January 25, 2012
The Lost Decades of Japan
Introduction and a Little Theory
Why did Japan grow so slowly from 1990 to 2010? At each end of this score years the answer is simple: there was a recession, the first caused by the bursting of a real-estate bubble and the second by spread from the bursting of a bubble in Europe and the U.S. In between is the problem. GDP growth was positive, but low. For a long time people attributed this to the banking crisis in Japan in
1990. “Recessions involving banking crises last longer,” they said, though I can’t think of any such recessions since 1925 except the Great Depression, Japan 1990, and USA/Europe 2009. The Great
Depression’s length, more than its severity, has been a longstanding puzzle for economists.
Benjamin Bernanke wrote a good article suggesting that it lasted so long because the closing of banks that went insolvent destroyed lending expertise and infrastructure that was necessary to revive investment. But Japan was not a country of small banks that dissolved in a crisis. (Find out how many banks did liquidate.) To be sure, interest rates were low, as they were in the Great Depression, at the same time as the quantity of loans fell. But it doesn’t look like Japan’s problem was lack of supply of investment funds.
Let’s turn, then, to what is taught in beginning macro courses. When wealth suddenly falls, as it did in 1990 when people realized that Japanese real estate was overvalued, people’s willingness to spend falls too. That is a negative aggregate demand shock; the aggregate demand curve shifts in and intersects aggregate supply at a lower level of output, so output falls.
The textbook solutions are to increase the money supply or to increase government deficit spending, both of which shift out the aggregate demand curve. Increasing the money supply has the long-run disadvantage of inflation. That certainly has not been a problem in Japan. Deficit spending has the long-run disadvantage of reduced capital formation and therefore slower future growth. That sounds like Japan, doesn’t it?
Thus, here is a first story for what happened in Japan. In 1990, a real estate bubble burst.
The government responded with massive deficit spending prolonged over many years. The recession was not big, but private investment never recovered, because it had to compete with government demand for funds.
A problem with that story is that interest rates were very low. Government demand for funds does not seem to have driven up the price of funds. So we must think about why businesses haven’t borrowed at the low interest rates the government has been borrowing at. That will be were our second story comes in later.
Let us start by thinking more about the first story. Even if the Keynesian Multiplier works, it has a cost. Government debt drives up the interest rate and crowds out private investment. Unless the multiplier is small, this is not a problem, because GDP increases overall. But the basic model is static. Let's add something to the story. Imagine an economy in recession, with GDP=100. It has a choice between two policies, laissez faire and deficit spending. This year, deficit spending would
1

increase GDP by 2% over laissez faire if there were no crowding out, but it does reduce private investment and so the overall increase is 1.8%, to 101.8. Under laissez faire, GDP will increase by
0% this year, to 100.
But carry on with the same model. It gets more complicated the second year. There are two costs to crowding out. One is the short-run effect, the Keynesian multiplier effect, of .2%. The other is reduction in future economic growth, since investment yields returns. How much growth would that lost investment have provided? I don't know, but I will be arbitrary and say 0.1% growth in
GDP per year for 10 years. Let's also assume that under either policy there will be a basic increase of 1% per year in GDP. In the second year, laissez faire yields 101.1 and Keynesian yields 102.8. By the 7th year, however, if we continue the Keynesian policy, the two GDP's are 106.7 and 107.0, in the 10th year they are 114.3 and 111.3. By the 20th year they are 139.4 and 122.98 and the difference continues to grow.
The Keynesian policy has the policy of doing better early on. If we take present discounted values of the next 25 years of GDP, discounted at 3%, then the laissez faire and Keynesian policies have values of 2129 and 2010.
We can think about what numbers are plausible for this story.
Technical Stuff to Learn as of January 18.
1. In WORD, is there a way to do Small Caps headers?
2. In STATA 12, I need to learn how to do the options. There is a way to make the axis labels sideways, and to change the axis origin.
The Big Facts of 1980 to 2010
The period 1980-2012 can be divided into three parts. First, there was the boom of 1980-1989.
Second, there was the malaise of 1990 -2007. Third, there was the recession of 2008-2012.
2

The puzzle: Was it bank unwillingness to lend, or company unwillingness to borrow? How would government borrowing affect these? Why didn’t interest rates rise with all this crowding out?
Is it possible that the Bank of Japan forced banks to charge a low interest rate, and so they didn’t want to make loans to businesses? This is a form of “financial repression”. See Reinhard and
Rogoff, “A Decade of Debt”, sidebar on page 6.
Maybe the Bank of Japan hurt things too by letting banks hold more cash in its accounts, or paying interest on them.
------------------------------------------------------------
Owing Debt to Yourself
Is Japan better off than Italy because more of its debt is owed to its own citizens? There is less
3

chance of default, for political reasons. Also, it is denominated in Yen, so Japan can inflate its way out.
But whether the debt is exterior or interior shouldn’t really matter. It will slow down growth the same amount either way.
1. Suppose Japan borrows 100 billion from its citizens for one year and consumes it, and there is complete crowding out, and a 5% rate of return. That will displace 100 billion of private investment, and so eliminate a 5% real return, so Japan will be 5 billion poorer than it would be otherwise.
Also, the Japanese taxpayer next year will have to pay 100 billion extra in taxes.
2. Suppose Japan borrows 100 billion from France for one year, and there is a 5% rate of return.
There is no crowding out because there is no government domestic borrowing. Next year, Japanese taxpayers will have to pay 5 billion in interest to the French, and also their taxes will rise 100 billion to pay off the principal.
Thus, either way government spending goes up 100 billion this year, taxes rise 100 billion next year, and 5 billion in income from growth is lost.
Confusion, though: in the domestic case, the 100 billion extra taxes goes to pay off 100 billion in domestic debt—so doesn’t that cancel out?
------------------------------------------------------------
Notes from Seminar at IU
1. An effect of govt. spending might have been to keep construction workers hired for too long, just delaying the necessary readjustment.
2. What is the REAL value of corporate debt? If interest rates fall, the market value of debt to the creditor increases, and maybe--- I am not sure--- the burden on the borrower increases. Certainly if there is deflation that is true--- the borrower has to repay in more valuable yen.
3. Maybe the banks wanted to lend at low interest rates to favored customers, and had for camouflage to charge low rates to everyone--- but therefore wouldn’t lend to most businesses.
4. What were bank shareholdings in corporations to which they lent?
5. Cite Miwa and Ramsyer on Keiretsu.
“True, thanks to falling prices, the purchasing power of workers’ remaining income has held up, but it is still down by more than 10%.” Check this out. Is real consumption down? Is household income down? Labor income?
--------------------------------------------------------------------
NOTES
According to the Financial Services
Agency, nonperforming loans, which had risen steadily and peaked at ¥43.2 trillion in 2002, declined to ¥11.9
4

trillion by 2007.65 .
Until the global financial crisis of 2008, Japan’s economy recorded modest but prolonged growth, averaging around
2% in real terms. This was to become the longest continuous period of expansion on record since World War II.
Although growth never rose dramatically, adjusting for Japan’s stagnant population growth and deflation by using real
GDP growth per capita, Japan’s economy grew during this period at a rate that exceeded that of other major developed economies such as the United States, Germany and France. 66 Data from Angus Maddison, Statistics on World
Population, GDP and Per Capita GDP, 1-2008 AD
For Intro:
“Scholars have proposed a wide range of Japan-specific explanations for the lost decade – e.g. underlying structural problems,19 macroeconomic policy mismanagement,20 misdirected “zombie bank lending,21 policy paralysis,22 and institutional rigidities.23 The” 19 Katz
20 Posen 1998; Bernanke 2000; Grimes
21 Caballero, Hoshi, and Kashyap 2008
22 Lincoln
First-Mover Disadvantage:
The Politics of Financial Crisis Response in
Japan and the United States
Phillip Y. Lipscy
Hirofumi Takinami1
A blog commenter:
You don’t for a moment imagine that Japanese people’s principal commitment to the Japanese Government Bond (JGB) market comes through the voluntary purchase of JGBs, do you? That accounts for about 5% of the market, off the top of my head. The other 90% is funneled through banks, the postal system, and the life insurers and is not in any way voluntary by any normal definition.
Another commenter:
Well, here’s a very crude measure that’s nevertheless revealing: GDP per person employed at constant 1990 purchasing power parity dollars, which among developed countries at least should smooth out changes in exchange rates, inflation, and the size of the workforce. The numbers come from the World Bank, here: http://data.worldbank.org/indicator/SL.GDP.PCAP.EM.KD?page=3
From 1991 to 2008, GDP by this measure rose 21.0% in Japan, 23.5% in Germany, 21.5% in France, 12.6% in
Italy, 45.2% in the UK, 35.8% in the US, and 84.0% in South Korea, leaving Japan at GDP of $45,587 in
2008, trailing all but Germany at $42,588 (because of East Germany) and South Korea (at $40,261) and compared with the UK at $51,697 and the US at $65,480.
5