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A Tale of Two Draconian Interest Rate Hikes

By Ichiro Suzuki Yasushi Mieno was a career central banker who served as governor of the Bank of Japan, for five years beginning December 1989. He rose to the helm of the BOJ at the height of a booming economy in Japan; the infamous Japan Bubble. At that time rampant rises in asset prices were becoming a social problem since a bubble in the real estate market drove house and condo prices beyond reach for the vast majority of people in the country. Sky-high real estate prices could be afforded only by corporations that had abundant cash on their balance sheets or a borrowing capacity backed by willing lenders to finance deals. Average man on the street was furious about their denied opportunity to own a house. That time was an unprecedented age of inequality for Japan. Mr. Mieno took the BOJ’s top job, determined to reduce the wealth gap, and stepped up a policy of higher interest rates that the BOJ was already undertaking for a year. The media hailed him on his arrival, projecting that he could be remembered one day as a man who restored equality in Japan. And he delivered it, in a sense. Aggressive monetary tightening that he held onto brought asset prices' spectacular collapse. The Tokyo stock market hit its peak at the end of the month of his promotion to governor, and then began to head south fiercely, taking the real estate market down with it. House prices fell in a visible fashion. If house ownership had symbolized inequality of the late 1980s, Mr. Mieno had solved the problem decisively making houses more affordable by the time of his departure. While house prices did fall, they did not stop at whatever levels Mr. Mieno and the BOJ might have thought as appropriate. Their prices kept sinking. The rule of law of the financial market became finally applicable to real estate prices in Japan. For decades until the end of the 1980s, real estate prices were believed to have only one direction: up. At the beginning of the 1990s the market has reversed their direction by 180 degrees. They collapsed into a point where no bottom appeared to be in sight. In the face of a spectacular fall, Corporate Japan has decided to clean up their balance sheets by unloading unnecessary real estate holdings and paying back the borrowed money that financed land purchases, thus further weakening the market with greater supply. Any potential buyer found no immediate reasons to jump into the sinking market anticipating further fall of the prices, thus drying up demand. Lenders felt acute pains, as some of their customers (borrowers) struggled and then failed to pay interests on loans and repay a part of principals. Bankers’ struggles made some average Japanese feel good. After all those years of witnessing bankers’ arrogant and condescending behavior, people felt good to see these guys in trouble, at last. Nonetheless, watching bankers’ plight did not lift average man’s financial positions, of course. It was quite contrary. As the Japanese economy had fallen into what turned out to be a generation-long economic slump, salaries and wages of average men stagnated, at best. Worse, their jobs that were once thought as sacrosanct in a lifetime employment system, were suddenly in jeopardy in a relentlessly weak economy. Mr. Mieno did bring real estate prices down, but far more deeply than anyone had imagined, and taking the economy down with it. The wealth gap has declined in the 1990s due to the top one percenters’ spectacular fall. The bottom 99% also fell, but far less than the top 1%. The wealth gap did narrow but it didn’t make anyone better off. As it turned out, Mr. Mieno was too obsessed with bringing down real estate prices. A central bank is responsible for stability of prices of goods and services as well as overall stability of the economy. He overstepped by expanding his mission to bringing down asset prices at a time when prices of goods and services were rising but not out of hands. Deep correction in real estate prices brought down the banking system, too, on mounting bad debts, thus causing a prolonged economic slump amid debt deflation. Ten years before Yasushi Mieno, Paul Volcker became chairman of the Federal Reserve Bank in 1979 and served in that capacity for 8 years. Raging inflation was plaguing the U.S. economy throughout the 1970s, due to lax fiscal and monetary policies. The economy was exacerbated by the OPEC’s oil embargo. Mr. Volcker took the job with a mandate to crush the inflation, and did it with a determined hawkish monetary policy. He did not hesitate to do what needed to be done, prepared to pay the price. The Fed Funds rate that averaged 11.2% in 1979 rose to 20.0% by the summer of 1981. His draconian monetary policy immediately caused a recession that cost President Jimmy Carter his re-election bid in 1980. In fact, Mr. Volcker brought two recessions in his first four years to weed out inflationary expectations though he didn’t have to deal with asset inflation like Mr. Mieno a decade later. Causing two recessions is an achievement for a central banker since his/ her job is to make tough decisions that politicians dislikes. He was also vilified by average Americans on the street as farmers and small time business owners were hit really hard. He withstood widespread criticism since he believed his predecessors were too obsessed with pleasing the White House at a time when the Fed was less independent. While Mr. Volcker crushed the inflation, he should also be credited for not missing a chance in reversing a policy direction to lower interest rates when he thought his mission was accomplished. He was aware of the necessity of giving the economy a new lease on life, and cut rates in time once his job was done. This set the tone for renewed prosperity in the 1980s and beyond. Mr. Volcker’s policy framework was handed over to his successors. Several weeks after Alan Greenspan rose to the helm of the Federal Reserve Bank in the late summer of 1987, the New York Stock Exchange suffered the biggest one day correction ever, a 22% remembered as the Black Monday. New Chairman Greenspan did not hesitate to slash interest rates aggressively, preventing the economy from sinking into a deep recession. (Later, the financial markets get addicted to receiving rate cuts at the time of a crisis, known as ‘Greenspan put’.) Mr. Volcker’s rate hikes succeeded in terminating sticky inflationary expectations in the U.S. economy, and hence those in the rest of the world. After two recessions, the U.S. economy was given a new lease on life and got onto a fresh growth path that led to the late 20th century prosperity. So all worked out very well. Nonetheless, sharp spikes in interest rates did not end without victims. Besides American farmers and construction company owners, the real victim of Chairman Volcker’s aggressive tightening was Latin America. The resource-rich region boomed amid higher prices of crude oil and other commodities in the 1970s. American banks designated Latin America as a region of the future, and recycled Arab oil producers’ windfall, so called ‘oil dollar’ into the region aggressively. Latin American governments responded to such a move with a profligate fiscal policies, and then were hit hard by sharply higher interest rates. The Fed’s tight monetary policy always hits the weakest link of the global economy. The 1980s turned out to be a lost decade for Latin America. An old Wall Street saying held true: When the Fed tightens, bad things happen. About the author: Mr. Suzuki is a retired banking executive based in Tokyo, Japan.


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