A striking story of a mania and a crash

The sharp increase in real estate prices and stock prices in Japan in
the 1980s was associated with a boom in the economy; Japan as Number
One: Lessons for America1 was a bestseller in the country. The banks head-
quartered in Tokyo and Osaka increased their deposits and their loans
and their capital much more rapidly than banks headquartered in the
United States and in Germany and in the other European countries; usu-
ally seven or eight of the ten largest banks in the world were Japanese.
Then at the beginning of the 1990s real estate prices and stock prices in
Japan imploded. Within a few years many of the leading Japanese banks
and financial institutions were broke, kaput, bankrupt, and insolvent,
and remained in business only because of an implicit understanding
that the Japanese government would protect the depositors from finan-
cial losses if the banks were closed. A striking story of a mania and a
crash—but a crash without a panic, apparently because of the belief that
government would socialize the loan losses.

Three of the Nordic countries—Norway, Sweden, and Finland—repli-

cated the Japanese asset price bubble at the same time. A boom in real

estate prices and stock prices in the second half of the 1980s associated

with financial liberalization was followed by a collapse in real estate

prices and stock prices and the failure of the banks.

Mexico had been one of the great economic success stories of the early

1990s as it prepared to enter the North American Free Trade Agreement.

The Bank of Mexico had adopted a tough contractive monetary policy

that reduced the inflation rate from 140 percent to less than 10 percent in

a four-year period; during the same period several hundred government-

owned firms were privatized and business regulations were liberalized.

Foreign capital flowed to Mexico because the real rates of return on

government securities were high and because the prospective profit rates

on industrial investments were also high. The universal expectation was

that Mexico would become the low-wage, low-cost base for producing

automobiles and washing machines and many other manufactured

goods for the U.S. and Canadian markets. Because the large inflow of

foreign savings led to a real appreciation of the peso, Mexico developed

a trade deficit that reached 7 percent of its GDP. Mexico’s external debt

was 60 percent of its GDP and the country obtained the money to pay the

interest on its increasing foreign indebtedness from the inflow of new

investments. Then several political incidents, partly associated with the

presidential election and transition in 1994, led to a sharp decline in the

inflow of foreign funds, the Mexican government was unable to continue

to support the peso in the foreign exchange market, and the currency

lost more than half of its value in several months. Once again the depre-

ciation of the peso resulted in large loan losses, and the Mexican banks —

which had been privatized in the previous several years—failed.

In the mid-1990s real estate prices and stock prices surged in Bangkok,

Kuala Lumpur, and Indonesia; these were the ‘dragon economies’ that

seemed likely to emulate the economic successes of the ‘Asian tigers’

of the previous generation—Taiwan, South Korea, Hong Kong, and Sin-

gapore. Japanese firms and European and U.S. firms began to invest in

these countries as low-wage, low-cost sources of supply, much as U.S.

firms had invested in Mexico as a source of supply for the North Ameri-

can market. European and Japanese banks rapidly increased their loans

in these countries. The domestic lenders in Thailand then experienced

large loan losses on their domestic credits in the autumn and winter

of 1996 because they had not been sufficiently discriminating in their

evaluations of the willingness of Thai borrowers to pay the interest on

their indebtedness. Foreign lenders sharply reduced their purchases of

Thai securities, and then the Bank of Thailand, much like the Bank of

Mexico thirty months earlier, did not have the foreign exchange reserves

to support its currency in the foreign exchange market. The sharp de-

cline in the foreign exchange value of the Thai baht in early July 1997

led to capital outflows from the other Asian countries and the foreign

exchange values of their currencies (except for the Hong Kong dollar

and the Chinese yuen, which remained rigidly pegged to the U.S. dollar)

declined by 30 percent or more. The Indonesian rupiah lost 80 percent

of its value in the foreign exchange market. Most of the banks in the

area—except for those in Hong Kong and Singapore—would have been

bankrupt in any reasonable ‘mark-to-market’ test. The crises spread from

Asia to Russia, there was a debacle in the ruble, and the country’s banking

system collapsed in the summer of 1998. Investors then became more