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Navigating the path of least resistance: financial deregulation and the origins of the Japanese crisis.

This article reexamines the period of the Japanese bubble (1985-1990) and emphasizes ill-supervised and ill-sequenced financial deregulation as a key proximate factor. Given the subsequent costs of this political choice, what explains such a path of domestic financial deregulation without the establishment of corresponding supervisory institutions? I argue that the suboptimal Japanese outcome represents the equilibrium point for political leaders who had to balance global pressures to deregulate the economy, corporate pressures to liberalize finance, and domestic resistance by an array of politically connected interest groups. The government chose ill-supervised financial deregulation as the path of least political resistance and the golden bullet that could both defuse trade tensions with the United States and readjust the Japanese political economy in a harmless way. Instead, as they interacted with other factors, the choices made in the early 1980s destabilized the Japanese system and carried the seeds of the ensuing financial crisis.

KEYWORDS: financial deregulation, Japan, financial bubble, financial supervision, financial globalization, interest groups, Yen-Dollar Agreement, East Asian Financial Crisis

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During the 1980s, the dramatic success of the Japanese and East Asian economies lent much credence to political explanations of economic development and led the World Bank, in its landmark survey The East Asian Miracle (1993), to question neoclassical views. (1) In turn, the Japanese stagnation since the bursting of the economic bubble in 1990 and the East Asian crisis of 1997-1998 have led most theorists to criticize the very institutions that were once thought to underpin the miracle. The rise and fall of the East Asian miracle thus provides a fascinating puzzle. How could the same East Asian institutions sustain both an unprecedented economic miracle that made them the object of emulation and fear and a massive economic downfall?

Most scholars agree that the Japanese crisis has followed a three-step sequence. From 1985 to 1990, the Japanese miracle went into a euphoric phase, with twin bubbles in the real estate and stock market, coupled with massive exchange rate appreciation (endaka). Real economic growth during the 1980s averaged 4.6 percent, the highest among G7 countries. (2) The party abruptly stopped in January 1990, when the sudden tightening of monetary policy provoked the collapse of the stock market. From 1990 to 1997, Japan gradually fell into a deep financial and economic crisis, as its institutions proved unable to respond to the collapse of the bubble (saki okuri, or delaying period). Real economic growth remained at 5.2 percent in 1990 and 3.3 percent in 1991, but it quickly fell to 0.9 percent in 1992 and continued at a pace of 1.74 percent per annum in 1993-1997. From 1998, Japan has engaged in a series of important financial, corporate, and economic reforms, even though their effectiveness has not yet been sufficient to completely lift Japan out of its crisis. The average annual real economic growth in the period 1998-2003 was 0.57 percent.

Each of the three phases in the Japanese crisis has led to separate and lively debates. In this article, I focus on the origins of the sequence: the creation of the bubble and Japan's drifting off the optimal path. I argue that the period from 1979 to 1989 is critical for our understanding of the end of the Japanese miracle and indeed for our evaluation of the broader East Asian economic model.

To analyze this period, two crucial components are necessary: an understanding of the proximate economic causes of the bubble, and the larger political economic explanation of those proximate causes. I address each of these components in turn. After singling out financial deregulation as a critical proximate economic variable in the Japanese shift from an economic miracle to a dysfunctional system, I present a political economic model to explain these policy choices.

Several other proximate economic causes have been identified in the literature as possible sources of the bubble. The usual prime culprit is the loose monetary policy that continued even in 1988 and 1989 when asset inflation in the real estate and stock markets had become apparent. (3) A second complementary economic factor was the conduct of fiscal policy. By restraining fiscal policy during the bubble period and selling off debt, the government forced the central bank to loosen monetary policy to maintain economic growth in 1985-1987. (4) Other scholars have emphasized the intrinsic weakness of a bank management system rooted in informal relationships. (5) A fourth set of explanations focuses on the real estate bubble and on factors such as misguided land planning in the 1980s. (6) A fifth group of economic explanations focuses on the international trading system, the failure of cooperation between Japan and the United States, and the ensuing rise of the yen (endaka). (7) This rising yen forced the Bank of Japan (BOJ) to keep monetary policy loose, contributing to excess liquidity.

These five proximate economic causes are not mutually exclusive, and empirical studies provide some support for the influence of all five. What is disputed is the contribution of each factor, and whether---even taken together--they are sufficient to explain the bubble and the collapse of the Japanese miracle. The mid-1970s also saw a period of loose monetary policy, and several factors highlighted above are structural and therefore present throughout the miracle period. Most explanations stressing longer-run institutional problems require supplementary hypotheses about why a system that was at one point functional became dysfunctional.

In this article, I suggest that the process of financial deregulation plays an important complementary role to these other explanations, and in doing so I integrate lessons coming from the literature on the East Asian financial crisis. Save for the work of a few economists, (8) limited attention has been devoted to the contribution of financial deregulation to the Japanese bubble and crisis. Even less attention has been devoted among political economists to the particular type of financial deregulation that took place in Japan during the 1980s. (9)

Financial deregulation can be broken down into two broad components: the liberalization of domestic finance and the opening of the capital account (external liberalization). The first entails the removal of tight domestic restrictions placed on capital markets and financial institutions in the wake of World War II in most countries, particularly non-liberal capitalist economies like Japan, Germany, and France. These restrictions not only favored bank-led financing and prevented the growth of bond markets, but also established a regulated framework for bank operations (fixed deposit and lending rates) and provided state guarantees for the survival of banks (the so-called convoy system in Japan). In a context of financial globalization and new financial technology, these restrictions gradually appeared costly for developed economies and were gradually removed. The second component of financial deregulation refers to the removal of obstacles to the free flow of capital across national borders. During the Bretton Woods era, portfolio capital flows were restricted and limited. The opening of the capital account includes the deregulation of inflows (attracting foreign capital, be it foreign direct investment, bank loans, or inflows into the bond or stock markets) and/or the deregulation of outflows (allowing national investors and corporations to invest abroad).

Taken as a whole, this double process of domestic and external financial deregulation represents a fundamental transformation of the political economic system of most developed countries in the 1980s and 1990s. This transition requires both a careful sequencing (10) and a transformation in the role of the state with respect to financial institutions. Guarantees against bank failure, as in Japan, always create risks of moral hazard. But the costs of such policies rise in the context of innovative bank behavior, increased competition, and integration into global capital markets. The shift to a world of liberalized and globalized finance requires the abolition of relational supervision and the setting up of new rules and monitoring agencies to ensure the viability of banks and securities markets. When the establishment of powerful regulatory institutions does not precede financial deregulation, economic systems are vulnerable to unexpected excesses and quick punishment from global capital markets.

The East Asian crisis represents one type of ill-supervised and ill-sequenced financial deregulation. Partly under foreign pressure, East Asian countries such as Korea and Thailand opened their capital accounts before establishing a strong domestic financial system and adequate financial supervision. (11) The result was a flood of short-term bank loans in dollars used for long-term investments in local currency (mismatch of currency and maturity). The authorities allowed short-term foreign loans to reach amounts far in excess of foreign reserves and assumed that their currency pegs were sustainable. The result was an external liquidity crisis when the flood of outgoing short-term flows overwhelmed reserves and led to a collapse of currency pegs.

The Japanese bubble and crisis represent another type of poorly supervised financial deregulation, but the culprit is domestic financial liberalization, not capital account liberalization. In the early 1980s, under both strong pressure from the United States and lobbying by large corporations, Japan's financial authorities gradually deregulated domestic banking and allowed major corporations to access global bond markets for corporate financing. In response, banks engaged in increasingly risky lending operations, both to recoup the loss of their best customers and to take advantage of new opportunities. Because bank loans were used to buy real estate and real estate served as collateral for bank loans, bank lending was at the center of the bubble. Yet, although financial liberalization began in 1984, the critical accompanying step of building up a Financial Services Agency (FSA) came only in 1998.

The key political economy question is: What explains the path of domestic financial deregulation without the establishment of corresponding supervisory institutions?

In this article, I argue that ill-supervised financial deregulation represented the path of least political resistance for a government that had to maneuver between strong global pressures to liberalize and strong domestic interests opposed to the establishment of new financial regulations. Pushed by large corporations seeking to take advantage of a nascent financial globalization and by a U.S. government seeking to indirectly resolve bilateral trade conflicts through financial deregulation in Japan, the Japanese government also found itself restrained by domestic interest groups with strong ties to the party in power (the Liberal Democratic Party, or LDP) and banks (important contributors of campaign funds to the LDP). In the end, the government gave large corporations the freedom to borrow abroad and compensated banks by allowing them to tap new markets and use new instruments (including a relative entry into the lucrative government bond market). Securities firms were compensated through more freedom in equity markets. Meanwhile, the Ministry of Finance was denied the means to monitor banks and securities companies in this new environment, and the no-failure guarantee was maintained. Given that financial globalization and financial deregulation were novel and relatively technical phenomena, political leaders were unable to forecast that the choices made in 1979-1986 would contribute both to the financial bubble and to its subsequent collapse.

This process of interactive navigation through points of political resistance led to a bad equilibrium: (12) discrete choices in response to different groups had compounding effects. The U.S. government pressed Japan for solutions on the trade front. Facing strong opposition by domestic groups tied to the LDP who would be hurt by any domestic measures that addressed trade issues directly, the government settled for the second-best plan: trying to resolve such trade imbalances through financial deregulation (whether or not the logic was defendable from an economic point of view, as proven by future events). Pressure from domestic firms added to this logic and led to a plan for financial deregulation. This led to potential costs for other main supporters of the LDP, namely banks and securities firms, and the government sought to compensate them. These compounding effects resulted in a bad equilibrium of ill-supervised financial deregulation. The consequences proved severe during the bubble period.

The remainder of this article proceeds in four steps. The first confronts the current state of the debate over the Japanese bubble with recent evidence from the economic literature. The second presents the theoretical framework of the paper and analyzes the politics of globally induced and ill-controlled financial deregulation. The third presents the key empirical components: the politics of the Yen-Dollar Agreement of 1984, key battles over the setup of supervisory institutions, and empirical evidence about the resulting outcomes. The last step closes the argument by linking the tale of the bubble with the larger Japanese crisis in the 1990s.

Proximate Economic Causality: Ill-Supervised Financial Deregulation as a Key Link in the Japanese Bubble

The political economy literature on the Japanese bubble has emphasized either an overly permissive monetary policy (particularly after 1987) or the dysfunctional role of the Ministry of Finance, in conjunction with a number of facilitating factors (land policy, tax system, inheritance policy, etc.). In these views, the Japanese bubble can be seen as a unique phenomenon, the result of institutional arrangements and political compromises in the 1980s. After offering a short overview of the bubble in the context of the Japanese miracle, this section confronts the existing literature with recent economic findings that suggest important similarities to problems in the countries hit by the 1997 East Asian financial crisis.

From Miracle to Bubble

The facts of the miracle are well known. Between 1955 and 1970, real gross domestic product (GDP) growth at constant prices averaged a world record of 9.3 percent. (13) Real growth was sharply reduced by the Nixon shock of 1971 and the two oil shocks but averaged a comfortable 4.1 percent in real terms between 1975 and 1990. However, because of the rising yen in this second period, growth in dollar terms averaged a stunning 12.8 percent. Consequently, Japan's gross national product (GNP) per capita rose from $153 in 1950 (below the level of the Philippines and of Mexico) to $1,953 in 1970 (between Italy's and Greece's GNP), before surging to $23,898 in 1990 (higher than the U.S. level). (14) The policies followed during the period of high growth in the 1960s included tight fiscal policy (balanced budget), active proexport industrial policy, and strong incentives to saving and investment.

In 1972, Tanaka Kakuei became prime minister and initiated the massive "plan for rebuilding the Japanese Archipelago." (15) This major investment plan added to the costs of major new environmental programs and to the negative impact of both the 1971 Nixon shock and the 1973 oil shocks. Japan thus entered a period of large budget deficits and high inflation, at least by Japanese standards. Even then, the government managed to take quick retrenchment actions in the late 1970s and showed a remarkable ability to control inflation and limit stagflation. In the early 1980s, the Japanese political economic system remained robust, even if this came at the cost of a rising trade surplus and growing external friction with the United States.

By 1985, however, the Japanese economy entered a new and long-misunderstood phase: the bubble economy. The bubble was characterized by a consumption and investment boom (16) and high GDP growth of 4 percent or more. It was also characterized by high liquidity and a speculative rise of both the real estate market and the stock market. The onset of the bubble can be traced to 1985 when the Bank of Japan took a series of interest rate cuts as a result of external pressure and in line with the Plaza commitments. This led to a prolonged period of extremely loose money (official rate at 2.5 percent between February 1987 and February 1989), which was conceived as a method to prevent recession without resorting to fiscal spending. Stock prices tripled between 1985 and 1989: (17) by December 1989, when the Nikkei index passed the 39,000 mark, Tokyo's stock market represented 42 percent of total world capitalization and 151 percent of Japan's GNP. (18) Similarly, land prices doubled between 1985 and 1990 and quadrupled in the six largest cities. Companies, banks of all sizes, and individuals all invested in land and stock and engaged in activities of dubious legality (such as investment accounts with guaranteed return between stock brokers and large companies). Banks in particular poured huge amounts of money into real estate or made loans based on land collateral. These activities were either authorized or ignored by the Ministry of Finance, which has the duty of oversight over all financial actors.

The period of the bubble is also remembered for a rising yen, massive current account surpluses, and an onslaught of Japanese foreign investment, particularly in the United States but also throughout Asia.

The bubble collapsed in early January 1990 in response to robust hikes in interest rates. Interest rates trebled from 2.25 percent in May 1989 to 6 percent in August 1990. Stocks tumbled in January 1990 and indeed lost 48 percent in the year 1990 alone. By October 1998, the Nikkei index had returned to its 1986 level (at 13,000, a third of its 39,000 peak). This fall was followed by a slower but similarly dramatic fall in land values, which came down to their 1985 level by 1997. The massive and unexpected drop in both markets led to a crippling blow to the financial system and banks in particular. (19) The financial system was further racked by a series of scandals involving stock brokerages (Nomura in 1989, all Big Four in 1990-1991, Daiwa in 1995); home-financing companies (Jusen crisis up to 1996); banks that concealed bad loans and engaged in hidden practices and indirect schemes (LTCB, IBJ); and financial system ties to the Yakuza criminal world.

Adding to the financial crisis and related credit crunch was a general loss of confidence with corresponding effects on aggregate demand. (20) The economy stopped growing through much of the 1990s and entered full-blown recession in 1998. Unemployment reached 4.3 percent in 1998, double the 2 percent level of the 1980s. The economy seemed crushed under the combined weight of the bubble overhang of huge bad loans, overinvestment and surplus capacity, highly leveraged companies, a confidence crisis, and an aging population.

Conventional Political Explanations of the Bubble

What can explain the striking shift from an economic miracle to a bubble? Conventional explanations can be divided into five groups: policy/political explanations (emphasizing the wrongheaded monetary and fiscal policies outlined above); institutional models (mostly emphasizing problems with the dominance of the Ministry of Finance); systemic approaches; technical approaches (land, tax system, inheritance); and purely international approaches (rise of the yen).

Because of the central role of monetary policy during the bubble, policy explanations have dominated the debate. According to such explanations, the BOJ made two crucial mistakes. First, it pursued an extremely loose monetary policy far too long, failing to react to the asset bubble. This inaction was particularly striking in 1988 and 1989, when the German Bundesbank and other central banks were raising interest rates, once the October 1987 crash had been successfully managed. Then, in 1989-1990, it overreacted by trebling interest rates and provoking a complete collapse of the bubble, instead of engineering a soft landing. During the 1990s, it continued an overly tight monetary policy, given the circumstances of deflation.

From an economic point of view, however, arguments centered on monetary policy (and its links to fiscal policy) or on the BOJ's failure to explain why the loose monetary policy led to an extreme bubble at this particular time and not in 1972-1974, for example. Further, evidence presented by Thomas Cargill, Michael Hutchison, and Ito Takatoshi shows that the BOJ's lack of independence until 1998 did not result in any inflationary bias in policy; to the contrary. (21)

In turn, various models have been presented to explain this sequence of monetary policy choice. Richard Werner argues that the ideological framework of the BOJ's ruling class and their direct grip over monetary policy explain the overly restrictive monetary policy in the 1990s (as well as the role of the BOJ leadership in proactively piercing the bubble in 1990). (22) Yet, this explanation is less helpful in explaining the overly loose monetary policy of 1988-1989. Kamikawa argues that the BOJ was simply unable to identify and track the phenomenon of asset inflation, particularly given the context of low overwall inflation. (23) Other scholars argue that, while monetary policy is the main culprit, it cannot be explained without a bureaucratic model focusing on the relationship between the BOJ and other political actors (second model).

The proponents of a bureaucratic/structural explanation primarily emphasize how institutional incentives played a key role in generating bad policy outcomes. Several scholars have documented the crucial role played by the Ministry of Finance (MOF) in influencing at the same time monetary policy, fiscal policy, and banking regulations. Some have argued that the suboptimal monetary policy analyzed above can only be explained by the lack of central bank independence, the domination of the MOF over the BOJ, and the suboptimal outcomes of strategic interactions between the LDR MOF, and BOJ. (24)

Peter Hartcher presents a more general argument and argues that MOF initially served the honorable mission of pursuing the broad national interest, and the interest of the LDP as a whole, by maintaining fiscal responsibility in the face of demands from narrow-minded politicians. (25) Yet, increasingly in the 1980s and 1990s, MOF became more interested in gaining leverage for itself, consolidating its power and preserving its elite status and vast jurisdictional boundaries. (26) Furthermore, MOF's internal rivalries among bureaus became fiercer and undermined effective policy. As a result, MOF took irresponsible measures during the bubble period (such as insisting on the exclusive use of monetary policy and not fiscal policy to stimulate the economy or not performing its oversight functions). It took even more irresponsible measures in the 1990s (saving its privileged links to the financial system rather than cleaning up the mess), all driven by a quest for power and survival. Jennifer Amyx also ascribes a central role to MOF in the crisis but takes a more benign view: MOF was merely entrapped in thick network relationships with private actors around it and was unable to pursue a purely independent policy. (27) In Amyx's view, however, the core networks of interest are those linking MOF with financial institutions (retired bureaucrats in institutions and bank staff seconded to MOF) and with the LDP. The explanation centers on MOF itself, rather than on politicians. These MOF-centered explanations go a long way in unpacking the microlevel processes that allowed the bubble to inflate to such levels but miss the crucial link of externally induced deregulation, as they attempt to explain the shift from an effective MOF to an incompetent MOE

The third group of explanations ascribes the blame to general structural weaknesses in the Japanese system, such as a maturing economy, (28) an aging society, (29) or overregulation. (30) These models all suggest that the Japanese system worked well as long as the economy was catching up with the world's most advanced economies but showed crippling weaknesses once it caught up. (31) This argument is certainly appealing, for it accounts for both the past success and the present crisis. However, this argument is almost impossible to falsify, since it hinges upon a loose and flexible definition of the stage of a developed economy. Arguably, Japan was already a developed economy (comparable to Germany or France) when it entered the Organization for Economic Cooperation and Development (OECD) in 1964 and yet continued its smooth march for twenty more years. What is missing in this argument is a precise explanation of what changed between the two phases, of how it affected the system and what parts of it, and of what impact this particular change had on the state. In essence, the maturity argument is an incompletely specified argument.

The fourth group of explanations is more technical and less encompassing. It includes a series of specific explanations related to pecularities of the Japanese system, such as land policy, inheritance, and property taxes, (32) and others related to economic features such as the Japanese excess savings. (33) These explanations offer useful pieces of evidence, but the variables analyzed can only be seen as facilitating factors in a larger story driven by more powerful factors. Indeed, land policy and inheritance tax were mostly the same during the stable years of the miracle.

Finally, a powerful international argument focuses squarely on the appreciation of the yen, although this argument is usually tied to a consideration of U.S. trade pressures. (34) According to Ronald McKinnon and Kenichi Ohno, mercantile pressures by the U.S. government and U.S. industrial lobbies aided by economists' theories that linked exchange rates with the bilateral trade balance have shaped the future expectations of foreign exchange traders and have forced dramatic yen appreciation. This ever-rising yen incapacitated monetary policy and brought Japan into an externally induced deflationary trap (once an economy is in deflation, even 0 percent interest rates are too high), thus provoking a high yen-induced recession (endaka fukyo). This argument works best for the period 1993-1995, when the acceleration of the rising yen drove Japan into recession. It is weaker at explaining why the bubble took the dimensions it did and why the government apparently lost control over financial processes.

These explanations are useful in analyzing how the bubble was pushed by structural factors. They remain, however, insufficient to explain the complete nature of the phenomenon. In contrast to these varied explanations, some recent economic analysis of the Japanese bubble seems to emphasize the crucial role of domestic financial deregulation as the main engine driving the great bubble of 1985-1990.

Economic Evidence on the Effects of Financial Deregulation

I noted in the introduction a number of proximate economic causes for the bubble, focusing mostly on monetary policy or a variety of systemic or idiosyncratic features of the Japanese regulatory system. In recent years, however, financial deregulation has begun to gain more attention. After a decade of debates, reports, and multiple analyses, the International Monetary Fund (IMF), in January 2000, put together a summary report on the Japanese crisis. Titled "The Japanese Banking of the 1990s: Sources and Lessons," it squarely identified ill-supervised financial deregulation in the 1980s as the culprit, arguing that the roots of the crisis could be traced "to accelerated deregulation and deepening of capital markets without an appropriate adjustment in the regulatory framework." (35) This analysis built upon an earlier authoritative report published in 1995, in which Ulrich Baumgartner and Guy Meredith concluded with the following: "In sum, the empirical results suggest that financial deregulation, which took place in the late 1970s and throughout the 1980s, had an important influence in redirecting the influence of monetary factors toward asset markets." (36) The economic literature has identified several principal effects of financial deregulation in Japan in the mid-1980s. First, the dual effects of financial liberalization (particularly external bond and equity issuance) and of the deepening of global financial markets made it possible for large corporations to access cheaper sources of funds than bank loans. Their dependence on bank financing and on the main bank system as a means of corporate control dramatically decreased as a result, as summarized by Takeo Hoshi and Anil Kashyap:
 The deregulation that began in the late 1970s gradually but
 dramatically changed the financial system in Japan. The change was
 most substantial in expanding the fund-raising options available
 for large firms. Given the opportunity, many large firms moved from
 bank financing and to capital-market financing. For those firms, the
 cost of keiretsu finance ... seems to have come to outweigh the
 benefits. (37)


Table 1 summarizes some of the key indicators of this growing independence of large manufacturing firms from their main banks. In fact, thanks to liberalization and to financial globalization, blue chip firms obtained U.S. $519 billion in equity financing alone from 1986 to 1990, an amount equal to Canada's GDP in 1989. (38) When Sony acquired CBS records in the United States in 1987 for $2 billion, it financed most of it ($1.5 billion or 76 percent of the purchase price) through a mix of new Sony shares and new convertible bonds. The cost of direct financing proved much lower than the annual interest payment on equivalent bank loans. (39) The shift in corporate financing also loosened the keiretsu ties between large industries and others (loosening of the Dore-type of vertical relationships) (40) and loosened the ties between large industries and banks (less dependence on capital, lowering of cross-shareholding). Meanwhile, corporations became themselves active investors in the stock market, thus having a further role in fueling the bubble.

These deep changes in corporate financing patterns are mirrored in the lending patterns of banks. Banks had to adjust to the gradual loss of their best customers through increased loans to new (and less reliable) customers. The profitability of loans also dropped due to the deregulation of lending rates. Banks began to increasingly rely on the latent profits of their investments in the stock market to ensure a decent bottom line. Table 2 summarizes some of the key trends induced by financial deregulation, as seen from the banking side.

First, banks were hit by the flight of their best clients: large firms. Taniguchi reported that corporations increasingly turned to equity financing ($519 billion in the years 1985-1989 alone) and to bonds and money markets. Banks suffered as a result. Equally important was the fact that, with the privileged corporate-bank link, the only existing system to monitor and evaluate risk also began to unravel. (41)

Second, banks were hit from the other side as deposit rates were deregulated after 1985. Banks saw their margins decrease as a result.

Third, banks found themselves in a situation of increased competition after being used to a cozy and regulated system for over three decades. Competition came from abroad (foreign banks moving in and development of euro-yen markets) as well as from within Japan as some firewalls were lowered. (42) The deregulation of deposit rates also put banks in a situation of increased competition with postal savings (with fixed deposit rates). Indeed, postal savings' market share of savings increased steadily over the period: the ratio of postal savings to total bank deposits rose from 30 percent in 1980 (11 percent in 1965) to 45 percent in 1996-1997. (43) This multifaceted competition, coming on top on deregulated deposit rates and fleeing corporate clients, put the squeeze on bank margins.

Fourth, as a result of the other three trends, banks were forced to develop alternative survival strategies and to adopt riskier loan and investment portfolios. (44) On one hand, they created new banking products and moved into financial technology (so-called zaitech). Building on their right to market government bonds since 1982, they also lobbied for the right to enter the securities business. On the other hand, they actively sought new customers, particularly small and medium-sized enterprises (SMEs) and real estate companies. These new ventures were encouraged by high tax incentives to organize speculative deals with property companies. (45) In the mid-1980s, banks found themselves engaged in large-scale real estate and construction lending. From 1985 to 1990, city banks and regional banks saw a decrease in loans to manufacturing big business by $70 billion, but an increase in lending to real estate by $168 billion and to SMEs (all included) by $540 billion. (46) Making things worse was the indirect lending mechanism, through which up to 50 percent of bank investments into the real estate market were channeled through poorly supervised nonbank institutions. (47) The October 1998 IMF Outlook summarizes the situation:
 Deprived to some extent of their traditional client base, facing
 competition from the nonbank financial sector, and operating under
 inadequate prudential regulations, banks expanded their lending to
 smaller firms that did not have the same degree of access to capital
 markets, and also to the property sector. The increased lending to
 the property market fueled the boom in the prices of both commercial
 and residential property. (p. 47)


Fifth, deregulation and the partial removal of firewalls between financial businesses gave considerable leeway to banks to directly purchase and hold equities. Bank credit thus increasingly flowed into the stock market. As their investments in the stock market increased, and in light of the computation method of the Bank of International Settlements (BIS) capital adequacy ratio (which includes unrealized equity gains), bank capital and bank lending capacity became increasingly dependent on the so-called hidden reserves of banks. These reserves, in turn, were dependent on the level of the stock market.

Finally, banks initiated major changes in their own funding by raising capital through instruments with deregulated interest rates. They also moved abroad in search of both cheap foreign capital and new investment opportunities. (48)

Incidentally, the implementation of BIS capital adequacy ratios (decided in 1988, to be implemented by December 1991) dealt a further blow to the financial system because of its timing right after the collapse of the bubble. This new requirement forced banks to sell equity and realize some capital gains. It also forced them to reduce lending, a key element in the present recession.

The trends and data presented above point to the key mechanisms through which financial deregulation has generated the Japanese bubble. Interestingly, early political models of the Japanese deregulation process not only missed out on these potential effects but drew almost the exact opposite conclusions about the strength of the Japanese banking system. Karel Van Wolferen, for example, has argued that financial deregulation only strengthened the collusion between government and business and increased the competitiveness of the system:
 The effect of the much publicized "liberalization" of financial and
 capital markets by the Ministry of Finance has been to foster the
 international emancipation of the Japanese banks, security houses
 and insurance firms, enabling them to compete better in the money
 markets of the world, and to give the trading companies a large new
 field for foreign investment. (49)


Consequently, Van Wolferen was far from predicting the end of the bubble period because, he argued, the bubble thrived on confidence and confidence came from faith in bureaucrats. (50) This verdict proved far from accurate. In 1988, in an influential popular book, Clyde Prestowitz argued that invincible Japanese banks and companies were about to buy up vast amounts of assets around the globe. He wrote: "The power behind the Japanese juggernaut is much greater than most Americans suspect, and the juggernaut cannot stop of its own volition, for Japan has created a kind of automatic wealth machine, perhaps the first since King Midas." (51) In sum, while monetary policy and fiscal policy played a key role in feeding the bubble, it is financial deregulation that changed the incentives of economic actors at the microlevel, created a situation of moral hazard, and compounded systemic risk.

Insights from the East Asian Financial Crisis

Some insights into Japan's circumstances can be gained by placing the country's troubles in the context of the lessons of the Asian financial crisis. Although the causes of the East Asian financial crisis are still the source of a lively debate, the crisis has led to a growing understanding that financial deregulation was a potentially destabilizing process and that it had to be carefully accompanied by the establishment of supervisory institutions. This is particularly true in Thailand, Indonesia, and South Korea. In turn, countries that retained a high degree of control of domestic finance and capital flows (Taiwan, China) were not as badly hit. Korea is a case in point. In November 1997, Korea found itself close to a situation of national insolvency. With only a few days of foreign reserves left and a massive outstanding short-term debt denominated in dollars, Korea had no choice but to accept a massive $57 billion IMF rescue package.

What caused such a massive crisis? The core of the debate on the crisis can be summarized in a single phrase: Asian sins versus global speculators. Was the crisis precipitated by crony capitalism and structural weaknesses in the financial system, or was it more the product of unprecedented contagion in the global financial system? Stephan Haggard further breaks down the domestic side of the debate into two subdebates. (52) "Fundamentalists," such as Giancarlo Corsetti, Paolo Pesenti, and Nouriel Roubini, put the emphasis on the vulnerabilities of exchange rate management (untenable pegs and crawling pegs). This work builds upon earlier work done by Paul Krugman on currency crises. (53) These first explanations are more relevant to the cases of Thailand and Malaysia than that of Korea, since Korea did not have a regime of fixed or pegged exchange rates (even if financial actors borrowed abroad in dollars on the assumption that the exchange rate would be stable). "New fundamentalists" such as Morris Goldstein (54) underline regulatory and structural problems, particularly in the financial sector. These problems include high corporate leverage, excess risk taking, and double mismatches (currency and timing) between borrowing and lending. Most of these problems stemmed from hasty financial deregulation in the early 1990s, a process that was not accompanied by the establishment of robust regulatory institutions.

In the case of Korea, this explanation puts the focus squarely on banks and their main customers (chaebols). At the end of 1997, the Korean ratio of short-term debt to international reserves was 300 percent, while the ratio of short-term debt to total debt was 67 percent. Both ratios were the highest of all East Asian countries and underscored the extent of chaebol indebtedness and exposure. Making things worse was the fact that much of this short-term debt was used by chaebols to finance a phenomenal investment binge in plants and other long-term assets. Yong-shik Park goes beyond financial weaknesses such as misallocations of financial resources, lax financial supervision, and excess debt financing. (55) He also emphasizes the primitive stage of corporate governance and opaque accounting, which ensured that chaebol managers could exercise absolute management control. In essence, this explanation blames the symbiotic relationship between chaebols, banks, and the state for creating moral hazard on a massive scale. (56) This explanation has been outlined in countless other books and was, at least initially, the dominant one.

On the other side of the debate are those that Haggard labels "internationalists." Internationalists, such as Paul Krugman, (57) George Soros, (58) and Alexander Lamfalussy, (59) place the emphasis on self-fulfilling speculative attacks and contagion. For example, the Korean crisis pointedly took place in the wake of the Southeast Asian currency crisis (July-October 1997, particularly in Thailand, Malaysia, and Indonesia), the Taiwan devaluation of October 18, and the stock market crash in Hong Kong and New York on October 28. The Korean crisis of November 1997 was itself accompanied by the Japanese financial crisis of November 1997 (collapse of major banks and Yamaichi Securities). It was followed by the Indonesian crisis (January-May 1998), the Russian crisis (August 1998), the global financial alert (Long-Term Credit Management [LTCM] bankruptcy in the United States, September 1998), and the Brazilian crisis (January 1999). Clearly, Korea did not crash alone. The internationalist argument focuses particularly on the process of contagion, particularly through competitive devaluation and through the "herd" behavior of global investors. (60) Global investors tend to assimilate countries with similar profiles (the so-called emerging markets) and to recoup losses made in one country by reducing their exposure in other countries.

The broad consensus that emerges from this vast literature is the probable interactive effects between an overly hasty financial deregulation (post-1992 in the Korean case), volatile capital flows, and an economic structure that was built upon a model of high-debt, high-investment, and weak corporate governance. Chaebols drove the Korean economic miracle (61) but were too risk-prone to be left free to roam on the global lending market. Meredith Woo-Cumings wrote: "Growing corporate reliance on the equity market and nonblank intermediaries over determined the political position of the chaebol. They no longer had much need for the state to run interference on their behalf." (62) In addition, the principal-agent relationship between the state and chaebols was further eroded by post-1987 democratization and the decrease of direct influence by the state. (63) At its core, the Korean crisis was caused by the unacknowledged socialization at the national scale of the high risk incurred by expansive chaebols. They thrived on the moral hazard induced by the "too big to fail" perception. On the eve of the financial crisis, the access to international finance allowed chaebols to engage in a massive investment binge. However, the proximate cause of the crisis was clearly the volatility of short-term capital flows, a point that has recently been heavily emphasized by Joseph Stiglitz. (64) Countries such as Korea became vulnerable to such volatile capital flows because of the process of financial deregulation initiated after 1992. In his seminal book, Stiglitz argues clearly that the U.S. Treasury imposed that financial deregulation on Korea. He argues further that capital flow volatility caused the Korean crisis and that the IMF took advantage of the Korean weakness to impose structural reforms that served the interests of global investors.

Between Scylla and Charybdis: A Political Economic Explanation for Ill-Supervised Financial Deregulation

If we accept the crucial role of financial deregulation in the Japanese crisis, how do we explain it? This section opens the black box of financial deregulation and presents a theoretical framework for the occurrence of ill-supervised deregulation. It is now understood that the benefits of financial deregulation can be reaped only if it is preceded by the establishment of tight supervisory institutions and monitoring systems.

Without such systems, the power and speed of global financial markets are likely to result in periods of euphoria followed by financial crises. However, in this section, I argue that an optimal path of financial deregulation (institutional buildup followed by liberalization) is, politically, very unlikely to occur, while a dysfunctional process is much more likely. This is due to the asymmetry in the timing and concentration of costs and benefits. It is also due to lack of understanding among policymakers of the full implications of financial deregulation.

Theoretical Premises: The Importance of Sequencing

In nonliberal systems, (65) corporate financing was the core institution sustaining the whole system. (66) Financial deregulation must thus be accompanied by a whole series of other legal moves, including the introduction of supervisory institutions, corporate reforms, and labor reforms. In the absence of these accompanying moves, the system risks remaining stuck in a transitional and dysfunctional stage. The initial complementarity and interlocking characteristics of the various components of a nonliberal system may become problematic as financial deregulation occurs and expectations about the system change. (67) In the ideal world, prudential regulation and other structural reforms should be precursors to financial liberalization, rather than the other way around. (68)

The Politics of Ill-Supervised Financial Deregulation: A Theoretical Framework

Given the high level of political trade-offs involved in financial deregulation, the key actors in the financial deregulation game are politicians. The forces challenging the initial equilibrium are external: the pull of global financial opportunities for large international corporations and the threat of sanctions by the political hegemon, the United States (or the IMF, or the European Union). As Frances Rosenbluth has argued, (69) export-oriented corporations discovered that they could raise funds more cheaply by going directly to the Eurobond market. The creation of such large financial markets under UK and U.S. leadership changed their external environment, making liberalization a highly desirable outcome. Even more strongly, these firms were competing with foreign companies that had access to finance at rates that were more desirable than their cost of borrowing.

The lobbying of domestic firms may be complemented by pressures from other states, which in turn might be seen as agents of their financial sectors. Direct pressure from another powerful state may serve to crystallize the focus on financial deregulation and complement the call of large corporations. The external push may be focused on something else, such as resolving a trade deficit problem, using financial deregulation as a means of reaching that other goal.

The key question is how domestic politicians respond to these external pressures. One way to solve the external pressure would be to liberalize the domestic market for goods and services. This, however, involves politically sensitive moves in fields such as distribution, transport, agriculture, or construction. In the case of Japan, these sectors are prime supporters of the LDP and any move hurting them would drastically affect political support for the LDP. Thus, the most powerful political interest groups are focused on preventing concessions in trade negotiations. Taking this into account and integrating an economic belief prevalent in the U.S. administration in the early 1980s that deregulation of domestic finance in Japan would offer new opportunities for foreign firms and help solve the trade deficit, (70) the Japanese government came to see financial deregulation as a cheap way to reduce international tensions.

Banks also shape the deregulation outcome and pursue two main objectives. First, they try to recoup the loss of corporate customers through new market opportunities, such as lowering the wall between securities firms and banks (access to the government bond market) and loosening controls on lending. Second, they successfully argue to politicians that any increase in oversight regulations by MOF would compound their pain and unfairly disadvantage them. They can put their large political contributions in the balance to block any move to increase transparency or banking oversight. The novelty of global finance and the seemingly painlessness of financial deregulation will further convince politicians that confronting such domestic actors may not be necessary. In sum, politicians are left maneuvering between a powerful external Scylla and an enduring dangerous Charybdis. They choose financial deregulation as a path of least political resistance. Figure 1 summarizes the array of forces involved in the choices of financial deregulation.

[FIGURE 1 OMITTED]

Figure 1 summarizes the dilemmas facing politicians on two dimensions: external versus domestic, and pull versus push factors. The external dimension is the first one to manifest itself. It poses immediate twin challenges to the continuation of the cozy protected status quo. On the pull side, large exporting firms are finding that their enduring corporate financing patterns (reliance on domestic banks within a regulated and closed financial system) begin to translate into a competitive disadvantage relative to their global competitors. The process of financial deregulation in the United States and the United Kingdom and the spread of euromarkets make new sources of financing available. If large Japanese firms do not resort to them, their financing costs rise relative to that of their competitors. These firms began to use loopholes and to emit bonds on euromarkets as early as the mid-1970s. This process in turn erodes the existing status quo and firms argue for more opportunities. The government is all the more dependent, because it needs large firms (and large financial investors) to participate in buying government bonds in a context of a growing budget deficit.

At the same time, trade tensions bring foreign governments (especially the United States) to the table, pushing for either direct market-opening measures or at least financial deregulation as an indirect way to solve trade imbalances (push factor).

On the domestic side, politicians face entrenched domestic groups (such as construction, distribution, small and medium-sized companies, protected industries, and agriculture) who have close ties to the LDP and a large impact on voting patterns and who are opposed to any market-opening measures. These groups with the highest political salience, on the other side, are indifferent about financial deregulation, except for local financial institutions (which the government can bracket out in a deregulation process).

The balance of these forces pushes politicians toward financial deregulation as a choice of least political resistance. Even if they have full knowledge that sequencing and supervising financial deregulation is crucial to make the process successful (which is only partly true), they then face a fourth ring of political forces: domestic opposition to any further transparency rules or supervision by banks who already stand to suffer immediately from the loss of corporate customers. To placate these big political donors, mainstream politicians choose deregulation without supervision.

In table form, Figure 2 summarizes the choices available to politicians. Given the pressures of both external opportunities and pressure from domestic firms, the status quo is not an option anymore. Indeed, the new reality of euromarkets and pressures from foreign governments over the trade surplus are destabilizing. The status quo has become both unstable (circumventing factors) and too costly.

Politicians could try to strengthen supervision and reassert the role of the state in a changing global environment, while not giving into financial deregulation (cell 2). This stick-only approach is politically indefensible, since it would raise unified opposition from both firms and banks, the two main providers of campaign funds for the LDP.

The economically efficient outcome (cell 4) is likewise politically infeasible. Although it would satisfy large firms, it would further empower the bureaucracy (MOF) relative to both banks and politicians and would enrage banks. Besides, the potential risks of financial deregulation are uncertain and distant in the future.

In the end, the dominant choice is financial deregulation without supervision (the choice of least political resistance).

Key Empirical Components: The Making of an Ill-Fated Deregulation Process

This section applies the general argument of ill-supervised financial deregulation as a political equilibrium in Japan before and during the bubble. It argues that Japan demonstrated all components of the ill-fated political sequence, albeit in a partially inverted sequence. Benefiting from the rise of euromarkets and initial timid deregulatory steps, large firms lobbied for further deregulation and a key step was achieved with the 1979 Foreign Exchange Law. In turn, Japan found itself under a powerful push from the U.S. government, as the United States tried to solve the growing U.S.-Japan trade deficit through the internationalization of the yen and the deregulation of Japan's financial system. Japan agreed to a wide-ranging deregulation process in the 1984 Yen-Dollar Agreement. However, because banks successfully preempted the MOF's attempt to establish a tighter disclosure system through direct lobbying of the LDP in 1982, deregulation proceeded apace without the establishment of necessary regulatory institutions and processes. This increased financial risks and contributed to the bubble.

The Corporate Push for Deregulation

Kent Calder has demonstrated that large corporations had an important role in pushing for early liberalization of Japanese finance, even if this role was enhanced by the growing economic predicament of the Japanese government. Calder argues that change was driven primarily by larger macroeconomic factors, chiefly the growing trade surplus in Japan, the growing emission of government bonds after 1975, and the growth of euromarkets. (71) Calder uses the label "Bankers' Kingdom" to describe the Japanese system before deregulation: "nominally state-directed credit allocation, administered and effectively controlled by the long-term credit and city banks during the 1950s and 1960s." (72) This system included a "maze of formal controls," such as artificially low interest rates, regulated bond issues, window guidance by the BOJ, and a range of sanctions ready to be invoked.

The key element, however, was the presence of capital controls in an era of capital-intensive industrialization, which in turn gave rise to complex clientelistic politics of industrial credit. Capital controls were a necessary condition for such rent-seeking and exchange relationships to continue. Liberalizing capital flows challenges these cozy relationships. Beginning in the early 1970s, Calder argues that key pillars of the Bankers' Kingdom began to unravel. In particular, rising international competitiveness (and growing financial surpluses) of large Japanese corporations, together with an economic slowdown (after 1973) sharply weakened corporate demand for externally generated funds (bank financing). Industrial corporations and politically connected securities firms managed to lobby for regulatory changes. (73)

In turn, the explosion of government bond issues after 1973 and BOJ's decision to stop repurchasing the bulk of government bonds and to rely on commercial banks to fulfill this role gave increased leverage to commercial banks in their relation to BOJ and MOF. As a result, banks obtained the establishment of markets in certificates of deposit (CDs, 1979) and money market certificates (1985), both of which increased the fundraising capabilities of city banks. This new power, together with rising liquidities, sharply decreased commercial banks' dependence on BOJ funds and on MOF's goodwill.

In addition, a complex chain of economic events led to the weakening of exchange controls, which had long insulated the Japanese economy from the international financial environment (particularly controls initially enshrined in the Foreign Exchange and Foreign Trade Law of 1948 and the Foreign Investment Law of 1950). Rising Japanese current account surplus removed the need for exchange controls since Japan was now accumulating a rising surplus. At the same time, the 1973 crisis and the growing government need to issue massive quantities of bonds domestically through the banks forced the government to allow banks to raise funds abroad by floating CDs. The further removal of exchange controls with the new Foreign Exchange and Trade Control Law of 1980 led to new financing and investment opportunities for banks and corporations abroad. This "led Japanese corporations en masse to issue straight and convertible bonds overseas, particularly in Euromarkets" (74) where the absence of collateral and the broad range of instruments available made funds cheaper than in Japan itself. In turn, corporations became less dependent on domestic bank loans. Next, "this explosion of offshore financing by Japanese corporations during the early 1980s ... further intensified the pressures building within Japan for financial liberalization." (75)

The first key liberalization moves were taken in 1979-1981 in response to a weakening of the yen and with the aim of correcting this through capital inflows. (76) The government seemed initially to be mainly responding to pressures from large exporting firms and to its own pragmatic macroeconomic concerns.

The Yen-Dollar Agreement of 1984 as a Key Link

U.S. pressures on Japan to solve the rising trade problem and to give equal treatment to foreign banks kept rising in the late 1970s. (77) U.S. pressures and domestic bank lobbying combined to convince the Japanese government to reform the Foreign Exchange and Foreign Trade Control Law in 1980. But the key reforms were yet to come.

The most crucial step in the sequence of Japanese deregulation was the second liberalization wave initiated by the U.S.-Japan Yen-Dollar Agreement of 1984. The goal of the agreement was to strengthen the yen through an increase in capital inflows and through the gradual international use of the yen. The most important measure was the deregulation of deposit rates, as emphasized by Charles Kindleberger (78) and K. Osugi. (79) Both Jeffry Frankel and Osugi wrote that the Yen-Dollar Agreement could be considered as "epoch-making" and as a turning point in the process of Japanese liberalization. Frankel wrote:
 The negotiations between the United States and Japan during
 1983-1984 over liberalization of the Japanese capital markets
 ... were a unique event in the history of international economic
 policy. Pressure from one country on another to liberalize its
 markets is common in trade policy, but never before has one
 country so pressed another to integrate its financial markets with
 the rest of the world and to internationalize its currency.
 Moreover President Ronald Reagan and Prime Minister Yasuhiro
 Nakasone launched the negotiations personally from their summit
 meeting in Tokyo in November 1983 in an effort to avert
 intensification of economic conflict between their nations. (80)


Writing with further distance and in a respected BIS economic paper, Osugi also agrees that the Yen-Dollar Agreement shifted the trajectory of financial deregulation in Japan and greatly accelerated the process. For the first time, the political leadership committed itself to actual deregulation targets and to a much faster pace. Both Osugi and the IMF clearly state that the Yen-Dollar Agreement and the ensuing process of financial deregulation were "US-instigated."
 It is true that the Japanese financial authorities at that time had
 already realized the necessity of liberalizing the financial
 markets in accordance with the worldwide trends toward financial
 deregulation and had actually taken various measures towards that
 end. However, it is clear that the pace of financial deregulation
 in Japan would have been considerably slower had it not been for
 US pressure and the resultant US-Japan accord. (81)


Interestingly, the oft-forgotten Yen-Dollar Agreement was the result of a high political bargain between the Reagan administration and the Nakasone government. According to Frankel, Lee Morgan, chairman of Caterpillar Tractor, played a crucial role in the story. Lobbying the White House in September 1983, he argued that his company was at a crucial disadvantage against its Japanese competitor, Komatsu, and that a key component of this growing unfairness in trade relations was the misaligned yen-dollar exchange rate. Morgan came up with the idea of convincing Japan to strengthen its yen through the liberalization of financial markets and the internationalization of the yen. Morgan met with a warm response from the White House and enlisted the support of Treasury Secretary Donald Regan and, eventually, that of President Reagan. During the November 1983 visit of President Reagan to Tokyo, the U.S. side pushed the idea on the agenda. Given his weak factional base, Prime Minister Nakasone put a high priority on a successful management of the U.S.-Japan relationship. As a result, according to Frankel,
 Some concessions in the area of financial markets must have seemed
 easier at the margin than settling thorny longstanding issues,
 such as US pressure for the Japanese to import more beef, citrus,
 metallurgical coal, natural gas, tobacco products, computer
 software, and telecommunications equipment, and also easier than
 suffering the consequences of exacerbated protectionist resistance
 to Japanese exports in the United States. (82)


Treasury Secretary Regan further pushed for an agreement during a well-remembered visit to Japan in March 1984. On March 24, 1984, Donald Regan pounced the podium in a public speech to Keidanren and declared:
 Your markets are not open to our financial institutions. Your
 markets are not open to the capital of the rest of the world to
 enjoy as is the United States market, and the message that I'm
 giving your Ministry of Finance, to others, is not a new message.
 It's a message that I've been delivering for three years now, and
 people have been saying to me: Patience, Patience. I'm about to
 run out of patience. I've had this now for three and a half years.
 How much more patience do you want? My response is: action,
 action, that's what I want now. I'm through with patience. (83)


And thus, by May 1984, a political bargain was struck, in which Japan committed to liberalizing its capital account (both inflows and outflows of capital), internationalizing the yen, giving a favorable treatment to U.S. banks in Japan, and deregulating domestic Japanese capital markets (including free deposit and lending rates). Table 3 summarizes the actual path of Japanese financial deregulation in the wake of the Yen-Dollar Agreement. Ironically, in the end, the 1984 agreement slowed down the rise of the yen once it started (after the 1985 Plaza Accords) by inducing major capital outflows from Japan (given the interest rates differential).

Another key external battle would play out in 1988, when Japan was convinced by the United States and the United Kingdom to join the establishment of international bank capital adequacy ratios (BIS ratios). Japan fatefully pushed for the inclusion of 45 percent of unrealized capital gains in the computation of bank reserves, thus making bank lending dependent on the level of the stock market.

The Banking Law Battle of 1982 and the Absence of Supervision

In the case of Japan, the defeat of efforts to improve financial supervision actually preceded the acceleration of financial deregulation. A first battle between banks and the MOF took place in 1978, when banks protested against the rising cost of underwriting government bonds and against MOF's opposition to their direct selling of government bonds. (84) Indeed, the rising government deficit meant both rising underwriting costs for banks and a growing opportunity cost of staying out of the trade of government bonds (a business reserved for securities companies). Banks protested against MOF by boycotting bond underwriting for three months in 1978. MOF was forced to yield to the banks and immediately authorized them to change accounting rules so as to hide their losses.

This battle was followed by a much greater battle in 1981 during the drafting of the new Banking Law. (85) In this law, the MOF was attempting to gain legal tools for the direct control and supervision of banking operations, tools that were lacking in the Japanese system of keiretsu banking. The draft law contained both a carrot and a stick. The carrot consisted in the long-desired authorization for banks to trade in government bonds. The stick consisted in tight disclosure requirements and MOF's acquisition of the legal ability to close or merge inefficient banks. MOF was also attempting to gain legal authority to dismiss incompetent bank management. Banks tried but failed to change MOF's mind. So, they resorted to a direct lobbying campaign of the LDE It has been estimated that banks organized to provide 500 million yen to each of the most influential LDP lawmakers, in addition to normal contributions of banks to the LDE (86) In the end, the two leading LDP committees involved in reviewing the law retracted their approval. Ironically, one of the two chairs of these committees was none other than Junichiro Koizumi, the current prime minister, who has tried to force banks to deal with bad loans. The Diet approved the Banking Law with the carrot, but without the stick. This crucial move would seal the fate of the deregulation process after 1984.

When deregulation accelerated after 1984, no actor was ready to replay the bruising battle of 1981 and the regulatory status quo prevailed. As a result, Japan would enter the fast waters of free finance with a weak MOF, one devoid of legal tools to either supervise banks or enforce bank closures. This counterintuitive outcome was confirmed to me in countless interviews with MOF officials in 1999 and 2000. MOF was neither sufficiently staffed nor sufficiently empowered to effectively control banking activities after 1985.

It is in this context that the political institutions began to show three further key weaknesses in the late 1980s: lack of oversight and control over the bubble speculation phenomenon (MOF's priority being budget control at the time); inability to handle a growing trade war with the United States; and an increase in the number and scale of political scandals leading to policy paralysis (for example, the Recruit scandal in 1989, Prime Minister Uno's forced resignation after only weeks in office due to a corruption and sex scandal in August 1989, and a weak Kaifu administration in 1990).

Conclusion: Closing the Circle in Japan and Larger Implications

In this article, I have argued that the origins of the Japanese crisis lie in the great bubble of 1985-1990 and that the bubble was partly caused by an ill-supervised, externally induced financial deregulation. The Japanese experience confirms the larger East Asian experience with financial deregulation, namely that financial deregulation is an extremely delicate and risky process. This process is prone to fall into a politically driven suboptimal equilibrium. Because of the need to navigate between twin reefs of global pressures and domestic interest groups, ill-sequenced and ill-supervised financial deregulation is often the equilibrium outcome.

True, the process analyzed in this article raises a question of information. Given what is understood about the high costs of ill-supervised financial deregulation, why do politicians continue to follow such a path and stumble into a catastrophic outcome? It is clear today that the second- and nth-degree implications of financial deregulation were not well known by policymakers in Japan, even though some officials in the bureaucracy and individual actors warned about them. The sequence of choices made by policymakers in 1982-1985 indicates a high degree of myopia and weak coordination in the Japanese policymaking process. It reveals that the pilot role played by the Ministry of Finance was probably already on the wane, badly weakened by Tanaka Kakuei's hands-on, pork-barrel politics. The sequence of financial deregulation reveals that neither the elite bureaucracy nor the central political leadership were able to resist the pulling and hauling of competing interest groups. None could steer financial policy toward an optimal outcome. The Japanese political system appears particularly fragmented and vulnerable to centrifugal forces.

The comparison to the Asian financial crisis reveals an overall similar pattern of ill-crafted financial deregulation laying the foundations for a major collapse of a hitherto successful "miracle" model. In both cases, corporate financing in the context of gradual internationalization proved to be the Achilles' heel of the system. Beyond this broad similarity, the differences between the Japanese and Asian cases are important and reveal the variety of pathways financial deregulation can take. While the Asian crisis was primarily one triggered by ill-crafted capital account opening and the compounding effect of an unsustainable currency policy, the Japanese crisis was primarily one of ill-supervised domestic financial deregulation. The government compensated banks for the loss of captive corporate customers through a potent mix of new market opportunities, lack of supervision, and continued government guarantees.

The Japanese experience also reveals that the move toward the costly pathway of ill-supervised financial deregulation was heavily influenced by strong links between particularistic domestic interest groups and a dominant single party, the LDP, in the context of a relatively noncompetitive parliamentary system. The strength of the model of money politics established in 1955 by Kishi Nobosuke and perfected in the 1970s by Tanaka Kakuei proves to be the crucial intermediate variable pushing the Japanese economic system toward this bad equilibrium. A different political system (presidential) or a parliamentary system with different party politics might have reacted differently.

In the end, financial deregulation tilted the Japanese political economy off balance after 1985, as it sought to take advantage of a changing global economy. The size of the bubble and the immense impact of its collapse landed Japan in a state of major crisis. The protracted nature of the government response after 1990 and of the financial reform process can be understood as being the added pains of a controlled non-liberal economic system going through financial liberalization in a postbubble situation.

Notes

The related fieldwork in Japan (1999-2000) was generously supported by the Japan Foundation.

(1.) World Bank, The East Asian Miracle (Oxford: Oxford University Press, 1993).

(2.) International Monetary Fund, World Economic Outlook, Spring 2003, available at http://www.imf.org/external/pubs/ft/weo/2003/01/data/index.htm#2.

(3.) Ulrich Baumgartner and Guy Meredith, "Saving Behavior and the Asset Price 'Bubble' in Japan," IMF Occasional Paper, International Monetary Fund, 1995; Ryunoshin Kamikawa, "Baburu keizai to nihonginko no dokuritsusei" [The bubble economy and autonomy of the Bank of Japan]. In Michio Muramatsu and Masahiro Okuno, eds., Heisei baburu no kenkyu: Baburu no hassei to sono haikei kouzou [The study of the Heisei bubble (vol. 1): The outbreak of bubble economy and background structures] (Tokyo: Toyokeizai shinposha, 2002), pp. 127-191; Yukio Noguchi, "The Bubble and Economic Policies in the 1980s," Journal of Japanese Studies 20, no. 2 (1994): 291-305; Christopher Wood, The Bubble Economy (New York: Atlantic Monthly Press, 1992); Richard Werner, Princes of the Yen: Japan's Central Bankers and the Transformation of the Economy (Armonk, N.Y.: M. E. Sharpe, 2003); William W. Grimes, Unmaking the Japanese Miracle: Macroeconomic Politics, 1985-2000 (Ithaca: Cornell University Press, 2001); Ronald I. McKinnon and Kenichi Ohno, Dollar and Yen: Resolving Economic Conflict between the United States and Japan (Cambridge, Mass.: MIT Press, 1997); Peter Hartcher, The Ministry: How Japan's Most Powerful Institution Endangers Worm Markets (Boston: Harvard Business School, 1998).

(4.) Hartcher, The Ministry; Grimes, Unmaking the Japanese Miracle; Michio Muramatsu and Masahiro Okuno, eds., Heisei baburu no kenkyu: Baburun no hassei tosSonoh haikei kouzou [The study of the Heisei bubble (vol. 1): The outbreak of bubble economy and background structures] (Tokyo: Toyo Keizai shinposha, 2002); Adam Simon Posen, Restoring Japan's Economic Growth (Washington, D.C.: Institute for International Economics, 1998); Takafusa Nakamura, The Postwar Japanese Economy (Tokyo: University of Tokyo Press, 1995).

(5.) Jennifer Ann Amyx, Japan's Financial Crisis: Institutional Rigidity and Reluctant Change (Princeton: Princeton University Press, 2004); Henry Laurence, Money Rules: The New Politics of Finance in Britain and Japan (Ithaca: Comell University Press, 2001); Kyoji Fukao, "Nihon no chochikuchoka to baburu no hassei" [Excess savings in Japan and the outbreak of the bubble economy]. In Muramatsu and Okuno, Heisei baburu no kenkyu, vol. 1, pp. 217-247; Mitsuhiro Fukao, "Japan's Lost Decade and Its Financial System," The World Economy 26, no. 3 (2003): 365-384; Tetsuji Okazaki and Hoshi Takeo, "1980 nendai no ginko keiei: Senryaku soshiki, gabanansu" [Management of the banks in the 1980s: Strategies, organizations, and governance]. In Muramatsu and Okuno, Heisei baburu nokKenkyu, vol. 1, pp. 313-358; Claude Meyer, La puissance financiere du Japon (Paris: Economica, 1996).

(6.) Hiroshi Yoshikawa, "Tochi baburu: Genin to jidai haikei" [The land bubble: The cause and the historical background]. In Muramatsu and Masahiro, Heiseib baburu no kenkyu, vol. 1, pp. 411-430; Natacha Aveline, La bulle fonciere au Japon (Paris: ADEE 1995).

(7.) Yoshihiko Kojo, "Baburu keisei, houkai no haikei toshiteno nichibeikeizai kankei: Purazagoi ikouno kokusai shushi kurogi zesei mondai to endaka kaihiron" [Japan-U.S. economic relations as the background for understanding the bubble formation and collapse: The problem of correcting the trade balance after the Plaza Accords and the theory of evasion of yen appreciation]. In Michio Muramatsu and Masahiro Okuno, eds., Heisei baburu no kenkyu: Houkaigo no fukyo to furyosaiken shori mondai [The study of the Heisei bubble (vol. 2): The recession after the collapse and non-performing loan problem] (Tokyo: Toyo keizai shinposha, 2002), pp. 345-371; Hiroshi Nakanishi, "Kokusaishisutemu no henyo to nihon no baburu: seisaku kyocho no zasetsu to gurobarizeshon" [The change in the international system and the Japanese bubble: The failure of policy cooperation and globalization]. In Muramatsu and Okuno, Heisei baburu no kenkyu, vol. 2, pp. 299-344; McKinnon and Ohno, "The Exchange Rate Origins of Japan's Economic Slump in the 1990's"; Mototada Kikkawa, Mani-haisen [The lost money war] (Tokyo: Bunshun shinsho, 1998).

(8.) Meyer, La puissance financiere du Japon; Robert Boyer and Toshio Yamada, Japanese Capitalism in Crisis: A Regulationist Interpretation (London: Routledge, 2000); Takeo Hoshi and Anil Kashyap, Corporate Financing and Governance in Japan: The Road to the Future (Cambridge: MIT Press, 2001); Baumgartner and Meredith, "Saving Behavior and the Asset Price 'Bubble' in Japan."

(9.) The political economy of financial deregulation (not in the context of the Japanese crisis) is well analyzed in Kent Calder, "Assault on the Bankers' Kingdom: Politics, Markets, and the Liberalization of Japanese Industrial Finance." In Michael Loriaux et al., eds., Capital Ungoverned: Liberalizing Finance in Interventionist State (Ithaca: Cornell University Press, 1997); Laurence, Money Rules; Frances Rosenbluth, Financial Politics in Contemporary Japan (Ithaca: Cornell University Press, 1989); John Goodman and Louis Pauly, "The Obsolescence of Capital Controls? Economic Management in an Age of Global Markets," World Politics 46, no. 1 (1993): 50-82; Louis Pauly, Opening Financial Markets: Banking Politics on the Pacific Rim (Ithaca: Cornell University Press, 1988). Several scholars include an analysis of financial deregulation but downplay its explanatory power relative to other structural features. Amyx, Japan's Financial Crisis; Laurence, Money Rules.

(10.) Ronald McKinnon, The Order of Economic Liberalization (Baltimore: Johns Hopkins University Press, 1993).

(11.) Joseph Stiglitz, Globalization and Its Discontents (New York: Norton, 2002); Stephan Haggard, The Political Economy of the Asian Financial Crisis (Washington, D.C.: Institute for International Economics, 2000). See also works by Chang Ha-Joon and Jomo KS.

(12.) I am grateful to Stephan Haggard for this concept of bad equilibrium.

(13.) Japan's Ministry of Finance (handout of the Banking Bureau).

(14.) Ibid.

(15.) A major plan to reduce regional inequities by relocating industries to the interior and to the Sea of Japan side and to link together the entire nation by constructing 9,000 kilometers of Shinkansen and 10,000 kilometers of superhighways. The plan's rationale was to spread more equally the fruits of high growth. See Nakamura, The Postwar Japanese Economy, p. 203.

(16.) Ronald I. McKinnon and Kenichi Ohno, Dollar- and Yen: Resolving Economic Conflict between the United States and Japan.

(17.) International Monetary Fund, Occasional Paper No. 124, Washington, D.C., 1995, p. 64.

(18.) Wood, The Bubble Economy, p. 8.

(19.) First, the collapse in land prices and the ensuing recession led to the quasi-bankruptcy of many real estate companies and other recipients of bank loans. Second, the collapse in stock prices led to a huge reduction in bank reserves (which include a large amount of equity due to company shareholding) and in turn to the necessary lending reduction in order for banks to fulfill the 8 percent BIS asset-reserve adequacy ratio. Third, the reduction of interest rates to 0.5 percent by 1995 and 0.25 percent by 1998 made it nearly impossible for banks to earn a high enough margin on loans. McKinnon and Ohno, "The Exchange Rate Origins of Japan's Economic Slump in the 1990's."

(20.) Paul Krugman, "Setting Sun, Japan: What Went Wrong?" in The Dismal Science (Slate, 1998); Paul Krugman, Further Notes on Japan's Liquidity Trap, 1998 (accessed July 20, 2005); http://web.mit.edu/krugman/www/liquid.html.

(21.) Thomas Cargill, Michael Hutchison, and Ito Takatoshi, The Political Economy of Japanese Monetary Policy (Cambridge: MIT Press, 1997).

(22.) Werner, Princes of the Yen.

(23.) Kamikawa, "Baburu keizai to nihonginko no dokuritsusei." See also Nakamura, The Postwar Japanese Economy.

(24.) Grimes, Unmaking the Japanese Miracle.

(25.) Hartcher, The Ministry: How Japan's Most Powerful Institution Endangers World Markets.

(26.) Ibid., p. 216.

(27.) Jennifer Amyx, "Okurasho nettowaku: kenryoku no kakudai to seiyaku no kiketsu" [The MOF network: The expansion of authority and the outcome of restrictions]. In Muramatsu and Okuno, Heisei baburu no kenkyu, vol. 2, pp. 273-296; Amyx, Japan's Financial Crisis.

(28.) Richard Katz, Japan: The System That Soured (Armonk, N.Y.: M. E. Sharpe, 1998).

(29.) Asher and Smithers, "Japan's Key Challenges for the 21st Century: Debt, Deflation, Default, Demography, and Deregulation," in SAIS Policy Forum Series (The Paul H. Nitze School of Advanced International Studies of The Johns Hopkins University, 1998); Krugman, "Setting Sun, Japan."

(30.) Asher and Smithers, "Japan's Key Challenges for the 21st Century"; Frank Gibney, ed., Unlocking the Bureaucrat's Kingdom (Washington, D.C.: Brookings Institution Press, 1998); Ichiro Ozawa, Blueprint for a New Japan: The Rethinking of a Nation (Tokyo: Kodansha International, 1994).

(31.) "How could the world's most acclaimed economic miracle have stumbled so badly? The root of the problem is that Japan is still mired in the structures, policies, and mental habits that prevailed in the 1950s and 1960s. What we have come to think as the 'Japanese economic system' was a marvelous system to help a backward Japan catch up with the West. But it turned into a terrible system once Japan had in fact caught up .... The Japanese 'economic model' that we see today is not, as some have suggested, a different kind of capitalism. It is rather a holdover from an earlier stage of capitalism. It is the spectacle of a country vainly trying to carry into maturity economic patterns better suited to its adolescence." Quoted in Katz, Japan: The System That Soured, pp. 4-6.

(32.) Aveline, La bulle fonciere au Japon; Wood, The Bubble Economy; Noguchi, "The Bubble and Economic Policies in the 1980s"; Yoshikawa, "Tochi baburu: Genin to jidai haikei."

(33.) Mitsuhiro Fukao, "1980 nendai kouhan no shizaikakaku baburu hassei to 90 nen dai no fukyo no genin: Kinyushisutemu no kinufuzen no kanten kara" [The outbreak of assets bubble in the late 1980s and the cause for the recession in the 1990s: Dysfunctional financial system]. In Muramatsu and Masahiro, Heisei baburu no kenkyu, vol. 1, pp. 87-126.

(34.) McKinnon and Ohno, "The Exchange Rate Origins of Japan's Economic Slump in the 1990's."

(35.) International Monetary Fund, "The Japanese Banking of the 1990s: Sources and Lessons," 2000, p. 1.

(36.) Baumgartner and Meredith, "Saving Behavior and the Asset Price 'Bubble' in Japan," p. 258.

(37.) Takeo Hoshi and Anil Kashyap, Corporate Financing and Governance in Japan: The Road to the Future, p. 258.

(38.) Tomohiko Taniguchi, "Japan's Banks and the 'Bubble Economy' of the Late 1980s," Princeton University Monograph Series, 1993, p. 19.

(39.) Ibid., p. 18.

(40.) Ronald Dore, "Goodwill and the Spirit of Market Capitalism," British Journal of Sociology 34, no. 4 (1983): 459-482.

(41.) Cargill, Hutchison, and Takatoshi, The Political Economy of Japanese Monetary Policy, p. 104.

(42.) Osugi, "Japan's Experience of Financial Deregulation Since 1984 in an International Perspective," BIS Economic Papers, 1990; Taniguchi, "Japan's Banks and the 'Bubble Economy' of the Late 1980s."

(43.) International Monetary Fund, Staff Country Report, 1996, p. 137.

(44.) Cargill, Hutchison, and Takatoshi, The Political Economy of Japanese Monetary Policy, p. 103.

(45.) Taniguchi, "Japan's Banks and the 'Bubble Economy' of the Late 1980s"; McKinnon and Ohno, "The Exchange Rate Origins of Japan's Economic Slump in the 1990's."

(46.) Taniguchi, "Japan's Banks and the 'Bubble Economy' of the Late 1980s," p. 27.

(47.) Cargill, Hutchison, and Takatoshi, The Political Economy of Japanese Monetary Policy, p. 105.

(48.) Osugi, "Japan's Experience of Financial Deregulation Since 1984 in an International Perspective," pp. 56-57.

(49.) Karel Van Wolferen, The Enigma of Japanese Power (New York: Vintage Press, 1989), p. 22.

(50.) Ibid., p. 400.

(51.) Clyde Prestowitz, Trading Places (New York: Basic Books, 1988).

(52.) Haggard, The Political Economy of the Asian Financial Crisis.

(53.) Paul Krugman, Currencies and Crises (Cambridge: MIT Press, 1995).

(54.) Morris Goldstein, The Asian Financial Crisis: Causes, Cures, and Systemic Implications (Washington, D.C.: Institute for International Economics, 1998).

(55.) Yong-shik Park, "The Asian Financial Crisis and Its Effects on Korean Banks," paper presented at "The Korean Economy in an Era of Global Competition," a symposium sponsored by George Washington University, the Korean Economic Institute of America, and the Korean Institute for International Economic Policy (Korean Economic Institute of America: Joint US-Korea Academic Studies, 2000).

(56.) Marcus Noland, "An Overview of South Korea Economic Reforms in Korean Economic Institute of America," paper presented at "The Korean Economy in an Era of Global Competition" symposium; see note 55.

(57.) Paul Krugman, The Return of Depression Economics (New York: Norton, 1999).

(58.) George Soros, The Crisis of Global Capitalism: Open Society Endangered (New York: BBS/PublicAffairs, 1998).

(59.) Alexander Lamfalussy, Financial Crises in Emerging Markets (New Haven: Yale University Press, 2000).

(60.) Paul Blustein, The Chastening: Inside the Crisis That Rocked the Global Financial System and Humbled the IMF (New York: Public Affairs, 2001), p. 124.

(61.) See, for example, Meredith Woo-Cumings, "The State, Democracy, and the Reform of the Corporate Sector in Korea." In T. J. Pempel, ed., The Politics of the Asian Economic Crisis (Ithaca: Cornell University Press, 1999), p. 120; Mark L. Clifford, Troubled Tiger: Businessmen, Bureaucrats, and Generals in South Korea (Armonk, N.Y.: M. E. Sharpe, 1998); Myung Hun Kang, The Korean Business Conglomerate: Chaebol Then and Now (Berkeley: University of California Press, 1996).

(62.) Meredith Woo-Cumings, "Slouching Toward the Market: The Politics of Financial Liberalization in South Korea." In Michael Loriaux, Meredith Woo-Cumings, and Kent Calder, eds., Capital Ungoverned: Liberalizing Finance in Interventionist State (Ithaca: Cornell University Press, 1997), p. 90.

(63.) See an example account of the chaebol debate in Yoo Seong-Min Yoo, "Corporate Restructuring in Korea: Policy Issues Before and During the Crisis," Korean Development Institute Working Paper (Seoul: Korean Development Institute, 1999). "The democratization since 1987 and the consequent instabilities put an end to the past patriarchal authoritarianism" (p. 142). Yoo also argues that the "chaebol problem" includes six major failures: failure of corporate governance, failure of the financial market, failure of the exit market, political influence of chaebol economic power over government policy decisions, misconceptions on the nature of business corporations, and failure of law enforcement (p. 146). See also Ku-hyun Jung and Dong-jae Kim, "Globalization and International Competitiveness: The Case of Korea." In Chung-in Moon and Jongryn Mo, eds., Democratization and Globalization in Korea: Assessments and Prospects (Seoul: Yonsei University Press, 1999) for an argument that combines deregulation, globalization, and democratization.

(64.) Stiglitz, Globalization and Its Discontents.

(65.) For the contrast between liberal and nonliberal systems, see Wolfgang Streeck and Kozo Yamamura, The Origins of Nonliberal Capitalism (Ithaca: Cornell University Press, 2001). Zysman further differentiates state-led economies such as France and Japan from bank-centered systems such as Germany: John Zysman, Governments, Markets, and Growth (Ithaca: Cornell University Press, 1983).

(66.) Zysman, Governments, Markets, and Growth.

(67.) On institutional complementarity and institutional crisis, see Masahiko Aoki, "Japan in the Process of Institutional Change" (Miyakodayori: Letter from the Capital: RIETI, 2002). Aoki, however, does not put the emphasis solely on financial deregulation as the agent of perturbation in the initial system.

(68.) On the review of the literature on sequencing and an application to financial liberalization in East Asia, see the excellent paper by Andrew Walter, "Financial Liberalization and Prudential Regulation in East Asia: Still Perverse?" Institute of Defence and Strategic Studies Working Paper (Singapore: Institute of Defence and Strategic Studies, 2002).

(69.) Rosenbluth, Financial Politics in Contemporary Japan, pp. 14-15.

(70.) See an excellent analysis in Jeffry Frankel, The Yen/Dollar Agreement: Liberalizing Japanese Capital Markets (Washington, D.C.: Institute for International Economics, 1984).

(71.) Calder, "Assault on the Bankers' Kingdom."

(72.) Ibid., pp. 17-18.

(73.) Ibid., pp. 19-20.

(74.) Ibid., p. 24.

(75.) Ibid., p. 25.

(76.) Osugi, "Japan's Experience of Financial Deregulation"; Frankel, The Yen/Dollar Agreement.

(77.) Pauly, Opening Financial Markets. Banking Politics on the Pacific Rim, pp. 73-78.

(78.) Charles Poor Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises, 4th ed. (New York: Wiley, 2000).

(79.) Osugi, "Japan's Experience of Financial Deregulation."

(80.) Frankel, The Yen/Dollar Agreement, p. ix.

(81.) Osugi, "Japan's Experience of Financial Deregulation," p. 9.

(82.) Frankel, The Yen/Dollar Agreement, p. 2.

(83.) Ibid., pp. 71-72.

(84.) Rosenbluth, Financial Politics in Contemporary Japan, p. 44.

(85.) See Rosenbluth, Financial Politics in Contemporary Japan, for the full account.

(86.) Ibid., p. 131.

Yves Tiberghien is assistant professor of political science at the University of British Columbia and a Harvard Academy Scholar (2004-2006). He obtained his Ph.D. from Stanford University (2002). He is an expert in Japanese political economy and spent a year as a visiting scholar at the Japanese Ministry of Finance in 1999-2000 with a fellowship from the Japan Foundation. He recently completed a book manuscript on Japanese corporate reforms in a comparative perspective.
Table 1 Selected Indicators of the Shift
in Corporate Financing During the Bubble

Indicator 1980 1985 1989

Bank debt/total assets for publicly 32% 25% 13%
 traded manufacturing firms (1990)
Share of bank borrowing in increase 85% 81% 63%
 of total corporate liabilities (all) (average (1988)
 1975-1979)
Security financing by listed firms 2,883 6,891 28,410
 (in [yen] billions)
Stock financing by listed firms 1,052 859 8,849
 (in [yen] billions)
Foreign bonds in total security 28% 51% 41%
 financing by listed Japanese firms
Share of manufacturing firms in IBJ 40.2% 22.7%
 loan structure (1982) (1,987)

Sources: Takeo Hoshi and Anil Kashyap, Corporate Financing and
Governance in Japan: The Road to the Future (Cambridge and London:
MIT Press, 2001), pp. 235, 240, 247; Osugi, "Japan's Experience of
Financial Deregulation since 1984 in an International Perspective."
BIS Economic Papers, 1990), p. 55; Tomohiko Taniguchi, "Japan's
Banks and the 'Bubble Economy' of the Late 1980s." Princeton
University Monograph Series: Princeton University, 1993, p. 20.

Table 2 Selected Indicators of the
Shift in Bank Lending During the Bubble

Indicator 1980 1985 1989

Flow of funds from banks to 13,602 25,158 37,485
 nonfinancial corporations
 (in [yen] billions)
Sectoral lending by banks (as % of N/A 8% 12%
 total loans) to real estate and (real estate) 70%
 total SMEs 54% (SMEs)
City bank spreads (interest income +0.5% -2% -4%
 on loans minus interest expenses (1990)
 on deposits)
Hidden assets of banks (land, 176,256 191,014 341,925
 in [yen] billions) (1983) (1988)
Hidden assets of banks (securities, 25,317 44,737 169,585
 in [yen] billions) (1983) (1988)

Sources: Yukio Noguchi, "The Bubble and Economic Policies in the
1980s," Journal of Japanese Studies 20, no. 2 (1994): 291-305,
294; International Monetary Fund, "The Japanese Banking of the
1990s: Sources and Lessons" (Washington, D.C., 2000), p. 37;
Akio Mikuni and R. Taggart Murphy, Japan's Policy Trap: Dollars.
Deflation, and the Crisis of Japanese Finance (Washington, D.C.:
Brookings Institution Press, 2002), p. 157; Taniguchi, "Japan's
Banks and the 'Bubble Economy' of the Late 1980s," p. 12.

Note: SMEs are small and medium-sized enterprises.

Table 3 Milestones of Japan's
Financial Deregulation Process

Step Year Contents

Initial system since 1949 Presumption is that capital
(up to late 1970s) flows are forbidden: features
 include controlled deposit
 rates, firewalls between bank
 types and security houses,
 convoy system (no failure).

1. Early changes euromarket
 (bond market)

* Government 1975 The large-scale flotation of
 bond market government bonds begins.

* Secondary 1976 Free money market
 market gensaki (spontaneously in operation
 since 1969) leads to gradual
 desintermediation of banks.

* Development 1979 City banks begin to issue
 of CDs negotiable certificates
 of deposit.

2. First major 1980-1982
liberalization

* New Foreign December Shift is to presumption that
 Exchange and 1980 international capital flows
 Foreign Trade are permitted, essentially
 Control Law liberalization of capital
 inflows (allowing foreigners
 to buy bonds, CDs, and certain
 loans).

* New bank law enacted 1982 Allows banks and securities
 firms to enter each other's
 markets only in a limited way
 (bonds); firewalls preserved.

* Foreign firms April 1982 Very limited number of seats
 allowed on Tokyo are available.
 stock exchange

3. Second major from 1984 Following the Yen-Dollar
 liberalization Agreement of May 29, 1984

* Liberalization 1984-1986 * Liberalization of
 of inflow and international banking
 outflows of business (euro-yen CDs,
 capital; 12/84; euro-yen lending,
 internationalization 1984-1985)
 of the yen
 * Liberalization of
 international bond issues;
 Samurai bonds, 1984; Shogun
 bonds, 1985

 1984-1986 * Relaxation of restrictions
 on Forex transactions
 (abolition of real demand
 principle and swap limit
 rule, 1984)

 * Relaxation of restrictions
 on purchase of foreign bonds
 by Japanese residents, 1985

* More favorable 1986 and * Widening of access to
 access for foreign 1987 Japanese markets (permission
 financial for foreign banks to engage
 institutions to in trust business, to deal
 Japanese markets in government securities,
 and to be members of Tokyo
 stock exchange; more seats)

 * Establishment of the Japan
 offshore market, December
 1986

* Deregulation 1985-1989 * Gradual liberalization
 of domestic of deposit rates (big
 capital markets and small)

 * Creation of new open markets
 (short-term money markets +
 futures)

 * Diversification of interbank
 market (free call-money
 markets)

 * More open market operations
 by BOJ (CDs)

4. Lowering 1992-1996 * 1992: Banks and securities
 of firewalls allowed to enter each
 other's business areas
 through subsidiaries

 * 1996: Subsidiaries of life
 and non-life insurance
 allowed to compete

5. Big bang 1996-2001 * Large-scale financial
 deregulation plan deregulation plan to
 make Tokyo a competitive
 financial center

Sources: Frankel, The Yen/Dollar Agreement: Liberalizing Japanese
Capital Markets; Nakamura, The Postwar Japanese Economy; Takafusa
Nakamura, Lectures on Modern Japanese Economic History (LTCB
International Library Foundation, 1994); Steven Vogel, Freer
Markets, More Rules (Ithaca: Comell University Press, 1996).

Figure 2 Typology of Political Choices Under External and
Internal Pressures

 Supervisory Status Quo Reform of Supervisory
 Structure (increase in
 direct supervision by
 the state)

No deregulation 1. Decaying status 2. Bureaucratic
 quo. Continuing trade dominance and
 conflicts, inability financing crisis.
 to prevent firms from Banking revolt (in the
 circumventing face of stronger state
 regulations, and loss regulations) and increase
 of campaign funds from in bureaucratic power,
 firms seeking state financing crisis
 liberalization

Deregulation 3. Short-term harmony, 4. Full financial
 long-term crisis. upgrade. Banking
 All actors satisfied revolt and loss of
 campaign funds (from
 banks)
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