Subprime: Is the U.S. Repeating Japan’s Mistakes?

Following a period of rapid growth, Japan in the 1990s, like the US last summer, experienced the bursting of its real estate bubble, which jolted the economy and led to longterm stagnation. Certain parallels have prompted concern that the US may be repeating Japan's mistakes.

The Carnegie Council's New Leaders hosted an event on Tuesday with speaker Edward J. Lincoln, Director of the Center for Japan-US Business and Economic Studies and Professor of Economics at New York University's Stern School of Business. Lincoln discussed similarities and differences between the lead up to Japan's financial crisis and the current economic downturn in the US.

Both countries experienced mistakes related to regulation/deregulation. The US was allowed to develop a junk bond market in the 1980s without enough regulation, while Japan's government asked mega banks to lend money to real estate.

Contributing to the problems in both countries has been the tendency of people to believe they have more insight than they do into how the world works and will be able to avoid negative outcomes. Hubris and greed cause people to ignore or misunderstand risks. In Japan, nobody believed real estate could depreciate in value. By the end of the '90s, the value of real estate is Japan's six largest urban areas had tripled since the 1980s, then dropped back to 1985 levels.

Both countries tended to underestimate the circumstances of the subprime problems. In 1992, the Japanese government asserted that it had fixed its policy and would be back on track quickly. Likewise, this past summer many in the US proclaimed that the subprime crisis could be easily resolved.

But a few key differences set the US circumstances apart from the Japanese crisis.

For one, Japanese banks had a weak inspection system and didn't disclose their bad loans until the end of the 1990s. The US on the other hand revealed their exposure to bad loans early on.

The countries' macroeconomic policy responses also differ. The Bank of Japan, in response to rising prices, raised interest rates and asked banks to stop lending money. The real estate bubble broke and deflation ensued, which made mortgage payment all the more difficult.

In contrast, the US Federal Bank, having learned in part from Japan's mistake, has issued a series of interest rate cuts to help the US economy. Current commodities prices also remain high.

Finally, the scale of the impact differs between the two countries. The face value of financial losses in the Japanese real estate market represented about 20 percent of GDP in a country with a slow economic growth rate and shrinking population. For the US, the figure is more like 8 percent of GDP, while the economy is growing and the population is increasing.

Everybody makes mistakes, but the question is whether or not you can correct those mistakes.

The US is likely to experience a mild recession in the near future. But, according to Lincoln, the bottom line is that the US is not repeating Japan's failure and will correct mistakes more quickly and experience smaller losses than Japan.