Prepare for a Japanese-style lost decade

Zombie banks and high unemployment look set to curse our economy as they did Japan’s, say Fraser Nelson and Mark Bathgate. A Conservative government could avoid disaster, but only if it is prepared to face the painful reality

To say a country is turning Japanese has a very special meaning to economists. It means entering recession and never properly escaping it. It means entering a world of zombie banks that are being kept alive by taxpayers’ money. It means year after year of huge government deficits: profligacy masked as Keynesian medicine. It means year after year of false dawns, high unemployment and lapses back into recession. It is an acute form of economic purgatory — and one which Britain might well be facing.

There are plenty of parallels for those with an eye to see them. Japan’s ‘lost decade’ followed a debt-fuelled boom, a mirage which politicians vainly mistook for prosperity. Once the bubble burst, the government entered denial and kept spending — thinking the deficits would somehow incubate a recovery. Crucially, Japan never applied a proper fix to its banking system — taking a ‘see no evil’ approach to the bad debts of the nationalised banks. It was a recipe for ten years of stagnation in a booming world economy. And it is a recipe that Britain is following to the letter.

The secrets and lies which surround Britain’s banking system are increasingly seen as the main problem. Last month Adam Posen, an American who sits on the Bank of England’s monetary policy committee, spelled out the threat. ‘The UK has an uncomfortable parallel with the Japanese financial system — when its economy began to recover in the mid-1990s and was unable to sustain it,’ he said. ‘The closer one looks, the more worrisome this specific parallel becomes.’ Until the banks are fixed, in other words, there might be no recovery at all.

For David Cameron, this raises an even worse political prospect: that he wins the election, pulls the levers of recovery (cutting corporation tax, reducing the deficit) and still nothing happens. Under the Japanese illness that Mr Posen alludes to, nothing will work if the banks are still broken and the money does not start to flow. So the surest way of kickstarting a recovery may be to perform the surgery that Gordon Brown has so far avoided.

The problem comes down to how little we know about the underlying losses of Britain’s banks. Just as Japan’s banks went on shopping sprees around the planet — the 1989 purchase of the Rockefeller Center being the crowning moment of hubris — so Britain’s banks loaned money around the world to clients who are not going to repay. The International Monetary Fund warns that the bill for Britain’s bad debts may amount to some £360 billion — a quarter of economic output.

Instead of a full audit, a damage report for the taxpayer, the Treasury has preferred not to ask questions. Like Japan, it feared what the answer might be.

Alistair Darling is finding out, as Japan did, that there is a price to pay for such evasion. Investors are unwilling to put their money into a black hole. Banks are even wary about lending to each other, suspecting themselves of hiding toxic debt and playing various games. The government has refused to force them to own up to their bad debts, as even ministers join in the game of ‘see no evil’. It is a game that few outsiders are minded to play with their own money — and this is the problem. When the likes of RBS and Lloyds cannot find finance, they tap the taxpayer instead — and a cycle of bailouts begins.

The scale of the secrecy was again made clear this week when Mervyn King, governor of the Bank of England, admitted he had authorised a £62 billion loan to RBS and Lloyds a year ago. Staggeringly, a sum of money equivalent to twice the annual defence budget was being sent to banks owned by the taxpayer — with no one being told. The money has been repaid, said Mr King, so there is no problem. But such surprises send further shock waves through the system: if they can conceal £62 billion, what other horrors are lurking undiscovered?

As investors opt not to find out, banks start to overcharge existing customers and deny credit to prospective new ones. This practice is having a direct and damaging effect on the British economy, as it did on Japan’s. Business investment is, as the Bank of England revealed, falling at a rate ‘by far the largest since records began in 1966’. A fall in investment is largely to blame for Britain’s status as the last major world economy still in recession. With growth booming in Asia, Britain is looking increasingly like the odd one out.

But Britain has not benefited from the worldwide application of cheap loans. Our base rate may be 0.5 per cent, the same as these recovering economies. But the typical British mortgage is charged at 4.3 per cent now — a gulf which is, itself, proof of the broken banks. Had mortgages come down as much as base rates, British consumers would be £50 billion a year better off — and the economy would likely have come out of recession, just as those in Europe have (the average mortgage on the Continent is charged at less than 2 per cent).

The Japanese disease of broken banks requires the Japanese remedy of printing money. It is a convenient political con to argue, as British policy-makers do, that the grandly named quantitative easing is needed because rates are so close to zero. We need it because, in an attempt to restore their balance sheets, the banks do not pass on the low base rate.

Britain’s other means of stimulating the economy is drawn from the Japanese guidebook of desperate measures: to allow state spending to lurch out of control. The government overspend was £11 billion last month alone — that is to say, for every pound the state spends, it has to borrow 25p. In the time you took to read that last sentence, national debt will have jumped up by about £35,000. Even in the first full year of a Conservative government, 2011, Britain is forecast to have the largest deficit in the developed world. Our net debt will top £1 trillion within four years — and is unlikely to ever fall below that point.

But Britain’s fate is not yet sealed. There is another short, painful yet proven route to recovery — which comes at the cost of immense political capital. If the Japanese problem was arrived at by evasion and dishonesty, the Scandinavians — who had a banking crisis at the same time — pioneered a method of full disclosure. Providing the whole truth about the losses in a bank is hardly in the nature of Gordon Brown’s government, which has focused on debt concealment. But forcing a spotlight into the dark recesses of the banking system is what happened in Stockholm and Helsinki.

When Japan’s bubble burst, the Scandinavian countries were in just as much trouble. Sweden and Finland had allowed their banks to pump up a property bubble, and when the bust came the bank losses were as great as in Japan and the UK today. But the Scandinavians saw what Japan in 1991 did not, and Britain today does not: that leaving zombie banks untreated will drag down their economies for years. They drafted in literally hundreds of external experts to produce a full audit. The result was indeed a horror story — but policy- makers in Stockholm and Helsinki both judged that evasion was the greater evil.

When investors became confident that there were no more hidden surprises in the Scandinavian banks, money returned quickly. As it did, the banks started lending to their customers. The wheels of a healthy economy, still fractured in Japan, started to turn again. And so they can in Britain: with the correct medicine.

A Conservative government could star t this by appointing a credible external banking auditor: a kind of truth and reconciliation commission for the City. Every bank would have to comply. If Mervyn King had secretly loaned anyone the equivalent of Estonia’s national debt, they would have to pay up. There would be no more secrets. Step two is to establish how much capital is required to fix the banks. It will be an almighty figure, likely to dwarf even the £33 billion of taxpayers’ money which went walkabout in the third bailout, quietly announced last month.

Finally, the banks should be forced to raise that capital themselves. If investors are sure that there really are no more nasty surprises or secrets being kept in the Bank of England, then the money may well come. Anyone who bought into the Scandinavian banks during their refinancing will have more than quadrupled their money. It is a virtuous circle: with transparency comes confidence. With confidence, money starts to flow again. And an economy is then in a position to capitalise from an economic recovery, in the way Japan failed to do in the mid-1990s.

Ever the optimists, British banks are trying the fundraising anyway. Lloyds (a once-healthy bank poisoned by the calamitous decision to buy the terminally ill HBOS) this week launched the largest fundraising exercise in British banking history. It is hoping to raise £13.5 billion from investors. It is doing so by fairly drastic measures, such as selling newly created shares at a 60 per cent discount. But it has to: people are still suspicious. As well they might be, given that HBOS is now being investigated for misleading investors before its £4 billion fundraising last year.

If Lloyds fails to raise the money, then there is — of course — a fallback option. The British taxpayer will be dragooned into providing yet another cash injection, owning a majority stake in a bank whose shares no one else wants to own. The bill will never be presented to the taxpayer, because it never is.

In next week’s pre-budget Report, Mr Darling will employ Japanese evasion tactics. He has sumo-wrestled the massive bank debts away from the public eye. He has invented the Treasury’s own special debt measurement, which strips away banking losses and literally pretends nothing had happened. Like Japan, Britain carries on with the delusion that the recovery will soon come and magic these problems away. That the taxpayers will get their money back.

The Scandinavian taxpayers, of course, did get their money back. It was a tale of two banking fixes, and soon the Conservatives may have to choose between them. As Mr Cameron is fond of saying, ‘sunlight is the best disinfectant’ — and sunlight is also the best way to cure zombie banks. As John Redwood says, the Tories will be taking power not over a country but of a large bank with a medium-sized government attached to it. For as long as the bank losses are not fully disclosed, the zombie banks will stalk Whitehall and bedevil hopes of a recovery.

As country after country returns to growth, helped by cheap loans simply not available in Britain, it is horribly clear what the problem is. With its broken banking system, Britain is very much in danger of turning Japanese. But if the Conservatives act quickly, and with enough resolve, there may just be time to turn it back.