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INTRODUCTION BY BILL TOTTEN (from Japan): In this continuation of the second installment of a three-part essay analyzing the roots of modern banking, economist Michael Hudson describes the unfortunate consequences of hasty deregulation on the U.S. banking and thrift sector in the 1980's. His analysis warns of repercussions for Japan, which appears to be blindly emulating the same expedient U.S. policies.

IV. Some contrasts between Japanese and U.S. banking

Today's Cold War victory of privatization and economic deregulation aims less at financing new industrial investment than at generating capital gains on assets already in place by inflating stock market and real estate bubbles. Toward this end governments are being turned into armies commanded by financial speculators who have neither the time nor the foresight to make their gains in ways that expand society's horizons. The politicians who staff these armies have become mercenaries, paid in economic booty divided among loyal officials in the form of campaign contributions. The more financial gains the new laws create in the hands of the wealthy, the larger these contributions grow. The first government payoff to campaign backers (headed by the real estate, banking and insurance industries) has been a fiscal reward. The tax burden is being shifted away from holders of real estate, stocks and bonds, onto industrial capital and wage- earners. Yet no one seems to be analyzing how credit is being steered into the capital and debt markets to inflate asset prices, creating economic bubbles. Even as Japan discusses its banking and financial reforms, no public official is explaining how this may help - or hinder - the nation's recovery of employment and direct investment in key technologies.

It is as if economics is discussing a just-pretend world of science fiction, not the real world around us. Japan's case is by no means unique. Nobel Economics Prizes continue to be awarded for theories of equilibrium even as the economic environment is suffering debt pollution and a polarization of wealth and income between rich and poor. People have come to recognize how the earth's atmosphere and biosphere are entering an epoch of extreme disequilibrium, but to many observers society's own widening economic imbalances seem still to be invisible. So thorough a victory for the financial and real estate industries hardly seemed likely eighty years ago. By the time World War I drew to a close, it seemed that the epoch of laissez faire had passed. After Russia's October Revolution even Europe's political right wing endorsed the principle of centralised government planning. Italy's fascists advocated a "corporate state," while Germany's national socialists sponsored heavy industry and employment on a military footing. National power seemed likely to be a function of economic planning and technological innovation, not financial and real estate gains for rentiers. John Maynard Keynes wrote a famous essay on "The End of Laissez Faire," and called for "euthanasia of the rentier." His General Theory contained a devastating critique of rentier capitalism. The essence of his theory of government planning was to show how unearned income from financial speculation and the debts it created was deflating purchasing power for the rest of the economy, deterring new tangible real investment and employment.

The situation began to change after the Second World War. Free- trade economists attributed the German miracle to free enterprise, a slogan Chancellor Ludwig Erhardt used later. But the real reason for the turning point occurred in 1947. The Allies canceled Germany's internal debts (save for the wages that employers owed their workers for their last few weeks' pay). The guiding logic was that most business debts were owed to former Nazi businessmen. The Allies also refrained from exacting reparations. Germany thus emerged from the war with almost no burden of taxes needed to defray interest charges on public debts, and almost no debt-servicing costs on private debts. Germany's government budget also benefited - as did that of Japan - by having no army to support. No wonder these two economies were able to compete so well in the international economy!

But the Allies' beneficence was not without political strings. Both Germany and Japan felt obliged to reimburse the United States for providing the Cold War umbrella. Both countries contributed heavily to American initiatives throughout the world. Their central bankers let the World Bank and its associated regional banks serve as vehicles to shift D-marks and yen into U.S. dollars, mobilizing the German and Japanese balance of payments to support America's own political programs and affluence. In the end, Japan's fiscal solvency was sacrificed to the United States, most notoriously under the Plaza Accord. With hindsight, it seems that Japan's economy was put in order mainly to serve the United States as a financial colony.

Recently, a thoughtful study of financial philosophy as it pertains to Japanese banking has been published. This best-seller, "The State We're In," by English economist Will Hutton, recommends that the solution to "the British disease" is to reform England's banking system along lines practiced for many years in Japan. Hutton analyzes British banks as having a short-term rentier mentality that has not changed much since the days of Foxwell. By contrast, he writes, from the late 1930s through the 1980s Japan mobilized its savings to fund industry. While its post office network collected long-term savings, the large public investment banks lent money in partnership with Japan's commercial banks to fund industries targeted by MITI as being in the national interest.

Is Mr. Hutton pining for a lost world? Besides the problems of corrupt bank officers being reported in recent news articles, haven't Japan's own banks become more "English" in their patterns of lending which, during the Bubble, was largely for real estate speculation? If they were enlightened industrial banks, what has gotten them into the trouble in which they find themselves today?

Placing the analysis of Japanese banking in historical perspective, Hutton describes how Japan's financial system adopted the Anglo-American model's short-term horizon in the 1930s, even as the rest of the world was centralising government economic and political control in the aftermath of World War I. At the time Japanese banks did not yet offer long-term loans, and the zaibatsu represented "only ten of the top sixty manufacturing and mining companies. In the non-zaibatsu firms quoted on the stock market, R&D and investment took second place to immediate profits." Workers were fired as business conditions fluctuated, and "senior management insisted on bonus and share option schemes as incentives to further effort." All this sounds very Anglo-American and un-Japanese indeed!

As Japan prepared for World War II, however, "the government moved to a 'New Economic System' which recast the financial and labour system along broadly contemporary lines. Stockholders' rights were limited, dividends were curtailed and individual firms were induced to become 'an organisation whereby employers and employees are bound together in their respective functions.'" The objective was to increase production, and financial institutions were directed to provide the needed credit. Some Japanese urged a more British-type free-for-all market system. It was perhaps fortuitous, however, that "after Japan's defeat the U.S. was too distracted by opposing communist trade unions and Japanese socialism to follow through in its attempts to change the system, and the underlying institutional structure [of war planning] survived." The result was that Japan's "regulated financial system is the least market- based, most traditional, above all most committed to its customers, of all the three principal capitalist variants" (England, Germany and Japan). Shareholdings represent long-term commitments to companies, not mere vehicles for short-term trading profits.

Japan's banks are linked to the rest of the financial system by a system of cross-shareholdings. "Mitsubishi, Mitsui, Sumitomo, Fuyo, Sanwa, and Daiichi Kangyo Bank are each City banks which, along with a trust bank, life insurance company and trading company, sit at the centre of a constellation of cross-shareholdings. The banks act as presidents of each group, channeling long-term loans, chairing negotiations over joint ventures and generally sharing information and business advice." The mutual shareholdings that cement inter- relationships among the kigyo shudan (industrial groups) represent some 40 per cent of the equities traded on Tokyo's stock exchange. An additional 30 per cent are held by the keiretsu, or sub-contractors that work for the major industrial companies.

This "relational market" accounts for some 70 per cent of Japanese stocks, constituting a system of mutual long-term commitments, Hutton concludes (p. 272). "The group companies, because of the dense network of cross-shareholdings, in effect own each other and are impregnable to takeover," while group pressures serve to monitor and improve company performance. Corporate raiders are thus alien to the Japanese spirit, while "other features of the Anglo-Saxon system like executive share options are banned."

Most notably, "in the event of bankruptcy the banks rank after the employees and subcontractors in having a claim on the company's assets." This leads Japan's banks to save their customers from insolvency rather than withdrawing financial support when business conditions turn down. This support helps the banks avoid being left holding the financial bag. "Japanese banks will lend up to four times more in relation to a firm's assets than British banks," Hutton finds; "the respective fortunes of the two countries' car and consumer electronics industries are a stark illustration of the competitive advantage that such abundant working capital and stability of ownership give the Japanese." (Likewise, he finds that Korea's chaebol incorporate within single conglomerates "a vast cluster of related enterprises that are given overt state support by the South Korean government and state banks.")

Finance and commerce are thus linked. In the process, their long- term relationships block foreigners from penetrating Japanese (and Korean) markets "even when they have saleable products. They are not part of the relationship network."

In the United States the three-pronged link is between banking, government, and the real estate sector. Manufacturing gets short shrift as over 70 percent of loans to businesses are real estate loans. New credit creation thus is based mainly on mortgage banking. This inflates the real estate bubble (and stock market gains) without funding new direct industrial investment. This bias is reinforced by a fiscal system that taxes capital gains at much lower rates than earned income. American investors accordingly aim at achieving capital gains (above all, land-value gains) rather than industrial earnings.

V. The Impact of Deregulation

For many years the U.S. financial system separated commercial banking from long-term mortgage lending to home-buyers and businesses. By World War II, mortgage banking consisted mainly of two specialized types of institutions. Mutual savings banks, created in the 1800's, were formed to benefit local depositors by mobilizing their petty savings (hence, names for savings banks such as Dime, Dollar, Emigrant's, Seaman's, and Bowery), and to lend out these deposits to small-scale borrowers. Savings and loan associations (S&Ls), created in the 1930's, were "share companies" to provide home-buyers with longer credit than the three-year renewable mortgages extended by commercial banks. The S&Ls were privately owned and run for the profit of their owners. Continuing their organization as joint stock companies until the 1980's, S&Ls accepted money as "shares." They were insured by the Federal S&L Deposit Insurance Corp.(FSLIC) rather than by the Federal Deposit Insurance Corp (FDIC), which insured commercial and savings banks. The names for most S&Ls concealed this non-bank character by calling themselves "First Federal" (or "First Federal Savings") in big letters, only disclosing in the small print that they were S&Ls rather than savings banks.

Japanese may compare U.S. savings banks to their own credit unions, and the S&Ls to their jusen. Unlike Japan's jusen, however, America's commercial banks did not hold stock in the S&Ls. Under U.S. law there was a strict separation of function. S&Ls were allowed to pay higher rates of interest, the costs of which they covered by taking more risks. Their fortunes were buoyed by America's postwar inflation of land prices. This enabled even badly conceived projects to be profitable, thanks in large part to the special tax breaks the real estate lobby won from Congress.

Most of the rise in interest rates occurred after 1964, when America escalated the war in Vietnam and pushed the nation's balance of payments deeply into deficit. Interest rates had to be increased to attract enough dollars to offset military spending. Rising interest rates curtailed the stock market run-up and slowed new construction until war-induced inflation led to a flight into property.

The problem for S&Ls and other mortgage lenders was that while interest rates were being buoyed by inflation (and inflation adjustments), market values of the financial community's long-term mortgage loans were declining against this real estate. Each rise in interest rates made the financial structure more shaky.

By the end of the 1970s the S&Ls were in trouble because they had reinvested their deposits into mortgage loans whose interest rates were fixed over periods of twenty or even thirty years. When market interest rates soared during the post-Vietnam years of Pres. Carter's administration (1977-80), depositors began to withdraw their funds from S&Ls. S&L portfolios of mortgage loans fell in value, just as prices of bonds and other securities yielding fixed income fell in value as interest rates rose.

The real estate loan problem faced by America in the late 1970s thus was different from that confronting Japan today. In the latter case, there is real estate overvaluation. But the problem in America was financial. Interest rates were rising, which reduced market value of long-term MORTGAGE LOANS against this real estate. Property holders with older, low-interest mortgages were in a favored position relative to new borrowers. Asset values of mortgage lenders, S&Ls and savings banks fell below their deposit liabilities. This threatened their net worth positions.

The S&Ls turned to the government to bail them out of their balance sheet problem. The FSLIC had been established as a source of emergency credit for just such circumstances. But already by the mid- 1960s, California's aggressive S&Ls had borrowed fully 25 percent of their liabilities from the FSLIC. They had used what was supposed to be emergency credit as a low-cost source of capital. The value of their mortgage loans fell and their dilemma became: how could they repay both their depositors and the FSLIC under such circumstances?

The S&Ls were able to get into this dilemma in the first place because their industry was assumed to be self-regulating. So much money was being made in real estate development that heavy mortgage origination fees could be paid. Mortgage lenders were even given some equity incentives such as shares in the real estate being financed. S&Ls indulged in real estate debt pyramiding. Their depositors were insured by the government. The Reagan Administration sharply increased government guarantees. Thus, S&Ls that made shaky loans could attract all the deposit money they needed in order to cover their losses and bad loans. In this way, all risk was transferred to the public sector, not to depositors. This was the true meaning of "privatization" under the Reagan-Bush administration: a free transfer of assets to benefit the private sector while the public sector received all the risk.

The real estate and financial industries joined forces to support this policy. More than enough money was available to buy Congressional support for deregulation in the early 1980s. Academic wisdom contributed, by depicting all market economies as being self-regulating. This was, after all, the laissez faire "equilibrium economics" for which Nobel Prizes were given out each year.

Reagan administration ideologues (known in Washington as "the crazies") were eager to believe that all economic problems were self- curing. To more hard-headed Republican politicians, every government policy, every pork barrel project, every tax break was put up for sale in exchange for campaign contributions or other favors. Financial deregulation thus went hand in hand with the environmental deregulation sponsored by James Watt, the parallel dismantling of the anti-trust law, and the decriminalization of much white collar looting of pension funds, gutting of companies, establishment of offshore tax havens and, in the banking sphere, holding companies. What formerly had been deemed criminal activity was rechristened "modern business management." Japanese who wish to know what their future might look like under the current "big bang" proposals might therefore benefit from studying the American experience that followed similar deregulation programs in the 1980s.

Part of the financial deregulatory process was abolishment of the historical separation of functions between savings banks and S&Ls, and between commercial banks, investment underwriters and stock-brokers. All these types of institutions had diversified to "follow the market place" and to break free of the designated functions for which they originally had been founded. Savings banks, for instance, campaigned successfully to change local banking laws to allow them to shift their deposits out of state, especially to large Florida real estate developments. A single such loan could absorb millions of deposit dollars that otherwise would have financed dozens of loans to the banks' local constituents. The parallel for Japan today is obvious. An increasing amount of Japan's savings will be lent to the United States and other foreign economies rather than be used to fund new investment within Japan. The nation's firms will be thrown into a bidding contest against borrowers in all other countries. Distress borrowing by, say, the Russian government to repay its bad debts may thus pull savings out of Japan, slowing Japan's investment or even creating a financial crisis. There are no international rules to encourage international lending in a productive way to finance new direct investment.

Reagan's policy makers rationalized financial deregulation on the grounds that it would let the S&Ls and savings banks "earn their way out of debt." Higher earnings were assumed to be freely available by taking bigger risks. Such speculation was supposed to enable the S&Ls to offer depositors higher rates to keep their money in these institutions. S&Ls were permitted to buy stocks and junk bonds, and even to undertake their own real estate development. Financial institutions thus became direct investors. In fact, deregulation of the S&Ls enabled real estate developers to create (or take over) their own institutions. These institutions then were given broad lending and investment privileges, along with higher federal deposit guarantees (FSLIC). Deregulation particularly benefited swindlers because it loosened constraints on their activities and legalized what hitherto was illegal.

Republicans assured doubters that deregulation would save the government from having to bail the S&Ls out of their low-interest mortgage portfolios. The S&Ls used the new rules to bid for new deposits on a vast scale, attracting large institutions that fully knew the risks, but understood that the government had re-classified what formerly had been "shares" in S&Ls as bona fide bank "deposits." The government was the ultimate underwriter, even for the most dangerous institutions which were obliged to offer the highest rates. Yet S&L examiners were not allowed to rein in self-dealing by operators, including many who subsequently were convicted as felons - men such as Charles Keating Jr., with his Lincoln S&L in Irvine, California; Donald Dixon with his Vernon S&L in Dallas; and David Paul with the Centrust Bank in Miami. These crooks (who claimed to be public benefactors and even heroic risk-takers) hindered government regulators by using deposits in their institutions as a fund from which to contribute generously to the election campaigns of the leading members of Congressional banking committees. This is how the notorious "Keating Five" members of the Senate banking committee shepherded Mr. Keating's criminal operations through government, calling Mr. Keating's activities free enterprise and virtually hailing him as a hero fighting the federal regulatory bureaucracy!

What is so striking, and so instructive for Japan today, is how relatively small contributions are able to produce such vast frauds. Charles Keating's case cost the government over $3 billion to clean up, and his criminal conviction was followed by a $1.6 billion civil judgment to compensate his victims for about three-quarters of their original capital investment. When Mr. Keating claimed to lack the funds to pay, two of his accounting firms -- Ernst & Young, and Arthur Andersen -- were found to be guilty of gross negligence (if not outright complicity), and were directed to share the blame for having lent unwarranted credibility to his financial malfeasance. This experience shows that politicians have been bought by major financial and real estate operators. Most of this political buying and selling is done legally, by lobbying Congressmen to pass laws legalizing practices that formerly were deemed illegal or immoral. Of course, economic and legal theorists in academic institutions have jumped on the bandwagon, led by the University of Chicago's business and law schools, which have become public relations advocates for the ideology of decriminalization in the name of "free markets." The new libertarians in fact consider putting any social objectives ahead of money-making as dereliction of administrative duty!

The effect of such deregulation for savings banks and S&Ls stands as an object lesson: They lost any social role beyond an obligation to their shareholders to make as much money as quickly as possible. In the case of the savings banks, deregulation let executives "go private." The result was similar to what occurred in Russia. The executives of these traditionally sleepy small institutions sold banks to themselves for virtually nothing. In effect, they registered the banks' accumulated reserves in their own names, giving the stock to themselves rather than distributing it to the depositors as a special dividend. They thus got rich by privatizing bank assets that were supposed to serve a public function. This private looting of public or social wealth and assets has been the essence of deregulation since 1980. The epoch of "value-free" economics had arrived with a vengeance.

As America's post-Vietnam inflation pushed up interest rates to double-digit levels, depositors found they could earn higher returns by shifting their deposits elsewhere. To meet these withdrawals, the S&Ls had to either raise the rates they paid depositors - and thus run an operating loss - or else sell off their mortgage portfolios at a substantial loss to their balance sheets.

While this financial restructuring was occurring, direct industrial investment was starved for funds. To ward off raiders searching for companies to buy cheaply, the entire industrial sector had to live for current earnings - rather than invest in long-term projects. Companies were obliged to support their stock prices in order to avoid being raided. One strategy was to pay out a higher proportion of their earnings as dividends. Another was to spend their revenue to buy up their own stock. Both policies were employed at the expense of funding R&D and other long-term investment.

Yet a third strategy against corporate raiding was for companies to load themselves down with debt (so-called "poison pills"). They would borrow so much money that no raider would be able to borrow enough money to break up a company, raid its treasury, its pension fund and its real estate. In such cases their earnings were used to pay interest rather than to finance new direct investment.

Japanese companies did not have to confront this kind of raiding during the 1980s because they were not run for the benefit of outside stockholders, raiders or investors whose main objective was to obtain as quick and high a rentier income as possible. Under normal conditions the objective of Japanese firms was to optimize their operations, benefit their own work force and their customers (who often, in Japan's case, were also major stockholders). Thus, when T. Boone Pickens came to Japan, his American-style financial methods were rebuffed. The "value-free" principle described above has become the foundation of Western banking systems. Instead of financing industry, the banks and S&Ls lent to its raiders. Instead of financing new direct investment, the financial game turned to asset stripping. In this way U.S. banking, and the "anything goes" economic philosophy prompting its deregulation, represents the antithesis of Japan's postwar financial philosophy.

The U.S. banking system's attitude toward depositors is well indicated in a training document that exhorted Mr. Keating's salesmen to "always remember [that] the weak, meek and ignorant are always good targets." The meek got separated from their money quickly by financial deregulation benefiting predatory insiders at the public's expense. What was funded by deregulation was not productive investment, but the economy's overhead of crooks and rentiers. This is the system that American advisors are now urging Japan to adopt. The drive to generate financial returns willy-nilly, even at the cost of cannibalizing manufacturing industry, downsizing the labor force, cutting pensions, minimizing taxes on real estate and stock market speculation, and making up the fiscal shortfall by raising consumption taxes first to 5 percent and then to higher levels - all this has become part of the new fundamentalist economic religion being foisted on Japan.

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