What Japan Did Wrong
And what we can learn from it.
Feb 23, 2009, Vol. 14, No. 22 • By DUNCAN CURRIE
Amid our current economic and financial turmoil, Japan's experience during the 1990s looms large in the minds of American policymakers. The 1990s were a "lost decade" for Japan, a period of deflation and widespread economic misery. In just a few short years, Japan went from being the world's model of economic success to its cautionary tale.
During the late 1980s, the Nikkei stock index climbed relentlessly upward, driven by a real estate boom. As Jeff Kingston noted in his 2004 book, Japan's Quiet Transformation, the Nikkei "tripled in the 45 months prior to the December 1989 stock market peak," at which point Japanese stocks represented some 44 percent of global equities. The bubble reached its apex at the end of 1989, a year in which the Bank of Japan raised interest rates several times. What followed was cataclysm.
"In 1990," Kingston observed, "property values in Tokyo, Osaka, and Nagoya fell between 40 percent and 60 percent from their bubble era peaks, while in 1991 alone the stock market average lost 36 percent of its value." As the economy began shrinking, loan defaults proliferated and Japanese banks saw their capital positions decline rapidly.
The government dithered. "Probably the very biggest mistake the Japanese made was to refuse to acknowledge there was a problem," says economist Edward Lincoln, director of the Center for Japan-U.S. Business and Economic Studies at NYU's Stern School of Business. "They did not take really serious government action until 1998."
Initially, the Japanese finance ministry thought--or hoped--that fallout from the crash would be minimal. After all, very few Japanese households owned stock; the bulk of household assets were in savings accounts. So Japanese officials reckoned that only greedy speculators (who were blamed for causing the crisis) would be seriously hurt. "Nobody in the Japanese government understood how far those [asset] prices were going to go down," says Lincoln. When policy-makers realized just how extensive the loan defaults were becoming, they colluded with the banking sector to downplay the problem and conceal its magnitude.
Then the 1997-98 Asian financial crisis hit and further exacerbated Japan's troubles. A series of large Japanese banks went bust, and denial was no longer an option. The Japanese parliament passed legislation to recapitalize the banking system and handle bank closures, but it didn't provide enough money and didn't allocate that money effectively, disbursing the funds without much regard for the health of individual banks. In 1998, two more large banks, the Long-Term Credit Bank and Nippon Credit Bank, collapsed. Once again, the government attempted to recapitalize the banks. This helped mitigate the crisis, but again the Japanese government failed to establish a sufficient level of bank capitalization. Numerous financial institutions continued camouflaging their portfolios of bad loans.
It was not until the premiership of Junichiro Koizumi (2001-06) that banks were finally forced to address their dodgy assets. As economists Takeo Hoshi and Anil Kashyap note in a recent paper, "the banks only really returned to being adequately capitalized in 2006 and 2007, when macroeconomic conditions improved and after supervision policy had changed."
It wasn't just the elected government that failed to recognize the severity of the crisis. The Bank of Japan, traditionally a conservative central bank, moved far too slowly in slashing interest rates after the crisis began. It took the central bankers several years to bring interest rates to zero. Then, in 2000, they prematurely started lifting them before deflation had ended.
As for fiscal policy, the Japanese government temporarily reduced income taxes in 1994. More tax cuts--some temporary, some permanent--were enacted over the next two years. But the government allowed all the temporary tax cuts to expire in 1997 and simultaneously increased the consumption tax. "My impression is that the tax cuts did work," says Lincoln. Indeed, the economy had briefly returned to decent growth levels in the mid-1990s. But after the 1997 tax hikes, it "got pushed back into recession," and then was battered by the Asian financial crisis.
Realizing its mistake, Tokyo implemented more temporary income tax cuts. In 1999, local governments began issuing consumption vouchers, which could only be spent on certain things and in certain places. The shopping coupons were mostly a flop. "There was an impact," says Takeo Hoshi, of the University of California, San Diego, "but the impact was small."
Japan also attempted to stimulate the economy with infrastructure spending. Throughout the postwar era, Japan had always devoted an exceptionally large share of public spending to its infrastructure. In the early 1990s, this spending mushroomed and led to an explosion of what Lincoln calls "absolutely stupid projects."
The construction binge would have worked better, says Hoshi, if the money had been targeted more prudently. He reckons that most of it was wasted, and that the tax cuts were a better stimulus than the public works schemes.
Others, however, take a more benign view of Japan's infrastructure spending. Economist David Weinstein, a Japan expert at Columbia, believes that Japanese government spending was more important than tax cuts in boosting aggregate demand during the mid-1990s. Japan was an "extreme case," he says, in which massive infrastructure spending made sense. Weinstein also thinks the 1997 tax increases were a major obstacle to Japan's recovery. "They were much too hasty in raising taxes."
Compared with Tokyo in the 1990s, Washington has been fast in its reaction to the financial crisis. The adoption of a zero-interest-rate policy took years in Japan; in America, it took months. Whereas Japanese officials spent years denying or sugarcoating their bank woes, U.S. officials have been much more forthright in tackling the bank credit crunch. Those American lawmakers who wish to see most or all of the Bush tax cuts expire at the end of 2010 should remember that, as Hoshi observes, Tokyo's 1997 tax hikes "put the Japanese economy back into recession."
Japan was not sufficiently aggressive in pressuring banks to sort out their bad loans, or in recapitalizing those banks. Weinstein points out that the U.S. banking system today is much more sophisticated than the Japanese system was in the 1990s, yet the response from Washington has been disappointingly similar.
In their recent paper, Hoshi and Kashyap stress that "the fundamental problem" plaguing U.S. banks is a capital shortage. This was also the basic problem plaguing Japanese banks after the bubble burst. Hoshi and Kashyap show how Japan's use of asset management companies (AMCs) to buy up bad debts had only minimal success, partly because of their limited asset purchases, and that, moreover, the AMCs did not help recapitalize the troubled banks. The Japanese bank saga demonstrates that recapitalization and removing toxic assets are two different challenges, Hoshi and Kashyap write, and that "care should be taken not to waste money propping up financial institutions that will ultimately fail."
So have U.S. policymakers learned the correct lessons from Japan's bank meltdown? Hoshi does not sound terribly confident: "I'm afraid we may be making the same mistake the Japanese government made."
Duncan Currie is the managing editor of the American.