Japan Lost Decades

Japan’s economy is the world’s third-largest economy by GDP after the US and China. However, the country has been experiencing deflation since 1991. How can a country be experiencing low price levels for more than 20 years and how does this affect its economy? How did this happen? In this article, we will look at the cause of Japan’s deflationary spiral and how despite the government’s aggressive policies, Japan's economy still can’t seem to get rid of deflation.

Understanding Deflation and Japan’s Lost Decades

First, let us quickly recap our understanding of deflation before we see how it relates to Japan's economy.

Deflation can be caused either by a fall in aggregate demand (AD) or a rise in aggregate supply (AS)

Falling AD

As you can see in the figure below, a decrease in aggregate demand causes prices to fall from P1 to P2 and real GDP also falls.

Figure 1. Deflation when AD falls, StudySmarter Originals

The decrease in AD could be caused by a number of factors:

• Increased consumer saving. An increase in consumers' marginal propensity to save (MPS) results in a fall in consumption, which causes AD to fall.
• Tight monetary policies. Higher interest rates deter consumers and businesses from borrowing. Less money is being borrowed to finance spending, causing consumption to decrease and thus AD falls too. With higher interest rates, consumers gain more by saving and so they will consume less.
• Reduced government spending. As government spending is a component of AD, ceteris paribus, a reduction in government spending will cause AD to fall.

Rising AS

As you can see in Figure 2, an increase in aggregate supply will cause prices to fall from P1 to P2, but real GDP increases from Y1 to Y2.

Figure 2. Deflation when AS rises, StudySmarter Originals

The increase in AS could be caused by a number of different factors:

• Increase in productivity. The more productive an economy is, the more goods will be produced. This could be due to a more efficient production process or workers who become more skilled.
• Improved technology. Technological improvements shift the AS curve to the right because production will speed up. More can be produced with the same amount of resources in time.
• Lower production costs. When costs are cheaper, more goods and services can be produced shifting the AS curve to the right.

Deflation caused by these factors might not cause governments to worry because the economy is still able to grow.

However, constant deflation is worrying to an economy because it could lead to:

• Delayed consumer spending. Consumers hope that prices will reduce even further, so they delay spending. This causes AD to fall even further and economic growth also shrinks.
• Debt increases in real value. Deflation makes the real value of money increase. Debtors now struggle to repay debts, so consumers have to spend a larger proportion of their income to repay debts. Less money is left for consumers to spend on other goods and firms have less money to invest. For governments, it is now harder to reduce their debt to GDP ratio.

Without any intervention, deflation causes more deflation, and this is known as the deflationary spiral.

As you can see in Figure 3, a deflationary spiral is a repetitive cycle consisting of falling prices and low wages that ultimately lead to a fall in AD. Falling prices cause consumers to delay their spending adding more deflationary pressure on the economy.

During a period of constant deflation, banks are less willing to lend, further causing a fall in spending, investment and confidence. The cycle continues further plummeting AD. Eventually, an economy will experience a recession or even a depression if not corrected. This was the case with Japan’s economy beginning in 1991.

Figure 3. Deflationary spiral, Alanna Odagbu. Created with icons from Flaticon.com - StudySmarter.

Japan’s Lost Decades: A Summary

Japan’s deflationary spiral first began with a boom in the real estate market. Speculation and low-interest rates sparked the high valuations of property and public companies. As always, such booms are unsustainable, so to control speculation and prevent the pop of this bubble, the Bank of Japan (BoJ) increased interest rates. This policy caused the burst of the bubble and Japan’s stock market crashed. Many borrowers couldn’t pay their debts that were backed by speculative assets. This resulted in a debt crisis.

Japan’s economy was sent into a period known as the ‘lost decades’. Economic growth stagnated for 10 years, and deflation took over. The Japanese property market never returned back to its pre-boom levels.

Between 1991 and 2010, Japan’s GDP growth averaged around 0.5%. From 2011 to 2019, the Japanese economy grew by just under 1%.¹

Causes of Japan’s lost decades: The Liquidity Trap

Different economists point to different causes of Japan’s prolonged slow economic growth and deflation.

Keynesian economist, Paul Krugman blames Japan’s liquidity trap.

He believes that Japan was stuck in a liquidity trap. As Japan has an ageing population that has a high marginal propensity to save (MPS), and consumer confidence was continually falling, the saving and lower spending made the economy grow even slower.

Other economists believe that the issue began with Japan’s monetary policy prior to and during the lost decades. They believe that it wasn't accommodating and was too restrictive to kick start economic growth.

Policies the Japanese government implemented to revive the economy

To revive the Japanese economy, the Japanese government tried many different policies.

The government started by lowering interest rates, but this had no effect on consumers and businesses. So, the Japanese government tried to reflate the economy by increasing the money supply, which is also known as quantitative easing.

The central bank buys back government and corporate bonds from financial institutions. Commercial banks have more cash reserves which allow them to give out more loans at cheaper rates to consumers and businesses. Consumers and businesses take advantage of cheaper loans to finance their spending or investments, thus increasing aggregate demand (AD), and increasing economic growth.

This is what the Bank of Japan did. However, when a central bank injects money into the financial system, commercial banks have more money to hand out, but they must be willing to lend that money out.

Banks in Japan, however, weren’t willing to lend out the money they had. This led Japan to experience a credit crunch.

Similar to a liquidity trap, a credit crunch also results in deflation. Less lending means that consumers and businesses are unable to borrow to finance their spending. This causes prices to fall because of the decrease in consumption and investment. Instead of Japan’s economy bouncing back, it worsened.

Japan's Lost Decades: Solutions

The general consensus among economists was that the Japanese government should've acted quickly if they were to avoid such long periods of deflation and low economic growth. However, let's consider two other policies the government introduced to help solve Japan's lost decades:

1. Increasing women participation in the workforce. This might seem like an odd aim, but what Japan's government want to do is increase the overall participation in the workforce. When more people in the economy are working, productivity increases and economic growth does too.
2. Corporate governance code. Corporate culture in Japan places the interest of management and employees ahead of shareholders. This often means that revenue is held as cash rather than being invested. The introduction of this corporate governance code helped boost capital efficiency and investment levels in corporations. Efficiency and investment help boost the economy, driving Japan away from deflation and slow economic growth.

These solutions along with many others did see Japan's economy grow, and it was on the way to recovery.

Effects of the Lost Decades on the Japanese Economy

The liquidity trap, credit crunch, and low consumer and business spending all impacted the Japanese economy.

Over the period 1995 to 2007, GDP in Japan fell from $5.54 trillion to $4.58 trillion.² Real wages fell and interest rates still remain low at -0.10%.

The Covid-19 pandemic hasn’t helped Japan’s deflation and low and slow economic growth. The country’s GDP contracted by 7.9% during the summer of the pandemic.³ Consumer prices fell by 0.9% and continued to fall during 2021.

That is why the years 1991 to the present are known as Japan's lost decades.

Lessons Learned from Japan's Lost Decades

Japan’s lost decades have provided many economic lessons for us:

• Central banks must act quickly: the Bank of Japan’s hesitancy to act caused a crisis of confidence. The slow reaction caused the problems to be exaggerated and resulted in long periods of low and slow economic growth.
• Lowering interest rates isn't always the answer: in the case of low consumer and business confidence, lowering interest rates in Japan had no effect on their spending. Central banks must use other monetary and fiscal policies to encourage and boost economic activity.
• Negative interest rates aren’t easy to quit: the Bank of Japan cut interest rates below zero to stop the deflationary spiral. This was implemented as a short term policy, but Japan is unable to increase interest rates, so they will continue to remain below zero.

Japan’s lost decades is a good economic case study to remember for your exams. It can be applied to many economic topics like deflation, the liquidity trap, and monetary policies.

Sources

1. World Bank, ‘GDP growth (annual%) Japan’, 2019.

2. World Bank, ‘GDP (Current US $) Japan, 2020.

3. Trading Economics, ‘Japan GDP Growth Rate’, 2022.