The wrong problem: Tokyo strategists think Japan's solution is to look to the U.S. 1980's example--eliminating bad bank debt. They're misreading history.

Listening to the heads of the U.S. Treasury, the IMF and the Bank for International Settlements, you might conclude that the single most important problem underlying Japan's economic sickness is the bad debt problem of the Japanese banks. It has been the economic focus in talks between President George W. Bush and Prime Minister Junichiro Koizumi. Even in bilateral meetings with Japanese officials to discuss responses to the terrorist events of September 11th, the U.S. Treasury insisted on taking up Japanese banks' bad debts.

Everyone knows that the bad debts of Japanese banks are huge. There are continuing arguments among policymakers and analysts about the size of bad debt because of the obscure Japanese methods of classifying debts as between "troubled" loans and truly nonperforming loans.

The truth is that the banks themselves do not know the scale of their bad debt problems. Japanese banks do not have accurate credit risk assessment capabilities, and internal information is of poor quality. Within the banks, bad news is often suppressed. Senior executives have little or no knowledge of the condition of many, if not most, of their borrowers. The Japanese government makes continuing declarations about the size of the bad debt, but its estimates are based upon the poor quality information passed on by the banks. Private sector analysts argue that the real number is some multiple of the official government estimates.

However, the current number is not as important as the trend. The Japanese economy has been floundering for more than a decade, and in 2001 has once again come into recession--a recession likely to last for several quarters, with recovery not likely until sometime in 2003. What this means is that sound loans now on the books will become troubled, and troubled loans will become nonperforming, as the economy deteriorates. Whatever the bad debt problem is today, it will be bigger in the future. There is no end in sight to the bad debts so long as the economy continues to weaken.

Prime Minister Koizumi started his leadership with a promise to clean up the bad loans, but little has happened in the months since he took office. The reason for delay is simple to understand politically: closing bad loans means shutting down businesses. Among these, the worst cases are Japan's big construction companies, which are the biggest employers in the nation, accounting for about 10 percent of all jobs. Unemployment would rise sharply if bad loans were closed out. Closing down bad loans would also necessitate government takeover of some banks, or new injections of public money into the banks. If the government fails to act, some big banks will eventually collapse, bringing collapse of additional companies and even higher unemployment.

A recent round of Japanese official explanations of the task was framed in a three-year, seven-year plan, with half the currently assessed bad debts resolved in the first three years, and the rest later. Investors in Wall Street threw up their hands, asking what would be done in the next ninety days, not in the next three years. Even more recently, a hot discussion has been taking place in the Japanese Parliament about the potential need for another round of public infusion of funds to the banks just to keep their capital base intact. And there has been hot discussion of whether the government should buy some of the bad debt, and if so, at what price.

Why is everyone focused obsessively on the bad debt problem, when Japan's economy is suffering from many other structural problems as well? The usual answer from the BIS, the IMF, and the U.S. Treasury is that the bad debts prevent banks from increasing lending to businesses, especially to new areas of activity. Banks have always been the dominant providers of funds for businesses in Japan, so this reasoning has superficial appeal.

However, it is highly unlikely that new bank loans will open the way for restructuring the Japanese economy. Right now, Japanese bankers argue that there are no creditworthy borrowers, so any money that comes along is invested in JGBs rather than placed in loans. If the government provides an infusion of new capital, the funds come right back to the government in bank purchases of government bonds.

But even if banks were willing to lend, bank loans are unsuitable for new startups, or for restructuring existing businesses. What is needed is equity capital and new sources of financing with instruments of lengthy maturity, to get businesses going, or get them past the current problems and into new modes of operation.

Kaoru Yosano, when he was MITI Minister a couple of years ago, said to me then that Japanese businessmen tend to develop strategies based upon experience in other countries. Japanese businessmen especially love to take me American template and apply it to Japanese business, often improving on the details in the process of emulation. Therefore, he suggested, what Japan most needs is to study the experience of the United States in the 1980's and early 1990's, when America restored its competitiveness.

Yosano recalled books and articles written at the start of the 1980's about the collapse of American competitiveness and the end of the American dominance of the global economy, and how all these writings proved wrong. He pointed out that the big U.S. banks had to undergo restructuring at the start of the 1980's, following the collapse of oil prices, with the result that major banks in Texas, Chicago, and elsewhere disappeared, partially absorbed in other banks. In the 1980's big and fat U.S. manufacturers downsized, becoming lean and competitive after several years of aggressive action to cut costs and boost productivity. At the end of the 1980's, America's thrift banks encountered a bursting of the real estate bubble, and had to be restructured with the helping hand of the U.S. Government, but this too was handled successfully. He also noted that public and private pension funds started the 1980's with serious underfunding problems, but by the 1990's had dramatically raised performance and become major suppliers of capital to the rest of the American economy. By the mid-1990's, America had successfully reestablished its role as the engine of growth for the entire world.

Yosano said that what Japan needs to do is study the American experience of the 1980's and 1990's, and apply the lessons to Japan.

Among the most important lessons, I responded, was that restructuring the American economy was not done with bank loans. It was done with innovations in the financial market that channeled non-bank funds into the revitalization of America. In the 1980's we had the rapid emergence of private equity and venture capital, high-yield bonds, securitization of debt, derivatives, and myriad other new financial instruments, which enabled companies to take bold steps without the continuing pressure of debt service obligations. This opened the way for dramatic changes in M&A activity, buyouts, mezzanine financing, incubation of startups, bundling of distressed assets, and many other essential steps on the path to restoring the competitive strengths of the U.S. economy.

Reflecting on that conversation with Yosano two years ago, I am surprised with the naive simplicity of current policy prescriptions that Japan must clean up its bad debts first before doing anything else. Working on bad debts first, without attention to the crying need for restructuring Japan's stalled economy, can only bring even deeper recession and more deflation--and more bad debt.

Japan does have huge bad loans. But Japan also has huge pools of "sleeping money" managed by "sleeping managers" including Postal Savings, public and private pension funds, and household savings. What is needed is to wake up the money managers and mobilize the sleeping money, channeling it into the restructuring of Japan.

This may sound fanciful at first, but consider the American experience. At the heart of the revitalization of the American economy in the last two decades was an evolution in the way money flowed from savers to those who needed capital. The dominant role of banks as financial intermediaries, taking deposits from savers and making loans to businesses, was gradually eclipsed by an entirely new array of financial mechanisms. Initially competing with banks, these new mechanisms eventually marginalized the banks in providing capital to entrepreneurs, ongoing businesses, and other forms of economic services. In the new century, bank lending continues to fall, now accounting for less than one-fifth of the total financing of American business.

The dominant players in the financing of business today are an array of new institutions including private equity firms, hedge funds, mutual funds, and specialized departments of securities firms, insurance companies and major banks which engage in leveraged, performance-oriented trading and investment.

Prominent among these new players in the last two decades were the private equity and venture capital firms. These organizations provided substantial capital for startups, buyouts, refinancing of troubled institutions and businesses, and M&A activities. They take the form of "limited partnerships" and are essentially unlisted, unregistered investment companies. Before 1980, there was little equity capital available in the United States for venture capital and restructuring of troubled businesses. The principal sources were wealthy individuals and some modest investment banking activity. By the 1990's, the dominant sources of private equity capital in America were public and private pension funds. Over half of all private equity was provided by pension funds, and much of the rest came from institutional investors including foundations, university endowments, and insurance companies. Manufacturing corporations also joined in by investing in a variety of startups. Wealthy individuals accounted for less than 10 percent of the total by the end of the 1990's.

This remarkable development of a vibrant non-bank financial market was not accidental. It was spurred by government policy, regulatory changes, and legislation. At the end of the 1970's it was recognized among politicians that something was needed to boost American economic growth. Among the ideas that emerged was encouragement of pension funds to broaden the scope of their investments, which would at the same time diversify their risks and strengthen performance.

In a short period of a couple of years, between 1979 and 1981, key alterations were made in public policy which opened the way for explosive growth in non-bank financial activities: In 1979 the U.S. Labor Department made two key revisions in its regulations under the Employee Retirement Income Security Act (ERISA), which governs the investment behavior of pension funds. To replace the previous prohibition of investments in "risky" instruments such as small company or new company securities, new guidelines provided that investments of pension funds would be permitted in such securities provided that they do not endanger a whole portfolio of investments. This opened the way for risk diversification. The second revision of ERISA rules was to allow investment in limited partnership investment companies, opening the way for pension funds to invest in unlisted or unregistered securities.

Then the Congress in 1980 revised the definition of "investment advisers" acting within the framework of limited partnerships, so as to remove a number of strict restraints on the managers and allowing them to utilize their capital in innovative ways to assist fledgling or troubled companies. Subsequently, the Congress enacted the Incentive Stock Option Law of 1981 to enable the use of stock options as compensation, opening the way for much stronger performance-based compensation.

The rapid growth in private equity and venture capital partnerships provided an alternative mechanism for routing pension savings into active deployment in the restructuring and functioning of the American economy, bypassing the traditional roles of banks and merchant banks. Indeed this flow of funds from U.S. pension funds in recent years has become so large that the American private equity and venture capital firms have begun to invest in the restructuring of European businesses. They have even begun to explore the application of their experience and the deployment of some of their capital in Japan.

In the United States, private equity firms played a large role in generating new businesses, saving old businesses, and creating employment while the big manufacturers were being downsized. Without their substantial role, unemployment would have risen sharply. These new private equity firms also functioned as "company doctors," providing management know-how and experience in building up new businesses and revitalizing troubled businesses.

These types of non-bank financial institutions constitute a major part of what are now characterized as "alternative investments," and can be found in the portfolios of most big pension funds, both public and private.

In Japan, MITI and the Pension Bureau of the Ministry of Health and Welfare studied the American experience and did recently push through new pension guidelines that would allow Japanese pension funds to diversify into alternative investments. But the society of pension managers was totally opposed to such adventures, and little has happened. Instead, Japanese pension plan providers continue to set endless conditions on how money should be invested when they pass funds over to the hands of professional asset managers. This effectively prevents professional asset managers from trying to improve investment performance, and locks the pensions into low rates of return. In time, this must inevitably lead to requirements for increased contributions and dramatically reduced benefits, and eventually an inability to pay pensions at all.

The application of American lessons to Japan is countered by some Japanese financial professionals who argue that Japan does not have the human resources to build up a major non-bank financial marketplace. The United States did not have this capability on a large scale prior to 1980--but it was generated in a few years, and is now big enough to be applied to other countries as well. Japan could learn from what took place in the United States. Moreover, Japan could welcome some of the most experienced American firms to work with Japanese businesses.

Right now, Japanese asset managers view the Japanese equity and bond markets skeptically. Buying of foreign bonds is once again in fashion, and staying the course in the U.S. equity market is seen as the safest investment in a generally troubled world. If serious restructuring started to take place inside Japan, based upon new flows of private capital from within Japan, then foreign capital would also start to flow into Japan. There would be far less need for public funds and public manipulation of the private sector if the financial market were to function fully. Japanese asset managers would join in and the equity market would inevitably strengthen. In such a context, the bad debt problem would stop growing and have a finite dimension; and at least some of the bad debt could be packaged and sold off to real buyers.

Of course, to build a fully functioning non-bank financial market many other steps would also be necessary, including reforms in debt collection, bankruptcy, dispute settlement, accounting and credit standards, etc. Greater financial transparency is coming this year and next with "mark-to-market" regulations, which will shock many stockholders and pensioners, but will enable investors to address opportunities realistically.

To conclude, addressing the bad debt problems of Japanese banks is important--but this is not a cure all. Many other steps are needed. American experience suggests that one important task is to reduce the dependence of Japanese businesses on banks.

Harald B. Malmgren is President of The Malmgren Group and a former Deputy U.S. Trade Representative (1973-75).