Japan's Forgotten "Lost Decade": The Showa Recession And Financial Crisis
Shedding Light on Japan's First Financial Crisis in Modern Economic History Nobody Knows About
Japan's Heisei recession of the 1990’s, commonly referred to as Japan's "Lost Decade”, has been subject to a great deal of research. According to widespread belief it was unprecedented in both depth and temporal dimension in Japan’s modern economic history. That is incorrect!
The Showa recession, financial crisis and depression, which ravaged Japan in the 20s and early 30s of the previous century resembled the Heisei recession on four important counts:
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First and foremost, the trend was deflationary. Second, after a severe and prolonged downturn, the stock market took 11 years to reach its lowest point. Thirdly, there were significant swings in the Yen. Finally, the climax was a full-blown synchronized global financial crisis and economic slump: The 1930-1931 Showa Depression.
In December 1919 Japan’s stock market peaked. What followed was a spectacular and prolonged secular bear market that lasted about 12 years. Finally, the Nikkei equivalent reached its low in November 1931, shedding 74% of its value. However, the extent of the damage to stock prices and business sentiment was so great that the stock market did not fully recover for another ten years.
Surprisingly, despite many striking similarities between Japan's "Lost Decade" and the Showa recession, financial crisis and depression, academics and investors in stock markets never really paid attention to the latter.
This is the first post in a two-part series that aims to change that. It is a story about economic policy blunders, financial follies, and the mismanagement of money and credit. It is the story about Japan’s forgotten “Lost Decade”.
Japan’s Pre-War Economy
Even though Japan stood by and watched the great war in Europe to play out, the economic impact was significant, and surprisingly positive.
Japan's prewar financial situation was precarious. Massive expenditures for the Sino-Japanese War (1894-1895) and the Russo-Japanese War (1904-1905) had left Japan's public finances in shambles, and the state-promoted shift toward military-oriented heavy industry around 1894 had resulted in large imports of raw materials and machinery and a massive structural trade deficit.
In essence, Japan was about to go bust on the eve of WWI, only able to kick the can down the road by floating a large amount of debt, denominated in foreign currency, thanks to the Anglo-Japanese alliance.
WWI changed everything. Japanese goods saw an increase in demand as European producers retreated from global markets. Latest with the war time boom in the U.S. that started in 1916, Japan’s economic expansion turned into full swing with the U.S. absorbing unprecedented quantities of Japanese exports.
The economic boom was nothing short of spectacular. In real terms, domestic manufacturing increased by 54%, and export value by 47%. The Japanese stock market was by far the best performing international market, rising by about 130 percent between 1914 and 1919.
Foreign currency and gold poured into the country. Japan would eventually have access to sufficient financial resources to possibly pay off all debt it had accumulated in previous decades. But this would not be the case. Instead, Japan decided to become a creditor nation, financing its own trade to maintain the frantic economic expansion.
The Showa Recession: From Boom to Bust
The wartime boom eventually came to an abrupt halt, and the bust that followed would be brutal. Even though there was a brief inflationary boom around the middle of 1919 that had all the characteristics of a speculative mania, the postwar shock eventually took the Japanese stock market with it.
In December 1919 the market reached its highest point before slowly declining. Investors were anticipating a hard landing for the Japanese economy, which led to an increase in the downward momentum in February/ March 1920.
Japan’s financial system was in a worrisome state. During the war boom, and the inflationary bubble that followed, many big banks and corporations had engaged in speculative activities and overextended. Additionally, a slew of dubious small and medium-sized financial institutions, known as Kikan Ginko, had contributed to the accumulation of bad debt.
The Masuda Bill Broker Bank in Osaka was the first bank failure during the Showa recession, triggering a bank run in parts of Japan. The stock market plummeted as a result. 21 Japanese banks' suspended operations between April and July 1920, either permanently or temporarily.
To ease tensions and stabilize the financial markets, the Bank of Japan (BOJ) intervened and extended a variety of "special loans." Additionally, it attempted to alleviate key industries. The BOJ's actions did temporarily calm the situation, but they were insufficient given that the Japanese economy was just beginning to enter a recession.
When the Ichi corporation, a lumber company located in Osaka that had engaged in massive speculative activities, declared bankruptcy in February 1922, Japan’s financial stability was once more put to the test.
Bank panic spread throughout the Kansai region. Then, from October to December 1922, bank runs spread to other localities. From December 1922 to April 1923, the BOJ granted "special loans" to 20 banks once more.
Additionally, the government enacted the Saving Bank Act of 1921 and imposed stricter regulations on small savings banks. Furthermore, it attempted to accelerate reforms of the entire financial system, including the larger ordinary banks.
The financial markets were once again calmed down by the BOJ and the government. However, within a short period of time a terrible catastrophe would strike Japan:
The Grat Kanto Earthquake
The earthquake of September 1923 seriously disrupted Japan's financial system, because it damaged not only the banks' financial, but also their physical assets.
Depositors were scared, fearing bank losses and loan repayment delays. The BOJ acted swiftly and provided banks in the region with special emergency loans in form of discounted earthquake bills (REBs).
REBs were essentially commercial bills. For "discounting," they were first taken to banks. Banks purchased the bills and paid in cash after deducting interest from now until the maturity date. The banks, on the other hand, returned these bills to the BOJ for "rediscounting", receiving cash. The BOJ's intention was to inject liquidity into the financial system as well as the real economy to prevent a full-scale financial meltdown and sustain economic activity.
The government also got involved. In response to the crisis it made special arrangements, like issuing a decree imposing a moratorium, allowing districts affected to postpone payments due from that month forward. In addition, on September 27th, the government indemnified the BOJ for any losses incurred by re-discounting bills and payables due in the affected areas. Depositors were relieved and by the time the moratorium was lifted in October 1923, financial tensions had been curbed.
“Zombie Lending” And “The Earthquake Bill Problem”
Although this rescue provided the Japanese financial market with temporary protection, the BOJ's emergency policy ultimately led to the creation of a new issue known as "Zombie lending."
When rediscounting commercial bills from the Kanto Region, the BOJ did not discriminate. Banks and businesses from all over Japan gladly presented their non-performing loans to the BOJ that had nothing to do with the Great Kano Earthquake, exchanging bad debt for good cash.
Japanese politicians and bureaucrats expected that, even though some of the Japanese companies might go bust, most would eventually be able to resume operations. If the problems were solely caused by the earthquake, the BOJ ought to be able to redeem most of the earthquake bills eventually. But that did not reflect reality.
After two years companies only redeemed approximately half of the loans that had been extended to them. “Moral Hazard” was creeping into the financial system with the Bank of Taiwan, and its major client Suzuki Shoten, being the biggest issue. “The earthquake bill problem” was born.
The Bank of Taiwan And Suzuki Shoten
The Bank of Taiwan was a strange case. Despite its official status being Taiwan’s central bank, it also actively extended loans to mainland Japan, including Suzuki Shoten. Thus, it had an official status but also served as a commercial bank.
On the other side of the issue was Suzuki Shoten, a relatively new, but nevertheless significant, trading company headquartered in the city of Kobe. Through speculative business expansions its sales turnover even exceeded that of large and established Zaibatsu trading companies at one point.
Suzuki Shoten, like many other Japanese businesses, experienced a severe problem with bad debt following WWI and the collapse of the war bubble. It repeatedly requested short-term rescue loans from the Bank of Taiwan, its main bank, to meet its debt obligations.
The Bank of Taiwan was unable to simply end its relationship with Suzuki Shoten. The bank's overall loan portfolio already comprised of an excessive amount to the company. It was essentially merely delaying the inevitable by rolling over existing debt and providing new loans with help of interbank "call" loans and borrowing from the Bank of Japan.
The Showa Financial Crisis of 1927
Finally the government acted. Two laws were drafted: The first would permit the use of government bonds as collateral to reschedule bad commercial bank bills for ten years. The second would make it possible for the government to give the BOJ a maximum of 100 million yen for deducting losses caused by the earthquake bills. Thus, some of the bad earthquake bills would be paid off with public funds, while others would become long-term debt that had to be paid back over time.
In January 1927, a parliamentary debate on those laws started. On March 14, 1927, Finance Minister Kataoka was grilled by the House of Representatives' Budget Committee. Extremely dissatisfied with the opposition, and the lengthy debate, Mr. Kataoka revealed explosive news that had just passed his desk.
“The Tokyo Watanabe Bank finally declared bankruptcy today around noon”.
The Tokyo Watanabe Shoku
Very likely Mr. Kataok’s intention was to illustrate urgency to the opposition. For the Japanese public and the financial markets, the news was an unexpected bomb shell. Japanese depositors immediately lined up in front of Tokyo Watanaba’s branches to withdraw their funds. Shortly after, numerous other banks were forced to temporarily close their doors in the Tokyo region.
Quickly, it became clear that, technically speaking, the Tokyo Watanabe Bank was not bankrupt. It “only” had liquidity issues that were fixed in a timely manner. The bureaucrat who conveyed the information to the finance minister had forgotten to correct the initial report.
Minister Kataoka was heavily criticized for his slipping words. However, regardless of Mr. Kataoka's careless and erroneous statement, any observer should have been aware that the Japanese financial system was at a point of no return. That the numerous bank runs that had beleaguered Japan were not cyclical but systematic in nature. Brought forth by an ulcerous of bad debt. that had been allowed to accumulate in the Japanese economy for such a long time.
The Bank of Taiwan Shoku
By the end of 1926, the Bank of Taiwan and Suzuki Shoten accounted for 48.4 percent of the “earthquake bill problem”. But there was no indication of any emergency; neither Suzuki Shoten's nor Bank of Taiwan's management seemed troubled. They viewed the two organizations to be systemically relevant and too big to fail. The informed public saw it similarly. The idea that the government would give up on the Bank of Taiwan and Suzuki Shoten was unthinkable.
It was a dreadful misapprehension. Eventually, Japanese policymakers would be determined to fix the "earthquake bill problem" once and for all. And tackling the issue would require resolving the Bank of Taiwan-Suzuki conundrum.
On March 26, 1927, after being put under pressure by officials, the Bank of Taiwan finally turned Suzuki Shoten down for further lending. Naturally, other commercial banks withdrew their call loans from the Bank of Taiwan as soon as the companies' separation was announced. The Bank of Taiwan could not survive unless it received additional loans from the Bank of Japan.
But the BOJ hesitated. Only when a new law had passed the parliament, covering future losses, was it willing to act as the "lender of last resort".
The government was in a hurry and issued an imperial edict of emergency that stated: (i) Until May 1928, the BOJ could make special loans to the BOT without putting up any collateral. (ii) The government would pay the BOJ up to 200 million yen for any losses from these loans.
Everyone thought the bill would easily go through the parliamentary process. But it was rejected by the Privy Council, which was highly politicized and heavily influenced by ultra-conservative politicians. The BOJ refused to lend to the Bank of Taiwan when the edict was rejected and could not be signed by the emperor.
On April 18, 1927, the Bank of Taiwan was forced to close its doors. On the same day, the Omi Bank also shut down. Meanwhile, banks still operating showed off tall stacks of currency notes at the cashiers to calm clients. But it was too late. A wave of bank runs spread throughout the peninsula. Although it was already the third financial panic in 1927, it was by far the worst.
In addition, this time it was accompanied by political turmoil. The Wakatsuki Cabinet resigned on April 20, 1927, and Korekiyo Takahashi, also known as the Japanese Keynes, became Finance Minister for the opposition Party.
Two days later the new government imposed a three-week "moratorium" on virtually all financial obligations and ordered all banks to "voluntarily" close for two days to safeguard banks. With the exception of small sums to cover people's living expenses, no deposits could be withdrawn.
With the exception of the numerous banks that had vanished, and the depositors who had lost their savings, things went back to normal when the moratorium was lifted.
The Showa Recession and Financial Crisis: The Outcome
The Showa recession of 1920- 1926, and the Showa financial crisis of 1927, was basically a banking crisis. The outcome was a severe contraction of bank credit, especially to small and medium-sized enterprises.
Surprisingly, the macroeconomic impact was adverse but not catastrophic. Between 1920- 1929, the rate of real economic growth was volatile, with frequent recessionary periods, but on average positive (1,8 percent). Although the period was deflationary, deflation was mild, averaging -1,3 percent.
The most significant outcome was the concentration in the Japanese banking sector by liquidating unsound banks and merging others. The number of ordinary banks dropped from 1'794 in 1922 to 1'028 in 1928. Although, the average paid in capital per bank increased, the total amount decreased steadily.
The typical depositor at a bankrupt bank lost 35-50 percent of his savings during the consolidation process. By imposing a minimum capital size and other requirements, the government encouraged further M&A of the remaining small banks The public shifted their deposits from small local banks to large banks with big names.
Thus, deposits were increasingly concentrated in the “Big Five” banks: Mitsui, Mitsubishi, Sumitomo, Yasuda and Daiichi. Some observers argue that the elimination of small banks, especially the Kikan Ginko, had not only adverse consequences. They claim that the concentration of the Japanese banking system was a significant step towards a more modern financial system in Japan.
Was The BOJ to Blame?
Regarding the BOJ's role during the Showa recession and financial crisis, many assert that, particularly with regard to the Bank of Taiwan, the BOJ did not fulfill its role as the lender of last resort.
However, there are still a few concerns regarding that claim.
Should the BOJ really be held responsible for the Bank of Taiwan's reckless behavior? The BOJ had been forced to save too many banks against its will and in spite of its own financial stability. The BOJ would have to reaffirm its political independence at some point. Even though allowing the Bank of Taiwan to fail was bad right away, it's highly unlikely that providing endless emergency loans would have been the right answer.
It's highly likely that the BOJ was well aware of the need to immediately provide unlimited liquidity to prevent a financial meltdown. However, there was simply too much political opposition to injecting public funds into a few large banks, both among the general public and in the parliament. Thus, the BOJ) was forced to take a hard line against the Bank of Taiwan as a result.
Although bank failures and closures are, without a doubt, painful in the short term, in the long run, they will ensure the stability of the remaining banks and the banking system as a whole. This was the case for the Japanese financial system during the latter part of the 1920s.
The Showa Financial Crisis of 1927 marked a turning point in the disposal of bad loans and the reorganization of Japan's banking sector, allowing the long-term issues that had engulfed the Japanese financial system for more than half a decade to be finally resolved.
Without doubt the Showa Financial Crisis cleansed the Japanese financial system and left it in a much better condition. Despite this, gloomy clouds had already begun to form in a different direction.
The United Kingdom was preparing for the return to the gold standard, a move that the United States of America had already taken in 1919, and the rest of the industrialized world was seriously contemplating at the Brussels Conference in 1920 and the Genoa Conference in 1922.
Finally, in 1925, the United Kingdom returned to the Gold Standard at prewar parity, and other major countries followed suit. Only one country hesitated for obvious reasons: Japan
Wartime and Post-war Economies (Japan) by Michael Schlitz
Yuji Kuronuma; Showa Depression: A Prescription for "Once in a Century Crisis"; Japan Center for Economic Research; April 2009
H. Moussa and J. Obata. "Economic Development and Financial Structure in Japan, 1868-1927", Atlantic Canada Economics Association, Working Paper Series 2002
Kenichi Ohno; The Economic Development of Japan: The Path Traveled by Japan as a Developing Country; GRIPS Development Forum; March 2006
Masato Shizume; The Japanese Economy during the Interwar Period: Instability of the Financial System and the Impact of the World Depression; Institute for Monetary and Economic Studies; May 2009
Kikan Ginko were "banks" that were subordinate to a parent company and only served one or a few customers. Naturally, there were a number of governance issues, including: no capacity for risk assessment or project evaluation, no information disclosure, no portfolio diversification, no managerial independence, and the same family frequently owned and managed both the bank and the business.
After the war the economy of the UK eventually recovered significantly and, after the UK industry had concentrated on fulfilling its war demand, it started to compete with Japan in the product markets of Asia and within Japan's colonies. Subsequently, Japanese companies experienced a heavy inventory buildup.