What Not to Do in a Financial Crisis: U.S. Learns From Japan

"The Japanese handling of the crisis was not very good, and in that way, has provided a lesson to the Americans in what not to do," said Shunpei Takemori, a leading economist at Japan's Keio University. "In an election year, many of us were sure they would not dare invest such a massive amount of public money by taking over Fannie and Freddie even if it was necessary. But they did."

The Japanese financial crisis was at once strikingly different and hauntingly similar to the one facing the United States. Both countries were slammed by the bursting of real estate bubbles and the need to address the resulting bad debt left to banks. Many have argued that the Japanese bubble reached more astounding heights -- in the late 1980s, for instance, the land under the Imperial Palace in Tokyo was said to be worth more than all the real estate in California. Yet housing prices in the United States in the run-up to their 2006 peak actually outpaced housing prices in the run-up to Japan's crisis.

Another key difference is that the Japanese real estate bubble was based more on the rise of commercial real estate prices and their links to corporations. Japanese firms became deeply entwined with highly speculative development projects, zapping those companies of market value as the reality of their folly became clear. A year before the real estate bust in 1990, Japan suffered a far more devastating stock market bust.

Yet Japan's fatal mistake, economists now mostly agree, was regulators' refusal to confront the stockpiled bad debt and in some cases encouraging banks to hide it. Such decisions not only sickened the banks and their clients further by allowing bad debt to get worse but also inhibited those banks from making fresh loans to healthy companies.

Many analysts still point to the 1997 decision to allow the failure of Yamaichi Securities, a large investment house, as the turning point when Japanese regulators began a serious clean-up effort. A more thorough fix did not come until years later, with the 2001 election of Prime Minister Junichiro Koizumi, who unleashed his crusading economic policy minister Heizo Takenaka on the banks, forcing write-offs.

Though Japan's economy appeared to get back into a groove in a prolonged expansion that began in 2003, real estate prices and the stock market never really did. To some extent, Japan is still wandering in an economic fog, its people searching for a new national identity to replace the one that vanished with the heady days of the 1980s.

"I don't think the Americans quite realize yet that behind this hill lies the Himalayas," said Takashi Watanabe, a top official at the Bank of Japan in the 1990s and now a professor at Tokyo's Bunkyo University. "The U.S. is going to go through a lot more before this is over."