Economic Policy - 3 BUS 0036

The economic stagnation in Japan in the
90s

Henning Schmidt

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1. Introduction

This report will examine the economic stagnation in Japan in the 1990s. The second

section will introduce the events in the 1990s and give the most important features,

followed by a closer look at the chain of events, explaining what caused what in a

chronological approach. From there, we will introduce a set of possible reasons for the

depicted developments and the theoretical frameworks in the third and fourth section

which will then lead to our conclusion based on the analysis given before, accommodating

the conclusion of Krugman of Japan being in a liquidity trap in our findings.

2. Japan in the 90s ­ summarizing macroeconomic developments

This section will introduce the phases considered, the building the "bubble" in the 80s,

"burst" of the bubble in February 1991, continuous recession and seeming recovery in

1996 and renewed economic downturn from 1997 on until 2000, the end of the considered

timeframe.

a. Build-up of booming asset and real estate market ­ "bubble economy"

Japans Economy in the 80s showed strong growth of above average, e.g. 4.1% ten year

average growth in 1986 (Weinert, 2001, p. 461) and very low inflation (Baig, 2003, p. 5).

Declining regulation of the financial sector and generally lax regulation led to a credit-

fuelled boom in the land- and asset-markets (Schrooten, 2000, p. 2).

Within this process, the boom-financing bank-loans were built on collaterals of mostly

land or stocks, accumulating risks in the loan books of the banks (Woo, 1999, p.7).

b. "Burst" of the bubble

By 1989, the Japanese stock market peaked, in 1992, land prices start to decline. Both are

related to government intervention, the stock market was affected by a change of the

discount rate by the Bank of Japan (BoJ) and the latter was influenced by a restriction of

maximum loans to real estate in April 1990 (Baig, 2003, p. 8). The economic downturn in

the aftermath was worsened by interconnection of bank loans and declining value of

collaterals.

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c. Economic down-turn and weak recovery until the "Big Bang" in 1997

By 1992, Japanese banks had to cope with increased financing cost (Baig, 2003, p. 8), at

the same time, lending to the real estate sector increased through "jusen" companies,

security and insurance companies engaged in home lending, further accumulating

potentially bad loans leading to the collapse of several "jusen" companies in 1996 (Baig,

2003, p. 24) and the first bankruptcy of a financial company. Overall, the financial sector

and its condition were in steady decline until 1997.

Especially in 1994 and 1995, the economy contracted strongly, the original expectations

of a merely cyclical downturn were rejected (Schrooten, 2000, p.3)

By 1995, the average 10 year growth had declined from 4.1% in 1985 to 1.4%, even

including the last years of strong growth before the burst of the bubble and the GDP

actually contracting in 1995 by ca. 0.5% (Weinert, 2001, pp. 461; 464).

d. "Big Bang" in 1997

By this year, the economic crisis had shown several aspects. The financial sector was still

in crisis, despite cooperation, favourable accounting and provision rules regarding non-

performing loans (NPL) and tapping of unrealized profits in balances (Baig, 2003, pp. 25

­ 28). Simultaneously, Japanese GDP grew in 1996 and 1997 considerably which lead the

authorities to conclude the economic down-turn had ended and to tighten fiscal policy too

early (Weinert, 2001, p. 471). With the Asia Crisis worsening financial problems, three

big banks actually suffered bankruptcy (Schrooten, 2000, p. 2).

By 1997, regulation attempts to finally clean up the financial sector were undertaken,

including a self-assessment process and new classifications of capital in the banks`

balance sheets. With the new law, problems turned transparent and enforced a massive

intervention of the state with money injections to save the financial sector worth

significant shares of GDP (Baig, 2003, p. 31).

Still suffering from the malfunctioning financial sector, economic output grew

significantly, the fiscal situation continuously deteriorated (Weinert, 2001, p. 464), while

a zero-interest policy was officially introduced by the government in 1999 to foster

growth and initiate economic growth (Schrooten, 2000, p. 3). The fiscal tightening in

1997, including the introduction of a new tax was strongly overambitious (IMF, 1998, p.

115).

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