Describe what happened to the Japanese economy during the “lost decade” (facts – provide data, tables, graphs that summarize economic conditions). Explain what caused the crisis (analysis). Why was deflation such a problem for Japan? Summarize and evaluate the government’s fiscal policy. Suggest alternative fiscal policies that might have worked better.
Summarize and evaluate the Bank of Japan’s monetary policy. Suggest alternative monetary policy that might have worked better.
In what ways is the current U.S. economic crisis similar to the Japanese crisis and how is it different? What are the lessons for current U.S. macroeconomic policy?
3
Executive Summary: 4
Part I: The Lost Decade 6
Part II: Fiscal Policy 7
Fiscal Policy Instruments 7
Fiscal Stimulus in the “lost decade” 7
Viewpoints 11
Consumption Tax Hike 12
Analysis 13
What would have probably worked 13
Monetary Policy 15
Comparison of U.S. economic crisis to the Japanese crisis 16
Similarities 16
Causes 16
Effects 16
Fiscal Policy 16
Monetary Policy 17
Differences 17
Causes and Effects 17
Fiscal Policy 18
Monetary Policy 19
Analysis 20
Lessons Learned 21
APPENDIX 24
Executive Summary:
Understanding Japan’s economy and the lost decade of Japan is like trying to solve a jigsaw puzzle before the complete picture emerges. There are many explanations and articles written about what happened to Japan to go from being one of the top most economies in the world to becoming an almost irrelevant economy. It has now become a reference point for countries to learn from to avoid a potential future such as the one Japan is in currently.
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To understand Japan’s current state, we start by understanding a little bit of Japan’s ascent to being the dominant country it was in the latter half of the past century [1] . Briefly, we can focus on two phases of Japan’s economic rise separated by a short recession in between. The first phase was in the post World War II era and the second was after the world oil crisis in the latter part of 1970s. The main aspects that stand out in the explosive growth of Japan’s economy in the first phase are high investment in education system and targeted heavy industrial growth like manufacturing, infrastructure, construction, and mining. During the second phase Japan focused more on new industries like semi conductors and computers, focusing on growth in the technological sector.
As growth continued and the value of Yen grew, there was an effort by the Japanese Government to focus more on domestic demand. As the investment in Corporates increased, it led to an exponential rise of the stock market combined with a real estate boom. The stock market rise was closely interlinked with the real estate boom as stock market speculators used real estate as a means of collateral.
The most important event that was responsible for the start of the downslide of Japan’s economy was the contractionary monetary policy that was enacted by the Japanese Government in the late 1980s (May 1989, to be precise), to counter the high prices in the real estate markets. This increase in interest rates affected the stock market sending it crashing and since it was so closely interlinked with real estate, it pulled the real estate market along with it. Japan slid into heavy recession in the early 1990s.
The fiscal policy analysis finds that there were a series of fiscal stimulus spending initiatives in the lost decade accompanied by a consumption tax hike in the latter half of the decade in 1997. Based on the facts gathered, the conclusion for Japan not responding effectively to the fiscal polices during this period is due to the inconsistent and diluted implementation of the policies. We evaluate this and find that the spending was in bursts over the time period accompanied by targeting projects which had no long term growth prospects for the economy. In addition to this, trying to balance the budget due to the fear of growing deficits seemed to contradict and negate the fiscal spending in the same period. The GDP growth fluctuated and the economy did not recover. Hence it helped form the overall perception that fiscal policy failed to help Japan’s fight against recession. Our recommendation is that Japan should have been committed to the fiscal spending with targeted long term growth projects and also worked on some structural reforms, which when supported by the momentum gained due to fiscal spending would have lifted the economy towards a positive GDP growth.
We also evaluate the similarities and differences of Japan’s lost decade with the recent US economic crisis. There are many common factors between the two crises in how it started with like real estate boom, banking crisis and how the recession was handled with the application of Keynesian principles. We place these in context with understanding how US is handling the economic crisis. Based on the comparison it appears that US has been more in control over its response and is not in the danger of having a lost decade of its own.
Part I: The Lost Decade
Part II: Fiscal Policy
Everything we have read and understood so far shows us that the key facts characterizing the lost decade were reduction in aggregate demand, unemployment, deflation, asset devaluation, high savings, loss of confidence in banking institutions and aversion to risk taking by the population. These seem to be the same factors that are typical of any recession, albeit here it is intensified indicating a severe recession.
Fiscal Policy Instruments
Fiscal policies are enacted by the Government. The macroeconomic tool box shows us some tools to counter some of the effects of recession. Of these, Government spending, engaging in public infrastructure or other key public work projects like energy, to increase aggregate demand and giving tax cuts to increase spending habits in the population and capital investment in the private sectors are the tools that have shown clear results in lifting US out of recessions it faced in the past century, specifically as we got out of the great depression in the 1930s. These are the short term Keynesian solutions which should help lift the economy out of recession.
The graph [2] below from the IS-LM model shows that expansionary fiscal policies can cause a large positive impact on the GDP with very little increase in interest rates during recessions as the LM curve tends to be flat.
Fiscal Stimulus in the “lost decade”
Based on this, we first look into the stimulus programs enacted by Japan to counter the recession. Unlike the recent US economic crisis where we find definite targeted fiscal acts enacted, the information about the fiscal policies enacted in Japan is not as concrete. The terms used to describe the fiscal spending during the lost decade range from “series of stimulus” to “insufficient stimulus” as cited in different references.
We gather that the major fiscal acts during the lost decade were mainly:
1) Key stimulus initiatives and,
2) A consumption tax hike in 1997.
Below is some supporting information about actual stimulus packages including both fiscal and monetary policies enacted by the Japanese Government during the 1990s [3] .
The claim is that there was anywhere from 65 to 75 trillion yen spent during the recession decade of the 1990s aimed to stimulate the economy. However in reality this number may have been exaggerated as it seems there was apparently only 33% (approx 23 trillion) of this amount actually spent by the Government, as it also appears from the table above. The distribution of this was mainly thought to be between public work initiatives and subsidies given to prop up some of the failing businesses.
The data table 2.5 below shows the budget plans Japan framed during the lost decade. The plan shows that the initial budget plan was supplemented with additional budget which was really the stimulus being pushed into the economy.
We see that the most significant allocation was in fact in the “Public Works” category which saw ~5 trillion and 1.6 trillion increases in 1995 and 1996 respectively but seemed to taper off in 1997.
The prevalent opinion on this is that the spending was wasted on unimportant public works projects and subsidies were given to business essentially delaying the eventual demise of these weak companies [4] .
A couple of examples seen on some major public work projects in this time include the Marine Bridge and the Sun Village sports center in the sparsely populated, with mostly an aging population, city of Hamada in the western region of Japan. Shimane, another region near Hamada had towns each with its own athletic centers which were unused. There was also the Nima Sand Museum which was a glass pyramid housing a giant hourglass which was built using the fiscal stimulus [5] .
Dr. Ihori of University of Tokyo concurs with this view above, that the fiscal spending done by Japan in areas of construction industry in rural areas and projects as above did not provide any benefit to the economy in total.
However, we see that the fiscal spending did prop up the economy as was reflected in the increase seen in the GDP in Fig 1.1. Analyzing the graph, we see an increase in the GDP around 1996. This does seem to correlate with the stimulus package announced in 1995 in Table 2.4 which is by far the largest of the stimulus packages announced thus far.
The margin of growth however, was very small. For every 1 trillion yen Japan spent on various infrastructure projects in this time yielded only 37% growth in GDP. A research done by a non profit group, Japan Institute of Local Government, found that investing in social services or education would deliver 64 – 74% growth in GDP as opposed to infrastructure projects. This seems to be substantiated by the fact that, some projects in Hamada which included a new University and an aquarium which housed beluga whales were viable long term growth projects since they provided many permanent jobs and also allowed for younger population growth in Hamada which had mostly become a place with aging population.
However, the economy regressed as soon as the spending ceased. The GDP chart for this period is shown below3:
Viewpoints
There are actually two very different points of view on why Japan did not respond to the fiscal policy. The first, lends itself to the view that Japan’s fiscal policy was insufficient and weak. The other which stands by the Japan’s fiscal stimulus attempts but says there is something fundamentally broken in Japan’s economy and there has to be a structural reform before it can respond to any stimulus.
The first point of view is represented by the reference article by Adam S. Posen, which discusses in length trying to see if there is anything fundamentally broken in the economic system in Japan which has prolonged the length and severity of the recession and comes to the conclusion that while there is a window for some structural reform, there is nothing to contra indicate that Japan would not respond to the known macroeconomic solutions.
The article [6] by Michael Cox and Jahyeong Koo, argues that the long stagnation in Japan’s economy is indicative of something beyond the normal business cycle recessions that are normally targeted by the fiscal and monetary policies. It comes to the conclusion that it is really the structural problems in Japan’s economy which has made it immune to any fiscal stimulus programs.
The first point of view indicates that when fiscal policies are enacted they should be fast, strong, purposeful and committed. This was probably a factor missing in the fiscal response started by Japan. We don’t see much evidence of a strong fiscal stimulus in the early parts of the 1990s, where the bubble burst and the economy started sliding. Japan did not intervene enough to counter the initial start of the recession. The fiscal response came later and here it seems like Japan’s fiscal policy was pumping up the economy intermittently in doses and stepping back as soon as it saw some positive response instead of simply keeping up the stimulus going till there was a clear indication that the recession had stopped. Further as many of the references indicate there was more of wasteful spending rather than targeted spending.
On the other hand, the converse view tries to explain that Japan and the financial institutions did not engage in the process called “creative destruction” [7] where one keeps on continually improving, but chose to support the staid industries from the earlier decades. This prevented new enterprises to enter into the market and slowed down productivity affecting the overall GDP. Along with this it also points out several key aspects of Japan’s financial regulations and laws that are not conducive to encouraging or reviving economic growth.
It appears that it is really the combination of factors presented by both these views which could explain the lackluster response of Japan’s economy to the fiscal stimulus.
Consumption Tax Hike
To complicate matters further, Japan was growing uneasy with the deficits and debt situation caused due to the fiscal spending during this recession period. There were internal pressures that it was more important for Japan to focus on long term restructuring rather than short term Keynesian fixes [8] .
The chart to the left shows how Japan’s debt had started ballooning relative to its GDP growth in comparison with US.
By around 1997 Japan’s debt to GDP ratio had reached ~ 120% and was still rising. This was creating a great deal of alarm in Japan.
Yielding into the pressures, Japan enacted a problematic fiscal policy, a consumption tax hike in 1997 [9] which acted against the signs of recovery that were seen in response to the Government spending. So we had an expansionary and a contractionary fiscal policy happening around the same time. Whether this was due to policy mismanagement or political pressures as the article states, the ending perception is that the fiscal policy did not work.
Analysis
The question to ask here is that, is fiscal policy a “one size fits all”? Does it work regardless of the culture and inherent framework and structures of countries? Is applying fiscal policy without some structural reform a myopic view of trying to lift Japan out of recession?
To answer these questions it is important to distinguish the short term and long term intended policies. There is a tendency to collapse these two into one view while trying to explain why fiscal policy worked or not in Japan. The short term Keynesian fixes are indeed applicable in all economies. This is analogous to saying, if there is a break in the dam we need to have a temporary fix to stem the flow of water before we can analyze and strengthen the dam for future. To let the water flow and think of rebuilding the dam later is setting up for a long and difficult restoration cycle.
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The reason that the GDP increase was not sustained can be attributed to the fact that the fiscal response came in increments and was not purposeful as pointed out already. In conjunction, it also implies that these short term stimulus would have never worked since the economy was stuck in an obsolete mode. The Japanese Government did not target the spending programs on new areas with long term growth prospects. And there was the tax hike to contend with along with the weak fiscal spending. So the economy basically dipped back into a recession which it had not quite gotten out in the first place.
What would have probably worked
Hindsight is always 20/20. There is no way to predict what would have happened had there been no fiscal spending policy initiatives in Japan during the lost decade. However there still seems to be some obvious policy mistakes that could have been avoided.
Everything we have learned so far indicates that balancing budget or focusing on deficits during recession is only going to make the recession worse. However the intense political pressure with focus on deficits led Japan to try to balance the budget during the recession period. So the fiscal stimulus on one hand, which in itself was not giving the intended result, combined with the tax hike on the other was giving an inconsistent message to help the economy recover.
We also learned that there are really two tools in the fiscal tool box, one is the fiscal spending and the other is tax cuts. It is not clear anywhere whether Japan tried providing tax cuts instead of resorting to fiscal spending. This may have boosted the swing in GDP as well as sustained it.
Finally, it seems like the timing of all these aspects were not in sync. When Japan planned the fiscal stimulus, if there were additional steps taken at the same time for structural reform which would communicate to the markets that while the temporary fix was working there was a more permanent solution in process, it would have boosted the confidence of the market and probably sustained the GDP growth seen in the mid 1990s. The short term fixes should have been prolonged with a focus to strengthen the economy to be capable of responding to a long term solution.
In an ideal world, the fiscal policies would work as we have learnt in the models in the course. However in reality, there are many tangential forces, political or structural, that can act against each other diluting the ideal nature of the policies, finally ending with some compromised inputs into the economy. While we cannot say that the fiscal policy failed, what would have worked better was probably a combination of the fiscal expansionary policy which included government spending and tax cuts with some political and structural reforms to ensure that these policies got the intended effect, along with delaying any initiative to balance the budget.
The recent signs of recovery show that this is probably finally happening in Japan. There is some political will and reform which is trying to shape the recovery of Japan from recession.
Monetary Policy
Comparison of U.S. economic crisis to the Japanese crisis
There are definite similarities between the recent US economic crises to Japan’s economic crisis that started in the 1990s. However, there are also marked differences.
Similarities
Both of the crises started with a stock market and real estate melt down that were precipitated by the actions of the financial institutions in the country, which included, reducing interest rates accompanied by many financial deregulations. [10]
Below is the summarization of the similarities [11] :
Causes
Boom of the asset prices causing an explosion of high risk debt levels followed by the bust of the same
Banks left holding bad debts due to the collapse of the real estate markets.
Collapse of financial institutions: In Japan, it was the Yamaichi followed by other long term credit banks, while in the US it was the Lehman brothers which started the domino effect followed by other highly leveraged financial institutions.
Effects
Reduced aggregate demand leading to reduced GDP causing recession
Deflation ( though this was for a very fleeting period in the case of US)
Increase in unemployment
Fiscal Policy
The similarity in both US and Japan fiscal responses to the economic recession was the fact that they were based on Keynesian principles of short term fixes to the economy.
US came out with some concrete acts to counter the recession. The first three acts below were under the presidency of Bush while the last one was under President Obama.
Economic Stimulus Act of 2008, which was essentially a $150 billion tax cut given back to the people to stimulate spending, in both consumer and capital arenas.
The Housing and Economic Recovery Act of 2008. This was a fairly complex act which involved trying to free the banks from the mortgage loans so they would not freeze up on providing loans to the public. A second part of this act was to provide a tax credit to first time home buyers. This was done to increase the support and also increase demand in the housing market which was seriously affected.
Economic Stabilization Act of 2008: This is more popularly known as the TARP (Troubled Asset Relief Program) which was again a form of fiscal stimulus. The intent here was also to free the financial institutions of toxic assets and free up the credit markets.
American Recovery and Reinvestment Act 2009: This was essentially government spending in the areas of green energy and infrastructure projects across the US. The intent was to create jobs in areas which would sustain long term growth of the economy. There were also other parts of this act which included directly stimulating the public spending like providing incentives for buying new cars, first time home buyers etc.,
While the information on Japan’s fiscal initiatives are not as clearly stated, it had similarities in the government spending aspect, where Japan started many infrastructure, public works projects.
Monetary Policy
The similarities of the monetary policy include reducing the nominal interest rates to near zero to allow borrowing and spending. However this only applies to a select period within the recession era in Japan, towards the middle of the 1990 decade. US have also strived to keep the interest rates low to allow for the economy to recover.
Differences
Causes and Effects
The differences between the US and Japan crises are very nicely summarized in table below:
The banking crisis in Japan was precipitated by both corporate loans which were secured by real estate assets as well as the collapse of the stock market. In US the crisis started primarily with the mortgage loan crisis.
The Japan crisis was domestic as pointed out above, however in US since the mortgage loans were all broken up into different pieces which went into different securities, the crisis turned global.
In Japan it seems like the banks had fundamental issues in their strategy planning and asset management, with most of the loans being in industries which were underperforming and real estate markets, thus leaving little margin to fund their domestic market. However in US, while the mortgage crisis was caused by sub prime loans, the fall of some of the financial institutions occurred due to lax regulations in loaning.
The other important factor was to do with the accounting systems. While there are cons in both of the accounting systems followed by Japan and US, it basically comes down to which one caused lesser damage to the economy. It appears that the US is on the more conservative side of accounting with very clear disclosures and more up to date accounting procedures. This may have aided in addressing the crisis earlier than later as it became apparent where the failure of regulations occurred. Japan’s accounting system allowed the crisis to become deep rooted and hence more difficult to address.
Fiscal Policy
In terms of the Fiscal Policy differences, it is clear that US Government has addressed the crisis and intervened quickly as the crisis started. In Japan this is not evident. The facts gathered indicate that the fiscal stimulus came in small bursts and did not have any targeted segments of growth. They were clearly intended to simply pump up the economy in the short term.
In addition to this, US have been consistent in keeping up the fiscal initiatives without any contradictory policies. In other words, though there is much media and political pressure about the rising deficits, there has been no move towards balancing the budget or removing the Bush tax cuts which are about to expire by the end of the year. These actions if implemented could cause a backlash in the economy. This is one of the key differences as compared to Japan’s fiscal policy which introduced an ill timed tax consumption hike just as there were signs of recovery.
Monetary Policy
The main difference we see between Japan and US with regards to the monetary policy was the timely way in which US acted. The graphs [12] below indicate that Japan reacted pretty slowly at the onset of the crisis in 1990
Source: Trading Economics Web Site
While both the countries have targeted the interest rates and reduced it to near zero, the real interest rate in Japan was still higher due to deflation. This could explain why the reduction of the interest rates did not impact Japan’s economy as expected.
It appears that Japan did not look into the process of quantitative easing during the lost decade and simply focused on interest rates [13] . It was only post the lost decade that it shifted its policy to focus on monetary base growth to tackle deflation, which seems to have received a huge positive response in the recovery of the economy. Whereas the US has already started this process in an aggressive manner with the Federal Reserve announcing that there will be quantitative easing to the tune of $600B in the near future [14] .
Overall it shows that while Japan expected that the economy would recover with limited push given by the fiscal and monetary efforts, US has been very committed to its expansionary policies till to date trying to ensure that the economy is on its recovery.
Analysis
There seems to be a general perception that US can probably recover out of this recession in a better way than Japan since the Government has acted and continuing to act fast with some key fiscal and monetary initiatives. However, this is also countered with fear inducing views of growing deficits and toxic banking assets with the notion that the US crisis is worse than Japan’s and that US is in denial over this. The reference article [15] gives us some data which helps us understand these view points better.
The above charts show that the GDP slow down in Japan was indicated way before the actual crisis occurred. Whereas, in US GDP is seen held at a steady rate. This is further supported by the other aspects of economic growth like the labor force, productivity and investment rates which leads one to believe that the fundamental economic infrastructure in US is better equipped to handle the crisis.
Going back to the process termed “creative destruction” by economist Joseph Schumpeter; we can see how this correlates with the charts above. The decline in Japan’s productivity in the years 1971 onwards shows that there was no evidence of a continual process of innovation which would underlie the growth in productivity. This is in line with the concept of capital deepening.
While these are some positive inferences, US should focus on long term fixes to restore the economy. The fiscal and monetary response to the economic crisis in US has been aggressive thus far countering the massive negative political feedback. However these alone will not carry the recovery far as we know these are short term fixes. We now look into what lessons US could use in with reference to Japan to impact our recovery phase.
Lessons Learned
Overall from the macroeconomic perspective, the key lessons learned from the Japan crisis,
Recognizing early signs on how a strong economy can lead to the creation of a bubble. The Government should have an insight in how the fiscal and monetary policies could play a role in assets driving markets and hence making the financial systems vulnerable to these assets.
Prioritizing the fixing of the banking systems as this is the backbone of the economic systems. It is crucial that there are better regulations that could prevent such crisis occurring in the financial institutions. And currently, for those banks which are troubled, strengthening the system by removing toxic assets, allowing the banks to re-establish their health and start loaning again to the public are key to the recovery of the economy.
Delay balancing the budget till the economy is firmly back on its recovery. This is an important lesson for any economy in recession, that no matter how much the pressure for balancing the budget, this would create more instability in the economy during a recession.
If in a deflationary economy:
Observe nominal GDP growth rather than real GDP growth which will be boosted artificially due to deflation.
Watch real interest rates rather than nominal interest rates. While Japan’s nominal interest rate was nearly zero, the real interest rate was still restrictive due to the deflation.
Target inflation (deflation) by money supply than simply reduced nominal interest rates.
Finally to lift an economy out of recession, both expansionary fiscal and expansionary monetary policies are required. It is necessary that these are managed in time and enacted in a manner to complement each other producing a combined positive effect on the economy.
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