Lessons from Japan’s „Lost Decade” for the World Economy Today
Differences in Initial Responses
Many economists and policy makers seem interested in Japan’s „lost decade,” that is the prolonged stagnation of the Japanese economy after the bursting of the bubble at the beginning of the 1990s. Needless to say, this is because of their concerns about the possibility of the global economy, or at least the developed world, to be trappped in a long period of recession with deflation a la Japan, and also because of their eagerness to learn lessons from the Japanese experience to save the world economy from possible longer-term stagnation. It might be pointed out, however, that there are so many apparent differences between Japan’s crisis then and the global crisis now, except an obvious similarity that is the bursting of huge bubbles in the real estate and financial markets.
First of all, it is clear that Japan’s crisis is “local” as it was essentially contained within Japan, whereas the current crisis is “global” by any definition. Second, facing the crisis, the Japanese economy managed to avoid negative growth until 1998, that is 8 years after its bubble bursting, whereas almost all developed countries have already registered significantly negative growth rates since the “Lehman shock” in 2008. Third, Japan was somehow able to keep the unemployment rate under 5 percent with no visible disturbances in society throughout the 1990s, while most economies in today’s world are facing ever-increasing unemployment, near or already in the double-digit range, with social unrests in some cases.
These differences are truly surprising, especially when we take note of the fact that Japan’s balance-sheet damage was huge and “the bubble’s collapse destroyed 1,500 trillion yen in wealth…..equivalent to three years of Japanese GDP” as pointed out by Richard Koo (The Holy Grail of Macro Economics, Wiley, 2008). Then, do these differences simply mean that the Japanese economy was slowly digesting its balance-sheet losses over time, actually more than a decade, while the global economy this time has reacted almost instantly, cutting losses and restructuring businesses, hopefully for a quick recovery? If that is the case, no lessons would be needed, the world economy should already be in the process of bottoming out and everything, even employment, might well be improving sooner or later. But the reality is not that simple, and there are some lessons to be learned, especially from crucial mistakes on the part of policy makers in Japan.
Similarities in Causes for Bubbles
It is important to realize that there exist a number of similarities between Japan’s crisis then and the US (the world) crisis now. Actually, it has become evident that a crucial factor for the both cases is huge “financial” bubbles, rather than real estate bubbles which tend to attract much attention, but should be regarded as a result or part of financial excesses.
In a big picture surrounding Japan’s bubble economy, “speculative financial activity came to the fore in the late 1970s and the 1980s” (Henry Kaufman, The Road to Financial Reformation, Wiley, 2009) with financial bubbles emerging and bursting almost everywhere in the world. And “Japan’s bubble was only one of several outbreaks of speculative fever around the world during the 1980s” (Paul Krugman, The Return of Depression Economics, Norton, 2009). So, in the 80s Japan was not alone in developing a bubble economy, which was bound to burst sooner or later. That means that the well-known real estate bubble in Tokyo and other major cities in Japan was caused not only by the Bank of Japan’s low interest rate policy to deal with the yen-daka (high-yen) recession in 1986 and to support the US dollar and the NY market after Black Monday in 1987, but also by the overall easy credit condition with financial deregulation in the world economy around that time.
This may sound very much like the situation in the early 2000s, when the speed of financial deregulation accelerated, due to keen competition among financial institutions in the US, EU and elsewhere, along with the US Federal Reserve Board’s low interest rate policy to avoid the recessionary impacts of the bursting of the “dot-com bubble” in 2000 and the “9.11 incident” in 2001, leading to housing bubbles in the US by the mid-2000s. We should also note that the US was not alone in developing such a bubble and some of the major EU nations experienced even more inflated bubbles than the US in their housing and financial markets, exemplified by sky-rocketing housing prices in the UK, Spain, etc. and extremely high leverage ratios for financial institutions in Germany, Switzerland, etc. As a result, European economies in general have been more adversely affected by the current financial crisis than the US.
Lessons Partially Learned by the US
Similarities between Japan then and the US now become even more striking, when we look into the direct cause for bubble bursting, that is the central bank’s high interest rate policy. In the case of the Bank of Japan, the official discount rate was raised from 3.25 percent in mid-1989 to 6.0 percent within a year, and kept that high rate for another year in an attempt to kill the real estate bubble “completely.” Similarly, the US Federal Reserve Board raised the federal fund rate from 1.35 percent in 2004 to 5.24 percent in mid-2006, and kept it above 5 percent for more than one year, while many subprime mortgage borrowers were having serious trouble refinancing due to sharply higher interest rates resulting from the Fed’s tight monetary policy.
It has been widely pointed out that the Bank of Japan’s over-killing of the bubble, along with the government’s regulation on real estate financing, seems to have contributed to the destructive bursting of the bubble, damaging the real economy (see Graham Turner, The Credit Crunch, Pluto Press, 2008, and John P. Calverley, When Bubbles Burst, Nicholas Brealey Publishing, 2009, for example). Actually, the size of the bubble in Japan then was not much greater than the average bubble size in various countries around that time, whereas Japan’s post-bubble recession was much longer than that in any other country, due to policy mistakes, as can be seen in the Table.
Then, didn’t the Fed learn a lesson from the Bank of Japan’s mistakes? Obviously, it didn’t as far as the mistake of monetary tightening to overkill the bubble is concerned. However, the Fed did learn from another mistake that the Bank of Japan committed, that is, too slow a move to cut interest rates when not only asset prices but also general price indexes were starting to fall, leading to the vicious circle of deflation (as pointed out by Graham Turner, op. cit., “When [interest] rates did start coming down, the decline was agonizingly slow. Real borrowing costs were up, not down [due to deflation]).
Having learned from this mistake on the part of the Bank of Japan, the US Fed lowered the interest rate hastily right after the bursting of the dot-com bubble in 2000, and also in the aftermath of the Lehman shock in 2008. It took 9 years since the bubble bursting for the Bank of Japan to subscribe to the zero interest rate policy, whereas it took only a few months since the Lehman shock for the Fed to adopt such a policy. This difference is vast. Owing to such aggressive interest rate cuts along with other monetary and fiscal policies including various bailout measures, the US and the rest of the world economy seem to be stabilizing with some financial markets rebounding rather strongly. In the case of Japan, however, there were no such quick responses on the part of policymakers or the markets.
Timing of the Exit Strategy
Then, does this mean that we have already learned a lesson from Japan to avoid a “lost decade” this time? Not quite. There is at least one more lesson to be learned from another mistake by the Japanese policy makers, that is, the wrong timing of the “exit strategy.”
Actually, Japan suffered what might be called a double-dip, or even triple-dip recession. “In 1997 the voices of fiscal responsibility prevailed and [the government] increased taxes to reduce the budget deficit. The economy promptly plunged into recession” (Paul Krugman, op. cit.). Furthermore, the Bank of Japan lifted its zero interest rate policy in August, 2000, its first effective rate hike in 10 years. But that turned out to be a spoiler for Japan’s economic recovery, and just several months later the Bank of Japan had to bring down the interest rate to zero again (BBC, “Japan Cuts Rates To Zero”; )
What we should realize is that once the economy suffers from massive asset price declines, it takes a long time to undo the balance-sheet damage and regain a clean bill of health for the economy as a whole. Just an apparent recovery of the economy in terms of GDP growth or even employment would not be enough, unless such a recovery continues and accelerates for a sufficiently long period of time. Otherwise, a tightening of fiscal and/or monetary policy might well ruin the steady effort of economic stimulation and rehabilitation over night.
Then, one might ask how to avoid another round of bubbles and their bursting if stimulus policies are to continue for such a long time. The answer should not be monetary tightening to target the bubble, because that might well repeat the mistake of “over-killing” that was committed by both the Japanese and US monetary authorities before. Instead, what we need is a more stringent global regulatory system to oversee the financial markets and institutions in the world economy, where huge amounts of money are moving around freely across national borders, often creating and bursting bubbles.
Actually, such a global regulatory system is exactly what world leaders are currently discussing at such meetings as the G20 summits. Their agreements on reasonable regulations over the financial markets and institutions from the global viewpoint are badly needed, before unreasonable, distorting regulations along with fiscal and monetary tightening in individual countries are introduced. If such individual measures spread all over the world now, that would almost certainly lead to a double-dip or triple-dip recession of the global economy, most likely with deflation a la Japan for a long time to come.
Short-term Vs. Long-term Issues
Having read this article thus far, the reader might notice that no mention has been made to Japan’s “structural problems” such as high savings, export dependency, the Keiretsu system, the aging and declining population, etc., and wonder if some more lessons could be drawn from such problems to avoid a long-term decline in today’s world economy. Interestingly, as pointed out by Richard Koo (op. cit.), non-Japanese observers tend to emphasize Japan’s structural problems, whereas Japanese economists often focus on the Bank of Japan’s monetary policy issues. In fact, the well-known debate between Richard Katz and Robert Madsen (“Comparing Crises,” Foreign Affairs, May/June 2009;) on comparing the Japanese and global crises is about whether the US and the world economy today are showing structural problems similar to those that are supposed to have caused Japan’s long-term economic decline.
It should be clear that structural problems generally concern long-term supply-side capacities which affect growth “trends,” in contrast to macroeconomic policy issues dealing with relatively short-term demand-side performance which determines economic “fluctuations” around the long-term trend (see the definition in the Table). In this sense, the phenomena of bubbles and their bursting are essentially short-term in nature, although Japan was, and still is, suffering from the long-term deflationary effects of the bursting of the bubble, due to the series of policy mistakes explained above. Needless to say, long-term capacities and tends by themselves are important issues, but they should be addressed separately from the bubble phenomenon.
This kind of distinction between short-term and long-term issues is crucially important, when we discuss the future of the financial system in the world economy. As briefly mentioned above, some kind of global regulatory scheme is urgently needed to prevent various financial institutions (including investment banks and hedge funds) from engaging in high-leverage activities, which could possibly lead to undesirable bubble phenomena. In the long run, however, such regulations are not enough, and a more fundamental restructuring of the international financial system is called for.
There seems to be a broad consensus that a new international monetary system should not be based on the US dollar as the sole key currency, which has so far contributed to the perpetuation of the global imbalance in terms of trade between the US and China rather than Japan these days. This is not only a long-term problem, but also an underlying factor for short-term bubble phenomena in the world economy with excess US dollars, resulting from the global imbalance. Here we have to learn lessons, not from Japan’s crisis 20 years ago, but from the post-WWII period 60 years ago as well as the Great Depression 80 years ago.
Bubble period Size of bubble Size of post-bubble recession
Japan 1987-91 7.8 -24.1
Austria 88-91 4.4 -6.1
Belgium 87-90 4.1 -3.8
Denmark 82-86 5.8 -1.7
Finland 87-89 5.2 -9.9
France 86-89 3.6 -7.0
Italy 84-89 3.2 -9.4
Sweden 84-89 4.9 -3.3
Switzerland 84-90 9.9 -5.9
Australia 84-89 7.2 0.9
New Zealand 83-87 9.8 -4.6
Average 6.0 -6.8
Definition: The sizes of bubbles and post-bubble recession are measured by the sum of the differences between actual (real) GDP growth rates and their long-term trend.
Reference: Yutaka Harada, Nihon no Daiteitai ga Owaruhi (When Japan’s Great Recession Ends), 2003, Nihon Hyoron Sha.