Japan's Lost Decade
What is Japan's Lost Decade?
Japan's lost decade was the long stagnation after its asset bubble burst, when debt-heavy firms repaid loans instead of investing and interest rates hit zero.
Japanese land and share prices reached extraordinary heights at the end of the 1980s, then fell for years, and the economy grew barely at all through the 1990s. The damage was to balance sheets: firms had bought assets at bubble prices with borrowed money, so when values collapsed their debts exceeded their assets and they spent years paying loans down instead of investing. That is why cutting interest rates did so little, since borrowers were not looking to borrow at any price. Banks with impaired capital kept rolling over loans to insolvent firms to avoid recognizing losses, which tied up credit that healthier companies could have used. With the policy rate near zero and prices drifting down, the real interest rate stayed positive and conventional monetary policy ran out of room, the situation known as the zero lower bound.
Japan's Lost Decade: a worked example
The zero lower bound is easiest to see in the real interest rate. Suppose the central bank cuts its policy rate all the way to 0 percent while consumer prices fall by 1 percent a year. The real rate equals the nominal rate minus inflation, and inflation here is negative one, so subtracting it adds: borrowing still costs 1 percent in real terms and the bank has nothing left to cut. Falling prices also raise the real burden of existing debt, since a firm owing 100 million yen owes a sum that buys 1 percent more goods each year while its revenue shrinks. Paying that debt down looks safer than investing, even when loans are nearly free in nominal terms.
The mistake students make with japan's lost decade
Students assume that if a central bank pushes rates to zero, borrowing must boom. When firms are trying to shrink debts because their assets are worth less than what they owe, the price of credit is not what is stopping them, so cheap money sits unused. The other error is calling the whole period a depression. Output stagnated and prices drifted down, but unemployment stayed low by international standards, which is why it is described as stagnation rather than collapse.
Japan's Lost Decade questions
What is a balance sheet recession?
A balance sheet recession is a downturn in which firms and households cut spending in order to pay down debt after the assets they borrowed against lose value. Because the goal is repairing net worth rather than earning a return, they will not borrow even at very low interest rates. Monetary policy loses traction, which is why fiscal policy is usually proposed as the answer.
Why did low interest rates not fix Japan's economy?
Low interest rates did little in Japan because the problem was a shortage of willing borrowers, not a shortage of cheap credit. Firms with debts larger than their asset values wanted to repay, and banks carrying bad loans preferred rolling them over to admitting the losses. With prices falling, the real cost of borrowing stayed positive even at a zero nominal rate.
Could a lost decade happen elsewhere?
A lost decade can happen anywhere an asset bubble is financed with debt and the resulting losses are left sitting on balance sheets instead of being recognized quickly. Later crises drew on the lesson: central banks moved to near-zero rates faster, bought assets outright, and pushed banks to raise capital and write down bad loans. The Japanese experience is the reason those responses looked obvious the second time.
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