In 1990, Japan was on track

to become the #1 economy

n Average Real Growth was exceptionally high
in postwar period
n 1950-1970: 8.4% annual per-capita
n 1970-1990: 3.4% annual per-capita (4.1% unadjusted)
n Large Trade Surpluses, especially with U.S.
n Offset by high rates of investment in U.S. and Asia.
n Value of Yen rising
n 360 Yen per Dollar before 1971, 300 in 1973, 130 in 1990 –
an average appreciation rate of 4% per year.
n Per-capita GDP higher than U.S.
n Adjusting for Purchasing Power Parity, 81% of U.S. level
(30% of U.S. level in 1870, 20% in 1929 and 1950)

Then the Bubble Burst

n Prices of Stocks fell dramatically:
n After rising from 12,000 in 1985 to 39,000
in 1989, stocks fell to 16,000 by 1992.
n Real Estate and other Assets similarly
affected.
n Bubbles happen, and bubbles burst, but
in Japan the decline never ended.
n Currently, the Nikkei is around 12,000.

1
 Nikkei 225 Index

14,000 45,000

40,000
12,000 Nikkei 225 Dow Jones Industrial Average

35,000
10,000
30,000

Nikkei 225 Index

U.S. Indices

8,000 25,000

6,000 20,000

15,000
4,000
10,000
2,000 Nasdaq Index
5,000

0 0
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Monthly Data

After 1991, Japan also

stopped growing
n Between 1990 and 2004, average real
per-capita growth averaged around
1.0%.
n Four identifiable recessions.
n After a year or so of hope, another one
may be beginning.

2
 Real Japanese GDP

160,000 12.0%

140,000 10.0%

120,000 8.0%
Real Quarterly GDP (100 million Yen)

Annual Growth Rate

100,000 6.0%

80,000 4.0%

60,000 2.0%

40,000 0.0%

20,000 -2.0%

0 -4.0%
1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002
Quarterly Data

What happened to Japan?

Why the world’s second largest

economy slowed down

Professor Elliott Parker

Department of Economics
University of Nevada, Reno
April 14, 2005

3
 Sources of Japanese Growth
n High Savings Rate:
n Minimal consumer credit markets
n Weak social security system, firm-based retirement
n Very little foreign direct investment, lending
n Postal savings system
n Accumulation of capital, research & development
n Focus on high-quality production
n Export Orientation:
n Subsidization by MITI
n Undervalued exchange rate until 1971
n Main Bank System (i.e., Keiretsu):
n convoy system of mutual support
n lifetime employment
n iron triangle of LDP, technocracy, large firms

Events in the International

Money Markets
n 1971-1973: Collapse of the Bretton Woods System.
n Bank of Japan bought Dollars to prevent Yen appreciation,
inflating money supply.
n Then 1973-1975 OPEC Oil Crisis helped accelerate inflation to
25%, BOJ began to tighten up, exports expanded, and Yen
started appreciating.
n 1981-1985: In U.S., tight monetary policy in U.S.
combined with large federal budget deficits led to high
real interest rates and a rising Dollar.
n Plaza Accord in 1985: Major economies agreed that U.S.
Dollar had appreciated too much, and central banks
began selling Dollars. Dollar fell.
n Louvre Accord in 1987: Agreement that Dollar had fallen
enough. Bank of Japan began buying Dollars and
increased rate of money growth, so interest rates fell to
historic lows.

4
 Direct Exchange Rates
1980=100

300 Major

Broad
250

Yen
200
Yuan

150

100

50

0
1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 200 200

Creation of the
Bubble Economy
Ø In spite of financial liberalization in the late 1970s and 1980s, financial
system was dominated by mutual support systems between politicians,
financial institutions, and regulatory authorities which limited bankruptcy.

Ø Regulatory and market innovations (e.g., deposit guarantee system)

subsidized risk taking, both by financial institutions and their business
clients.

Ø Accommodative monetary policy in the second half of the 1980s, as Bank

of Japan focused limiting Yen appreciation, plus high GDP growth rates
and low inflation rates, made asset values increase.

Ø Increased monetary growth led to increased bank lending, which

increased the demand for land, real estate, and equities. Feedback effect
supported additional lending (land as collateral for loans and “hidden
reserves” in determining bank capital.

5
 Bursting the Bubble
Ø Low interest rates and high expected earnings growth led to rising
asset prices:
n Housing/income ratio in 1983 equals 6.7 times the ratio in 1950 (7.9
times in Tokyo). From 1985-1989 it tripled again.
n The Nikkei index more than tripled in three years.

Ø The Bank of Japan raised the discount rate in May 1989, and
continued with tight monetary policy through 1994.

Ø The decline in asset prices weakened bank balance sheets, reduced

investment and consumption spending, and generated a
nonperforming loan and borrower problem.

Ø In hindsight, the Bank of Japan continued too long with tight

monetary policy and did not shift aggressively enough to monetary
easing after 1993, when its policy changed.

Financial Distress
Ø Regulatory authorities were unwilling to close insolvent financial
institutions, permit bankruptcy in the corporate sector, and instead
adopted a policy of denial and avoidance.
Ø Accounting gimmicks, “white knight” mergers and other “convoy system”
approaches in which the stronger supported the weaker

Ø Regulators were unwilling to allow bankruptcy to remove inefficient

capital from the market (especially in the financial sector), and this
“forgiveness and forbearance” continued to support weak borrowers.
Ø Those who could not obtain credit from the banking system shifted to
government banks in the Fiscal Investment and Loan Program.
Ø Postal deposits grew relative to total deposits in response to increased
concern about the stability of the banking system, and provided increased
funding for government banks.

Ø Financial distress only increased:

Ø insolvent institutions, nonperforming loans

6
 Fiscal Policy
Ø LDP lost power in 1993, Hosukawa stepped down in 1994, then a rapid
turnover in weak coalition governments until Koizumi came to power in
2001.

Ø Government consumption spending rose after 1994, financed in part by

deficit spending. In 2003, the deficit was 25% of government spending,
and government debt rose to 200% of GDP.

Ø Fiscal stimulus packages were enacted that did little: traditional “pork
barrel” spending (e.g., construction) and loan guarantees.

Ø Yen appreciated through 1995, exports fell by a third; Yen then fell, but
exports slow to recover.

Ø Combined with the nonperforming loan problem embedded in the private

banking system and the nonperforming loan problem embedded in the FILP,
Japan has accumulated an unprecedented amount of debt.

Monetary Policy
The Bank of Japan not only imposed tight monetary policy for too
long a period of time in the early 1990s, but it also failed to
prevent disinflation from becoming deflation.

When the BOJ finally acted, it focused on decreasing nominal

interest rates (e.g., the ZIRP) but failed to recognize that the
decline in prices had increased the real rate of interest.

Fisher equation: real interest rate = nominal rate – expected inflation.

Low interest rates therefore did not mean than monetary policy
was stimulative.

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 Why is Deflation a Problem?
Inflation in Japan was already low in the late 1980s, but
inflation rates fell further. After 1994, inflation
turned negative.

Is deflation a cause or just a symptom?

In Basic Model of Aggregate Supply and Demand, an

economy in recession can be returned to full
employment by either:
n Stimulating Aggregate Demand through Monetary Policy or
Fiscal Policy, or
n Allowing the Price Level to fall so that value of money and
other paper wealth rises relative to the cost of products.

Aggregate Supply and Demand

200
190
180
170 Current
160 Aggregate Monetary
150 Demand or Fiscal
Stimulus
140
130
120
Price Level

110
100
90
80
Current
70
Aggregate
60 Supply
50
40
30 Full
Price Employment
20
Adjustment
10
0
5,000 6,000 7,000 8,000 9,000 10,000 11,000 12,000 13,000 14,000 15,000
Real GDP

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 Unexpected Effects of
Price Deflation
n Fisher’s Debt-Deflation connection:
n Debt repayment becomes more difficult, firms default on loans.

n Real Interest Rate rises, decreasing Investment.

n Money Demand increases:

n If bonds and other debt instruments pay really low interest rates then
people may prefer to hold more money, which pays zero interest.

n Consumption falls in anticipation:

n Consumers who expect deflation may wait for prices to fall before buying.

n Money Supply tightens:

n If banks prefer to hold safer government bonds and cash than to lend, then
the Deposit Expansion Multiplier shrinks.
n Money Supply may not grow even when the Central Bank increases the
Monetary Base.

Deflation makes it worse…

Price Deflation as a result of an increase in Aggregate Supply
is no big deal.

During a recession, Price Deflation can make things worse by

further reducing Aggregate Demand.

Monetary Policy can become much more difficult to

implement. Money Demand increases, and it becomes
more difficult for the Central Bank to increase Money
Supply.

Eliminating deflation requires the Central Bank to convince

markets to expect inflation. Temporary or timid efforts to
increase money supply will cause money demand to rise,
but not prices.

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 Money Supply / GDP Ratios in the U.S. and Japan

1.6

1.4
Japan
M2+CD
1.2
Money divided by GDP

1.0

0.8
Japan
M1
0.6
U.S. M2

0.4

0.2
U.S. M1

0.0
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
Year (Quarterly Data)

Why So Little, So Late?

n The BOJ wanted to force the Ministry of Finance to reform
the banking system, so it delayed intervention.
n Once interest rates fell and the BOJ bought government
bonds to increase the monetary base, it did not want
interest rates to rise with inflation because that would
weaken its balance sheet.
n The BOJ did not understand the severity of the deflation
problem, and was concerned that creating inflation would
undermine its reputation.
n The BOJ did not want to admit it was wrong.
n After a year of trying to stimulate the economy with rapid
money growth, the BOJ is now targeting monetary
reserves – another misguided policy.

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 Many Changes in the
Japanese Economy
n Gradual acceptance of the need for
closing down insolvent firms and banks.
n Gradual erosion of the Keiretsu system,
the lifetime employment system, and
other features of the Japanese system.
n Lifting of restrictions on foreign
investment and ownership.

Continuing Problems
n Most Japanese do not see this as a crisis; Japan is still a
wealthy, high-tech society, albeit with weak growth.
n Most Japanese voters continue to support the LDP,
perhaps due to the spending projects in their district.
Koizumi comes from a reformist faction in the LDP, but
the opposition outside the LDP is disorganized.
n Reform since 1997 is significant but still lagging and
insufficient.
n Large exporting firms able to “opt out” by going to
international markets, and do not press for more reform.
n Japan has an aging population, with women increasingly
opting out of both parenthood and the workforce.
n Deflation continues to be a problem.

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