Japan’s Bubble

Economics 285

Fall 2000

Prof. Michael Smitka

Two key causes

• Management geared for high growth

Interacting with

• Macroeconomic policy mistakes

As a result...

• Interest rates were 0%

• Firms overborrowed• Projects that earned a mere 0% passed muster

• Banks overlent• Collateral or track records were enough

• Asset prices proved unrealistic• Projects didn’t earn 0% ex post

• Banks couldn’t collect on their loans

Japan’s Case- high-growth underpinnings of a bubble -

• Management had no need for financial controls– project selection was easy

– failure was hard / recessions were few & far between

• But pricing long-lived assets was hard– Real estate grew faster than economy

– Stock prices grew faster than economy

– Growth industries grew very fast indeed!!

Why the “bubble”?- the lending side -

• Change undermines rules of thumb for banks

– Change in types of industry / borrowers

– Change in strategic environment / flow of funds

– Change in regulatory environment

• Mistakes are made …

– … and a shock produces crisis

Growth Dynamics

• Transition out of agriculture– Fast productivity growth in industry– Urbanization!

• Household formation

• Infrastructure, housing

• But it’s a one-time transition!– And eventually ends

Slowdown

• Industry no longer needs funds• 1970s: 10% of GDP swing in under a decade!!

• But households keep saving• Past savings were when incomes were low

• So accumulated wealth was modest

• So people needed to keep saving to fund old age

• Who then will borrow this funds?• Paradox of Thrift!!

Shifts in Japanese Savings Flows

1961-65 1966-70 1970 1971-75 1976 1976-80 1981-85 1986-92I (business) 17.0 16.7 19.6 15.2 8.8 8.3 8.5 11.1

S (business) 5.2 8.7 10.7 4.0 0.8 2.7 2.9 2.3S - I -11.7 -8.0 -8.9 -11.2 -8 -5.7 -5.5 -8.8

I (household) 2.8 4.3 4.5 4.0 7 6.1 2.8 1.3S (household) 12.1 12.0 12.8 16.4 19.9 17.1 13.6 11.6S - I 9.2 7.7 8.3 12.4 12.9 11.0 10.8 10.3

S - I Private -2.5 -0.3 -0.6 1.2 4.9 5.3 5.3 1.5

I (Center 5.5 5.7 5.7 6.9 6.5 7.5 6.8 6.4S & Local) 6.9 6.6 7.6 6.7 2.3 2.4 3.6 8.3T - G 1.4 0.9 1.9 -0.2 -4.2 -5.1 -3.2 1.9

T - G + S - I -1.1 0.6 1.3 1.0 0.7 0.3 2.0 3.4

The Primary Shock1970 vs 1976

• Corporate investment fell 10% of GDP

• Savings rose!

• Banks were left to scramble

Interregnum

• Japanese fiscal deficits– created a new borrower for banks– MOF policy stopped that by 1982

• Reagonomics: US consumption boom– Export-led growth from 1982– Appreciation / Plaza Accord stopped that from

1986

Secondary Shock

• Bad macro policy– Easy money from 1986– “Japan as Number One” psychology

• Just as banks sought new borrowers– Real estate … and more real estate!– Small business– Also international loans

0.0%

1.0%

2.0%

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6.0%

10/22/834/22/84

10/22/844/22/85

10/22/854/22/86

10/22/864/22/87

10/22/874/22/88

10/22/884/22/89

10/22/894/22/90

10/22/904/22/91

10/22/914/22/92

10/22/924/22/93

10/22/934/22/94

10/22/944/22/95

10/22/954/22/96

10/22/964/22/97

10/22/974/22/98

10/22/984/22/99

10/22/994/22/00

10/22/00

BOJ Discount Rate Target Call Rate

Nov 1, 1986following

"Plaza Accord"

Feb 23, 1987

May 31, 1989first anti-"Bubble"

rate hike

Aug 30, 1990

Jul 1, 1991interest rates

kept high for 18 months following

the "bubble's" peak

Sept 8, 19950.5%

discount rate!!

Feb 12, 1999"Zero InterestRate Policy"commences

Christmas 1989rate hike

– "bubble" peaks –

Shocks, continued

• “Bubble” economy – Stock prices doubled– Urban real estate prices rose even more

• Fiscal policy mistakes accentuated– On-again, off-again policy built up debt

• Regulatory policy errors accentuated– Banks allowed to make more bad loans

Stock market- today’s market is no higher than in 1986!! -

Closing Price, Nikkei 225

10000

15000

20000

25000

30000

35000

40000

8/4/862/4/878/4/872/4/888/4/882/4/898/4/892/4/908/4/902/4/918/4/912/4/928/4/922/4/938/4/932/4/948/4/942/4/958/4/952/4/968/4/962/4/978/4/972/4/988/4/982/4/998/4/992/4/008/4/00

Peak = 38957Dec 31, 1989

Today's Close14,988 is 37% lower than 10 years ago, and 61.5% below peak!

Today’s Dilemmas

• Monetary policy doesn’t work• Interest rates can’t be pushed below 0%

• But prices are falling ==> real rates are positive

• Banks (rightly) fear bad assets• Outstanding loans are shrinking!

• Money growth is of cash…

• “Liquidity Trap”• If monetary policy doesn’t work, how about fiscal??

ZIRP

Interest Rates

Current lending rates:Short-term prime rate: 1.5%Long-term prime rate: 2.25%

Credit Creation & Money

Fiscal Policy

• Repeated fiscal packages• Short-term policies are discounted by consumers

• Higher temporary incomes are counteracted by stagnant consumption

• Credibility lost

• Permanent tax cuts??• Huge deficits already - 7% of GDP

• Demographic “old age” boom looms

• No room left to add fiscal stimulus?

Predictions

• Japan will underperform growth elsewhere

• Safety valve: exports?• Real wages / labor costs remain high

• Must have counterpart capital flows

• Global capital markets are crippled• Can’t sustain large trade surpluses / capital deficits

• Firms engaging in DFI - doesn’t help domestic GDP

• J will permanently underperform OECD