See Also: Part 1, Part 3

This is the second part of a three part series on how the credit crisis started, where it has left us, and how we can start re-powering our economy starting today. 

Credit Crisis 101 - Learning from Japan's Housing Bubble

While the banking crisis itself is unlikely to be resolved over the next few months, the re-capitalization effort by central banks should eventually bring about an end to the funding panic that has caused stock markets to meltdown worldwide over the past few weeks. This is not to say that these steps will work to counter the recessionary pressures taking root, but at least these measures will go some ways to reducing the systemic pressures faced by our financial system.

As a hedge fund manger and bank proprietary trader focused on Japan, I have spent nearly two decades following a credit crisis similar to the one we are currently experiencing. In fact, the steps being taken now, government guaranteed liquidity injections, public purchases of distressed assets, and a re-capitalizing the banking sector were the three core strategies used to successfully counter Japan's "lost decade".

The Japanese "lost decade" has many similarities to the problems currently facing the US. First, Japanese banks were forced to write off a huge amount of bad loans (nearly $1trln worth from 1992-2003). Second, the Japanese government approved a $700bln bailout package to help re-capitalize their banking system. Is this sounding familiar? And finally, third, the two credit crises share the same cause, over-borrowing. In the case of Japan it was primarily the corporate sector and in the US it is mainly the household sector, but the impact of this over-borrowing on the banking system has played out in essentially the same way. In both cases the banks saw losses mount from bad loans and reacted by cutting their lending activities which had the effect of reducing investment and pushing their economies into a recession. 

The good news from Japan's experience with a credit crisis is that the amount of taxpayer funds actually lost to help re-capitalize the banks was less than 15% of the total, or $117bln. This number is actually projected to shrink to around $70bln over time as more of the money is recovered and should be viewed as a positive sign given the American taxpayers are being asked to foot the bill.

The bad news from this comparison is that it took Japan over a decade to emerge from the recession that followed their housing bubble. Japan's main policy failure was that they thought they could just spend their way out of the problem. The government offered one directionless stimulus package after another and after spending nearly $1trln on bridges to nowhere had next to nothing to show for it. The only thing these stimulus packages did was get Japan deeper and deeper into debt.

Lessons from Japan's Experience

Lesson 1 - Act Sooner than Later

Clearly the US is demonstrating that it has learned from Japan's mistakes and is making important steps to address the main problems facing the banks. Unlike Japan, it is not waiting for things to get better. Instead it is pro-actively looking to contain the banking sectors problems using the three pronged approach of providing liquidity, buying distressed assets, and re-capitalizing the system. 

The banks will take time to recover from the worst hit to the sector since the great depression but they should pull through in some consolidated form. The next question is where does this leave the economy once things stabilize for the banks?

Confidence in the Japanese economy was not restored immediately after the banks got themselves back on dry land, and with the credit markets shut for weeks now it appears we may fall into a similar pattern of low spending due to weak consumer confidence leading to lower growth. This perpetuates the cycle of layoffs which reduces spending, and ultimately forces lending to contract further, making it more difficult to finance needed investment. 

Sure there will still be investor interest in investments like high grade infrastructure projects, but without the hedge funds around to take the riskiest pieces of these deals, who do we expect to underwrite them? The banks will be in no position to do this for the next year or two at least as more and more hedge funds are likely to be forced to shut down due to poor performance and sell their risky loan portfolios back into the market at cut rate prices.  I am in no way touting the virtues of hedge funds here, but as far as we still need investors to take equity-like risk on large scale investment projects, the boots of the hedge funds who invested in these deals will be tough to fill over the next few years.

Lesson 2 - Build Bridges to Somewhere You Actually Want to Go

Economic stimulus packages will certainly help reduce the pressure on the economy, but unless these projects are very well structured there is a risk that they will just go the way of Japan's $1trln spending spree and get us deeper in debt and no closer to a way of this mess.

What is needed is a program that creates jobs in new industries to ensure that the US economy benefits not just tomorrow but decades from now in terms of our global competitiveness. An investment program designed to improve our national security, re-tool industry, build a new transmission infrastructure, and reduce our balance of payments deficit. What we need is a way to re-power our economy in a way that will put the banks back to work doing the job that many of us assume is their primary role, lending for economic investments that will help grow the economy. 

Lesson 3 - Give the Banks Confidence to Lend Again

The answer to what kind of program can deliver on all those promises is not "drill, baby drill" its "cap, baby cap". Put a price on carbon emissions and let the markets direct capital to create a new energy economy that will help get us through this economic crisis on our own terms. The banks are no longer able to provide the kind of investment capital needed to grow our economy out of this recession on their own. By using the revenues from a cap and invest plan as a form of collateral for the banks to tap, it will give them confidence to participate in this new economy which is the start of bringing them back to their real day jobs. 

Government spending on stimulus packages won't be enough, as Japan's $1trln bridge to nowhere program clearly demonstrated, unless it is well directed. Cap and invest can mobilize resources to solve our energy and economic problems in a way that is revenue neutral and will pay its way by providing high quality jobs in new industries for the American worker.

If we gain anything from Japan's experience is that we cannot make our credit problems simply go away by throwing money at the problem. The sooner we realize we need a platform like cap and invest that can help mobilize America's innovative spirit, the shorter this recession will be.

The next part of this series will show how capital from a cap and invest program can be deployed today to help re-power our economy.