Dogs and Demons

We are ready to take a look at the long financial travail Japan has been experiencing since 1990, the aftermath of wild speculation known as the Bubble. The meltdown of the stock market and property prices has wiped away assets worth $10 trillion, with another $3 trillion likely yet to go. These vanished assets are not trivial, for they make up one of the most grievous declines of wealth experienced in human history, the sort of loss that usually happens in war or at the fall of an empire. To see how Japan could have got itself into this incredible situation, we must go back to the heyday of Japanese financial power more than a decade ago.

When, toward the end of 1987, black limousines began lining UP each afternoon in front of Madame Onoe Nui's house in Osaka, the neighbors thought little of it. The cars disgorged blue-suited men carrying briefcases who disappeared inside, sometimes not to emerge until two or three the next morning. Nui operated a successful restaurant, and it appeared that she had expanded her dinner business into earlier daylight hours. Only later did the neighbors learn that Madame Nui's visitors were not coming for the good food. The men in blue suits were coming to pay homage to a shadowy resident of Nui's house, a figure later revealed to be the single most important player in the Japanese stock market at the time. He was Nui's pet ceramic toad.

Toads, as is well known, are magic beings that like badgers and foxes are adept at weaving spells, especially those involving money. People like to have as charms in their gardens ceramic statues of badgers with a jug of wine in one paw and ledgers of receipts in the other. Toads, though less popular, are more mysterious, as they can transform themselves into demon princesses, and they know ancient sorcery from China and India.

The blue-chip Industrial Bank of Japan (IBJ), Japan's J. P. Morgan, especially favored Madame Nui's toad. Department chiefs from IBJ's Tokyo headquarters would take the bullet train down from Tokyo to Osaka in order to attend a weekly ceremony presided over by the toad. On arriving at Nui's house, the IBJ bankers would join elite stockbrokers from Yamaichi Securities and other trading houses in a midnight vigil. First they would pat the head of the toad. Then they would recite prayers in front of a set of Buddhist statues in Nui's garden. Finally Madame Nui would seat herself in front of the toad, go into a trance, and deliver the oracle-which stocks to buy and which to sell. The financial markets in Tokyo trembled at the verdict. At his peak in 1990, the toad controlled more than $10 billion in financial instruments, making its owner the world's largest individual stock investor.

Madame Nui was also the world's largest individual bank borrower. «From the mouth of the toad,» she proclaimed, «comes money,» and she seems to have called considerable Chinese and Indian sorcery into play, for she parlayed a small initial set of loans made in 1986 into a vast financial empire. By 1991, in addition to IBJ, which lent Nui ¥240 billion to buy IBJ bonds, twenty-nine other banks and financial institutions had extended her loans totaling more than ¥2.8 trillion, equal to about $22 billion at the time.

Onoe Nui was riding the success of the so-called Bubble, when Japanese investors drove stocks and real estate to incredible heights in the late 1980s. In 1989, the capitalization of the Tokyo Stock Exchange (TSE) stood slightly higher than that of the New York Stock Exchange; real-estate assessors reckoned that the grounds of the Imperial Palace in Tokyo were worth more than all of California; the Nikkei index of the TSE rose to 39,000 points in the winter of 1989, after almost a decade of continuous climb. At that level, the average price-to-earnings ratios for stock (about 20 to 30 in the United States, the United Kingdom, and Hong Kong) reached 80 in Japan. Yet brokers were predicting that the stock market would soon rise to 60,000 or even 80,000. Euphoria was in the air. Japan's unique financial system-which is based on asset valuation, rather than on cash flow, as is the norm in the rest of the world-had triumphed.

When the crash came, it hit hard. In the first days of January 1990, the stock market began falling, and it lost 60 percent of its value over the next two years. Ten years later, the Nikkei has still not recovered, meandering in a range between 14,000 and 24,000. When the stock market collapsed, so did real-estate prices, which fell every year after 1991 and are now about one-fifth of Bubble-еrа values or lower. Many other types of speculative assets also evaporated. Golf-club memberships, which during their heyday could cost $1 million or more, today sell for 10 percent or less of their Bubble price, and bankruptcy looms over many golf-club developers, who must return tens of billions of dollars taken in as refundable deposits from members.

Despite the best efforts of Madame Nui's bankers and the toad, her empire crumbled. In August 1991 the police arrested her, and investigators found that she had based her first borrowings on fraudulent deposit vouchers forged by friendly bank managers. Nui's bankruptcy resulted in losses to lenders of almost ¥270 billion, the resignation of the chairman of the Industrial Bank of Japan, and the collapse of two banks. The «Bubble Lady,» as the press called her, spent years in jail, along with her bank-manager patrons.

Banks, which lent heavily to speculators like Madame Nui to buy stock and land, found themselves saddled with an enormous weight of nonperforming loans. For years the Ministry of Finance claimed that bad loans amounted to ¥35 trillion, only grudgingly admitting, in 1999, that they surpass ¥77 trillion. Even so, most analysts believe the figure is much higher-perhaps twice that. Taking the more conservative figure favored by many analysts, ¥120 trillion, Japan's bank fiasco dwarfs the savings-and-loan crisis of the 1980s in the United States. The S amp;L bailout, at $160 billion, came to about 2.7 percent of GNP at the time, but the cost of rescuing Japan's banks could reach as much as 23 percent of GNP, a crushing burden. By the end of the century, despite a decade of rock-bottom interest rates maintained by the government to support banks, and despite a massive ¥7.45 trillion bailout in 1999, Japan's financial institutions had written off only a fraction – perhaps 20 percent – of the loan overhang.

What were the policies that caused a supposedly mature financial market to fall prey to a mania completely askew with economic realities? The answer is simple. It applies not only to this question of finance but to questions in almost every area in which Japan is presently suffering: Japan's financial system rests on bureaucratic fiat, not on something that has intrinsic value. What occurred in Japan is an elegant test case, better even than that of the U.S.S.R., of what happens when controlled markets defy reality. For fifty years, the Ministry of Finance (MOF), the most powerful of Japan's government agencies, has set levels for stocks, bonds, and interest rates that nobody has dared to disobey. The financial system was designed to enrich Japan's manufacturing companies by providing cheap capital, and in this it succeeded spectacularly well for thirty years. Money from savings flowed to the big manufacturers at very low rates-in the late 1980s, the cost of capital in Japan was about 0.5 percent. (In contrast, American and European companies paid rates ranging from 5 percent at the lowest to more than 20 percent.) And while in other countries investors and savers expected returns and dividends, in Japan they did not.

In the West, financial gurus sometimes lament that Wall Street holds corporate earnings captive to shortsighted demands for profit, whereas in Japan, rather than paying dividends to greedy stockholders, companies retain most of their earnings and pour them back into capital investment. Even though they didn't pay dividends, stocks kept climbing throughout the 1970s and 1980s. Thus arose the myth that stocks in Japan were different from those in other countries: they would always rise. When in 1990 Morgan Stanley began issuing an advisory that included warnings of which stocks to sell, MOF viewed this as an ethical lapse out of tune with the moral tradition of the Japanese stock market.

Concentrating only on the benefits to companies that need not pay dividends leaves out several important factors. We all know there are various standard ways to value stock. Most important of these is the price-to-earnings ratio (P/E ratio), which tells you what percent of your investment you can expect a company to make as earnings. A P/E ratio of 20 means that in one year the company will earn one-twentieth, or 5 percent, of the price of the stock, some or all of which it will pay out to you, the shareholder, in the form of dividends. These dividends will be your basic return on investment.

Calculating the true value of a stock gets complicated if you expect the company's earnings to grow dramatically in the future-which is why investors have snapped up Internet stocks in America even though many dot-coms have never made profits and have even suffered losses. But the general principle still applies; that is, the investor expects to be paid dividends, now or in the future, on earnings.

This has not been true in Japan, where the accepted wisdom held that stocks needn't pay out earnings; before the Bubble burst, P/E ratios reached levels undreamed of elsewhere in the world. The Dow Jones average, at its most inflated in early 2000, averaged P/E ratios of about 30, at which point analysts screamed that it was overheated. In contrast, average P/E ratios in depressed Japan reached 106.5 in 1999, more than three times the American level. A P/E ratio of 106.5 means that the average earnings per share of companies listed in the Japanese market is essentially zero.

A situation like this is paradise for industry, because it means that companies can raise money from the public for practically nothing. It works for investors, however, only if stocks always magically rise somehow, despite producing no earnings. That is to say, it works only as long as the stocks continue to find eager buyers. As part of the recovery after World War II, Japan's Ministry of Finance engineered just such a system, and it was a modern miracle. It worked partly because there was then relatively little stock available to the public, given a policy called «stable stockholding,» by which companies bought and held each other's stock, which they never sold. The purpose, as with many of MOF's stratagems, was not economic (which is why Japan's system baffles classical Western theorists) but political, in the sense that it was a means of control. It prevented mergers and acquisitions, which MOF could not allow: the threat of a takeover forces a company's management to manage assets to produce high returns, and this would go against the government policy of building up industrial capacity at any cost.

In order to restrict the stock available to the public, MOF raised high barriers for new companies coming to market. Only long-established firms could ever consider a new listing on the Tokyo Stock Exchange. Even Japan's over-the-counter market (OTC), equivalent to the NASDAQ exchange in the United States, followed this "bigger and older is better" approach. The average review period for a company to list on the OTC was 5.7 years, and typically companies listing on the OTC have been around for decades, not a few years or months, as is the case with NASDAQ. «It's a cold, hard fact that in Japan newly launched companies have had no way of raising direct capital. In America they can; in Japan they can't,» says Denawa Yoshito, the founder of an over-the-counter Internet stock market for unlisted venture companies.

Matters began to change only in 1999, when, borne on the crest of a new wave of Internet euphoria, the OTC spurted upward, its index quadrupling in just one year. Even so, the OTC remains so dysfunctional, so far from the Internet-friendly marketplace that Japan's new entrepreneurs will need, that in the summer of 2000 Son Masayoshi, Japan's Internet wizard, set up a Japanese version of NASDAQ («Jasdaq»). In addition to easing the way for Japanese investors to buy American NASDAQ stocks, Jasdaq envisions listing promising Japanese ventures in New York, where they can source funds denied to them in Japan. The Tokyo Stock Exchange meanwhile set up its own emerging stock market, named Mothers. The pieces would seem to be in place for a brand-new form of stock investing. At the same time, all the old rules still apply over at the Tokyo Stock Exchange, where P/E ratios are still astronomical. It remains to be seen whether Mothers, the OTC, and Jasdaq can nurture stock that pays dividends and rewards investors-or whether they will follow the pattern of the Tokyo Stock Exchange in the 1980s and merely engineer another big Bubble.

During much of the past half century, money poured into the Tokyo Stock Exchange, driving stocks relentlessly upward. After decades in this hothouse atmosphere, Japan's financial community came to believe in the «magic of assets»: assets would always rise in value, especially when calculated by a technique, dear to MOF's heart, known as «book value accounting.» According to this system, owners of stocks, bonds, and property do not need to assess their holdings at market value. Instead, balance sheets show stock at the price purchased-the stock you bought at 100 seven years ago, though now worth 200, still appears on the books at 100.

This is a complete fiction, and it spawned a concept known as «latent profits,» which is the difference between purchase value and current value. The concept of «latent losses» did not exist. Investors have ignored dividends and looked exclusively at «asset value» and «latent profits.»

The same principles have ruled in real estate, where returns have averaged 2 percent or lower; even minus returns were common. The crash came even harder for real estate than it did for stocks, and by 1996 official land prices for Japan as a whole had dropped to half their 1991 peak (real prices were 88 percent off or lower at auction) and stayed low for the rest of the decade. Vacancy rates in Tokyo's commercial sector grew as high as 15 to 25 percent, and rents were half or a third of what they had been in 1988.

The «magic of assets» leads to a distorted view of Japan's strengths, since so much energy has gone into making banks and securities houses bigger but not necessarily better. In 1995, when ranked by assets, the top-ten banks in the world were all Japanese, with twenty-nine banks in the top one hundred (versus only nine U.S. banks). However, when Moody's Investors Service quantified liabilities, it found that only five of Japan's eleven city banks had assets in excess of bad loans; no banks rated A, only one rated B, three C, and twenty-six banks D. By early 1999, the average rating of major banks had slid to E+, meaning that they were essentially bankrupt. Obviously, size alone is not a good measure of financial health, since liabilities may equal or even exceed assets, and the truest measure of health is profitability, in which case not a single Japanese bank got into the top one hundred.

Lack of profits sapped the energy of Japanese banks, so that in time foreign banks outstripped them through profitable growth and mega-mergers. By July 1999, only two Japanese banks had made it into the world's top ten. One had a negative return on assets, the other nearly zero – at a time when Citigroup and BankAmerica, the top two on the list, were making more than 1.3 percent returns on much larger asset bases.

In Japan's asset-based system, size meant everything; in time, therefore, MOF mandated a wave of mergers so that Japan's banks could reclaim their position as the world's largest. Moriaki Osamu, the director of the Restructuring Agency, is reported to have said, «In order to preserve the financial system we have to shut our eyes [to unprofitable banks]. But, since they can't survive on their own, we've ordered them to merge.» In other words, Japan's bank mergers simply combined small hills of losses into larger mountains of losses. In August 1999, three banks – DKB, IBJ, and Fuji Bank – merged to create the world's largest bank by assets, yet the merger did nothing to make the resulting behemoth profitable. The well-known consultant Ohmae Ken'ichi compares the bank to the Yamato, Japan's giant warship in World War II that sank before it had a chance to fire its guns. By mid-2000, Japan once again had four of the five largest world banks – all of them huge money – losers.

This did not disturb MOF, however, because in Japan's credit system losses and debt have no consequences. Banks rarely make unfriendly recalls of debt within their keiretsu (industrial groupings), allowing companies within their grouping to borrow safely far more than their counterparts in the rest of the world. It has been in a company's best interest to borrow as much as it can so as to acquire more and more capital assets and never to sell them. A company would borrow against assets such as land, and then reinvest that money in the stock market. The market would rise, and the company would then have «latent profits» against which to borrow more money, with which to buy land. And on to the next round.

This cycle of assets-debt-assets is the background for the madness that seized Japan during the Bubble. It explains why IBJ lent Madame Nui money to buy IBJ's own bonds in a deal that cost her $30 million the moment she signed the contract. IBJ knew well why she wanted those bonds. She took her bondholdings to other banks, which were glad to lend her more billions because she had such blue-chip collateral.

This system flies in the face of Western economic theory, but it worked brilliantly in Japan for the first years after World War II, allowing Japan to pull itself up by its own bootstraps. Karel van Wolferen calls the system «credit ordering,» and it is important to remember that it really did achieve great success, turning Japan in a few decades into the world's second-largest industrial power. Since then the South Koreans have copied Japan's credit ordering and so to a greater or lesser extent have most of the so-called Asian Tigers.

This new paradigm of capitalism once appeared to have triumphed over old-fashioned Western values such as the law of supply and demand. There was just one little flaw. As Nigel Holloway and Robert Zielinski wrote back in 1991, «The competitive advantages that Japanese companies gain from their stock market depend on a single factor: share prices must go up.» The Ministry of Finance patched together an intricate machine to support this market: stocks that yielded no dividends, real estate that produced no cash flow, debts that companies never needed to repay, and balance sheets that legally hid losses and liabilities. In this market, no Japanese company could ever go wrong. It was the envy of the developed world.

It was a powerhouse, but it also was a Ponzi scheme. Ponzi schemes work well as long as money keeps flowing in; when the flow stops or slows down, trouble ensues. During the period of high growth that lasted until the late 1980s, Japan's financial system seemed invincible. The economy grew at an annual rate of 4 to 6 percent for so long that everyone took it for granted that this would continue indefinitely. When, in the early 1990s, it slowed to 1 percent or less, the system began to fall apart.

The aim of the contraption the Ministry of Finance had rigged up for Japan's financial world was peace or, rather, stasis. No bank could ever fail; no investor could ever lose by playing the stock market. Everywhere, cartels and monopolies ruled, guided by the firm hand of bureaucrats. This desire for peace, for no surprises, is such a strong factor in traditional Japanese culture that the Law of No Surprises comes first in my personal Ten Laws of Japanese Life. There is no better paradigm for this than the tea ceremony, where detailed rules determine in advance every slight turn of the wrist, the placement of every object, and virtually every spoken word. No society has ever gone to such extreme lengths to rein in spontaneity. In the industrial arena, employees rarely change companies; small start-ups do not challenge established large firms. Concrete slabs armor river-banks and seacoasts to guard against any unwelcome surprises from nature.

The Law of No Surprises means that people find it difficult to let go of failed policies and cut their losses-a process that we will see at work in many fields in Japan. The inability to cut losses is what underlay the Daiwa Bank scandal of July 1995, when the U.S. Federal Reserve discovered that Daiwa had hidden $1.1 billion of trading losses from federal authorities, and also the Sumitomo Trading scandal of October 1996, in which a copper trader for Sumitomo Trading in Great Britain ran up $2.6 billion in secret losses. Both cases involved a spiraling series of bad trades that lasted years-in the case of Daiwa, for more than a decade. Neither the traders nor their parent companies were able to call a halt at an early stage.

Traditionalists hold the hallowed word Wa (peace, or harmony) as Japan's ultimate ideal, even going so far as to use Wa as an alternate name for Japan itself. The nation's first constitution, promulgated by Prince Shotoku in 604, began with the words «Harmony [Wa] is to be valued, and an avoidance of wanton opposition to be honored.» To update this to the twentieth century, read «market forces» for «wanton opposition.» There is a hankering after a peaceful golden age, when everyone knew his place and all human relations worked like clockwork-the quiet harmony of the feudal era. In the words o^ the seventeenth-century novelist Ihara Saikaku, Japan is the land of peace, with «the spring breezes stilled and not a rippl upon the four seas.»

The trouble is that the world does in fact change, and as it does, inflexible systems grow increasingly removed from reality. Small losses accumulate into torrents of red ink, as Daiwa Bank and Sumitomo Trading discovered. A beautiful stock exchange, lovingly engineered with a thousand clever devices so that prices will always rise, results in the biggest banking fiasco the world has ever seen. With a twist: in banking fiascos elsewhere, banks typically go under; in Japan, with a few exceptions, the government cannot allow that-so the nation has paid the price in other ways.

There is a moral to the story, and it strikes at the root of authoritarian societies everywhere. The Soviet Union under Brezhnev, Japan under its bureaucracy-each is an example of a society that believed it had achieved eternal balance: central planners had everything under their control. Change, and all the social chaos to which it gives rise, had been banished. But alas, we can never banish change. Machiavelli writes: «If a man behaves with patience and circumspection and the time and circumstances are such that this method is called for, he will prosper; but if time and circumstances change he will be ruined because he does not change his policy... Thus a man who is circumspect, when circumstances demand impetuous behavior, is unequal to the task, and so he comes to grief.»

One aspect of Japan's failure to keep in touch with reality was that the Ministry of Finance and Japan's banks and brokerage firms failed to acquire the technology used in financial markets elsewhere. This may be one of the most surprising aspects of the Bubble, for it runs against the common wisdom about Japan's alleged gift for high technology.

If debts need never be repaid and stocks produce no yields, what is the measuring rod of value? There was none, aside from Madame Nui's toad. In the 1980s Japan's securities houses, dominated by Nomura, towered over all competitors and many believed them to be practically invincible. But traders at Nomura and other brokerage houses did not learn the mathematical tools that Wall Street brokers developed in the 1980s, and that led to the complex computer trading and new financial instruments that dominate the market today. Since 1991, they have seen one long series of retrenchments, with Nomura consistently losing money, or barely scraping by in the United States and Great Britain. Daiwa cut its foreign branches from thirty to eighteen in 1999; Nikko reduced its overseas operations; and Nomura is closing foreign desks. By January 1998, Japanese securities firms had fallen completely out of the ranking for the world's top-ten bond dealers. Nomura made it only to No. 13; the other firms did not get into even the top twenty. And by then foreign brokerage houses were handling almost 40 percent of all trades on the TSE. In the fall of 1997, Yamaichi Securities, one of the Big Four brokerages, declared bankruptcy when more than $2 billion in losses surfaced in hidden offshore accounts. And then there were three. «Just as the U.S. brokers toppled England's largest securities firms, the same thing is happening here in Japan,» said Saito Atsushi, Nomura's executive managing director.

However, there was to be one last mission for MOF's financial machine to accomplish, albeit a suicide mission. MOF decided that it should expand into Asia, which it considered Japan's natural sphere of influence. Land prices had been rising in Thailand, Malaysia, and Indonesia for decades-all the old Bubble rules still seemed to apply there. So Japan in effect exported its Bubble to Asia, lending heedlessly to build office towers, shopping centers, and hotels, as was done in Tokyo and Osaka years ago. «We are just asset eaters,» says Sanada Yukimitsu, an associate director at Tokyo Mitsubishi International in Hong Kong. «The Europeans and Americans consider profitability, they manage their assets. If there is no profit, those banks just withdraw. But Japanese banks lend even when the price isn't so good.»

And lend they did. Asian countries modeled their markets on Japan: under the leadership of strongmen such as Indonesia's Suharto and Malaysia's Mahathir, governments set values, and told large investors what to buy, and they obeyed. From MOF's point of view, Southeast Asia was one last blessed corner of Eden that was still free of dangerous wild animals like P/E ratios and cash-flow analysis. From the mid-1990s on, Japanese banks doubled and tripled their loans to Southeast Asia, providing the lion's share of loans to Korea, Malaysia, and Indonesia, and more than half of all foreign money lent to Thailand.

There is an old Yiddish joke that asks: Question: What does the saying mean, Though he slips and falls on the ice, the Avenging Angel will still catch up with you? Answer: He's not called the Avenging Angel for nothing! Alas for MOF. In the fall of 1997, the Avenging Angel arrived in Southeast Asia waving the flaming sword of «real value.» The Korean, Thai, Malaysian, and Indonesian currencies collapsed overnight. Suharto and Mahathir watched in helpless rage as the markets, long used to obedience, went their own way: down. The mistake of the Asian nations was to lower the walls around their credit systems, something Japan would never do – hence when the crash came they could not control it as MOF did in Japan.

A massive financial meltdown of the sort that had been taking place slowly in Japan over seven years happened within a few months. Japan's banks, whose loans to the region were four times those of U.S. banks, are writing off tens of billions of dollars of bad debt. The results for Japan, however, are not entirely negative, for while the banks lost heavily, Japan's manufacturers benefited from the Asian crisis to snap up businesses and properties at bargain prices. Much is at stake in MOF's new offensive in Asia. Japanese banks and stockbrokers are in such trouble at home, and have lost so much business in the United States and Europe, that if their Asian policy does not succeed they may languish permanently as second-class citizens in world finance. «What's left if this fails?» asks Alicia Ogawa, the head of research for Nikko Salomon Smith Barney. «That's a good question.»

Meanwhile, what about the size of the stock exchange? In 1989, the New York and Tokyo stock markets stood very nearly equal in market value (Tokyo's was slightly larger). Eleven years later, in August 2000, the New York exchange had reached a total capitalization of about $16.4 trillion; Tokyo's had $3.6 trillion, making it less than one-fourth the size of New York's. Even more sobering, while Japan's OTC market for emerging stocks fizzled, NASDAQ grew to be a giant in its own right. Indeed, NASDAQ, with a market cap of $2.9 trillion, came within striking reach of the Tokyo Stock Exchange; when the TSE dipped in June 1999, NASDAQ even surpassed it! Together, monthly turnover at NASDAQ and New York exceeded Tokyo by eleven times.

One of the more puzzling aspects of post-Bubble Japan has been the unwillingness to reform a market that has obviously failed. By 1996 it was clear that drastic changes would be necessary, and MOF came up with the idea of a Big Bang, a deregulation modeled on the market-opening of the 1980s in London, when the «Big Bang» sparked dramatic growth in the London financial world.

The problem is that Japan's banks and securities firms rely for their very life on unreal values. Like Japan's rural villages and their dependence on dam building, the banks are hooked on the narcotics of these unreal values, and kicking the habit will bring about severe withdrawal symptoms. Deregulation in Japan, scheduled to take place over several years starting in

1999, has turned out to be anything but a Big Bang. Speaking on the subject of Japan's reforms in 1996, Sakakibara Eisuke, the director of MOF's International Finance Bureau, announced, «We bureaucrats are giving up all of our power.» This was followed, according to The Wall Street Journal, by «a quick outline of how Mr. Hashimoto's Big Bang program would unleash market forces. But then Mr. Sakakibara made an important qualification. 'Of course,' he said, giggling, 'we can't allow any confusion in the markets' – a phrase bureaucrats often invoke to justify a go-slow approach to reform.»

The go-slow process began immediately The insurance industry, due to open to newcomers in 1998, won a reprieve until 2001 – or later. The Ministry of Finance announced that banks must set aside capital against bad loans under a system known as «prompt and corrective action» but quickly began to water down the standards, phasing in the rule piecemeal, applying it first to large banks and only later-if ever-to small banks, where most of the trouble lies. As Japan entered the twenty-first century, the hype about the Big Bang had died out, and it was consigned to dusty shelves as just another government report. It was business as usual in Tokyo.

This brings us to a striking feature of Japan's post-Bubble trauma: paralysis. Instituting a real Big Bang is simply out of the question, for the whole edifice of Japanese finance might crumble if MOF allowed economic rationalism to infiltrate. It has been said that the Bubble losses were not as severe as they seem because they were merely «paper losses» – but for Japan, paper losses are a serious issue because the very genius of MOF's system was its ability to inflate assets on paper: Japan's rapid postwar development depended on it. So when troubles began to appear, MOF trod very gently, afraid to make any sudden moves.

The concept of «latent profits» has come home to roost in the form of «latent losses.» Banks lent heavily to real-estate companies that own land now valued at a fifth or a tenth of the price they paid for it a decade or two ago. As the real-estate companies go under, these properties become the problem of their lenders, but rather than write down the losses year by year on a present-value basis, the banks have kept these properties on their books at purchase value; the moment they sell, they must suddenly report huge losses. So the market came to a near-complete stop in the 1990s: banks didn't sell because of «latent losses,» and few bought because not enough transactions occurred to lower the prices to profitable levels.

Paralysis also rules in the stock market. The amount of money raised by new stock offerings in 1989 was ¥5.8 trillion; by 1992, it had fallen to ¥4 billion, a shocking 0.07 percent of what it had been three years earlier. By 1998 this figure had crawled back up to ¥284 billion, still a tiny fraction of its earlier height. Another telling statistic is the number of companies listed on the exchange. In Tokyo, that number remained almost flat during the 1990s, while that of the New York Stock Exchange rose by 45 percent.

Overall, the Tokyo and Osaka stock exchanges raised about ¥1.5 trillion (about $13 billion) in initial and secondary public offerings in 1995-1999; the equivalent for the same period on the combined New York and NASDAQ exchanges was considerably more than $600 billion, a truly staggering difference. To get a sense of the scales of magnitude involved, consider that in the first three months of 2000 alone the NYSE and NASDAQ raised $92 billion through public offerings, far more than the total raised in Tokyo and Osaka over the entire past decade. The original purpose of a stock market is to provide a forum for companies to sell equity to the public, but the TSE abandoned this role for ten years; for most intents and purposes, it was shut down.

Remarkably, in spite of all this, very little has changed in Tokyo. It is important to realize that as Japan enters the new millennium its financial system remains essentially intact, with only a nod to what Americans and Britons would consider universal reality. Banks and real-estate companies continue to keep properties on their books at exorbitant values; the stock market remains high when measured by P/E ratios, and the big players stay obedient to the system and never blow the whistle. It might seem that Japan has gotten away with it. Western theorists, convinced of certain invariant laws of money – like the laws of physics – find themselves baffled.

The paradox lies in the fact that money is to a great degree determined by society and its belief systems. If everyone agrees that Japan's failed banks are still functioning, then they function. If everyone agrees that unrealistic land and stock values are acceptable, then this is indeed so. And this explains the paralysis, because all these artificial values are linked, each propping up the other.

One must also remember that the collapse of the Bubble was slow, not fast. When it began to deflate, MOF officials took the situation in hand and did their best to manage events, and so controlled was the deflation that some have even speculated that MOF itself initiated and directed the entire crisis. While the theory of MOF invincibility is unrealistic – during most of the 1990s the ministry was fighting one long rearguard action – the fact remains that Japan escaped with remarkably little apparent pain.

Or did it? Japan's success over several decades shows that the laws of money are not immutable; they can be altered to a great degree by such systems as Japanese-style credit ordering. However, post-Bubble paralysis shows that the laws will reassert themselves if such systems are carried to an extreme. Most interestingly, the pain may come in unexpected places. Japan protected its system on the surface: bankrupt banks kept their doors open for business, and the stock market appeared to have stabilized-but the trouble, driven underground, surfaced elsewhere.

The authorities are in a position similar to a player of the Whack-a-Mole game in arcades a few years ago. In front of you is a big box punctured with little portholes out of which a mole pops up now and then. You grab a rubber hammer, and your job is to hammer the mole. As the game goes on, the mole moves faster and faster-when you hammer the mole over here, it pops up over there. One of the busiest mole games played by MOF goes by the name of the Bank of International Settlements. BIS, the world's central banks' central bank, prescribes that banks must maintain a minimum «capital adequacy ratio» of 8 percent of capital to outstanding loans. This means that in order to lend $100,1 need to have at least $8 of my own money as supporting capital. If a bank's capital falls too low, it will face restrictions on its international lending ability.

The Japanese mole game began in the early 1990s, when stocks began to fall. Banks, which own large stock portfolios, found their BIS ratios sinking below the 8 percent cutoff point, so MOF ordered insurance companies and pension funds to buy stock to support the market, pounding the BIS mole back into its hole. But soon other moles were popping up in unexpected places: insurance companies and pension funds, after years of investing in low-yield stock, are receiving near-zero, or even negative, returns on their assets. Save the stock market, and you bankrupt the pension funds and insurance companies. Relieve them, and the banks have to curtail international lending. Allow the Nikkei to fall below 10,000, and P/E ratios would return to health, attracting domestic and foreign investors, but at that level it would no longer be possible to pretend that the banks are solvent-and belief in the system is the keystone that props it all up. So, on goes the mole game, fast and furious.

One unexpected consequence of the Bubble was the discovery that Japan's financial community was becoming irrelevant to the developed world. The barriers raised by MOF were so high that when the crash came, others could hear the sound of crumbling columns and smashing glass, but it had very little impact on local economies elsewhere. Japan lost more money than any nation had ever lost in all of human history, from the Sack of Rome to the Great Depression of 1929, but it affected the United States and Europe not a jot, and the bourses in London and New York went on to flourish as never before.

The Ministry of Finance assumed that Japan's national borders are absolute barriers, and within them it did indeed command absolute obedience for decades. But with money now flowing in an instant from one country to another at the news that interest rates have shifted one-tenth of a percentile, old ways of controlling the market no longer work. MOF discovered this when it tried to restrict the futures market in Osaka, only to find that Singapore and Chicago had grabbed the lead in Osaka's absence.

There is one important area in which Japan's financial system may not be globally irrelevant, and this is the nation's enormous dollar holdings. This brings us to another artificial financial system, one that has perhaps the most far-reaching repercussions of all: Japan never took the dollars earned over decades of trade surpluses and exchanged them back into yen.

The economist R. Taggart Murphy and Mikuni Akio, a pioneer of independent rating agencies in Japan, have examined this issue in some detail, and the gist of their analysis is as follows: For Japan to repatriate all the dollars earned abroad (net holdings came to a colossal $1.3 trillion by the end of 1998) would put pressure on the yen and drive it upward, increasing imports and weakening Japan's ability to export, and the point of MOF's financial system was to repress imports and allow Japan to keep exporting at all costs; so manufacturing firms and the government left these dollars abroad, while funding their external balance with «virtual yen» – that is, yen borrowed at almost no interest from domestic lenders. This system worked well for decades, but by the 1990s it had come under huge strain. It is now more difficult than ever for Japan to repatriate its foreign reserves, since if it did, the dollar would drop like a stone, which would drive up inflation in the United States, raise interest rates, and put an end to America's long economic expansion; at the same time, it would result in a shockingly high yen, bringing Japan's exports to a crawl. So it is not only Japan that wields power over the United States; it goes both ways. Murphy says, «Japan and the United States have realized the financial equivalent of the nuclear balance of terror-mutually assured destruction.»

It's sobering to realize that the supposedly «rational» United States, too, relies on an artificial system to support its economy, persistently ignoring the mountain of dollars piling up in foreign ownership-it has been called America's «deficit without tears.» For the time being, foreigners continue to finance the U.S. economy with money earned from America's huge trade deficits, but sooner or later they will cash in those dollars and the American economy will suffer severe pain.

Or maybe not. If Japan suddenly sold off its dollars, it would hurt the U.S. economy but damage Japan's far more. Furthermore, Japan is not the only country to hold dollars; all of America's trading partners do, and China, running the largest trading surplus with the United States, is building up the biggest reserves of all. In coming years, Japan may not necessarily exert the determining influence on what happens to the dollar. The very existence of so many dollars abroad is also a plus for the United States, because it makes the dollar the de facto world currency-so there is less need for foreign nations to trade their dollars in for local money. Perhaps the United States will turn out to have practiced a bit of financial magic of its own, holding those dollars hostage indefinitely-or, at least, until a time beyond the horizon when economists can make predictions.

Meanwhile, Japan continues to keep most of its dollars abroad, diverting ever more «virtual yen» at home to fund its huge external surpluses, and this is getting harder and harder to do. Uncontrolled bank lending in the 1980s (the Bubble) could be seen as an early attempt to inflate the domestic money supply without bringing the dollars home. We have seen what the effects of the Bubble were. In the 1990s, the government tried another approach: pumping money into the economy through public works, paid for with a burgeoning national debt. This, too, cannot go on forever. Another crash may be coming, and this one could drag Japan down – and with it the entire world economy.

It might seem incongruous that while a great sword hangs over the world's head in the form of Japan's external dollars, its domestic markets are becoming irrelevant. The paradox, however, lies in the fact that each is the complement of the other: Japan's external reserves exist only because domestic markets, in order to preserve MOF's system, are cut off from the world.

The most vivid demonstration of the irrelevance of domestic markets to world finance is the collapse of the Tokyo Stock Exchange's foreign section, launched in the late 1970s in a bid to make Tokyo an international capital market. At its height in 1990, the TSE's foreign section boasted 125 companies. However, the rules hedging in foreign firms were so restrictive that fees far outweighed the anemic trading in foreign stocks. By the spring of 2000, the number of companies had dropped to 43. Average trading volume shrank nearly to the vanishing point: during the week of June 1-5, 1999, only 19 of the remaining companies traded at all on an average day. In an era of international finance, such a foreign section goes beyond failure to farce.

In the meantime, foreign listings on other stock markets skyrocketed. By April 2000, London listed 522 foreign firms, the three American stock exchanges featured 895 foreign firms, and even Australia (60 foreign listings) and Singapore (68) had surpassed Tokyo. Foreign stocks in New York accounted for just under 10 percent of all trading, while trading volume on the TSE's foreign section came to a fraction of 1 percent of the trading on NASDAQ's foreign section alone.

Embarrassed by the TSE's poor showing, MOF relaxed some of the restrictions and lowered costs in 1995, but this failed to stem the withdrawals. Starting in 1994, the listing department began sending delegations to Asian capitals beating the drum, and after almost two years of soliciting, it managed to persuade Malaysia's YTL Corporation to debut on the TSE's foreign section, which it did with great fanfare in February 1996. YTL's offering raised $44 million (versus the $700 million raised by Korean Mobile Telecom and more than $1 billion raised by Telkom Indonesia in New York around the same time). A year later, only one more Asian firm joined the Tokyo exchange, and in 1999 none did.

Once known as the «land of technology,» Japan is now out of touch with the times. While Merrill Lynch and Goldman Sachs were developing elaborate computer algorithms to predict the future of the market, brokers at Nomura were still using abacuses, on which they knew how to do only one operation: add. That is why Madame Nui's toad held such sway over the Industrial Bank of Japan. The toad's utterances were as good a predictor as any of which direction the market would go.

The lesson of the Bubble is not that Japan should be castigated for departing from Western norms. Credit ordering, Japanese style, was a huge success, and it has helped other Asian nations to expand their industrial bases with great speed. To some degree, the Japanese system is still providing benefits to the nation, just as America's «deficit without tears» aids its economy. Both these systems, however, stretch underlying laws of money and have the potential to become dangerous when carried to extremes. For the United States, the danger of surplus dollars abroad is a real one, but the threat is not total: market forces do rule large segments of the U.S. economy, thus lending stability to the structure. In Japan, on the other hand, inflated assets, «virtual yen,» and imaginary balance sheets rule all, making the structure much more fragile. The issue is one of balance. As in the case of the construction industry, Japan's financial world carried things to extremes, pushing credit ordering beyond reasonable limits. In the process, the Ministry of Finance, Nomura, bank executives, and pension-fund managers lost all idea of what a healthy financial position really consists.

Indeed, in following Madame Nui's toad, the IBJ deserves credit, for in the never-never land of late-twentieth-century Japanese finance, toad magic and spells from ancient China were the best available predictors of the market. The toad told Madame Nui sometimes to buy and sometimes to sell, and as a result she lost only $2.1 billion out of combined loans of $22 billion, fairly respectable damages of about 10 percent; MOF and Nomura, on the other hand, advised investors only to buy – and never, ever, to sell – and as a result those who stayed in the market squandered 50 to 60 percent of their investments between 1989 and 1999. The Ministry of Finance is still ordering pension funds and insurance companies to buy. Japan might be in better shape today if the banks had gone on listening to Madame Nui's toad.