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Jabari A. Lucas Japanese Stagnation: A Lesson from the Lost Decade April 22, 2015

In the late 1980s, the West held Japan as a beacon of alacritous economic

progress. Not only had Japan mesmerized its academic onlookers, its gross domestic

product was also projected to overtake the output of the United States by 2000 (Krugman

1999, pg. 61). The economy’s break-neck expansion from 1958 to 1973, with

extraordinary annualized growth rates of approximately 10%, was roughly analogous to

that of modern-day China (Ito and Weinstein 1996, pg. 205). Growth, after 1973, started

to slow. Due to a mixture of imprudent banking and easy money, the economy by 1990

had not only reached a slowdown; the economy began a long decade of stagnation that

has been popularized in the academic nexus as the “lost decade.” This unnecessarily

extended period of economic struggle provides a lesson to the rest of the modern world as

to how policymakers should legislate after severe asset bubble. Aggressive monetary and

fiscal policy and extended rounds of purchasing troubled assets lay the foundation for a

faster, more robust recovery from large asset bubbles.

The Japanese economy, following World War II, experienced a “growth miracle.”

Particularly in the late 1940s, the reconstruction of critical infrastructure served as a great

jumpstart to Japan’s output. In accordance to the Solow growth model, the construction

of new capital stock, when the supply thereof was previously scarce, tends to increase

output expeditiously until it reaches the “steady state.” (source?) This is the point at

which the rate of new construction becomes equal to the rate of capital depreciation.

However, even after Japan had effectively rebooted its capital stock and reached its

steady state, the economy continue to expand at exorbitant rates. This was the point at

which the Japanese economy effectively earned its epithet, because economists using this

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model to analyze Japan’s rapid growth thought that the model was not able to explicated

continued high growth rates past the construction of rudimentary capital. Alternatively,

the best explanation is found in the structural shifts in the economy. In the late 1800s’,

the agrarian sector was the predominant segment of the economy. (In fact, agriculture, for

historical or cultural reasons, continues to garner political support as evidenced by the

soon-to-be-mentioned Housing Loan Administration Corporation.) In 1885, the

agricultural facet of the economy was 40% of national output, while manufacturing and

mining put together comprised 7%. However, by 1970, the manufacturing sector had

amassed 36% of GDP, indicating a shift in the deployment of resources to more

profitable, worthwhile production (Ito 1996, pg. 212).

The effects of economic structural reform began to fade and the 1980s began to

temper growth. Japan, as a part of a 1984 agreement with the United States, began to

deregulate interest rates, allowing them to fluctuated along with market trends. Because

of the deregulation, coupled with the economic woes in the United States, Japan’s

currency, the yen, began a stark uptick in value, with Yen to Dollar exchange rates

dropping from 260-1 in 1985 to 150-1 in 1986 (See Figure 1). This decrease in the

exchange rate decimated demand for exports. Because a large chunk of the Japanese

economy is dependent on exports, GDP growth dropped from 4.4% to 2.9% over the

same period. The response by the central bank, while logical, proved to be costly. The

Bank of Japan (BOJ) slashed the discount rate from 5% to 2.5%, in an effort to increase

the money supply and counteract the yen’s robust appreciation (Powell 2002, pg. 35).

The actions by the central bank failed in two fashions: it failed to cheapen the currency

and simultaneously created frothy increases in asset prices.

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In the environment of cheap money, banks dramatically increased loans to real

estate developers and other non-banks exploded from 19% to 27% of total lending by

1989 (Taniuchi 1997). Banks not only relaxed lending standards, but they were more

inclined to accept overvalued lands as collateral and even use funds to purchase stocks.

The accessibility to money pushed up real estate prices to an extremely precarious high

(See Figure 2). The Nikkei 225, the Japanese equivalent to the Dow Jones Industrial

Average, a coincidental economic indicator, exploded to a near 40,000 yen, a figure that

was not reached before nor since (See Figure 3). To put this astronomical valuation into

prospective, not only was this share price not converted to 2015 yen, the current share

price of the index is a meager 20,000 yen. Non-financial firms’ share of profits

diminished ostensibly from 86.3 percent in 1986 to 82.4 percent in 1989, providing even

more evidence of the bubble’s severity. Furthermore, the ubiquity of easy credit also led

to the increase of leverage by 50% over the stretch of the central banks highly

accommodative monetary policy (Chow and Foster 2010, 580). The BOJ, after seeing the

bubble, promptly raised the discount rate to 6% by 1989, and asset prices plummeted.

The decrease was so acute that it eroded 1.5 trillion yen away in wealth, approximately

three years of the nation’s total output (Koo 2000, pg. 16).

This had the effect of reducing the prospective incomes of investors, speculators,

and borrowers, who all benefit from easy-money lending. These different actors in the

economy, in response to a decline in the value underpinning assets, began focusing on

“de-levering.” Instead of continuing to consume or invest at normal rates, individuals and

firms tooled their resources towards debt repayment. This resulted in a short fall of

aggregate demand. This economic narrative beget noted economist Richard Koo’s

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hypothesis of a balance sheet. His supposition is that there are “two phases to an

economy, the ordinary (or yang) phase where private sector is maximizing profits, and

the post-bubble (or yin) phase where [the] private sector is minimizing debt or otherwise

obsessed with repairing damaged balance sheets” (Koo 2008, pg. xiv).

From the firm’s perspective, this was extremely evident in the credit markets. Not

only did corporate bond offerings plummet, the market share of foreign banks also

declined, providing an indisputable sign of reduced demand for credit. Corporate demand

diminished by 20 percent, and the decrease in liabilities became so sizeable that, by 1998,

the corporate sector became a net saver (Koo 2000, 19-20). Households had decreased

their liabilities so much so that its aggregate size had shriveled to less than half of the

value of the money supply (Chow and Foster 2010, pg. 582).

The most devastating effect of the bursting of the bubble was the prompt

devaluation of the balance sheets of banks. Non-performing loans took a toll on their

capacity to lend, as money that was expected was lost to the bankruptcy or default of

their borrowers. Non-performing loans ballooned from 2.2% of total loans in 1992 to

3.5% the following year (Taniuchi 1997). More severely, 74% of loans stemming from

housing loan companies, which had issued munificent amounts of credit, were non-

performing by 1995 (Taniuchi 1997). While big banks tried to shore up their positions by

using proceeds from the sale of government securities as backstops, the problems still

persisted because of their inability to recover their losses.

The 21 major banks tried to form their own bailout found, so to speak, called the

Cooperative Credit Purchasing Company (CCPC), which was designed to help them

eradicate these illiquid assets. The insuperable structural fault however, is that the

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imperiled banks had to provide the credit to give the fund the requisite capital to buy

these bad loans. The CCPC would then attempt to either collect payments on the loan or

sell the collateral and provide the banks with the resulting return according to the terms

of the banks’ loans to it. However, out of its 12.9 trillion yen portfolio, the CCPC proved

highly unsuccessful at converted these assets into cash. Only 4.7% of its portfolio was

converted to cash because of protracted weak real estate conditions (Taniuchi 1997).

Instead of completely absolving banks from their feckless loans, as TARP did for United

States following the 2008 Great Recession, the CCPC essentially substituted one toxic

asset for another.

The Housing Loan Administration Corporation (HLAC), a government-initiated

entity that was intended to provide liquidity to the market, had a similar problem. The

HLAC liquidated housing loans companies and assumed debts and some equities from

banks and agricultural cooperatives. The involved lender institutions provided 6.5 trillion

yen in loans to fund this rescue program, and with the exception of the agriculture

interests, no one fully recovered their losses (Taniuchi 1997). Because of the precipitous

drop in real estate prices, similar to the CCPC, the HLAC could not cover all losses. The

agreement in the resolution called for the remaining losses of the HLAC, at the time of its

closing, to be equally shouldered by the involved lender institutions and the government.

While this policy could have been intended to curb the negative influence of moral

hazard (and one can imagine that there were probably incensed liberals who would have

preferred this sort of bailout structure when TARP was being debated), it was not

effective at ensuring ample liquidity when it was absolutely necessary.

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It was not until 1998 that Japan began more expansive troubled asset purchasing

via the Resolution and Collection Corporation. Up until 2005, the program had amassed

bad assets with a cumulative face value of 4 trillion yen, but had only provided

institutions with 353 billion yen in exchange, far from adequately ensuring healthier

capital positions (Fujii and Kawai 2010, pg. 15). At around the same time, the

government had initiated broader capitalization plans totaling 1.8 trillion yen and 7.5

trillion yen respectively. However, losses stemming from non-performing loans had

snowballed to 22 trillion yen (Fujii and Kawai 2010, pg. 13). From 1992-2005,

government efforts to facilitate the capitalization of banks totaled approximately 48

trillion yen; losses, however, totaled 96 trillion yen. As a result, banks did not regain a

reasonable level of health until 2003 (Fujii and Kawai 2010, pg. 12).

The lasting damage in bank balance sheets and the fixation on debt repayment had

several negative consequences on the economy. The first is that they served as huge

impediments to the restoration of aggregate demand. Because the process of de-levering

was protracted over several months or even years, debt repayment left aggregate demand

below the full-employment level for a longer time. Even more so, because this process

effectively reduces the marginal propensity to consume, the spending multiplier for fiscal

stimulus was reduced, and jointly, the efficacy of fiscal stimulus was reduced. Even

monetary policy is less effective in this scenario because of a reduced demand for

borrowed funds and a reduce capacity to issue such credit. This presented a policy

quandary for Japan’s government, but the unfortunate economic predicament does not

provide it a subterfuge for inaction. In fact, there could be a hefty price for doing nothing.

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Because of an exceptional paucity of loans, the money supply could contract and

exacerbate the recession in the absence of outsized government borrowing.

Japan, understanding that assumption, proceeded with aggressive fiscal and

monetary policy. The Bank of Japan started aggressive policy, slashing the discount rate

from 6% to 1.75% by 1994 (See Figure 3). Simultaneously, the government began

extensive fiscal action that included 65.5 trillion yen of spending programs from 1992-

1995, and income tax cuts in 1994. In 1998, Japan tried a temporary 2 trillion yen tax cut

coupled with 16.7 trillion in spending (Powell 2002, pg. 39). Overall, the Japanese

appropriate approximately 100 trillion yen for the purpose of stimulating aggregate

demand. Conservative Austrian economist, Benjamin Powell, would cite continued

laggard growth as a strike against Keynesian and Monetarist policy. Certainly, slow

growth continued past the first efforts of stimulus (See Figure 4). Additionally, there may

have been squawking from inflation hawks, who would see such huge nominal stimulus

measure and fear it would trigger intractable increases in prices. However, as seen in

Figure 8, inflation not only remained meager, but there were periods in which harsh a

deflationary spiral seemed nigh. That development alone begged for more aggressive

policy.

However, as Koo notes, without aggressive fiscal policy, the money supply would

have further contracted and retarded any prospect of recovery. Government fulfilled its

function in the Keynesian model by replacing the reduced spending by consumers and

firms with prodigious expenditures. This helped to prevent aggregate demand from

decreasing as severely as it otherwise would have, and even miraculously kept the

economy growing. Furthermore, instead of a monetary contraction that would have

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ravaged an already vulnerable economy, the money supply (M2 plus certificates of

deposit) actually increased by 2 to 4% (Koo 2008, pg. 33).

Even with these enormous cash infusions that, on its face, appear to be extremely

aggressive, there are areas wherein more possible could have been done. Following the

huge upticks in government expenditures, Prime Minister Ryutaro Hashimoto

implemented austerity measures to combat ballooning in the percentage of debt-to-GDP,

and the economy, once again, began to slide (Krugman 1999, pg. 75). This can be seen

easily in Figure 4, in which growth rates decline demonstrably in 1997. Also, even

though growth had remained alarmingly slow for approximately 8 years, the Bank of

Japan had not began an extended period of bond purchasing until 2001.

Compared to the BOJ’s actions following Japan’s post-bubble economic malaise,

the Federal Reserve, following a similarly devastating asset bubble in late 2008,

immediately began an unparalleled, and some would say harrowing, expansion into the

bond market. Not only had it cut the discount rate and interests on reserves, the Fed

began massive periods of bond acquisitions that approximately quadrupled it’s holdings

from $925 billion in late 2008 to $4.5 trillion as of April of 2015 (Federal Reserve Board

of Governors 2015). The Bank of Japan had only tinkered with the discount rate, and

neglected to use all of its tools to counteract the economy’s elongated downturn. This

prompted a Yale economist to surmise snidely but poignantly that, “the BOJ behaved as

if it chose the most ineffective instruments in order to convince the public how

ineffective monetary policy was” (Chow and Foster 2010, pg. 576). Once it finally began

open market operations, the bank increased liquidity at a more brisk pace that it was able

to effectuate prior. What’s more, the real economic growth rate exceeded 2 percent in two

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successive years (2003-2004) for the first time since 1990-1991 (Chow and Foster 2010,

pg. 586). However, for unjustifiable fears of inflation, the Bank of Japan rolled back its

quantitative easing program too quickly, preempting the long delayed recovery.

While the recovery Japan was seeking looked eminent, growth remained anemic

throughout the 2000s to the chagrin of policymakers and economists around the globe.

Through the Great Recession of 2008 (which did hurl Japan’s growth rate into the

negatives), the economy has recovered, but, once again, is back to expanding at its

lethargic rate. The economic lassitude had remained so obstinate against traditional

mechanisms that the old theory of secular stagnation, which was once embarrassingly

debunked, has been revivified and has found some validity in the Japanese economy

Keynesian economist Alvin Hanson, when evaluating the United States economy

after World War II, hypothesized that economic growth, while it would remain positive,

would move at a more lackadaisical pace (Hansen 1939). Population growth, he

premised, would slow, and as a result, its sluggishness would negatively affect output by

diminishing both aggregate demand and aggregate supply. A lesser number of individuals

in a country would subsequently result in a fewer number of consumers, and thus weigh

down the customary enlargement aggregate demand for an extended period of time. Even

more so, slower population growth would result in a population’s aging, and to prepare

for the consumption smoothing that would take place at retirement, more individuals

would be actively saving. Fewer individuals would also be a part of the workforce than

otherwise would be available in the event of normal population growth, and this would

taper the growth of aggregate supply. Because of a population boom in the late 1945 and

substantial increases in productivity, Hansen’s theory, pertaining to the United States,

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was disregarded. However, Larry Summers, in a 2013, resurrected the idea in regards to

both the United States and Japan (Summers 2014). The data shows that this supposition

regarding Japan is not exactly conclusive.

It is indisputable that Japan has experienced a substantial reduction in labor force

participation (See Figure 7). Also, Japan’s median age is steadily increasing, making it

one of the oldest populations on earth (See Figure 8). However, this increase in age has

actually elicited a period of dissaving, contrary to the presumption of aging societies

(Warnock 2014). Dissaving provides an ephemeral boost to consumption and helps to

boost the economy in the short-run, and has not resulted in stagnation. However, this

does not erase the need for continued intervention. It does not even preclude the

possibility secular stagnation occurring down the road.

Over time, as the rate of savings approaches 0%, households will have to borrow

to continue to their current pace of spending and risk another credit bubble. Or,

households will begin to save again, reducing aggregate demand and retracting a critical

scaffold that has supported economic growth. Either way, government will have to use

measures that compensate for a diminished private demand. At first, the government

appeared to be getting that message, as new Prime Minister Shinzo Abe signed into law a

10 trillion yen, $29 billion, fiscal stimulus (Sekiguchi 2014). The Bank of Japan, at

around the same time, announced extremely expansive monetary policies, and as a result,

the economy began to grow 3.5% in the first quarter of 2013 (McNeil 2014, pg. 14).

However, just like the BOJ did in 2006, the government preempted a sustained period of

faster growth by raising the sales tax from 5 to 8 percent. This sent the economy into

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7.1% tumble in the second quarter of 2014, the worst decline since the 2011 tsunami

(McNeil 2014, pg. 15).

Many times in life, people often repeat the same mistakes over again; obviously,

Japan is no exception. No matter how clear history has been or how obvious the correct

route of recourse is, policymakers, because of the imperfections that come with their

humanity, still err. Irrational hawkish policy preempted robust recoveries twice, once in

2006 and in 2014. Let us hope that maybe the third time will be the charm.

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Appendix

Figure 1

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Source: Board of Governors of the Federal Reserve System (US), Japan / U.S. Foreign Exchange Rate [EXJPUS], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/EXJPUS/, April 21, 2015.

Figure 2Source: Bank for International Settlements, Real Residential Property Prices for Japan© [QJPR628BIS], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/QJPR628BIS/, April 21, 2015.

Figure 3

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Source: International Monetary Fund, Interest Rates, Discount Rate for Japan©[INTDSRJPM193N], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/INTDSRJPM193N/, April 21, 2015.

Figure 4Source: "World Economic Outlook Database October 2014." International Monetary Fund. Accessed April 22, 2015. http://www.imf.org/external/pubs/ft/weo/2014/02/weodata/index.aspx.

19801982

19841986

19881990

19921994

19961998

2000

-4

-2

0

2

4

6

8

Japan Gross Domestic Product, constant prices Percent Change

Year

GD

P (

Per

cen

t Ch

ange

)

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Figure 5Source: International Monetary Fund, General government gross debt for Japan©[GGGDTAJPA188N], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/GGGDTAJPA188N/, April 21, 2015.

Figure 6Source: Organisation for Economic Co-operation and Development, M1 for Japan©[MANMM101JPA189S], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/MANMM101JPA189S/, April 21, 2015.

Figure 7

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Source: US. Bureau of Labor Statistics, Labor Force Participation Rate in Japan (DISCONTINUED) [JPNLFPRNA], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/JPNLFPRNA/, April 22, 2015.

Figure 8Source: "Median Age (Years)." UNdata. Accessed April 21, 2015. https%3A%2F%2Fdata.un.org%2FData.aspx%3Fd%3DPopDiv%26f%3DvariableID%253A41.

19801990

20002010

20102010

20102015

20152015

201505

101520253035404550

Japan Median Age

Year

Med

ian

Age

Figure 9

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Source: World Bank, Inflation, consumer prices for Japan [FPCPITOTLZGJPN], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/FPCPITOTLZGJPN/, May 4, 2015.

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