 years, and typically companies listing on the OTC have been around for decades, not a few years or months, as is the case with NASDAQ. «It's a cold, hard fact that in Japan newly launched companies have had no way of raising direct capital. In America they can; in Japan they can't,» says Denawa Yoshito, the founder of an over-the-counter Internet stock market for unlisted venture companies.

Matters began to change only in 1999, when, borne on the crest of a new wave of Internet euphoria, the OTC spurted upward, its index quadrupling in just one year. Even so, the OTC remains so dysfunctional, so far from the Internet-friendly marketplace that Japan's new entrepreneurs will need, that in the summer of 2000 Son Masayoshi, Japan's Internet wizard, set up a Japanese version of NASDAQ («Jasdaq»). In addition to easing the way for Japanese investors to buy American NASDAQ stocks, Jasdaq envisions listing promising Japanese ventures in New York, where they can source funds denied to them in Japan. The Tokyo Stock Exchange meanwhile set up its own emerging stock market, named Mothers. The pieces would seem to be in place for a brand-new form of stock investing. At the same time, all the old rules still apply over at the Tokyo Stock Exchange, where P/E ratios are still astronomical. It remains to be seen whether Mothers, the OTC, and Jasdaq can nurture stock that pays dividends and rewards investors-or whether they will follow the pattern of the Tokyo Stock Exchange in the 1980s and merely engineer another big Bubble.

During much of the past half century, money poured into the Tokyo Stock Exchange, driving stocks relentlessly upward. After decades in this hothouse atmosphere, Japan's financial community came to believe in the «magic of assets»: assets would always rise in value, especially when calculated by a technique, dear to MOF's heart, known as «book value accounting.» According to this system, owners of stocks, bonds, and property do not need to assess their holdings at market value. Instead, balance sheets show stock at the price purchased-the stock you bought at 100 seven years ago, though now worth 200, still appears on the books at 100.

This is a complete fiction, and it spawned a concept known as «latent profits,» which is the difference between purchase value and current value. The concept of «latent losses» did not exist. Investors have ignored dividends and looked exclusively at «asset value» and «latent profits.»

The same principles have ruled in real estate, where returns have averaged 2 percent or lower; even minus returns were common. The crash came even harder for real estate than it did for stocks, and by 1996 official land prices for Japan as a whole had dropped to half their 1991 peak (real prices were 88 percent off or lower at auction) and stayed low for the rest of the decade. Vacancy rates in Tokyo's commercial sector grew as high as 15 to 25 percent, and rents were half or a third of what they had been in 1988.

The «magic of assets» leads to a distorted view of Japan's strengths, since so much energy has gone into making banks and securities houses bigger but not necessarily better. In 1995, when ranked by assets, the top-ten banks in the world were all Japanese, with twenty-nine banks in the top one hundred (versus only nine U.S. banks). However, when Moody's Investors Service quantified liabilities, it found that only five of Japan's eleven city banks had assets in excess of bad loans; no banks rated A, only one rated B, three C, and twenty-six banks D. By early 1999, the average rating of major banks had slid to E+, meaning that they were essentially bankrupt. Obviously, size alone is not a good measure of financial health, since liabilities may equal or even exceed assets, and the truest measure of health is profitability, in which case not a single Japanese bank got into the top one hundred.

Lack of profits sapped the energy of Japanese banks, so that in time foreign banks outstripped them through profitable growth and mega-mergers. By July 1999, only two Japanese banks had made it into the world's top ten. One had a negative return on assets, the other nearly zero – at a time when Citigroup and BankAmerica, the top two on the list, were making more than 1.3 percent returns on much larger asset bases.

In Japan's asset-based system, size meant everything; in time, therefore, MOF mandated a wave of mergers so that Japan's banks could reclaim their position as the world's largest. Moriaki Osamu, the director of the Restructuring Agency, is reported to have said, «In order to preserve the financial system we have to shut our eyes [to unprofitable banks]. But, since they can't survive on their own, we've ordered them to merge.» In other words, Japan's bank mergers simply combined small hills of losses into larger mountains of losses. In August 1999, three banks – DKB, IBJ, and Fuji Bank – merged to create the world's largest bank by assets, yet the merger did nothing to make the resulting behemoth profitable. The well-known consultant Ohmae Ken'ichi compares the bank to the Yamato, Japan's giant warship in World War II that sank before it had a chance to fire its guns. By mid-2000, Japan once again had four of the five largest world banks – all of them huge money – losers.

This did not disturb MOF, however, because in Japan's credit system losses and debt have no consequences. Banks rarely make unfriendly recalls of debt within their keiretsu (industrial groupings), allowing companies within their grouping to borrow safely far more than their counterparts in the rest of the world. It has been in a company's best interest to borrow as much as it can so as to acquire more and more capital assets and never to sell them. A company would borrow against assets such as land, and then reinvest that money in the stock market. The market would rise, and the company would then have «latent profits» against which to borrow more money, with which to buy land. And on to the next round.

This cycle of assets-debt-assets is the background for the madness that seized Japan during the Bubble. It explains why IBJ lent Madame Nui money to buy IBJ's own bonds in a deal that cost her $30 million the moment she signed the contract. IBJ knew well why she wanted those bonds. She took her bondholdings to other banks, which were glad to lend her more billions because she had such blue-chip collateral.

This system flies in the face of Western economic theory, but it worked brilliantly in Japan for the first years after World War II, allowing Japan to pull itself up by its own bootstraps. Karel van Wolferen calls the system «credit ordering,» and it is important to remember that it really did achieve great success, turning Japan in a few decades into the world's second-largest industrial power. Since then the South Koreans have copied Japan's credit ordering and so to a greater or lesser extent have most of the so-called Asian Tigers.

This new paradigm of capitalism once appeared to have triumphed over old-fashioned Western values such as the law of supply and demand. There was just one little flaw. As Nigel Holloway and Robert Zielinski wrote back in 1991, «The competitive advantages that Japanese companies gain from their stock market depend on a single factor: share prices must go up.» The Ministry of Finance patched together an intricate machine to support this market: stocks that yielded no dividends, real estate that produced no cash flow, debts that companies never needed to repay, and balance sheets that legally hid losses and liabilities. In this market, no Japanese company could ever go wrong. It was the envy of the developed world.

It was a powerhouse, but it also was a Ponzi scheme. Ponzi schemes work well as long as money keeps flowing in; when the flow stops or slows down, trouble