🧗 OIJ (#10) The Lost Decade: Examining Japan's Economic Downturn of 1989-1991
Short essay exploring the bubble economy and its aftermath. Elements that led to the - so called - Lost Decade
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Preliminary note
Here’s a post that adopts a completely different approach. This one leans more towards the academic side, drawing heavily from my readings and experiences back in 2018 while living and working abroad in Tokyo, Japan.
Please let me know if you enjoy this type of content by leaving a ❤️ and a comment.
Executive Summary
This essay explores the causes and effects of the Japanese crisis of 1989-91. The crisis stemmed primarily from poorly executed financial liberalization, asset price deflation, non-performing loans, risky investments, the Plaza Accords, failures in the tax mechanism, and the land lease law. These factors contributed to a bubble economy that burst, plunging Japan into the ‘Lost Decade’, characterized by long-term deflation and widespread economic impact. The crisis adversely affected the banking sector, land prices, and investment, as evidenced by severe declines in the Nikkei Index. Although the government implemented various measures before, during, and after the crisis, these efforts fell short of achieving their objectives. This essay also proposes alternative measures and discusses the ongoing consequences of the crisis that persist to this day.
Introduction
The Japanese crisis of 1989-1990 exemplified how unchecked optimism and abundant capital can drive a nation to make disastrous decisions. The end of the 1980s ushered in a new era of economic distress that would culminate in the 2008 global financial crisis nearly 20 years later. During this period, financial deregulation allowed institutions to profit from indiscriminate lending. Politicians enjoyed high approval ratings due to ever-rising asset prices, and the Yen gained global prominence for both positive and negative reasons. Japan transitioned from an economy fueled by domestic savings to one reliant on foreign investment and debt.
Amid progress, excess became the norm, leading to unsustainable debt accumulation and widespread loan defaults. Financial institutions' speculative investments in land backfired as property values plummeted, causing the money market to contract to a mere 3% of its previous size.
In examining 'The Lost Decade,' we identified several critical issues, including the government's response, the resilience of the Japanese people, and the international community's reaction.
In each case, we pinpointed the root problems and proposed alternative solutions. Instead of postponing the inevitable, addressing the core issues directly could have allowed Japan to flourish in the long term. However, the short tenure of politicians often led to a focus on immediate, personal gains rather than long-term national benefits.
The issues of debt and overvaluation/over-investment were not solely domestic; external influences played a significant role. Our research into interactions with G7 countries, particularly the United States, revealed the impact of Federal Reserve actions and White House policies on Japan's economic situation, especially concerning account balances and Yen appreciation.
Lastly, we explored the lessons the world can learn from this crisis. Prevention, more often than not, is the best strategy for avoiding a repeat of the Japanese crisis of 1989-1990.
Main economic indicators
The history leading up to the actual crisis is fascinating because some events, if properly analyzed, could have served as warnings for what was to come. Similar to other crises, Japan experienced a bubble, primarily caused by an overheated economy and excessive savings (in the form of illiquid assets) by consumers and companies, which ultimately slowed the economy down. This economic bubble resulted in high unemployment, capital flight, and a sharp decline in the stock markets. Below are the key events that led to Japan's financial crisis, commonly known as the Lost Decade.
The first event worth highlighting is the Plaza Accord, signed in New York in 1985. This agreement aimed to promote economic growth by devaluing the U.S. dollar, which was necessary due to the United States' current account deficit. On the other side, European nations and Japan had current account surpluses and negative GDP growth, which hurt their external trade. The Plaza Accord can be seen as the starting point of the crisis, setting the stage for economic disaster for Japan.
With Japan's signature, the Yen appreciated significantly against the U.S. dollar, severely impacting Japan's trade advantage. Some argue that this was a strategic move by the United States to curb Japan's growing economic power. However, for political reasons, Japan was willing to allow the Yen to appreciate in exchange for the U.S. not imposing punitive tariffs on Japanese exports.
Later, in 1986, significant changes in monetary policy occurred. The government repeatedly reduced the official discount rate throughout the year. The first reduction happened on January 30, when the rate was cut from 5.0% to 4.5%. Subsequently, on February 22, 1987, the official discount rate was further reduced to 2.5% following the Louvre Accord. This agreement led the Bank of Japan to seek monetary policy tightening and maintain a steady discount rate.
In light of these circumstances, the Tokyo Economic Summit Conference took place to establish a framework to stabilize the economic environment. Additionally, the Mayekawa report aimed to “attain the goal of steadily reducing the nation’s current account imbalance to one consistent with international harmony” by “setting [it] as a medium-term national policy goal.” The report included recommendations for “basic transformations in the nation’s trade and industrial structure” and “striving for economic growth led by domestic demand.”
Political discussions led to further reductions in the discount rate as mentioned above. Japan struggled to find a stable rate for its economy, considering the impact on its external economy and how the discount rate would affect it. By continually lowering the rate, Japan aimed to ensure that the United States would continue to cooperate on exchange rate issues.
Another significant event is Black Monday of 1987, recognized as the worst stock market crash in history. On that day, the Dow Jones Industrial Average plummeted by 508 points (Black Monday: Remembering the Worst Day in Wall Street History, 1987). This crash also affected Japan's economy, exacerbated by the volatility of its discount rate. Consequently, the Nikkei Index experienced a substantial impact, as detailed below.
On January 12, a 666-point plunge in Tokyo's key Nikkei average kicked off a 71-point sell-off in the Dow-Jones industrials. A few weeks later, a 600-point plunge in Japan sent the Dow tumbling 60 points in the first half-hour of trading. They used to say that when the U.S. sneezes, the rest of the world catches pneumonia. No more. Japan's awesome financial and economic muscle has reached the point where its kushami, or "sneezes," can make Wall Street sick. - “When Japan Gets the Jitters, the Rest of the World Trembles," Business Week, Feb 12, 1990
However, opinions were divided on how Japan's economy could impact the global market.
Many of the people who thought Japan's stock market was stupendously overpriced worried that the bubble's inevitable burst would set off a chain reaction of stock market plunges around the globe. So far, there is no sign of that doomsday link. While the Tokyo stock market is down 14.37% —this year,—grn^V marlcp.r- elsewhere in the world haven't fallen as steeply and don't seem to be following the Nippon lead. - “So Far, Tokyo Isn't Dragging Rest of World Markets Down," Wall Street Journal, Feb 27, 1990.
As shown above, two highly contradictory articles discussed the instability of the Japanese economy. This contrast highlights the lack of stability and the extreme levels of volatility it exhibited at the time.
Following these events, Prime Minister Takeshita Noboru decided to pass a bill introducing a consumption tax to promote austerity in the country. In April 1989, a 3% consumption tax was imposed, but shortly afterward, the Prime Minister was forced to resign due to a corruption scandal. Subsequently, monetary tightening began, and the discount rate started to increase. On May 30, 1989, the rate was raised from 2.5% to 3.25%, and by August 30, 1990, it had surged to 6.0%, partly influenced by the Gulf Crisis.
The Japanese Prime Minister Kaifu's response was also flawed; his heavily political approach damaged the economy, especially the 600 billion yen lent to Iraq by Japanese corporations. Japan's difficulty in separating economics from politics exacerbated the crisis. As a result, stock prices plummeted to half their peak level, solidifying the crisis in the country.
The Japanese yen continued to appreciate against the US dollar, the Nikkei 225 dropped to 22,984, and land prices in Tokyo fell dramatically. To this day, Japan hasn't fully recovered, despite the Nikkei reaching new highs in 2024.
Possible Factors behind the Japanese Asset Price Bubble Burst
A. Poorly Executed Financial liberalization
When the United States was in recession in the early 1980s, the U.S. government attributed part of the problem to the exchange rate imbalance between the U.S. dollar and the Japanese yen, although the fundamental issue was the declining competitiveness of domestic producers. To achieve a depreciation of the U.S. dollar and an appreciation of the Japanese yen, the United States focused on removing financial restrictions in Japan and increasing the demand for the yen.
At the time, Japan's financial restrictions prevented the yen from being freely purchased and invested in by foreign countries. In 1983, the United States and Japan established the Committee for Yen and the U.S. Dollar to reduce exchange rate friction. Through this committee, the United States strongly urged Japan to deregulate and ease restrictions on financial and capital transactions.
As a result, in 1984, Japan removed restrictions on future exchange transactions, allowing not only banks but also companies to engage in currency trading. Later that same year, regulations on converting foreign funds into Japanese yen were also eliminated. The abolition of these financial restrictions opened up the Japanese financial market to international investors, significantly increasing the demand for the Japanese yen.
Moreover, this shift changed how Japanese businesses obtained funding. They began using the capital market instead of relying on the banking system, despite traditionally being considered deposit savers. This shift led to changes in bank behavior, as major firms were no longer keen to use banks as their primary source of funding. Consequently, banks were forced to aggressively promote loans to smaller firms backed by properties. Around 1987-1988, banks also began lending to individuals backed by their properties.
This change had a significant impact on the Japanese asset bubble. Firstly, cheap and easily available loans reduced funding costs for speculative purposes. Secondly, rising stock prices lowered capital costs, facilitating capital market financing. Lastly, the simultaneous increase in land and stock prices boosted the value of assets held by corporations. This effectively increased their funding sources by raising the collateral value of their assets.
At the same time, this financial deregulation enabled firms to borrow substantial amounts of money to invest in commercial real estate, private land, and - funnly enough - golf club memberships. Financial deregulation provided corporations with various financing options, reducing their dependency on banks for funding. During the 1980s, Japanese banks shifted their primary focus of credit supply from the manufacturing sector to non-traded goods industries, such as real estate, finance, and other services that were not subject to strict global competition.
B. Asset Price Deflation
Financial liberalization and inadequate laws led to a significant increase in asset price levels. In the first half of the 1980s, controls on capital movements were dismantled, deposit interest rates were deregulated, and new financial institutions were established. As banks lost large firms to international capital markets and domestic securities markets, they sought alternative lending opportunities in small and medium-sized firms. These firms could borrow for risky or low-return projects based solely on real estate collateral.
Additionally, the monetary policy implemented in the second half of the 1980s further fueled asset price inflation. The Bank of Japan’s official discount rate was halved to 2.5% between the end of 1985 and early 1987 and remained unchanged for two years, despite robust economic growth.
By 1989, even the Ministry of Finance recognized that the bubbles in real estate and stock prices were unsustainable, anticipating that price levels would eventually decline. Contrary to their belief, total bank assets plummeted from 508 trillion yen in 1989 to 491 trillion yen in 1990. Monetary policy was sharply tightened starting in May 1989, with the official discount rate being raised incrementally to 6 percent by August 1990.
Equity prices began to fall in early 1990, and the Nikkei index declined by over 60 percent from its peak at the end of 1989. In response, the Ministry of Finance introduced guidelines limiting total bank lending to the real estate sector. The fall in stock prices, which began in early 1990, continued until the end of 1992.