The morning after: explaining the slowdown in Japanese growth in the 1990s

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Abstract

This paper uses a VAR to investigate four possible explanations of the extended slump in Japanese economic activity over the 1990s: the absence of bold and consistent fiscal stimulus; the limited room for expansionary monetary policy due to a liquidity trap; overinvestment and debt overhang; and disruption of financial intermediation. The results indicate that all of these factors played a role, but that the major explanation is disruption in financial intermediation, largely operating through the impact of changes in domestic asset prices on bank lending.

Introduction

What explains the Japanese economic slump of the 1990s? This question has gained increased importance with the economy’s recent plunge economy into recession. Before the latest bout of weakness, many regarded the downturn in activity which followed the bursting of the asset price bubble in 1991 as following a normal cyclical pattern, although somewhat longer than usual due to the size of the asset deflation. In particular, the nascent signs of economic expansion through much of 1996 and early 1997 appeared to confirm that the economy was regaining its balance (albeit assisted by some demand shifting in anticipation of the consumption tax hike in April 1997), and could be expected to recover steadily over the next few years.

Rather than recovering, however, in 1997 the economy entered into its first recession since the early 1970s. Combined with the earlier weakness, this means that Japan has now been in a slump for almost eight years. Growth has averaged only 3/4 percent per annum over this period, and the output gap is estimated to have moved from plus 4 1/2 percentage points of potential output in late 1990 to minus 7 1/2 percent by early 1998. This makes Japan’s current situation the most serious economic slowdown experienced by any major industrial country since the early 1950s. Furthermore, this slump has occurred despite significant counter-cyclical policies, involving a considerable expansion in the fiscal deficit (largely through packages aimed at fiscal expansion) and reducing the overnight call rate to its effective floor in early 1999.

The proximate causes of the initial slowdown in output in the early 1990s are generally agreed. In mid-1989 the Bank of Japan started to raise interest rates so as to cool the asset price inflation which had started in the mid-1980s. The tightening of monetary policy pricked what was later identified as an asset price bubble, and stock and land prices started falling rapidly. Just as the run up of asset prices in the upswing of the bubble had encouraged domestic spending and driven the economy significantly above potential output, so the collapse of asset prices lowered domestic demand and output, and the economy grew at an annual rate of 1 percent or less through 1994.2

As the Japanese slowdown has turned from temporary slowdown to slump, however, its causes have come under further scrutiny, and a number of competing hypotheses have emerged. They fall into four main categories. The first is that the slump reflects inadequate policy responses, particularly as regards fiscal expansion (Posen, 1998). Although the Japanese government has unveiled a number of fiscal packages aimed at reviving the economy over the 1990s, the argument goes, most of these packages contained limited amounts of “real water” (i.e., measures which have a direct impact on activity). The main exception was the September 1995 stimulus package, to which the economy responded vigorously until the recovery was derailed by a switch to fiscal contraction in early 1997.

An alternative view, which focuses on monetary policy, holds that Japan is stuck in a liquidity trap (Krugman, 1998)3. Consumption is historically low in Japan, creating a high structural saving rate, which was offset during the golden years by high investment. However, a slowdown in anticipated growth has led to a sufficiently large imbalance between saving and investment that the equilibrium real interest is now negative. The anti-inflationary reputation of the Bank of Japan is sufficiently strong that expectations of future inflation are low. As a result, despite record low nominal short- and long-term interest rates, the monetary authorities are unable to reduce the real interest rate sufficiently far to bring the economy back to full employment.

A third view holds that the slowdown reflects the low rate of return to capital due to over investment (Ando, 1998). Japan is in a vicious cycle, in which past over investment is reducing the rate of return on capital, which both lowers current investment and spurs saving, as consumers fail to achieve their desired level of asset accumulation. The usual wealth effects which cause cyclical downturns are being elongated by the inefficiency of the corporate sector, exacerbated by significant corporate debt overhang which further reduces the incentive to invest. In the absence of wealth-creating investment opportunities, the economy will remain depressed4. This explanation gives primacy to wealth effects (largely through the stock market, as land prices have divergent effects on property owners and those with no land).

A final view holds that the slump reflects problems with financial intermediation. Banks play a much more important role in financial intermediation in Japan than in “Anglo-Saxon” financial systems such as the United States or United Kingdom5, and are the main providers of loans to small- and medium-sized enterprises (SMEs). During the asset price bubble, the banks lent large amounts of money to firms using land as collateral. With the steady fall in land prices since the bursting of the asset price bubble, many of these loans have stopped performing. The bubble in stock prices further exacerbated these effects by first boosting and then reducing bank capital6. Lax accounting rules and a permissive regulatory environment have allowed banks to survive, but with only limited ability to lend to companies due to the competing needs of writing-off bad loans and maintaining capital adequacy ratios7.

These explanations are not mutually exclusive. Indeed, it would be unlikely that a slowdown of the type being currently experienced in Japan had a single cause. However, each explanation points to a different set of variables — fiscal, monetary, stock prices and land prices plus bank loans — as the major factor explaining the current slump8.

This paper examines the reasons for the slowdown in activity in Japan empirically using a vector-autoregression (VARs) involving the main competing explanations: fiscal policy, monetary policy (including the exchange rate), domestic asset prices and lending to the private sector. A VAR was chosen for a number of reasons. It allows the variables underlying the alternative explanations to be incorporated into a single empirical approach. For example, their impacts on output can be compared using the relevant impulse response functions. In addition, estimating a system of equations allows interactions between different variables to be examined, in particular the relationship between domestic asset prices, bank lending, and output. Finally, the historical role of each variable can be examined using the decomposition of past movements in output implied by the VAR.

Section snippets

Econometric analysis

This section reports the results from VARs using output, two fiscal variables (the structural general government deficit is divided into direct government spending and taxes net transfers9), two monetary variables (the real short-term interest rate and the real exchange rate), two domestic asset prices (real stock prices and real land prices), and financial intermediation. (Data sources are provided in the

Conclusions

This paper has examined the reasons for the marked slowing of growth in Japan in the 1990s in the context of a VAR analysis which includes the impact of fiscal policy, monetary policy, domestic asset prices, and bank loans. The results are used to attempt to differentiate between a number of alternative explanations of the current slump, including the absence of bold and consistent fiscal stimulus, the limited room for expansionary monetary policy due to a liquidity trap, asset deflation

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An earlier version of this paper was given at an NBER Japan Project conference held in Tokyo, October 29–30, 1998. The present draft has benefited from comments by conference participants, particularly Valarie Ramey, Andy Rose, Anil Kashyap, and two anonymous referees, as well as colleagues at the IMF. Youkyong Kim who provided excellent research assistance. The views contained are those of the author, and do not necessarily represent those of the IMF.

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