Housing, Credit Constraints, and Macro Stability: The Secondary Mortgage Market and Reduced Cyclicality of Residential Investment by Joe Peek and James A. Wilcox. Published in volume 96, issue 2, pages 135-140 of American Economic Review, May 2006

We examine the misallocation of credit in Japan associated with the perverse incentives faced by banks to provide additional credit to the weakest firms. Firms are more likely to receive additional bank credit if they are in poor financial condition, because troubled Japanese banks have an incentive to allocate credit to severely impaired borrowers in order to avoid the realization of losses on their own balance sheets. This “evergreening” behavior is more prevalent among banks that have reported capital ratios close to the required minimum, and is compounded by the incentives arising from extensive corporate affiliations.

The Japanese banking crisis provides a natural experiment to test whether a loan supply shock can affect real economic activity. Because the shock was external to U.S. credit markets, yet connected through the Japanese bank penetration of U.S. markets, this event allows us to identify an exogenous loan supply shock and ultimately link that shock to construction activity in U.S. commercial real estate markets. We exploit the variation across geographically distinct commercial real estate markets to establish conclusively that loan supply shocks emanating from Japan had real effects on economic activity in the United States.

The size of Japanese bank lending operations in the United States enables us to use U.S. banking data to investigate the extent to which the sharp decline in Japanese stock prices was transmitted to the United States via U.S. branches of Japanese parent banks, as well as to identify a supply shock to U.S. bank lending that is independent of U.S. loan demand. We find that binding risk-based capital requirements associated with the Japanese stock market decline resulted in a decrease in lending by Japanese banks in the United States that was both economically and statistically significant.

This article demonstrates why the procedures used in previous studies do not permit inference about the relationship between interestrates and taxes. We present a model that leads to direct estimates of the degree to which interest rates respond to changes in tax rates. The empirical results imply that the adjustment of taxable interest rates has been large enough to render after-tax yields impervious to tax rate changes. Further, tax-exempt yields are unaffected by changes in taxrates. Thus, there is no evidence of fiscal illusion in interest rates.

During the 1980's, theories were developed to explain the striking correlation between real exchange rates and foreign direct investment (FDI). However, this relationship broke down for Japanese FDI in the 1990's, as the real exchange rate appreciated while FDI plummeted. We propose the relative access to credit hypothesis and show that unequal access to credit by Japanese firms contributes to the explanation of declining Japanese FDI. Using bank-level and firm-level data sets, we find that financial difficulties at banks were economically and statistically important in reducing the number of FDI projects by Japanese firms into the United States.