Japan's Lost Decade Revisited

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Revived as a U.S. ally against Communist expansion, Japan rose quickly from the ashes of World War II and within a few decades boasted the world’s second-largest economy. It grew rapidly from the 1960s through the 1980s as the country became an innovative and high-volume exporter, yet unseen flaws in the system emerged that would weaken it from within. The bubble burst in 1990 and the Japanese economy has never been the same since.

Japan entered the global financial and economic crisis in a far more precarious situation than the world’s other developed countries. In 1990, Japan suffered the collapse of a massive housing and equities bubble that triggered an extended period of financial distress and economic malaise — the famous “lost decade” — which actually persisted through 2003. Mild growth from 2003 to 2007 convinced some that Japan had finally reached the path to recovery, though STRATFOR strongly disagreed at the time. Now the global crisis of 2008-2009 has erased gains made during this period and caused further deterioration in Japan’s already-dismal public finances.

Considering its rapidly diminishing population, it is difficult to overstate the challenges facing Japan in the coming years. But first it is necessary to review Japan’s recent past to see how bad of a position it was in before crisis struck in 2008-2009.

Japan’s Economy

Despite the widespread devastation of World War II, Japan rose quickly from the ashes. The United States rehabilitated the country as an ally against the Soviet Union, and a significant aspect of this process was turning Japan into a booming capitalist economy based broadly on the American model. Under the “San Francisco system,” which was developed from the U.S.-Japanese peace treaty after the war, the United States gave Japan privileged access to American technology and consumer markets while maintaining military and naval bases in Japan to serve as strategic outposts against the Communist Soviets and Chinese. The relationship proved remarkably fruitful for a Japan that needed to escape from the agony of defeat, and within a few decades Tokyo had transformed itself into the world’s second most powerful economy.

Throughout the 1960s and 1970s, the Japanese economy seemed to have no limits to its dynamism. It grew at double-digit rates into an innovative and high-volume exporter as Japanese companies seized greater global market share in their respective sectors. Indeed, Japan came to rival the United States in the financial, automotive and high-tech industries, and its consensus-seeking management style and emphasis on labor security were hailed as great improvements on its U.S. capitalist model.

Yet it was during this time of economic strength that Japan’s financial and economic system developed characteristics that would eventually weaken it. The state was heavily involved in every sector of the economy and played a prominent role in choosing the direction of Japan’s development, especially by way of the Ministry of International Trade and Industry and the highly regulated banking system. Banks were managed closely by the Ministry of Finance and Bank of Japan not as competitive businesses but as instruments of the government, and they were expected to channel the high amount of savings by Japanese citizens into loans for industrial development. The Fiscal Investment and Loan Program, controlled by the Ministry of Finance, used tax revenues and public savings (through the popular government-run Postal Savings System) to finance massive industrialization and infrastructure projects, providing Japan with fast, state-directed development.

The banks were also closely intertwined with the corporate world. Giant conglomerates called keiretsu — reincarnated from pre-World War II industrial groups led by elite families — combined mutually supportive manufacturing enterprises with their own closely knit banking system. Government planning and political linkages guaranteed cheap and virtually limitless credit for these key groups, creating conditions that seemed suitable for unlimited expansion. The strategy prized rapid growth and high employment levels above efficiency and profitability.

The result was the so-called “iron triangle,” consisting of elected politicians, bureaucrats who ran critical government ministries, and banking and industrial magnates — all of whom were connected through professional or family ties and many of whom held multiple posts in different areas over the course of their careers. As long as economic growth continued apace, banks could provide cheap credit and businesses could grow, employing more people and providing more votes for established politicians who worked (and contended) with bureaucrats in managing various interests and perpetuating the system.

The Bubble Bursts

The flaws inherent in this political and economic structure were not immediately apparent. Though no longer advancing at double-digit rates as it had done in the 1960s and 1970s, the Japanese economy maintained strong growth (4-7 percent) throughout the 1980s, which seemed to signal that it had successfully made the transition from a high-growth to a sustainable-growth economy. Investment in real estate and stock markets reached feverish highs. From 1985 to 1990, the Nikkei 225 stock index rose by about 60 percent (to nearly 35,000 points, compared to the 9,000-10,000 range today) and urban real estate prices quadrupled. A gigantic asset bubble was taking shape.

A crucial factor in Japan’s bubble economy was Japan’s expansionary monetary policy. With interest rates relatively low (well below those of Europe and the United States), credit was abundant, feeding the inflationary trends already raging in equities and real estate. Risks multiplied rapidly due to the mutually reinforcing relationship between bank lending and rising asset prices. Banks counted their equity holdings as part of their capital reserves, so the higher the prices, the more they could lend. At the same time, new loans were collateralized through real estate prices, which were climbing sky high due to high demand, limited supply and rampant speculation. High-priced property added more apparent strength to banks’ loan portfolios. With reserves looking strong, banks could lend profusely, and with massive credit flowing through the system, corporate profits, shares and property prices continued to rise. All of this supported banks’ reserve positions and enabled further credit expansion with very little knowledge of how prudent the loans were.

During the 1980s the United States began to feel threatened by Japan’s growing economic strength and responded by pressuring Japan to reform its system. From the U.S. point of view, Japan had benefited for three decades from the special economic partnership and American security guarantees while it closed off its domestic economy to competition from American goods and investment. But with China having opened up its economy and the Soviet Union beginning to falter, the United States had less reason to give Japan special treatment.

The trade balance was decidedly in Japan’s favor, and Japanese companies were out-competing their American rivals in areas where Americans had long reigned supreme (such as cars). As a result, the United States leaned on Japan to liberalize its financial system and smooth the path for foreign investment. Washington also pressed Tokyo to reverse its policy of maintaining a weak yen to make Japanese exports more attractive and allow the yen to appreciate. Japan complied with some U.S. requests, letting in multitudes of foreign investors and closely coordinating monetary policy with the United States. In 1986, after allowing the yen to appreciate relative to the dollar, Japan dramatically lowered interest rates once the appreciation had gone too far, from 5 percent to 2.5 percent, in order to devalue the yen. This in turn caused rampant lending and sent economic growth back up to the 7-8 percent range.

Other reforms meant to make the system more transparent and to monitor risk were half-hearted and uneven, so it was not clear how much the hidden risks were expanding. Japan had not seen a bank fail in the postwar era (given that the government was funneling personal savings directly into the banks), so there was little sense of urgency about the need to reform. Reform certainly did not penetrate the fog surrounding the dealings among the keiretsu, the Ministry of Finance and political leaders. As banks continued to lend hyperactively and investors continued to speculate with borrowed money, few people knew much about the quality of the loans that were piling up.

Suddenly, in 1990, the bubble popped. The Bank of Japan had been raising interest rates since 1989 to dampen the bubble, then exports fell as the American economy slowed, and finally investors who had come in following the U.S.-imposed reforms sensed the prevailing winds and bolted. By 1992, stocks had fallen by roughly half and real estate prices had begun steadily sliding downward. The collapse of the asset bubble caused a chain reaction in which Japanese banks and corporations saw their balance sheets erode rapidly and scrambled to pay their debts, causing private demand to decline.

The collapse in asset prices revealed that many of the loans that had been granted when credit was free and easy (both by public and private institutions, in Japan and abroad) were of very poor quality. Non-performing loans (NPLs) mounted in Japan’s private banks and in the major public banks and agencies. NPL ratios ranged from 6 to 12 percent of total loans, depending on the type of institution. Trust banks, long-term credit banks, regional banks and credit cooperatives recorded the highest NPL ratios. (By contrast, American banks come under close federal scrutiny if NPLs rise above 1 percent.)

By 2002, Japan’s Financial Reconstruction Commission calculated that the total value of NPLs at troubled major and regional banks amounted to 43.2 trillion yen (about 8 percent of GDP). But the highest estimates by academics claim that by the late 1990s, the total value of Japan’s private and public financial institutions’ NPLs reached as high as 25 percent of GDP (around 120 trillion yen). The Ministry of Finance set up special programs to administer the rising tide of bad loans, but they were not able to resolve or dispose of very many of them. Meanwhile, the entire financial system was dragged down in the attempt to pay down the debt.

A handful of Japanese banks failed in the first few years of the 1990s, but the government did not yet perceive a crisis. The Bank of Japan tried to ease the pain by again loosening monetary policy, cutting its discount rate from 6 percent to below 0.5 percent from 1991 to 1995 in order to flood the system with ample credit. But only when major banks and securities houses neared insolvency in November 1997 and bank runs threatened to bring down the whole system did the government launch a full-fledged emergency policy, unleashing massive amounts of public funds to rescue ailing institutions and attempt to stabilize the country’s finances. The government infused troubled institutions with capital (12.5 trillion yen from 1998 to 2003), took NPLs off banks’ books and stored them in resolution and collection houses, forgave debts, and bought shares held by banks to prop up bank balance sheets — all at great expense. Eventually, the financial crisis contributed to an economy-wide recession and the Ministry of Finance launched a series of multi-trillion-yen supplementary budgets and stimulus packages meant to pick up the slack.

Deflation and Debt

The problem for Tokyo was that, try as it might, none of these financial stabilization or stimulus policies worked particularly well. On the financial front, all of the rescue plans were justified by the belief that asset prices would eventually recover their previous value, which never happened because they were inflated by speculation to begin with. Near-zero interest rates throughout the 1990s and early 2000s enabled banks and corporations to take out new loans to cover the bad ones, creating a legion of “zombies” that otherwise would have been insolvent. Meanwhile, fiscal stimulus focused heavily on public-works projects meant to benefit politically-connected companies and regions and to soak up extra labor to prevent social instability. All this resulted in perpetuating inefficiencies in the system and allocating massive resources toward investments that would see no returns. Moreover, when each new stimulus wore off, this growth driven by public demand proved unsustainable. Japan underwent several recessions (bottoming out in 1992, 1997 and 2000), with each broken up only by brief and intermittent periods of slight growth that never amounted to a true recovery.

Graph: Japan's consumer price index 1988-2009Another factor that made Japan’s recession particularly malignant was the onset of price deflation. Deflation is a general, sustained decrease in price levels. It becomes self-reinforcing when consumers increase their savings and delay purchases in anticipation of ever lower prices, creating a nearly inescapable swirl of decreasing consumption, business profits and investment. (This was seen as a major factor in the disastrous effect of the Great Depression in the United States in the 1930s.) In Japan, deflation has been blamed on the Bank of Japan (for tightening monetary policy briefly from 1989 to 1991 in response to the bubble), on heavy deficit spending that left little room for a recovery of private investment that could have spurred prices, and on fiscal stimulus policies that artificially propped up manufacturers at a time when demand remained low, creating a surplus of goods that drove prices down further.
Japan Total DebtWhatever the case, consumers could not be prodded into spending enough to drive prices back up to where they had been. Japan’s consumer price index went negative several times from 1994 to 1996 and most tenaciously from 1998 to 2006 (with prices falling their fastest in December 1999 at -1.3 percent and in February 2002 at -1.9 percent). It happened again in the spring and summer 2007 after several years of GDP growth. The persistence of deflation in Japan further snarled the economy, worsening recessions and dampening periods of growth.

The net effect of Tokyo’s fiscal policies and financial rescues during the lost decade was to dramatically speed up the accumulation of public budget deficits and, ultimately, government debt. Expenditures soared and revenues plummeted, leaving Japan with national account deficits worth over 30 trillion yen (about 6-7 percent of GDP) every year from 1998 to 2006, all of which was covered by issuing bonds. Total government debt grew twice as fast in the 1990s as it did in the 1980s, and from 1993 to 2005 it rose by 209 percent, after growing at yearly rates of above 10 percent in 1994 and from 1996 to 1998. By 2005, Japan had amassed 827.5 trillion yen in debt (153 percent of GDP), the highest in the world.

Koizumi Era

Financial turmoil quickly translated into political turmoil throughout the 1990s. In the summer of 1993, a coalition of opposition parties defeated the Liberal Democratic Party (LDP) in parliamentary elections, shattering its 38-year political dominance. Though the LDP returned to power in less than a year, it was deprived of its full majority and forced to form coalitions with smaller partners to stay in power. Meanwhile, battles were raging between various government entities with different agendas, most notably the Ministry of Finance (which controlled fiscal planning) and the Bank of Japan (which controlled monetary policy). The combination of financial and economic disaster and political chaos created a volatile situation in the upper echelons of the LDP, and prime ministers and cabinets were shuffled through even more rapidly than usual for Japan, thus depriving the country of a unified leadership in the crisis. This meant uncertainties and mistakes in policy, such as the overly optimistic plan to impose fiscal discipline in 1997, which slowed the economy, causing a drop in tax revenues and a huge increase in deficits.

Finally, Japan emerged from this extended period of financial and economic distress — though only for a brief time — during the premiership of Junichiro Koizumi (2001-2006), a reformer who attempted to privatize government agencies, cut wasteful programs, rein in Japan’s budgets and map out a plan for reducing the country’s bloated national debt. With the U.S. and global economy booming from 2003 to 2007, Koizumi’s Japan saw consecutive years of growth for the first time since 1997 (though at an unimpressive rate of around 1 percent). Koizumi’s reforms were a start, but in comparison to the size of the country’s problems they were humble. He did little more than slow Japan’s descent. Though he shrank budget deficits during his term, he did not manage to bring them back down even to 1995-1996 levels, and national debt continued to grow (though at a much reduced rate).

The Koizumi era appeared to mark Japan’s recovery from the lost decade — but the financial system was never restructured, repeatedly high public deficits crowded out private investment, and the rising number of retirees drawing on pensions and health care promised to consume more and more of the country’s private wealth. Japan was not likely to rebound easily from its economic and fiscal woes even if the economy had not begun to decelerate again in 2007, following a U.S. slowdown. The year 2008 saw the onset of recession at home, massively amplified by financial turmoil in the United States’ that triggered a global recession.

A Stratfor Intelligence Report.
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