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1999-2004
Causes of Japan's Economic Stagnation

Why has Japan's economy, once the envy of the world, fallen on such hard times, and why has recovery taken so long? The nine scholars analyzing Japan's economic crisis from 1985 through 2000 have identified six underlying causes:

Surplus in Savings: Japan has traditionally enjoyed an unusually high savings rate and a comparatively low consumption rate. During the decades of recovery and high-speed growth, this "savings surplus" supplied sorely needed capital to private industry in the form of bank loans. This money was used to build and expand Japan's industrial infrastructure and to achieve the rank of a world-class manufacturing power. However, during the 1990s, the "savings surplus", once the indispensable fuel for high-speed growth, became a serious, structural impediment, leading to a severe slump in demand and causing a heavy drag on Japan's economic recovery.

Liberal Democratic Party (LDP) and Vested Interest Groups: LDP support from interest groups representing protected, inefficient sectors of the Japanese economy has contributed to Japan's economic malaise but has also made it difficult for the Japanese state to implement the reforms necessary to get back on track. Focused on staying in power, the LDP has been reluctant to implement far-reaching reforms or tackle the tough issues, such as the ominous overhang of nonperforming loans (NPLs). The LDP's coalition of interest group supporters, which supplies money and votes, has lobbied hard to sandbag or dilute reform measures. The unprecedented length of Japan's asset deflation and liquidity trap is largely due to the absence of effective, far-sighted political leadership. Whether Prime Minister Koizumi, who has a clear-cut electoral mandate to reform an outmoded economic system, can push through necessary but politically painful changes remains to be seen.

Policy Mismanagement: The lack of political will and effective leadership are reflected in serious policy mistakes. These include: the consumption tax hike in 1997, which stifled nascent signs of recovery; the unparalleled slowness in disposing of NPLs; and the heavy-handed reliance on interest rate cuts from 1985Ð1987 to deal with the deflationary impact of sharp yen appreciation following the Plaza Accord. While it would be unfair to blame the bubble, asset deflation, and the liquidity trap solely on Japan's politicians and policymakers, it is accurate to say that policy mismanagement has aggravated the problems and prolonged the processes of recovery.

Structural Impediments: The complex structure of Japan's political economy - particularly the close, symbiotic ties between the economic bureaucracies, like the Ministry of Finance (MOF), and the corporations under their regulatory jurisdiction, like banks and insurance companies - has also contributed to Japan's problems. The interests of the Banking Bureau of MOF and the banking industry are interdependent. There is little transparency or public accountability. Information is hoarded about the actual scope of bad loans. Old methods of crisis management (specifically, administrative guidance) prevail. These elements help to explain why it took the government so long to deal with the massive hemorrhaging of Japan's financial system. Although Japan has made progress toward developing a more transparent, rules-based system, the problems of nontransparency and weak accountability have not disappeared.

Yen Appreciation: Another underlying cause of the bubble, sustained asset deflation, and the liquidity trap is the steep, long-term appreciation of the yen relative to the dollar. For Japan, yen appreciation has been a chronic problem. Exchange-rate factors have limited the effectiveness of certain policy tools that might have cleaned up Japan's financial mess. Caught in a classic liquidity trap, for example, the option of designing monetary policy to hit specific inflation targets would be difficult, in part because a sudden, sharp devaluation of the yen would put enormous pressure on South Korea and Taiwan to devalue their currencies. In an era of global capital flows, the constant national need to make adjustments in the value of key currencies, and the costs of overshooting, misalignment, and potential speculative attack have enormously complicated domestic macroeconomic management.

Global Capital Flows: Japan's rapid growth from 1955-1975 and its steady growth from 1975-1991 can be understood as part of a global expansion of trade. But if postwar Japan has benefited from the globalization of trade, it has profited less from the globalization of capital flows. Neither the public nor private sector has handled the liberalization of capital movements as adroitly as the liberalization of global trade. Japan has received surprisingly low returns on its massive dollar assets abroad. Moreover, the Asian financial crisis between 1997 and 1998 crippled the country's efforts to shake off its stagnation. Japanese manufacturing industries were better prepared to take advantage of the globalization of trade than Japanese financial institutions were to utilize the opportunities created by the globalization of capital flows.