by Arnav Singh
In the 1980s, the Japanese economy was booming. Japan was the world’s second-largest economy in terms of gross domestic product (GDP) and had the highest per capita income in the world. The rapid economic expansion that facilitated such success was dubbed the Japanese economic miracle.
During this phase, experts even predicted that Japan would soon overtake the United States and claim the title of the world’s largest economy. Unfortunately for Japan, this was not to be - in fact, the reality was quite the opposite.
Between 1991 and 2001, the Japanese economy underwent a period of low economic growth at a dismal rate of 1.2% annually, with stock market indices and real estate prices crashing to an all-time low. This period of economic stagnation and deflation is popularly termed as the Lost Decade.
The biggest contributors to the aforementioned economic miracle were
a) financial aid from the United States following the events of the Second World War, and
b) Japan’s Ministry of International Trade and Industry, which was responsible for establishing communication between the government and the private sector, enabling both to work together to maximize productivity and growth through joint initiatives and policy decisions.
So what went wrong? Where did it all begin?
The Plaza Accords
Japan’s troubles started in 1985 with the Plaza Accords. The US Dollar had appreciated by fifty percent against the Japanese Yen from the period between 1980 and 1985, making Japanese imports cheaper than goods manufactured domestically in the United States.
As a result, the US market was flooded with cheaper Japanese products, leaving the US with a massive trade deficit with Japan, not to mention the job losses for those working in the manufacturing sector.
American IT and construction companies, such as IBM and Caterpillar (CAT), began to request the government to intervene. This outcry eventually led to the Plaza Accords, which were signed by five nations - United States, Japan, United Kingdom, France, and West Germany - at the Plaza Hotel (hence the name) in New York on September 22, 1985.
The aim of the agreement was to devalue the US dollar, and its clauses were designed to benefit all countries involved. The United States would be able to rein in its budget deficits, while a stronger Yen would lead to greater expansion opportunities for Japanese conglomerates, thus increasing Japan’s global influence.
However, the Yen appreciated faster than expected. This made exports from Japan more expensive to the importing nations, which naturally led to a decrease in sales and huge losses for Japanese companies.
Since Japanese economic growth had, up to this point, relied heavily on their high quantities of exports and the resulting trade surplus, the Japanese economy found itself unable to cope with such developments. Subsequently, their economy underwent a recession during the period between 1985 and 1986.
The Bank of Japan Loosens Monetary Policy
To solve this predicament, the Bank of Japan and the Japanese government sought to increase domestic consumption by lowering interest rates from 5% to 2.5% in 1987. Additionally, they issued money for public investment.
Prices of goods and real estate gradually started to increase, as more and more people started buying assets in the hope that prices would continue increasing. Trusting in this speculation, buyers put up their assets as collateral and obtained cheap loans from banks. They reinvested the money thus acquired in the stock market and in real estate.
As a result, from 1985 to 1989, the Nikkei, the stock market index that tracks the performance of 225 public companies in Japan, tripled to 39,000. Meanwhile, real estate prices ballooned - properties in Tokyo were valued at over 350 times those in Manhattan, New York.
In fact, the land beneath the Tokyo Imperial Palace was valued at more than the cumulative value of all the land in California.
Economist Paul Krugman has explained the situation perfectly:
"Japan's banks lent more, with less regard for the quality of the borrower than anyone else's. In doing so they helped inflate the bubble economy to grotesque proportions."
An Economic Meltdown
By early 1989, the world watched Japan’s inflation and speculative trading reach all-time highs. The central bank then decided to increase interest rates and tighten monetary policy to stabilize domestic prices.
At that time, Officials were confident that such measures would only cause a modest decline in the markets and only impact the speculators but things played out quite differently from what the officials had envisaged.
The speculative asset bubble burst wide open, and demand for real estate crashed. Immediately, prices in Tokyo’s prime neighborhoods fell by a whopping seventy percent.
The Nikkei 225 also plunged from its high of 39,000 in 1989 to 15,000 in 1992, and the economy fell into its worst crisis in centuries. The crash left organizations and individuals alike with piles of bad debt.
Many were on the verge of bankruptcy. At first, these companies and banks tried to hide their financial situations - during this time, tampering with one’s balance sheets was a common occurrence amongst these firms. When the cat was let out of the bag, the global reputation and trust placed in these Japanese companies took a big hit all over the world.
As a result, investors became wary of investing in Japanese firms and private investment fell.
The Bank of Japan and the Japanese government decided to bail out the companies deemed ‘Too Big to Fail’, also called ‘Zombie Companies’. The term refers to companies that only have enough cash to cover their operating expenses but are unable to pay off their debt and have no capacity for further expansion.
Experts such as Micheal Schuman argued that this policy of keeping companies artificially alive through cash inflows worsened Japan’s situation and prolonged the stagnation of the economy. The Bank of Japan slashed interest rates down to 0.5% in a feeble effort to reverse the damage, but it was already too late for a substantive recovery.
Investors lost confidence in Japan’s short-term ability to recover from the crash, and the uncertain business environment led companies to stop investing or buying assets. Economist Paul Krugman has accused consumers and companies of worsening the crisis by sitting on cash and not spending enough.
This situation is termed as a liquidity trap, wherein consumers start losing confidence in investing in assets, instead choosing to conserve cash, viewing this as a safer bet in spite of low-interest rates.
Banks in Japan stopped lending since most of them had accumulated bad debt from exposure to the real estate market. These banks chose to hold onto their reserves in attempts to repair their balance sheets and to reduce risk.
Over the next decade, the Bank of Japan unveiled multiple stimulus packages that infused capital in the Banking Sector to purchase non-performing assets and bad debt. The Government decided to increase expenditure in public investment, launching multiple infrastructure projects across the country.
The flaws in the implementation of these policies undermined their positive impact on the economy. The infrastructure spending was often wasteful and politically motivated and no efforts were made to transfer money directly to consumers or strengthen Japan’s weak social security net.
In addition to poor and inconsistent monetary policy, the Japanese failed to address structural issues such as unfavorable demographics - Japan has the world’s largest aging population.
This aging population has exerted a lot of pressure on the young to save money for retirement of elder family members leading to Japan’s high saving culture which forces people to save rather than consume. Moreover, there are not enough young people to fill labor shortages as more and more people retire.
In the end, the crisis was of Japan’s own making, however inadvertent. The Bank of Japan failed to take into account the consequences of the appreciation of the Yen. The drastic lowering of the interest rates in 1987 was a recipe for disaster.
Additionally, the Bank of Japan was too slow to respond to the onslaught of (self-fulfilling!) asset speculation in the economy. On top of that, the sudden raising of interest rates in 1989 threw the economy into a free fall.
The Japanese economy has still not completely recovered. According to Economist Richard Koo, Japan’s asset bubble crash wiped out three times more wealth as a share of its economy than the Great Recession did in the United States in 1929.
The country is still reeling from the aftershocks of the crisis: consumption levels have not recovered since their peak in 1989, and Japan’s national debt stands at 238% of its GDP. The Nikkei Index currently stands at a modest 22,000, and property prices have still not recovered.
On a more hopeful note, massive quantitative easing programs, in addition to the buying of public debt, initiated by the Bank of Japan have brought back modest growth and have prevented unemployment from reaching more than 6% of the population.
Still, Japan’s handling of the Lost Decade has left a lot to be desired and should serve as a reminder and a lesson to other countries to prevent their economy from falling into a long term recession.