Throughout the 1980s, Japan’s economy appeared to be invincible.  Its stock and real estate markets took off and reached unbelievable highs.  As the economy grew at rates around 5 percent in the late 1980s, it seemed as if only a few years would pass before Japan would replace the United States as the world’s largest economy.  In 1990, though, Japan’s bubble economy burst, and what had been a miracle economy suddenly became a nightmare.  The stock market crashed several times and in “Black August” it fell 16 percent.  Since then the real estate market has lost 50 percent of its value and the stock market has lost 60 percent of its value.  Since 1990, an economy that was at once used to a minimum annual growth rate of 5 percent was growing at 1 percent, if that much.

                Along with this asset devaluation came scandals that rocked the foundations of Japan’s powerful banks and securities firms.  These scandals even tainted the mighty Ministry of Finance (MOF) and pushed the Liberal Democratic Party (LDP) out of power.  Now, in the 1990s, Japan appears to be a country in disarray, with a political party trying to regain its stature, banks and securities firms trying to regain their reputation, and a ministry struggling to hold on to its power.  

                This paper will start by defining the bubble burst and its major events.  After 1990, both stock and land prices fell in tandem.  The two assets are intricately linked in Japan.  Land was used as collateral for numerous loans in the late 1980s.  Often, these loans were used to buy stocks.  This practice created a cyclical relationship between the two assets, and tied their values together.  The skyrocketing prices in both of these assets in the late 1980s bred several scandals.  Banks, eager to loan, went to the extent of forging certificates of deposits as collateral for their clients.  Securities firms, eager to entice large clients into the booming stock market, offered “risk free” investment accounts guaranteeing them against losses.  Companies took advantage of these accounts to boost their profits during these bubble years.  All of Japanese business was affected by and took advantage of this bubble economy.

                Several economic forces caused this bubble.  First, the Bank of Japan (BOJ) kept interest rates very low during the late 1980s.  Low interest rates made it easy for people to get loans.  The borrowers would then use the money from these loans to buy stocks or real estate.  Either of these activities would drive the price of each asset up, causing a bubble.  The MOF also begrudgingly deregulated some aspects of Japanese finance at this time.  Among other things it removed many controls on foreign exchange transactions and allowed banks to set certain interest rates.  In the aftermath of this deregulation, banks saw many of their best clients, large blue-chip industrial firms, raise their capital from equity markets, often in Europe, and not through debt.  Banks, under pressure to maintain their market share, then made loans to less deserving individuals.  Often these individuals were more interested in buying land or stocks, rather than in investing in Japan’s industrial future.  In the meantime, as the MOF slowly deregulated interest rates, its major instrument of control over the banks was slowly eroded.  Soon, banks began to use interest rates to compete for loans, offering higher rates for deposits than they were later able to pay once the bubble burst.  In addition to monetary policy and deregulation, there were long simmering structural problems in the Japanese economy that allowed the bubble to build to such a high volume.  These structural problems affected both land and stocks and how they were valued.  These problems will be discussed in greater detail later.

                Yet, why would the Japanese government, supposedly so capable, allow this bubble to build?  Why did the bureaucracy or LDP not act to stem these problems before they drove the Japanese economy into ruin?  Several political models have stood the test of time to explain Japan’s success in the past.  The Developmental model puts the emphasis on the bureaucracy.  According to this model the bureaucracy rules Japan, and the LDP merely insulates it from interest group pressure.  The ministries use administrative guidance to regulate business.  Administrative guidance is an informal method of regulating industry.  Nothing is written down.  Rather, the ministries work with industry to formulate these policies.  While these policies are informal in their presentation, the ministries expect business to follow them closely.  Through this system, the ministries are able to rule in Japan’s long-term interests and promote its industry, without being subject to short-term politics.

                The liberal model claims the opposite — that the LDP actually rules in Japan.  The LDP has manipulated the electoral system to secure its power.  The LDP holds ultimate authority over the bureaucracy and through various means commands its respect.  Although the LDP does not rigorously police the ministries to ensure that specific policies are enacted, the ministries know that if they step outside the LDP’s guidelines, the LDP will make its opinion known.

                The market institutions model puts the emphasis on neither the bureaucracy nor the LDP, but rather the private sector.  It focuses on the powerful banking and industrial groups in Japan and shows how these institutions act in the long-term interests of the Japanese economy.  The bureaucracy is relegated to a reactive role in this model, merely reacting to external shocks to Japan’s economy, forever seeking to maintain stability.  Japan’s economy gets its strategic drive not from this reactionary bureaucracy but rather from a private sector that fosters industries such as consumer electronics to insure Japan’s long-term growth.

                Yet these models were all proven in the 1980s when Japan’s industrial companies ruled the world.  These models largely ignored how the bureaucracy, LDP, and the private sector interacted to affect Japanese finance.  This paper will explain how the market institutions model does the best job at explaining the bubble burst.  The MOF was a reactionary organization through the late 1980s.  While the MOF did take steps to deregulate the financial sector, it did so only when under extreme pressure to do so.  In general, the MOF stubbornly maintained control over vast aspects of Japanese finance.  This control was exercised to the detriment of the Japanese economy.  Unlike industrial firms that can develop products and pursue strategies, without regard to the Japanese bureaucracy, financial firms must pay heed to the MOF and its regulations when developing new products and services.  As a result, Japan’s finance industry was unable to adjust to a global economy, and fell into corruption and recklessness.

What Was the Bubble Burst?

                A “bubble” began to build in the late 1980s as Japan’s assets, specifically land and stocks, became extremely overvalued.  In the 1990s, after this bubble had burst numerous scandals occurred in the banking and securities industries, as things which those companies did in the late 1980s came back to haunt them.  This section discusses stocks, land, and the relationship between them.  It also covers the main scandal in the banking industry — certificate of deposit forgery — and the main scandal in the securities industry — loss compensation.  These are the main elements of the “bubble burst.”

Stocks and Land

                In the late 1980’s, assets became extremely overvalued in Japan.  Stock and property values careened to unbelievable heights.  In 1990, successive stock market crashes shook Japan’s economy.  First in February, then in March and April, the stock market sharply decreased.  In “Black August,” after the Iraqi invasion of Kuwait, the stock market dropped 16 percent (Ito, page 433).  Stock prices lost 60 percent of their value in the succeeding years going from a high Nikkei average of 38,916 yen to a low of 14,309 yen in 1992 (Euromoney, Japan page 16).  As the stock market began its downward slide, property values slowly decreased, losing 50 percent of their value in those years.

                This fall in both stock and property prices is not coincidental.  Property and stocks are intricately linked in Japan.  Many companies own significant pieces of real estate as well as large stock portfolios.  A Japanese company carries this real estate and stock at book value, i.e. the original purchase price.  So, as these assets increase in value, so does this company’s current net worth, making the company’s stock worth more.  Likewise, as either stocks or land decrease in value, the value of that company’s stock would decrease.  For example, NEC includes a 21,000 square meter plot of Tokyo land in its accounts at its original purchase price of 204,000 yen.  In 1990, that land was worth 210 billion yen (Euro. Sup., Japan).  Hiroshi Okumura, a Professor at Ryukoku University, states, “Thus, the rise in stock and land prices created a huge volume of ‘hidden assets’” (page 44).  As stock and land was driven to unbelievably high prices (at one time all of the land in Japan was worth 25 times all of the land in the US), stock prices of Japanese companies also were driven to unbelievable highs.

                In addition, land was used as collateral for loans.  Yukihiro Harada, a managing director at the LTCB Institute of Research and Consulting, states, “In the bubble era, if there was security that was all that was needed [for a loan].  That was our credit analysis.  And the security was always land” (Hirsch).  Henny Sender, a writer for Institutional Investor, states, “Unfortunate for the banks, property was what they settled on to underpin the credit system.  Real estate furnished the collateral for 70 percent of all loans.”  At the time, this practice made sense.  Land appeared to be safe collateral -- especially since its value always seemed to increase.  People would use the borrowed money to buy stocks.  They assumed that their return from the stock market would be far greater than any interest they paid on their loan.  As this paper will discuss, interest rates were particularly low in he 1980s.  When stock prices fell, people could not repay their loans.  Banks would then try to collect the collateral.  As the banks sold land, real estate prices decreased, and the collateral suddenly became worth less than the banks thought.  In the meantime, people were selling stocks trying to reap whatever capital gain they could before the market decreased further, in order to pay back their loans.  Robert Cutts, in the Harvard Business Review, describes this cyclical process as a “money machine” fueled by “a kind of double leveraging of the land itself” (Int. Herald Tribune, Japan).  So, as stocks decreased in value so did land and vice versa.

                As banks tried to collect their collateral they ran into some problems.  Many people had used a single piece of land as collateral for multiple loans.  First, a piece of property would be appraised at an already overvalued price for a loan.  Later, another lender would come and reappraise the property at a higher price, as land prices had raised since the first appraisal.  This would continue with a third lender and so on as property prices skyrocketed.  In the meantime, often the original lender had no idea that his or her collateral was now also the collateral for several other loans (Sender).  As a result, when the borrower decided not to repay his loans, several banks would end up fighting over a piece of property that was not even worth the value of the first appraisal.

                Also, many people who owned land would use it as collateral to buy stocks on margin.  To buy stock on margin means that the stock is purchased with borrowed money.  Once they had these stocks, they would use them for collateral for more real estate (Rudolph, page 50).  Of course if stock prices went down, a margin call would occur and the lender would ask for more collateral.  Often, in order to meet a margin call, people would sell stock or land to raise the required collateral.  This action would drive the prices of both assets down.  So, the value of stocks and land is intertwined.  The fall in the value of one leads to a fall in the value of the other.

                Rising stock prices also meant that banks could lend more money.  Most Japanese banks held large stock portfolios.  These banks are allowed to count 45 percent of the market value of their security holdings toward the Bank for International Settlements tier 2 capital requirements.  These requirements dictate that a bank has to back its loans up with a certain amount of collateral in order to ensure the safety of its deposits.  As the stock market hit record highs, the banks’ “capital” grew enormously, and they were able to lend out more money.  Of course, in the 1990s when the stock market crashed, the banks saw this collateral evaporate.  As a result, they were unable to lend out as much money as they had forecasted.  Sender states, “Without sufficient capital, banks cannot extend fresh loans to generate desperately needed interest income and thus grow their way out of their current bind.”  So, the banks in Japan now find themselves in a very bad position.  The same stocks that allowed them to extend a multitude of loans in the 1980s are now preventing them from doing the same in 1990s.  Many banks are now stuck with many bad loans that they had extended in the late 1980s.  Yet they cannot supplant these bad loans with new, hopefully safer, loans due to the capitol requirements they must meet.

Scandals

                Banks got caught up in a lending frenzy.  There were only so many times a piece of property could be appraised.  Borrowers needed more collateral in order to borrow more money.  Banks were willing to give it to them by forging certificates of deposits.  The first big scandal broke on July 25, 1991, when the president of Fuji Bank admitted that three of the bank’s Tokyo branches had issued forged certificates of deposits valued at 260 billion yen.  Twenty-three (unnamed) property companies had accepted these phony CDs for collateral (Wood, page 142).  Within days, two other city banks, Tokai Bank and Kyowa Saitama Bank, made similar admissions.  Christopher Wood, a writer for The Economist, states, “Forging certificates of deposit was, it seemed, almost a common practice” (page 143).  The banks claimed that these forgeries were committed by rogue employees and not sanctioned by upper management.  However, Wood states, “It is hard to believe the banks’ claims that they knew nothing about the forgeries … The forgeries looked suspiciously like a devious scheme to get around government controls on lending” (page 143).  Whether the banks did know about this or not, it is impossible to say.  However, it remains that these forged CDs were used for significant amounts of collateral and show how eager the banks were to lend money away during the late 1980s.

                The largest forgery scandal hit the Industrial Bank of Japan.  An individual, Nui Onoue, an Osaka restaurateur, managed to borrow up to 500 billion yen, 187 billion yen from the Industrial Bank of Japan and its affiliates.  IBJ is a pillar of the Japanese banking community.  Stefan Wagstyl, a writer for the South China Morning Post, states, “IBJ seemed scandal proof.  With a tradition of ties to government and blue-chip groups, the bank portrayed itself as a national institution, dedicated as much to public service as profit.”  Why would IBJ lend so much money to an individual, especially one of “questionable” background?  It is unknown where Onoue got all of her wealth.  Furthermore, Onoue seemed to relish in her mysteriousness by holding midnight rites at her restaurant with the supposed purpose of getting stock tips from the divinities.  This bizarre scenario took a criminal turn when the stock market began to fall.  IBJ and her other lenders began to curtail their loans.  Onoue persuaded an official at Toyo Shinkin Bank to forge deposit certificates worth 342 billion yen (Wagstyl).  Onoue then used these certificates as collateral to get more loans, some from IBJ itself.  How one person, with no reputable background, managed to borrow so much money is unknown.  What is known is that in the late 1980s, banks were too eager to loan their money, and this scandal is a glaring example of that.

                Securities companies also managed to get involved in scandals in the late 1980s.  In the mid 1980s “eigyo tokkin” accounts or money trusts were approved by the MOF.  In these accounts “the securities firms themselves, rather than the investment advisory firms, managed the money” (Wood, page 119).  So, effectively, companies would put their money into these trusts, and let other companies invest that money for them.  But these “other companies” are not companies whose sole purpose is to invest money, such as mutual funds in the United States.  Rather, they are the securities companies or traders themselves.  In the US, a mutual fund, such as Fidelity, would call an investment bank, such as Goldman Sachs, to make a large transaction.  In Japan, all of this happened within one firm, such as Nomura.

                Many companies took advantage of these “tokkin” accounts in a practice known as “zaiteku” or “money engineering.”  Basically, numerous companies in Japan saw that easy money could be made in the ever-rising Tokyo stock market.  So, they would invest their own money in “tokkin” accounts and other financial instruments, hoping to add to their profits for that year.  When they made money, as they inevitably did during the late 1980s, their profits increased driving their stock price ever higher.  Steve Burrell, a contributing writer for the Australian Financial Review, states, “It also meant that these companies cashed up to the gills with cheap money could make much more pumping these funds back into the ever-rising share market or property than using them to make cars, televisions or anything else … Zaiteku brought Japan’s biggest companies into the market as speculators, sold on brokers’ promises of big returns without risk.”  These “riskless” investments were the result of brokers’ promises to compensate their clients for losses.  Burrell goes on to state, “The liquidity surge [resulting from these ‘zaiteku’ transactions] effectively turned the Japanese economy into a money pump.”  So Japanese companies made money as the value of their tokkin accounts went up.  These same profits pushed these companies’ stock prices up, resulted from money they made off increasing stock prices through tokkin accounts.  This was a dangerous cycle that was bound to break apart.

                Nomura and other securities firms paid compensation to their large corporate customers who lost money in these accounts.  Effectively, the securities companies had guaranteed their customers a risk-free investment.  If the tokkin account lost money, the securities companies promised to compensate their customers for the loss.  During the late 1980s, compensation was not paid much, simply because the market never fell.  In the 1990s, though, compensation was paid in large amounts.  The tax bureau discovered these payments when the securities companies tried to deduct these payments from their taxes.  The public was outraged.  As the stock market went down, many small investors saw their life savings go down also.  Now, the public discovered that the large companies were being saved from their bad investments, while they were left to lose money.

                Many say that the fixed commission system in Japan was a cause of these scandals.  One foreign analyst states, “The rationale is that you can’t compete with discounts on commissions … You have to compete for customers by doing other things … Compensating losses or guaranteeing returns on investment is one type of service” (Sieg).  Fixed commissions effectively eliminated competition among the brokers in Japan, and their clients had no choice but to accept these high rates.  The securities companies were able to fund these loss compensation payments through the large profits they generated from these fixed commissions.

                Interestingly, the MOF was implicated in this scandal.  “Little” Tabuchi, the President of Nomura, who ended up resigning over the scandal, publicly admonished the MOF claiming that it had “not only approved the payments made by Nomura to favored clients to compensate them for their investment losses, but it had also given the firm the green light to deduct those payments against taxes” (Wood, page 122).  Of course, the MOF publicly would not admit to this.  Nevertheless, Tabuchi’s remarks shocked the public, for rarely had a top Japanese executive ever spoke out against the bureaucracy.  Ryutaro Hashimoto, the Finance Minister, stated, “It is extremely shameful that we have been led to the situation in which Japan needs a legal ban on compensation.”  Hashimoto seems to suggest that the securities companies should have shown higher ethics (Blustein, page C1).  However, many in Japan think that the MOF, too, should have shown higher ethics by never acquiescing to this loss compensation practice.  Conveniently, the scandal stopped here; Hashimoto did not have to admit to anything since the “administrative guidance” procedures that the MOF follows leave no paper trail.

                Wood gives further insight and suggests that the MOF did encourage loss compensation.  Wood claims that the MOF was stuck between two grim alternatives.  On one hand, they wanted to ban the “tokkin” accounts that had created rampant speculation in the stock market, driving share prices up.  On the other hand, the MOF knew that the securities companies could not end these accounts without paying compensation to their clients (most of these tokkin accounts were deep in the red after the 1990 stock market crash).  The MOF decided to turn a “blind eye” to the loss compensation payments hoping that the tokkin accounts would go away quietly.  That was not to be, for the tax bureau discovered the loss compensation payments when the securities companies tried to deduct those payments from their taxes as “business payments” (Wood, page 117).  Thus, the scandal described earlier erupted.  This seriously damaged the ministry’s reputation in Japan, especially among small investors.  To them it appeared that the MOF was not looking out for the consumer’s interests but rather the interests of the securities industry.

                In addition to making money off of their tokkin accounts, Japanese firms looked for other ways to make money off of the stock market.  They did this by reducing their dependence on debt.  After all, if the stock market was reaching new highs each day, it only made sense for companies to raise their capital through stock offerings.  Okumura states, “Japanese companies took advantage of these high [share] prices to implement equity financing, and effectively procured massive amounts of capital from the securities market at minimal cost (1% or less)” (page 44).  As companies did this though, they had less need to take on debt from banks.  As a result banks began to lose their blue-chip customers.  Yet the banks still needed to make money, so they began to issue loans to less deserving individuals.  This is the root of the Onoue scandal, discussed earlier.

                Of course, the securities industry did not want to have to compensate their clients for losses, they wanted to make money.  Some, such as Nomura, wanted to eliminate any chance of loss.  They did this by “ramping” a certain stock.  Basically, Nomura would “pick” a stock.  Then, it would direct all of its clients to purchase that stock.  The stock price would go up, and everyone would make money.  Often they would do this for companies making an equity offering through them.  Okumura points out that “the brokers have long pursued policies which cater to the needs of the issuing companies and worked hard to jack up their share prices … The brokers couldn’t admit that they were recommending stocks to individual customers to generate profits for their biggest clients” (page 44).  Nomura and Nikko got caught in 1991 when they tried to ramp the shares for Tokyu Corporation, a railway company.  Interestingly, they were doing this not for one of their large corporate clients, but rather a “yakuza” gang.  Ramping decreases the efficiency of a stock market, and creates an unfair investment climate.  Nomura should only recommend a stock if the fundamentals of the company are sound.  It should not recommend a stock with no regard for the fundamentals, but rather just with the purpose of pushing the price of that stock up for a rich client.

                These are the main characteristics of the bubble burst.  Stock and real estate prices sky-rocketed, only to come crashing down to Earth in 1990.  Scandals erupted throughout Japanese finance, humbling the proud Nomura and tainting the pristine IBJ.  All of these scandals had one thing in common — businesses and individuals taking advantage of rising land and stock prices in unethical ways.  These scandals also demonstrated the lack of control the MOF had over the industry it was supposedly regulating and called into question the policy of administrative guidance.

Why Did It happen?

                Why was this “bubble” allowed to build, and why was it allowed to burst?  There is no easy answer to this question.  The Japanese economy is very large and complex.  The reasons for the bubble burst fall into the following three categories:  monetary policy, the haphazard deregulation of the Japanese economy, and structural problems in the Japanese economy.

Monetary Policy

                In the late 1980s the Bank of Japan, Japan’s central bank, followed a very easy monetary policy, with low interest rates.  There are numerous reasons why it followed this policy.              In 1985, the Group of Five nations reached the Plaza Accord.  The effect of this agreement was to “correct” the exchange rates, chiefly that the yen and mark would be revalued and the dollar downvalued.  This drastically strengthened the yen with respect to the dollar.  In 1985, the exchange rate was 240 yen to a dollar.  A year later, the yen had fallen to 150 yen to the dollar (Takafusa, page 291).  Burrell states, “To encourage demand and to cushion the blow to Japanese business of the yen’s appreciation, Japan adopted the easiest monetary policy in its history.”  The ministries were worried that the high yen would cut into Japanese exports.  So, by offering a low interest rate at home they hoped to stimulate domestic demand to offset this feared loss of exports (Samuelson).

                Toshito Hayano, director and general manager of the corporate research department at the Nomura Research Institute in Tokyo, states that the Bank of Japan was forced to delay its rate hike due to concerns over the ever increasing twin deficits of the United States.  To encourage Japanese liquidity to flow overseas, finance the US deficit and support the health of Japan’s most important export market, Japan’s rates had to be cut continually, according to Hayano (Euromoney Supplement, Japan).  Nakamura Takafusa, a Professor Emeritus at the University of Tokyo, states, “One of the conditions that fostered the influx of Japanese investments into the United States was the constant gap between Japanese and US interest rates, the former being consistently 3-4 percent lower than the latter.  Naturally, Japanese funds flowed overseas” (page 289).  If the Bank of Japan or Ministry of Finance did fear for the health of the US economy this policy would make sense.

                So, the Bank of Japan kept interest rates low throughout the late 1980s.  It only raised them in 1989 under a new governor, Yasushi Mieno.  This rise in interest rates was the immediate trigger of the bubble burst.  After that rise, the stock market crashed successive times, and the Japanese “miracle” was over.  In hindsight, many say if the BOJ would have raised interest rates earlier, the bubble would have never built to such a volume, and the Japanese economy may have been able to take a “soft” landing.

                The effect of the easy monetary policy in the late 1980s was easy money.  Banks’ cost of capital was low, so they passed it on to their customers.  People were able to borrow money more easily, allowing them to invest in real estate or stocks where they hoped to make far more than the meager interest rate they actually paid on the loan.  Banks saw their loans as risk-free as the stock and real estate market passed milestone after milestone, and the bubble built.

Deregulation

                Also throughout the 1980s Japan haphazardly deregulated its securities markets.  The effects of this deregulation are many, but the most important effect it had was to reduce the power of the Ministry of Finance in a couple key areas of the economy — foreign exchange and interest rates.  In the late 1970s, foreign exchange controls were gradually relaxed.  This deregulation was finalized in the 1980 revisions to the Foreign Exchange and Trade Control Law.  Effectively, these revisions removed controls on foreign exchange transactions in principle (Calder, page 216).  Later, throughout the 1980s the Ministry of Finance removed additional controls:  in 1984 removing the “real demand” rule; in 1985 allowing banks to deal with one another in yen-dollar trades; in 1986 inaugurating an offshore market; in 1987 permitting banks, insurance companies, and securities firms to trade in overseas financial futures markets; and finally in 1989 allowing the opening of an international futures exchange in Tokyo (Calder, page 221).

                Previous to this deregulation, when Japanese companies wanted to raise money, they had to raise it in Japan.  They traditionally did this by getting loans from banks within their “keiretsu,” or industrial groups.  They would get these loans at low interest rates, and be able to fund their businesses.  Banks had no choice but to provide loans at these low rates, because the banks were regulated by the MOF.  In return for loaning at an interest rate that gave banks a smaller profit than they would have liked, the banks were able to demand “compensating balances.”  Basically, companies had to borrow more money than they needed, and let the banks keep the extra portion as “compensation.”  However, once foreign exchange transactions were deregulated, companies found that it was easier to raise money overseas by issuing bonds than by taking on debt from Japanese banks.  Kent Calder, an Associate Professor at Princeton University, states, “The removal of controls in principle in normal times helped ratify and accelerate the historical movement of Japanese corporate finance away from the reliance on domestic bank loans … The erosion of exchange controls … led Japanese corporations en masse to issue straight and convertible bonds overseas particularly in the Euromarkets” (page 217).  As companies began to raise capital from overseas though, banks began to lose business.  This led them, due to competitive pressures, to make loans to less deserving individuals.

                Interest rates were also deregulated.  “Banks insisted on more freedom to compete with overseas financial institutions, and in 1988 the government began a series of moves that allowed banks and credit unions to set their own interest rates” (Int. Her. Trib., Japan).  This deregulation allowed some banks to offer interest rates much higher than other institutions.  One such institution, Kizu, saw its deposits triple in three years (Int. Her. Trib., Japan).  Unfortunately, this same institution also ended up making bad loans valued from 570 billion to 1 trillion dollars.

                Why did the MOF allow these banks to set unwise interest rates?  In a sense, they had no choice.  As controls on foreign exchange transactions and interest rates were scrapped so were two key instruments the MOF used to keep financial institutions in check.  David Shireff, a contributing writer for Euromoney, states, “The MOF had been used to allocating capital around the economy.  And it has kept the market segmented for the safety of the participants.  But the market has grown too big.  Instruments flow across the compartments as banks, investors, and securities houses trade derivatives and cash securities.”  Shireff suggests that the MOF is having trouble coping with this loss of control and the internationalization of Japan’s markets.  He states, “The intention may be benign, but MOF interference in some of Japan’s markets to cure short-term problems may have heaped up long term trouble.”  He goes on to list several miscues the MOF made, such as restricting new equity issues during the 1990s and sponsoring “price-keeping operations,” which have pressured pension funds and banks to prop up the stock market from further collapse.

                The MOF was reluctant to reduce its power and control over the Japanese economy. The MOF had no choice but to relax foreign exchange controls, and free the banks from interest rate regulation due to the internationalization of Japan’s economy.  As the 1980s progressed, trade soared, and it was impossible to keep Japan’s economy isolated from the rest of the world.  However, the MOF refused to completely deregulate the economy, often keeping itself intimately involved in the financial industry using administrative guidance.

                The MOF appears to be unable to adjust to the new economy in Japan.  First, it does not have enough people to deal with a deregulated finance industry.  Sender states, “The Japanese authorities are in no way equipped to handle a large-scale crisis like the US savings and loan fiasco.”  Sender goes on to tell of one MOF official, disgusted, who states, “We have had one person working on one case for almost twelve months.  At the US Resolution Trust Corp., they dispose of one case every day.  But we don’t have 2000 people at the Banking Bureau.  We don’t have the resources for more than a few cases.  How can we custom-make solutions for 200 cases?”  Yet, keeping tabs on an industry with such a large scope requires a lot of manpower.

                Besides being understaffed, many question their expertise.  Wood notes “Japan is woefully short of securities lawyers” (page 166).  Many of the securities lawyers that do exist were educated overseas, for there is “no course taught in securities law in the University of Tokyo’s law department.”  However, new financial instruments, such as derivatives, are very complex.  Japan needs people who are learned in these products to regulate them.  Unfortunately, it seems like the securities lawyers who are in Japan are not employed by the MOF but rather by the securities companies themselves.  The MOF is then put in the odd position of having to rely on the securities companies for advice.  The extent of this reliance became obvious in the aftermath of the loss compensation scandal at Nomura that has been described earlier.  Wood states, “Nomura was off in a sulk because it felt betrayed by officialdom that summer … This left a gaping vacuum for the bureaucrats who were accustomed to leaning heavily on Nomura for practical advice when it came to drawing up regulations and the like” (page 168).  Wood then goes on to explain how the MOF decided to draw up “voluntary guidelines” for avoiding loss compensation scandals.  He states, “However well intentioned, the bureaucrats were coming up with rules that were often hopelessly impractical and that revealed their ignorance about the way financial markets work” (page 168).  One rule it put forth when drawing up guidelines to stop loss compensation was that no more than 10,000 shares of any new issue could be placed with any investor.  Of this, Wood states, “Yet clearly a major institutional investor like Nippon Life … will want to purchase more than 10,000 shares in any issue it decides to buy” (page 168).  So, to some extent, the MOF relied on the very industry it was regulating to make regulations.

                This lack of knowledge combined with the ambiguity of administrative guidance, leads to problems.  This can be seen with a Forward Rate Agreement (FRA), a financial instrument used to lock a certain interest rate for a period of time.  FRAs are effectively over-the-counter futures.  The problem is that they are in no man’s land in Japan.  David Shireff, a contributing writer for Euromoney, states, “Until now [1994], however, the MOF has disallowed them [FRAs] or rather, has deferred to the criminal code, warning that the Ministry of Justice might interpret the payout on the rate-differential as gambling.”  But, then Sender goes on to point out that the BOJ has no position on FRAs, and that it is ridiculous to think of a FRA as gambling.  A source at the BOJ states, “The FRA is getting rather symbolic of legal uncertainties, which is not good for the Japanese market.”  Sender states, “FRAs are set to grow … in the gray area where the MOF has given no definite guidance.”  Gray areas are a problem, though, in an industry where so much money flows through financial instruments every day.  The MOF needs to give guidance on these types of instruments, rather than let them grow in such an atmosphere of uncertainty.

                Christopher Wood states, “When there is no written rules, there is no accountability” (page 164).  This lack of accountability goes both ways.  On one hand, the MOF can escape criticism, as it did in the loss compensation scandal.  On the other hand, companies don’t really know if they are in safe territory or not when they make a decision, as with FRAs.  Administrative guidance is flexible, but with increasingly complicated financial instruments being developed and a lot of money at stake, it is not very clear that the system needs flexibility.  Sender tells of an unfortunate foreign house that found itself subject to a Securities and Exchange Surveillance Commission audit.  The MOF found evidence that this firm was “gray-market” dealing in domestic bonds.  The MOF decided that since the bonds were not yet securities at this stage, then securities firms should not be trading them.  Sender states, “Every bond dealer in Tokyo knows this but each finds it essential to deal in the gray market.”  This particular house lost its case though, and no longer does gray-market dealing.  Despite this, though, the Japanese Securities Dealers Association (JSDA) refuses to issue a directive against this practice (Sender).  So, these gray areas are not good because no one really knows what is OK and what is not OK.  In this example, you have numerous firms practicing an illegal act, and one firm is singled out and punished.  Yet at the same time, other firms continue to practice their gray-market dealings and the JSDA still refuses to take a definitive stance one way or another on this specific instrument.

                Currently, there is a lot of “bashing” against administrative guidance in Japan.  Many Japanese feel that the MOF led their country astray and was unable to deal with the bubble burst.  Even the Finance Minister, Ryutaro Hashimoto, admitted that administrative guidance was weak, stating that the scandals “forced me to realize the limitation of ministry policy which heavily depended on administrative guidance and other informal measures” (Youngblood).  The scandals forced many Japanese, including the press, academia, and the government itself, to realize the limitations of administrative guidance.  The Nikkei Weekly, a respected business journal in Japan, stated, “The scandals … have clearly exposed the limitations of administrative control.  Indeed, administrative control itself may be the source of the problems.”  Shoichi Royama, a professor of money and banking at Osaka University, sums up the problems of administrative guidance well, saying, “The administrative guidance system must be revised to meet development and diversity.  Now that Japan is open to the world, there are too many loopholes and places for financial institutions to play outside the country” (Finance:  Bankers as brokers page 46).  In fact, in the aftermath of the scandals that struck the securities industry, the “Ad Hoc Commission on Administrative Reform” suggested, among other things, “more formal and transparent regulatory guidelines to replace the ministry’s informal ‘administrative guidance’” (Burrell, Watchdog).  The commission also recognized the MOF’s inability to regulate the industry under its current structure, and after much debate recommended an independent watchdog for the industry.  The MOF, fearing the loss of power, used its influence to scratch this proposal, and while a “watchdog” was created it was put under the control of the MOF.  Nonetheless, the initial findings of this independent commission prove that administrative guidance, the time-tested practice of the bureaucracy, has come under much criticism in the past few years for the uncertainty it creates in Japanese finance.

Structural Issues

                There are also key structural reasons for the bubble burst.  These structural problems deal directly with how stocks and land are valued in Japan.  First, a characteristic of the Japanese economy is that many corporations own shares of other corporations.  This cross-holding is due to worries in the 1970s that strong American companies would buy out their weaker Japanese counterparts.  For example, around 1970, General Motors wanted to buy a sizable stake of Isuzu.  Of this time, Kenichi Miyashita and David Russell, joint authors of Keiretsu:  Inside the Hidden Japanese Conglomerates, state, “Kiichi Miyazawa [minister of the Ministry of International Trade and Industry] told the Japanese legislature that the most important task facing the nation was to preserve the independence of Japanese management in the face of an invasion of foreign capital.  Miyazawa noted that Japanese firms could block foreign takeovers by owning each other’s shares.  ‘It is not necessary to employ holding companies to carry out this stable cross-shareholding strategy,’ he advised, ‘for it is quite possible through the cooperation of related financial institutions’” (page 41).  So this corporate cross-holding phenomenon had a history in Japan.  It resulted in “keiretsus” in which a central bank would own shares in numerous companies, from life insurers to traders to industrial enterprises.  Often, all of these entities would own shares in each other.  The bank would be the main source of financing for all of the businesses within its keiretsu.  Japan ended up with large keiretsus dominated by large banks such as Mitsubishi, Sakura, and so on.

                Cross-holding increased throughout the 1980s, especially as the stock market took off.  In fact, in 1991, about 70 percent of Japanese stocks were held in this way (Aus. Fin. Rev., Japan).  One obvious effect of this cross-holding is that as share prices exploded, the value of the stock portfolios of all of these companies exploded thus increasing their stock price.  This phenomenon was already described in the first section of this paper.

                However, there is another, more insidious result of this cross-holding that would occur regardless of whether or not stock prices went up or down.  The companies that participated in this “stable” ownership plan held on to their stock regardless of prices fluctuations.  After all, this is what underpinned the system.  Okumura states:

This situation [cross-holding] strained the relationship between stock supply and demand, and eventually caused prices to rise … In the past, the relative value of … stock prices was computed by dividing the yield … by the prevailing interest rate.  It was assumed that when stock yield fell below the yield of … government bonds, investors would sell their stocks and switch into bonds.  However this theory is based on the idea that stocks are held for the purpose of receiving dividends.  As corporate ownership increased for stable shareholding purposes, this was no longer the case.  Investors continued to hold stocks and prices continued to rise (page 44).

So, the “stable ownership” goal in Japan effectively inflated stock prices over where they would be given a normal market.  This stable ownership may have allowed Japanese companies to focus on long-term goals, but it overvalued their companies.

                At the same time, during the 1970s equity offerings began to occur at market value instead of par value.  This meant that the higher the stock price, the more capital a company could raise (Okumura, page 44).  So it was to the issuing company’s advantage to have an inflated stock price.  As discussed before, brokerages realized that they could encourage more stock offerings and thus more business if they could work with companies to push up their stock price.  However, as companies issued more and more stock, raising capital for as little as 1 percent, it made it harder and harder for them to continue their “stable ownership” policy.

                Big corporations were torn between continuing their “stable” share ownership policy, and raising more capital through equity offerings.  Okumura states, “The balance between these two forces was upset, leading to the over-issuing of stock … The over-issuing of stock rendered it impossible to control supply and demand, and the bottom quickly fell out of the market [in 1989]” (page 44).  So, Okumura argues that the very success of the “stable” ownership policy is what led to its eventual demise.  As more and more companies issued stock, the supply grew so large that large corporations could no longer maintain their stable ownership policy.  Yet it was this stable ownership policy which drove the stock prices higher in the first place.  And, higher stock prices encouraged more and more equity offerings.  So, it was a cyclical process that was bound to collapse.

                Besides this stable ownership policy there is another structural problem in Japan’s stock market.  At times it can be a “riskless” market.  This paper has already discussed the “tokkin” accounts that the securities industry guaranteed against losses.  These accounts were effectively a riskless investment for their holders.  However, only the largest corporations in Japan were able to secure these accounts, mainly due to the large commission fees they paid the brokerages.  Smaller investors were left taking the risks.  This paper has also already discussed the “ramping” of certain stocks by Nomura.  There was another practice that did affect the market and that was the “price keeping operation” (PKO) on the part of the MOF.  The MOF decided, at times, that the market should not go down.  It did various things to ensure this.  One of the things it did was put a ban on new equity issues.  This was done to combat the problem discussed earlier where the supply of stock outweighed the demand.  However, in other countries, the government would never dictate when a company could make an equity offering.  One senior official at an US firm says, “The ministry of finance has to wake up and let the markets use their own prerogative.  It is ludicrous that some official can tell you whether or not you can do an equity offering” (Dyer).  This comment shows one effect of the MOF’s attempt to prop up the stock market — the  reduction in the efficiency of the stock market.  Speculators are not the only people who participate in the stock market.  It is also used by businesses — businesses prowling for strategic acquisitions, businesses looking to raise capital, and so forth.  When the MOF decides to prop up that market, they decrease the efficiency and utility that a stock market provides to these businesses and the economy as a whole.

                The MOF has gone farther than just implement “emergency measures” to combat the fall in the stock market.  They have actively “encouraged” pension funds and banks to “put or keep money in the stock market to prevent a further fall” (Shireff).  These “encouragements” are part of massive PKOs that the MOF engineers to prop up the stock market.  The Economist states that the MOF “has ordered public-sector agencies to buy Japanese shares.”  The magazine goes on to state that there has been a “flurry of administrative guidance, including arbitrary changes in accounting rules designed to prevent institutions from selling shares at a loss or even recognizing their diminished value in the books … And the futures market is being manipulated to protect share prices:  the Tokyo Stock Exchange, a mouthpiece of the finance ministry, wants the right to prevent securities firms from trading stock-index futures on their own account any time it thinks the stock market is overheated” (Re-regulating Japan).  The MOF has taken an active role in the stock market rather than the passive role that normally characterizes a regulatory body.

                Besides affecting businesses, this role affects investors.  One US investment banker states, “Big equity investors no longer have a strategy for picking stocks unless they have a feeling the MOF is supporting” (Shireff).  This “support factor” means that the most successful investors are those with access to the MOF.  Otherwise, one would not know what stocks to buy.  Shireff states, “For the transparency of the market it is no good at all.”  Shireff goes on to tell of one fund manager who states, “If you accept that the equity markets represent a pool of value and that it’s important that the assets be accurately priced, then what the MOF did was unforgivable” — unforgivable because people buy things assuming that the price is real.  If the MOF artificially supports the price of a stock, then people who buy that stock are paying more for it than they should.  This shatters investor confidence.  Less confident investors are less likely to put money into an already shaky market, leading to a continued slump for Japan’s stock market.

                There is also a deep structural problem with how land is valued in Japan.  The value of land is not based on real transactions because there are so few of them.  Rather, according to Alan Woodhull, a real estate analyst for Merrill Lynch, appraisers ask this question:  “If this site were to be sold today, without any liens or encumbrances, what would it be worth?” (Ins. Inv., What’s scaring?).  These values are not based on reality but the imagination of the appraiser.  This paper has already described the ridiculous values land reached in the late 1980s.  For example, in early 1990, Japan in theory could have bought all of America by just selling off metropolitan Tokyo (Wood, page 50).  Obviously, land prices were truly fictional in the late 1980s.  At first, these values may appear meaningless; in a real transaction the true value of the land would come out, as no buyer would pay such an inflated price.  However, as discussed earlier, land was used as collateral for many loans during the late 1980s.  The banks assumed that the land the borrowers provided for collateral was worth what the appraisers valued it at.  This assumption turned out to be the death sentence for many banks.  As loans went bad, the banks would try to sell the collateral.  But they either could not sell it, due to the illiquidity of the real estate market in the first place, or, worse, they could sell it, only at a price far below its appraised value.  When a transaction such as this would happen, it would further depress land prices.  This created a cyclical effect, as banks suddenly saw all of their collateral decrease steadily in value.

                Thus, the driving factors behind the bubble burst are many.  The easy monetary policy of the central bank was a key cause.  Yet, at the same time, the partial deregulation of Japan’s financial markets in the late 1980s ripped apart the administrative guidance system and exposed the weaknesses of the MOF to control its own markets.  Throughout all of this deep structural problems relating to how stocks and land are valued in Japan finally were exposed in the late 1980s.  No one of these reasons is the sole reason or most important reason behind this financial calamity.  Rather, all of these factors contributed to the burst of Japan’s bubble economy.

How Can It Be Explained?

                How can it be explained that Japan’s vaunted bureaucracy and ultra-stable political party did not recognize these factors and their possible detrimental effect to Japan’s economy? And, making an optimistic assumption that they did recognize some of these factors, why could they not act to stem them?

                As was discussed in the introduction to this paper, there are three mainstream models of Japan’s political economy that have stood the test of time in explaining its “miracle” success over the past few decades.  The developmental model suggests that the bureaucracy controls Japan and charts its future.  It is this impartial bureaucracy that has pushed Japan on its high growth course.  The liberal model suggests that the LDP actually controls Japan.  The LDP successfully manipulates the electoral system to maintain its power and the bureaucracy to do its bidding.  The market institutions model suggests that neither the bureaucracy nor the LDP controls Japan but that powerful banking groups and business associations guide its policies.  These models can explain “miracles.”  But can these models explain disaster?  Can these models explain the worst economic calamity to ever hit Japan?  Can these models explain why Japan’s economy has barely grown at all in the last few years?

                As will be seen, the developmental and liberal model both break down in the late 1980s.  The market institutions model successfully explains the reactionary stance of the MOF.  But, the strategic impulse that it suggests the private sector harbors does not come forth in the finance industry.  This section will start with a critique of the developmental model.

The Developmental Model

                Chalmers Johnson, in his book, Japan, Who Governs?, states, “Who governs is Japan’s elite state bureaucracy” (page 13).  The bureaucracy writes all of the laws, and enforces them.  The politicians act as a buffer against interest group pressure.  This allows the bureaucracy to operate with the purpose of furthering Japan’s long-term economic welfare, without worrying about short-term political gains.  So, there is a separation between the politicians and the bureaucracy.  In Johnson’s terminology, “the politicians reign and the bureaucrats rule” (MITI Miracle, page 316).

                In the closing chapter of his epic book, MITI and the Japanese Miracle, Johnson lays out four main points of the developmental model.  I summarize these points below only to fully define the model, so that its insufficiencies in the late 1980s become clear.  Note that Johnson concentrates on MITI.  Johnson’s model explains the interaction between bureaucracy and private industry.  The basic principles of this model can be applied to Japan’s bureaucracy at large, and specifically the MOF, the ministry with which this paper is focused.  The MOF, like MITI, sees its job as “fostering the health of the industry” – in this case the finance industry (Wagstyl, page 17).

                Johnson first states that a small elite bureaucracy, staffed with the best managerial talent available is key.  This talent should be well versed in economics and law, but have a managerial focus, and be among the best and brightest in the country.  This bureaucracy would then be vested with the power of directing the development of Japan’s industry, in the case of MITI, and finance in the case of MOF.  MOF was staffed with the best and brightest graduates from across Japan in the late 1980s.  These graduates were also well versed in law and economics.  Unfortunately the “laws and economics” that they knew were no longer pertinent in the late 1980s because the securities industry had changed drastically once it was partially deregulated.

                As was discussed earlier, the MOF was undermanned and confronting many changes in the securities industry.  It compensated for this by relying on advice from the very companies it regulated — chiefly Nomura.  After the loss compensation scandals, Nomura withdrew from the MOF, and left the ministry to formulate policy on its own.  It’s track record since then has been questionable.  As discussed earlier, it embarrassed itself while drawing up guidelines to ban loss compensation making “hopelessly impractical” rules.  The FRA fiasco, in which trading FRAs were labeled as “gambling” by the MOF also shows the inability of the MOF to react to new increasingly complicated financial instruments.

                Johnson’s first point then breaks down.  Japan’s bureaucracy may have had the “best and brightest” men in Japan but these men had little knowledge of global financial markets and were used to a time when Japan’s securities market was closed to the world.  Therefore, the developmental model appears to falter due to the inability of Japan’s bureaucracy to adjust to a global financial system.

                Johnson’s second point is that the political system must be set up so that the bureaucracy can function without worrying about interest group pressures, and can formulate long-term policy.  The politicians must satisfy these interest groups in various ways, and Johnson admits that scandals may develop as a result of this process.  However, Johnson specifically states, “If they [scandals] occur among the bureaucracy, they signal the need for quick surgery and reconstitution of the system” (page 317).  There is ample evidence that a bureaucracy, once impervious to outside influence due to its pride and insularity, became corrupt during the bubble years.

                Since 1990 numerous scandals have broken out, proving that corruption did exist in the MOF.  For example, shortly after the bubble burst in 1990, it became clear that at least some bureaucrats knew about the fake certificate of deposits that certain banks issued.  In fact it appears as if some bureaucrats actually encouraged this practice.  For example, in 1991, after Fuji was hit with numerous bad loans resulting from this process, the secretary to the Ministry of Finance, as well as other bureaucrats, was accused of helping several companies secure loans from Fuji without collateral (Alexander).  Likewise, as has already been explained, the MOF was implicated in the loss compensation scandal as well.  While the MOF formally prohibited loss compensation in the end, it did so reluctantly, after discreetly permitting and encouraging it through administrative guidance for several years.   Instead of admitting its mistake, it then proceeded to pin all of the blame on the securities companies, with the minister of the MOF calling them “shameful.”  Johnson, in 1991, states, “What this underscores is that this is not a securities industry scandal as much as a Finance Ministry scandal.  In this case, the real administrative guidance was camouflaged.  They’re just playing Grand Kabuki and pretending their dictates were violated” (Sterngold, Clamor for change page 1).  Even Johnson acknowledges that the MOF was in the wrong in this case.  Government agencies should not protect themselves with such fanaticism that they will go to the extent of denying a directive they made, and then implicate the subject of that directive for following it.  The tight, informal relationship between the MOF and the various finance companies led to corruption within the ministry.

                Even in the present, scandals continue to unfold in the MOF.  In the summer of 1995, the MOF agreed to use BOJ funds with private-sector money to create a special bank to absorb two scandal-tainted credit unions that had collapsed due to bad debt (Sieg).  Needless to say, the Japanese public was not very happy that their money is being used to bail out corrupt credit unions.  The Finance Minister, Masayoshi Takemura, then dismissed a “senior ministry bureaucrat” over questionable business links to the close acquaintance of the head of one of the failed credit unions (Sieg).  Jim Nakamura, business editor of Yomiuri Shimbun, tells of one senior official that “has been found to have received huge sums of money from businessmen, evaded taxes and devoted himself to accumulating personal wealth,” while another high-ranking official “allowed himself to be lavishly entertained by businessmen, beyond the bounds allowed for public servants” (page 7).  These officials are not indicative of a ministry that prides itself on selfless civil service and austerity.  The MOF can no longer boast of having a workforce that is dedicated to civil service beyond all else.  The very fact that the ministry created an environment for these activities prove that it can no longer ward off the powerful force of money and is becoming subject, at some level, to special interest groups.

                Burrell sums up the state of Japan’s bureaucracy well, saying “The supposedly incorruptible and omniscient Japanese bureaucracy has been revealed as, at best, incompetent and, at worst, badly compromised in its role as regulator of the system” (Burrell, Tokyo scandals hold lesson).  A key tenet of Johnson’s developmental model was a bureaucracy free from corruption.  The cases above show that the MOF is not free from corruption.  While some of the scandals may have been immaterial, the loss compensation and fake certificate of deposit scandals involved large amounts of money.  So, Johnson’s second point becomes invalid in the 1990s.

                Johnson’s third point is that the bureaucracy has to perfect “market conforming methods of state intervention in the economy” (page 317).  He goes on to state that the concept of “administrative guidance” is a key weapon the Japanese bureaucracy uses to regulate the private sector.  Administrative guidance provides for negotiation with the private sector, and has an inherent flexibility.  This policy differs from that in the United States, where agencies often impose regulations from above and clearly dictate them.  In the US flexibility usually enters the system through a long drawn out legal brawl when disgruntled firms inevitably counter “unfair” regulations in court.  In Japan, ministries make regulations in conjunction with business.  Since business is involved in the process, they are often willing to comply with the regulations, and rarely if ever do they resort to a court battle.

                Administrative guidance breaks down in the 1990s and with it the third tenet of Johnson’s model.  As Japan’s financial markets were deregulated and internationalized, the MOF could no longer use administrative guidance and be market conforming.  There were two key reasons for this.  First, while the heavy handed tactics it used in a regulated market could perhaps be called “market conforming,” those same tactics were no longer “market conforming” in a deregulated market, where government was expected to not interfere in the economy.  Second, by definition, the policy of administrative guidance is not market conforming.  Enacting policies without clearly writing them down and dispersing them to all firms would not be market conforming regardless of the nature of the policies.

                Numerous MOF policies were not market conforming.  It has already been discussed how the MOF tried in vain to prop up the stock market in the 1990s, engineering massive PKOs.  These were anything but market conforming.  The tokkin accounts and loss compensation guarantees that the MOF tacitly permitted were not market conforming.  All of these policies sought to create a “riskless” market where the Nikkei average would only go up.  Those are not market conforming policies.  Market conforming policies leave the market alone and only interfere to correct market inefficiencies, such as insider trading.  They do not contribute to the inefficiencies of the market; they seek to eliminate those inefficiencies.  The policies the MOF has put forth contribute to the inefficiencies in the market and are thus non-conforming.

                In addition to the nature of the policies themselves, the way the policies are enacted through administrative guidance harms the market.  This can be seen by looking at the attitudes of foreign investment banks that do business in Japan.  These banks are used to working in the US or European markets where sophisticated financial instruments, such as derivatives, are available.  Shireff states, “Their discontent is focused on the MOF and the obscure and torturous way it governs the market.  Many financial operations, like the launch of new instruments, cannot be done without the MOF’s approval.  But asking the MOF is like asking the sphinx.”  Shireff then goes on to tell of two foreign investment bankers who complain, “You don’t even know sometimes who to ask … or even what answer you have been given.”  This confusion is not good.  Perhaps when Japan’s securities market was tightly regulated, and foreigners were kept out, administrative guidance may have worked.  Now, Japan’s markets are operating in a tightly integrated global economy, and administrative guidance has no place in this system.  One European banker comments, “The Americans are obsessed about getting a precise legal opinion on everything they do.  They cannot stand situations where there are no precise rules about what you can and cannot do” (Dyer).  That is because the Americans are used to an efficient financial market common in first world countries.  The Japanese financial markets are “still virtually in the dark ages” according to one foreign analyst (Pitman).  Administrative guidance can no longer function and still be market conforming.  Administrative guidance is no longer a strength of the MOF, but a weakness.  Thus, Johnson’s third point is invalid in 1990s.

                Johnson’s fourth point is that a “pilot” organization is needed in a government to incorporate his previous three points.  I merely mention this point for completeness; it has no pertinence to the argument here.  The pilot organization for Japan was MITI.  In the model, this organization only serves as a startup for the developmental state.  Its importance decreases as the state matures.  In the late 1980s the developmental model breaks down; while it may explain Japan’s industrial success in the 1970s and 1980s, it fails to explain Japan’s financial failure in the 1990s.  As the securities industry was deregulated, the bureaucracy lacked the knowledge to guide Japan’s financial system soundly.  The tight, informal relationship between the MOF and the private sector led to corruption.  Finally, administrative guidance no longer helped the market but harms it.  Thus, the developmental model does not appear to explain the finance industry as well as the manufacturing industry in Japan.

The Liberal Model

                J. Mark Ramseyer and Francis Rosenbluth, in their book, Japan’s Political Marketplace, state “The LDP does monitor and police its bureaucrats … The image of a largely autonomous bureaucracy that promotes its own distinctive vision of the Japanese commonweal may be no more than a mirage.  Real Japanese bureaucrats … administer in the shadow of the LDP” (page 119-120).  According to proponents of the liberal model, the bureaucracy is a pawn of the LDP and the ministries never stray too far from LDP policies.  Ramseyer and Rosenbluth list several powers the LDP has over the bureaucracy (pages 183-184).  First, they state that the LDP can veto any bureaucratic initiative in the legislature.  This is not done often in Japan, but the threat of this veto would be enough to discourage any ministry from pushing its own agenda too far.  Second, they state that the LDP has independent sources of expert information.  In other words, they do not need to rely on the ministries for all the data and information they need to formulate a policy on a certain issue.  Third, many bureaucrats want to enter politics.  The only way to do this until recently was to join the LDP.  After all it had held a monopoly on political power for decades.  Obviously, a bureaucrat that constantly pushed his or her own agenda and fought countless wars with the LDP bosses, would not be welcomed into the LDP with open arms.  So this bureaucrat would generally adopt the LDP’s agenda to further his or her long-term political goals.  Fourth, bureaucrats of competing ministries check each other’s power.  One ministry can never get too powerful in Japan because there is always a competing ministry trying to enter its turf and check its power.  This conflict weakens the bureaucracy as a whole, and opens it up to the LDP’s influence.  Finally, the LDP can block promotions of bureaucrats.  In a job where one either is promoted or asked to leave, bureaucrats’ careers depend on promotions.  So, it is doubtful that any would ever cross the LDP’s path for fear of losing their job.  So, according to the liberal model, the LDP is the one that dictates Japan’s economic policy, not the bureaucracy.

                Ramseyer and Rosenbluth state, “LDP leaders both set the basic contours of regulation and constrain their bureaucratic agencies effectively enough so that they can rely on them to perform politically sensitive jobs” (page 140).  It is impossible to delve into the many personal relationships that intertwine Japanese politics and determine whether or not specific politicians influence specific bureaucrats.  It is true that politicians have been known to be much more receptive to money than bureaucrats and there is a strong possibility that individual politicians may call up friends in the MOF and pressure them to enact a certain policy.  The LDP may have drawn up “basic” guidelines, but it is doubtful that it got itself enmeshed in the MOF-Nomura relationship or any of the day-to-day regulations the MOF puts forth.  The LDP, if it were interested in keeping policies “politically acceptable” would not have endorsed the loss compensation directive from the MOF.  If the LDP had signed off on this policy, surely it would expect that once these policies were known to the public it would be dealing with an electoral nightmare.  It is likely that the LDP would be much more concerned with direct election issues (such as keep the economy going) rather than obscure financial regulations.  So, it is doubtful the LDP would have been able to monitor every single policy the MOF put forth.  Yet, in finance every single policy matters.  Obscure policies can have large effects on the economy at later dates.  Instead, it is likely that the very close relationship between the MOF and the finance industry pushed the LDP out on the sidelines of policy-making.

                It is true that a politician may have been bribed and had personal incentive to push the bureaucrats to accept certain improprieties.  As the 1990s went on and these major scandals came out, there was a political uproar, and the LDP was thrown from power in 1993.  The new prime minister, Morihiro Hosokawa, took power pledging to break the “iron triangle” or the “collusive link among big corporations, politicians, and bureaucrats” (Sterngold, Clamor for Change). Hosokawa’s pledge put him in direct conflict with the principles of the bureaucracy.  He shortly was forced to resign over a personal financial scandal.  Of this, Clyde Prestowitz, President of the Economic Strategy Institute, states, “His [Hosokawa’s] hopes, his objectives would have tremendously reduced the authority of the Japanese bureaucracy.  And I think what you’re seeing is that they got him, he didn’t get them” (Moneyline).  After his resignation, the LDP retook power in a coalition with the Socialist Party.  It is safe to say that since the bubble burst the LDP has seen its power drastically decline since the bubble burst.

                The bureaucracy has not seen its power decline in any comparable sense.  After the loss compensation scandals, an independent commission that had been formed to determine ways to “streamline” the bureaucracy, tried to determine whether or not an independent enforcement agency, similar to the Securities and Exchange Commission in the United States, should be formed.  They were given six weeks to make up their mind, after which they were supposed to deliver a report to the prime minister.  The head of the commission was Eiji Suzuki, chairman of Mitsubishi Kasei Corporation, a major chemical company.  The council initially insisted it wanted an independent agency.  However, it was immediately assailed by the MOF.  There was a stalemate between these independent minded commission members and the MOF.  This stalemate lasted, until, according to the The Nihon Keizai Shimbun, Mr. Suzuki announced the commission was leaning towards an independent body.  The Finance Minister Ryutaro Hashimoto met with Suzuki and then met with Toshiyuki Masujima, the commission’s staff director.  Shortly after this meeting, Masujima took a more active role and discouraged the formation of an independent agency.  In the end an agency was created, but it was attached to the MOF and staffed by MOF bureaucrats, so it was hardly independent (Sterngold, Clamor for change).  In addition, it was given no power to penalize companies that violated its rules.  So, the MOF got what it wanted and maintained its regulatory power.

                The Finance Minister was a LDP politician.  Public opinion was definitely against the MOF at the time, and was for an independent agency.  In fact on September 14, 1991, just a day after the report was presented, The Nikkei Weekly stated, “Only such an independent organization will be able to do the job [of keeping tabs on the securities industry]” (Should not be muzzled, page 6).  Yet, Hashimoto still acquiesced to the wishes of his bureaucrats (whom he supposedly controls) and pressured the commission to put the agency under the MOF.  It is doubtful this act helped the LDP’s chances for reelection.  It appears as if the bureaucracy won this battle, not the LDP.  From just this one event, it appears that the LDP does not have control over the bureaucrats.

                This paper has already discussed the backlash against administrative guidance in Japan in the wake of the scandals.  In 1994, the “Administrative Procedure Law” went into effect amid hopes that it would “end arbitrary and excessive government interference in corporate activity” (Fulford).  Among other things, the article states “directives should be put in clear, understandable writing.”  Yet, a headline in the April 8, 1996 issue of The Nikkei Weekly screams, “Law to limit bureaucratic rule fizzles.”  Apparently, according to this article, regardless of the law, administrative guidance still rules over business in Japan.  The paper claims “the Finance Ministry and most other ministries routinely circumvent both the legal system and the Diet when they make decisions.”  So much for the legislative veto power that Ramseyer and Rosenbluth claim the LDP can use to check the bureaucracy.

                The bureaucracy has not seen its power decrease any appreciable amount since the bubble burst.  The LDP and politicians have.  There have been several different governments elected in six years, and they have been unable to check the power of the MOF in any appreciable way.  Therefore, while the liberal model may have explained Japanese politics some time in the past, it no longer explains them today.  The LDP is the lame duck in Japan, not the MOF.

The Market Institutions Model

                But does the MOF deserve all of the blame for this debacle?  Was it just an agency unable to adapt to the internationalization of Japan’s markets, due to corruption or incompetence?  Or was some agent behind this inability to adjust?  The market institutions model suggests that there is another force besides the LDP or the bureaucracy that affects policy outcomes in Japanese politics — the private sector.  Powerful industrial groups centered around banks and trading companies have combined with private long term credit banks to form a “Banker’s Kingdom” in Japan.  A decentralized bureaucracy and stable government have made this possible (Calder, page 263).

                Kent Calder, in Strategic Capitalism, states, “Japanese capitalism … was  ‘corporate-led strategic capitalism’ — neither state dominated nor laissez-faire.  The state, in the aggregate, was more stability than strategy oriented” (page 251).  Calder specifically singles out the MOF as a “regulator,” focused on maintaining stability.  The MOF fought and still fights deregulation with all of its might.  That can be seen above when two years after the Administration Procedure Law is passed, the MOF still manages to work around it and keep administrative guidance alive.  This paper has also described how the MOF has successfully warded off an independent securities watchdog.  Indeed, The Times calls the MOF “Japan’s self-appointed guardian of stability and continuity” (Pitman).

                Much of this is due to power struggles among the ministries.  Ramseyer and Rosenbluth state, “That Japanese bureaucrats fight over turf is commonplace, of course” (page 115).  Because no one ministry has control over economic planning as a whole, yet each has a different constituency (MOF — banks, MITI — industry).  It is rare that a policy in one ministry does not affect a constituency of another ministry.  When something like an independent securities watchdog is proposed, that would infringe on the MOF’s “turf,” the MOF acted swiftly to destroy it.  Joanna Pitman, a contributing writer for The Times, says that the MOF’s reluctance to deregulate is due to “the matter of power which inevitably shrinks as liberalization proceeds.”  Much of the “stability” focus appears to result from the MOF’s thirst for power.

                In addition, the MOF is made up of numerous bureaus, each having its own constituencies.  The ministry as a whole has two conflicting constituencies — banks and securities firms.  Throughout the 1990s banks have continued to want to enter the securities industry at some level.  The securities firms are not interested in the increased competition, and want to keep the banks out.  Anthony Rowley, a contributing writer for Far Eastern Economic Review, states, “This [increased competition] would rob the big brokers of many of their prime clients” (page 37).  Yet, the banks were worried that if they did not venture into the securities business, they would lose all of their clients to the securities firms.  The MOF has been caught in the middle.  When they tried to appease the securities firms, the banks were angry.  When the MOF finally agreed to allow the banks to set up securities arms, the securities firms were very angry.  Either way, the MOF could not make a decision that pleased everyone.

                Calder lists four ways that the Japanese state deals with a certain private industry when deciding whether or not to lend that industry money.  Although Calder writes these relating to how the state supports industry, we can relate them to how the state interacts with the private sector in general, such as how the MOF deals with the finance industry.  First, Calder states that the government will react to an external shock in the economy, or the “strategic state response.”  His example is how MITI supported the Japanese computer industry in the 1960s only after the threat of American competition.  There were definitely several external shocks in finance in the 1980s — angry foreign governments, open foreign markets, and the yen-dollar exchange rate.

                Foreign governments were angry for two main reasons.  First, they were worried that the closed Japanese market gave Japanese companies an unfair advantage, chiefly in the form of a low cost of capital.  It has already been discussed how Japanese companies were able to raise money effortlessly and for little cost in the late 1980s due to the soaring stock market.  Lawrence E. Summers, the Undersecretary of the Treasury for International Affairs (1993), stated that the financial barriers in Japan against foreign financial institutions could “provide Japanese manufacturers with an unfair advantage by giving them access to capital at cheaper rates than their foreign rivals could get. “ (Sterngold, Big Bang).  A less open financial market means that Japanese investors have fewer options for investing than their American or European counterparts.  This means that more of their money stays in the Japanese market.  This is especially true since pension funds are predominantly run by Japanese firms due to MOF regulations.  These firms are more apt to invest in Japanese stocks (especially given the MOF’s PKOs described earlier), than would a foreign firm.  This bias implies that Japanese stocks are bought that would not have been bought had a foreign firm been doing the trading.  This is only one example of a possible advantage the closed financial markets give Japanese industry.  With the concern the United States places on the US-Japan trade deficit it is no surprise that they applied pressure to the MOF to open up Japan’s finance industry to competition.

                Foreign firms were also angry because they knew their investment banks could compete on an equal if not superior footing with the Japanese securities firms.  Unlike General Motors in the early 1980s, no one would question Goldman Sachs or Morgan Stanley’s ability to compete with their Japanese counterparts.  American and European banks invested a lot of money in Japan to build indigenous operations.  They were expecting a large return on that investment once Tokyo became the “London of the East.”  However, when the MOF backed off of its promise to completely deregulate Japan’s markets many firms shifted their focus from Tokyo to Hong Kong.  Larry Greenberg, head of Asian commercial banking for Bank of America in Hong Kong, states, “The expense level in Tokyo is just too high, and being in Hong Kong puts us closer to our big thrust into China”  (Sterngold, Big Bang).  The effect of this shift in focus is clear.  Instead of Tokyo being the financial capital of Asia, it could be Hong Kong or some other city in East Asia.  As a result, Japan could lose jobs, influence, and prestige to its counterpart.

                This effect on Japan can be seen in the present.  The Osaka Stock Exchange launched a very successful Nikkei index future.  The MOF, though, did not like this instrument and worried that it was responsible for the stock market decline.  Incidentally, American investment banks showed their prowess during this time, making huge amounts of money by trading this product.  The MOF put forth regulations dampening the product in 1991.  It did not go away however.  The Singapore International Monetary Exchange, popularly known as SIMEX, took up the business that Osaka lost with its own Nikkei index future (Sterngold, Big Bang).  It is interesting that Nick Leeson, the now infamous investment banker with Barings, bankrupted the firm trading derivatives on the Japanese stock market.  He did not trade these in Osaka, but in Singapore.  It is doubtful that Osaka will ever get the business back that it lost, even though this derivative product is on the value of its own country’s stock market.  The damage to Japan’s finance industry should be clear.  Not only do the Japanese markets lose this business, but also decisions affecting Japan’s economy are made in Singapore and not Japan.  And these decisions are made whether the MOF wants them to be made or not.  This is a clear example of foreign pressure on Japan’s economy.  Realistically, the MOF had no choice but to allow that futures contract on the Osaka Stock Exchange.  By not allowing it, it achieved nothing but the degradation of Japan’s financial power.

                There was another foreign shock that also occurred in the late 1980s:  the 1985 Plaza Accord that increased the value of the yen with respect to the dollar.  It has already been discussed how this shift in the exchange rate affected the Bank of Japan’s decision to raise interest rates in 1987.  So, Calder’s first point seems to hold true in the events of the bubble burst.  It successfully explains the reactionary stance of the Japanese government throughout the bubble burst.  However, it is interesting to note that these “reactions” were tepid at best.  The MOF did not completely deregulate the financial system in an attempt to modernize Japan’s economy.  On the other hand, in the cases Calder cites, such as MITI’s assistance to the Japanese computer industry, the response was one of overwhelming support.  MOF’s response to this foreign pressure has been anything but overwhelming.

                Calder identifies a second interaction between private business and government -- the “minimal” interaction.  Calder cites cases where MITI actually tried to prevent a company’s success, such as Sony (page 110).  Basically, the company does what it wants regardless of what the bureaucracy wants it to do.  Calder calls this “Corporate-led strategic capitalism.”  This forms a core part of the market institutions model.  The private sector sees a promising opportunity and goes for it regardless of the bureaucracy’s opinion.  It is a lot easier for an industrial firm to disregard the bureaucracy than a financial firm.  In the futures case explained above, the Osaka Stock Exchange probably faced a reluctant bureaucracy when it wanted to introduce a Nikkei index future.  It did it anyway, and a couple years later saw the rug yanked out from under it.  It is a lot easier for the MOF to prevent the introduction of a new financial instrument than it is for MITI to prevent Sony from manufacturing stereos.  So, although Calder’s second way has merit in a government-industrial business relationship, it has less merit in a government-finance relationship since the financial industry is a service industry and its products are regulated in a different environment.

                Calder’s third way that the government interacts with private business is “clientelism.”  In this way, the government effectively finds itself bound to a certain industry due to a historical relationship of support.  Calder focuses on agriculture, shipping, mining, and oil refining (page 111).  As has been stated before, the MOF had two main constituencies — the banks and the securities firms.  Each expected that the MOF would look out for their interests.  Of course, that was impossible, for in the deregulated environment that developed, the banks wanted to enter the securities industry, while the securities firms wanted to keep the banks out.  Those two objectives put the two main constituencies in direct conflict with each other.  As a result of this clientelism, the MOF could not formulate a clear policy, for no policy would please both constituencies.  When they finally allowed banks to enter the securities industry, the securities firms were incensed.

                Calder also has a fourth way government and private business act in Japan.  In this final way, the government effectively picks the industry, lends money, and builds it up from nothing.  Calder cites very few examples of this in industry.  This did not happen in finance.  The banks and securities firms fell far behind their American and European counterparts.  However, the MOF would have needed to fully deregulate the economy and remove controls that sheltered these firms from competitive pressure and modern financial practices.  As this paper has explained, the MOF refused to do this, and did not want to see its role as regulator deflated in any way.  It spent most of its time simply trying to maintain its own power.  Tokyo would never be transformed into the “London of the East.”

The interests of the MOF in this case became just as important as the interests of the banks or securities firms, since all three parties were in direct conflict.  The securities firms did not want the banks to enter their industry; the banks, seeing their best customers disappear, wanted to enter that same industry.  The MOF, caught in the middle, tried to mediate between the two entities on the one condition that it would maintain its power.  These conflicting interests resulted in a stalemate.  In Calder’s model, strategic corporate-led capitalism might very well take over at this point.  Perhaps the banks would just brazenly enter the securities industry, successfully retaining their clients, and break the oligopoly that Japan’s big four securities firms held on the industry.

                Unfortunately, while strategic capitalism works well in an industrial setting, it fails in finance.  If Honda wanted to enter the retail business and compete with Wal-mart, it could.  It may encounter frowns from MITI, and it may have trouble raising the necessary capital, but when all is said and done, Honda could enter the retail business and compete with the likes of Wal-mart and Kmart, if it so chose.  In finance, though, banks cannot just enter the securities industry.  They cannot just enter the insurance industry.  Due to the controls the government exercises over these industries, it robs the private sector of that initiative.  This was made clear when the Osaka Stock Exchange saw its future contract crippled.

                In reality, the banks were totally dependent on the MOF or the Bank of Japan to allow them to enter the securities industry.  When Japanese finance was hit with several external shocks, the MOF began to formulate a “strategic state response.”  Unfortunately, due to the conflicting interests of the MOF, the banks, and the securities industry, this response lingered and did not proceed in a fluid fashion.  This lingering caused the bubble burst and the haphazard, partial deregulation that followed.

                So, the MOF does not have ultimate authority to do as it chooses, as the developmental model suggests.  If it did, it would have had the foresight to “mitigate” the banking and securities interests and put forth a policy of deregulation.  At the same time, the MOF does not follow the “politically correct” path as the liberal model would suggest and follow the LDP’s bidding.  If it did, it would have acquiesced to the creation of an independent securities watchdog and agreed to end administrative guidance.  As the market institutions model suggests, the MOF is largely a reactionary body and the deregulation it put forth was largely a response to foreign powers. Unfortunately, the conflicting interests of the ministry itself, the banking interests, and the interests of the securities firms undermined this process, and the finance industry was never deregulated completely.  The private sector does not have the strategic initiative in the finance industry that the market institutions model would suggest, and was unable to circumvent the rule of the bureaucrats.

Conclusion

                The bubble burst was a very complex event.  The twin spike in land and stock prices in the late 1980s and the numerous scandals to hit both private industry and the government shook the world’s faith in Japan’s government and brought to question the country’s famous long-term focus.  The economic factors behind this bubble burst were many.  Easy monetary policy created a pool of cheap capital that was the fuel for this economic catastrophe.  The deregulation of the Japanese economy put the MOF in an unfamiliar position and it was unable to react to the quick internationalization of the economy.  Long simmering structural problems affecting the valuation of stock and land also came to the forefront during this catastrophe and undoubtedly contributed to its severity.

                Models that have been able to explain Japan’s success in the past can no longer explain it in the present.  The developmental model no longer holds true.  The bureaucracy is not “all knowing” or always well meaning.  Its main tool, administrative guidance, is outmoded in an international economy.  The liberal model also fails.  The LDP has seen its power hemorrhage like never before.  The bureaucracy has filled its void, and has openly worked around laws at stemming administrative guidance.  The market institutions model successfully explains the reactionary stance the MOF took to deregulating Japan’s economy.  However, the strategic impulse it suggests lay with the private sector does not apply in finance and further explains why Japan’s economy has not moved forward.  The banks and securities firms are reliant on the MOF to completely deregulate Japan’s financial markets.  Until this deregulation occurs, it is doubtful that Japan’s economic situation will improve.