The Boom
During a bullish boom, most capitalists are optimistic about the future, so many expand credit in the expectation that most uses of credit will earn profit. This creates a self-fulfilling prophecy, at least for some time, because credit expands faster than real output. New net credit increases purchasing power, whether for real goods or investment assets like stocks and bonds.Inflation
Thus, as the boom matures, asset inflation tends to be superseded by price inflation of real goods as demand for adding capacity pushes up prices of machinery and equipment, along with wages. Rising wages and employment also tend to increase consumer prices until new output can catch up with expanded demand.The Bust
But credit cannot continue to expand if potential creditors expect falling bond prices. The creditors demand higher and higher interest to hold debt rather than equity assets. Rising interest rates mean that indebted firms and real estate investors must pay more and more to roll over their debts, leaving them less capital to spend on real investment in factories, productive equipment, and construction.Demand for new capital goods starts to sag. Demand for investment tends to be more volatile than consumer spending, since consumers are more oblivious than capitalists about economic trends. When capitalists see slowing growth, there is less need to invest in expanded productive capacity. Meanwhile, as long as they have jobs, consumers just keep spending as usual.
Here is where the controversy starts. I first had this idea during my PhD dissertation research when I stumbled on the dynamics of the Japanese financial crisis of 1927. During my decades of reading and research since, I have found the pattern I saw then to be rather common. Creditors exert their power to squeeze debtors and make a profit.
1920s Japan
The 1927 crisis in Japan ended a four-year economic boom on the heels of an enormous earthquake in the Tokyo area in 1923. The devastation and loss of life were immense, but the rebuilding effort stimulated a period of vigorous growth. The world economy also was thriving at that time, termed “the Roaring ‘20s.” Japan’s textile and apparel exports took off, and the country surpassed Britain as the world’s largest cotton textile exporter by the early 1930s, soon dominating the new rayon trade as well.The region was largely at peace. Japan was not yet deeply involved in the ongoing Chinese civil war, and enjoyed good relations with all the major powers, except the isolated Soviet Union. There was no conspicuous or universally accepted trigger event for the crisis. To most of the public, it seemed to come out of nowhere.
But beneath the surface, there was a growing polarization and divergence of strategic interests among Japanese business conglomerates, known as zaibatsu. They were bifurcated into the older zaibatsu and the structurally different, newer, more risk-taking ones. The older ones were centered on large banks and general trading companies oriented toward international trade, while the newer groups concentrated in heavy industries such as chemicals and shipbuilding that depended on tariff protection for survival because Japan was not yet internationally competitive in those products.
The biggest difference was that the older zaibatsu, led by the “Big Four” (Mitsui, Mitsubishi, Sumitomo, and Yasuda), each controlled one of the five largest banks in Japan, along with large insurance companies. They had all the financing they needed within their own groups. The newer zaibatsu, by contrast, had to borrow extensively to finance massive capital investments in heavy industries. And they borrowed almost exclusively from outsiders. Most of the new zaibatsu’s long-term financing came from government-owned development banks that favored their projects for policy reasons, including strengthening Japan’s war readiness.
Yet the capital the new zaibatsu could borrow from government banks was never enough to satisfy their growth plans. They supplemented their capital with call loans from the five largest banks. Those big banks, who distrusted excessive bullishness, would only lend to the new groups overnight loans that had to be renewed every day or loans that could be “called” at the whim of the creditor, meaning the creditor always reserved the right to cancel the loan and demand immediate repayment.
One day, the big banks controlled by the Big Four cut the credit line to their fast-rising competitors and adversaries. They demanded payment; when it was not forthcoming, they forced several of Japan’s largest new zaibatsu into bankruptcy. The Big Four profited mightily. Since many ordinary investors panicked, not knowing which banks were exposed to the failing groups, deposits flowed out of scores of lesser banks and into the biggest banks, which were believed to be safe. Within months, these biggest banks doubled their share of Japan’s total deposits to two-fifths from about one-fifth.
Furthermore, as many of the new zaibatsu were bankrupted, the Big Four were able to buy their choice of industrial and mining companies at a steep discount, eliminating competitors and enlarging their own groups. By the 1930s, Mitsui, the largest, controlled roughly 300 companies comprising about 15 percent of Japan’s total output. The Big Four together controlled almost half of Japan’s economy, including the lion’s share of its foreign trade.
Like every crisis throughout history, Japan’s 1927 crash had winners and losers. It was not just a random exogenous event, but the outcome of strategic interaction among contending parties, much like in war. The polarization that primed the country for this crisis was deeply embedded in divergent business interests and strategies, not just irrational panic.