The Lost Decade: Lessons From Japan’s Real Estate Crisis

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The Lost Decade: Lessons From Japan’s Real Estate Crisis

What Was Japan’s “Lost Decade” Real Estate Crisis?

Free market economies are characterized by the presence of economic cycles. Economic cycles are periods of varied economic growth and contraction, as measured by the gross domestic product of a nation. Economic cycles may last for a number of years (GDP).

The length of economic cycles, which may be broken down into development and contraction phases, can be somewhat variable. The traditional definition of an economic recession is a period of two or more consecutive quarters in which GDP is below its previous level. Long stretches of economic contraction are frequently referred to as economic depressions. A prime example of an economic depression is the Great Depression of the 1930s.

Japan experienced what is known as “Japan’s Lost Decade” between the years 1991 to 2001. This was a time of economic stagnation as well as price deflation. During this time period, economic growth occurred in Japan; however, it occurred at a substantially slower pace than it occurred in the rest of the industrialized world. During this time period, the economy of Japan was plagued by a credit crisis as well as a liquidity trap. Both of these problems were caused by a lack of credit.

Key Takeaways

  • Unhappily, re-inflation is difficult to achieve, especially in circumstances when banks are unwilling or unable to lend. Milton Friedman, a prominent American economist, put out the idea that a liquidity trap may be sidestepped by going through financial intermediaries and giving money to consumers in the form of spending money directly. “Helicopter money” is the name given to this practice since it is possible for a central bank to distribute funds by dropping them from a helicopter. 8
  • Unhappily, re-inflation is difficult to achieve, especially in circumstances when banks are unwilling or unable to lend. Milton Friedman, a prominent American economist, put out the idea that a liquidity trap may be sidestepped by going through financial intermediaries and giving money to consumers in the form of spending money directly. “Helicopter money” is the name given to this practice since it is possible for a central bank to distribute funds by dropping them from a helicopter. 8
  • Unhappily, re-inflation is difficult to achieve, especially in circumstances when banks are unwilling or unable to lend. Milton Friedman, a prominent American economist, put out the idea that a liquidity trap may be sidestepped by going through financial intermediaries and giving money to consumers in the form of spending money directly. “Helicopter money” is the name given to this practice since it is possible for a central bank to distribute funds by dropping them from a helicopter. 8
  • Unhappily, re-inflation is difficult to achieve, especially in circumstances when banks are unwilling or unable to lend. Milton Friedman, a prominent American economist, put out the idea that a liquidity trap may be sidestepped by going through financial intermediaries and giving money to consumers in the form of spending money directly. “Helicopter money” is the name given to this practice since it is possible for a central bank to distribute funds by dropping them from a helicopter. 8

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What Is a Liquidity Trap?

Understanding Japan’s “Lost Decade” Real Estate Crisis

In the 1980s, Japan’s economy was the envy of the world because it grew at an average annual rate (as measured by GDP) of 3.89%, which was far higher than the rate of growth in the United States, which was 3.07%. 1 Despite this, Japan’s economy struggled throughout the 1990s due to a number of factors.

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The bubbles that had formed in Japan’s real estate and stock markets began to break in the fall of 1989. Prices of equities dropped by sixty percent between late 1989 and August 19922, and the value of land continued to decline throughout the 1990s, reaching an astounding seventy percent less by the year 2001. 3

Because of this, the economy of Japan grew at a pace of 1.14% per year from 1991 to 2003, which lagged far behind the rates of expansion seen in other industrialized nations. 1

The Bank of Japan’s Interest Rate Mistakes

It is generally accepted that the Bank of Japan (BoJ), which is Japan’s central bank, made a number of mistakes that may have made the negative effects of the bursting of the equity and real estate bubbles more severe and lasted for a longer period of time.

As an example, monetary policy was irregular, and the Federal Reserve was concerned about rising prices, sometimes known as inflation, as well as the rising value of assets. It is possible that the Bank of Japan’s decision to tighten monetary policy in the late 1980s was a contributing factor in the bursting of the equity market bubble. The Bank of Japan continued to raise interest rates despite the precipitous drop in stock prices because it was concerned about the continued growth in the value of real estate. 4

Increasing interest rates were successful in putting a stop to soaring land prices, but they were also responsible for sending the whole economy into a spiral. In 1991, as a result of falling equity prices and falling land values, the Bank of Japan made a sudden shift in policy and cut interest rates. 5 However, it was already too late; a liquidity trap had already been constructed, and a credit crisis was approaching in the near future.

The Liquidity Trap

A liquidity trap is an economic condition in which families and investors hold cash on hand, either in short-term accounts or physically. This may happen either physically or in short-term accounts.

They may do so for a variety of reasons, such as a lack of trust in their ability to generate a higher rate of return by investing, a belief that deflation, or decreasing prices, is on the horizon (cash will gain in value compared to fixed assets), or a belief that deflation already exists. These are just some of the potential motivations behind their actions. The beliefs of households and investors become a reality due to the intimate connection that exists between these three factors.

In a liquidity trap, the use of historically low interest rates as a tool of monetary policy is rendered ineffective. Spending and investment is not done by individuals or investors. They believe that goods and services will be sold at reduced prices the following day, and as a result, they put off purchases in the hope of earning a greater rate of return by keeping their money in savings rather than putting it to work. However, despite maintaining a discount rate of 0.5% during much of the decade of the 1990s, the Bank of Japan was unable to jumpstart the Japanese economy as deflation persisted. 6

Breaking out of a Liquidity Trap

It may be possible to escape a liquidity trap via the implementation of fiscal and monetary policies; but, individuals and businesses will need to be prepared to spend and invest.

Fiscal Measures

One method to encourage them to do so is via the use of fiscal policy. The reduction of tax rates, the issuance of tax refunds, and an increase in government spending are all examples of ways that governments might provide money directly to consumers.

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Japan investigated a variety of potential courses of action for its fiscal policy as it sought a way out of its liquidity bind. On the other hand, there is a widespread presumption that these limits were poorly administered, resulting in money being squandered on inefficient public works projects and given to businesses that were unsuccessful. The vast majority of economists are of the opinion that money must be efficiently dispersed for the fiscal stimulus strategy to be successful. Putting money directly into the hands of consumers gives them the ability to decide where to spend and invest it, which in turn gives the market more flexibility.

Increasing Money Supply

To “re-inflate” the economy by increasing the actual quantity of money rather than concentrating on nominal interest rates is an additional strategy for evading the liquidity trap and freeing oneself from its shackles. By engaging in open-market operations, a central bank has the ability to inject money into an economy without taking into account an established interest rate goal (such as the fed funds rate in the United States).

When a central bank purchases a bond, it is basically exchanging the bond for cash, which results in an increase in the amount of money in circulation. The practice is known as “monetization” of the debt. (When a central bank monetizes debt, it does so without taking into mind a target interest rate; in contrast, open-market operations are used to reach and maintain target interest rates.)

In 2001, the Bank of Japan began targeting the amount of money in circulation rather than interest rates, which was beneficial in reducing the severity of deflation and fostering economic growth. 5 When money is injected into the financial system by a central bank, not only do banks immediately have access to more funds, but they also have to be prepared to lend those funds to customers. This brings us to the second problem facing Japan, which is a crisis in the credit market.

The Credit Crunch

A credit crunch is a scenario that arises in the economy when the terms under which banks lend money are made more stringent, and the majority of the time, banks do not lend. There are many different reasons why financial organizations may choose not to lend money, including the following:

  1. Unhappily, re-inflation is difficult to achieve, especially in circumstances when banks are unwilling or unable to lend. Milton Friedman, a prominent American economist, put out the idea that a liquidity trap may be sidestepped by going through financial intermediaries and giving money to consumers in the form of spending money directly. “Helicopter money” is the name given to this practice since it is possible for a central bank to distribute funds by dropping them from a helicopter. 8
  2. Unhappily, re-inflation is difficult to achieve, especially in circumstances when banks are unwilling or unable to lend. Milton Friedman, a prominent American economist, put out the idea that a liquidity trap may be sidestepped by going through financial intermediaries and giving money to consumers in the form of spending money directly. “Helicopter money” is the name given to this practice since it is possible for a central bank to distribute funds by dropping them from a helicopter. 8

A free market economy cannot function without the calculated taking of risks and the availability of funding. When capital is invested, this leads to the creation of employment, an increase in consumer spending, and the discovery of ways to be more efficient, which in turn results in greater productivity and economic growth. On the other side, when banks are reluctant to provide credit, it is difficult for the economy to flourish.

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A credit crisis brings about deflation for the same reason as a liquidity trap does: it prevents banks from lending money, which in turn brings about deflation. As a consequence of this, both individuals and businesses are unable to spend money, which leads to a fall in prices.

Solutions to a Credit Crunch

Because financial institutions become reluctant to provide loans, a credit crunch has the same effect as a liquidity trap in that it results in falling prices. When there is less lending going on, there is therefore less new money being added to the economy. As a direct result of this, despite the historically low interest rates, people and businesses are unable to borrow money and spend it, which further drives down prices. The following is a list of possible solutions to a credit crisis that may be considered.

Bank Restructuring

During the financial crisis that hit Japan in the 1990s, Japanese banks were cautious to take any losses on their books. The banks did not reorganize their balance sheets despite the fact that public subsidies were available to assist them in doing so. This was due to the social stigma that came with acknowledging losses that had been concealed for a long time, as well as the fear of losing control to foreign investors. 7

In order to emerge from a credit crisis, it is customarily required that bank losses be recognized, and the financial system must be open and accessible. Additionally, financial institutions have to have trust in their own skills to assess and mitigate risk.

Fighting Deflation

As a result of falling asset prices, households and investors save money with the expectation that it will be worth more in the future than it is right now. This results in a whole host of problems. As a direct result of this, you run the risk of falling into a liquidity trap. When the value of an institution’s assets goes down, so does the value of the collateral that supports its loans, resulting in losses for the institution. When financial institutions suffer losses, they cut down on lending, which may lead to a crisis in the credit market.

In most circumstances, inflation is a cause for worry on the economic front since it tends to drive up prices and lessen the purchasing power of consumers. However, re-inflation could be necessary for Japan if it wants to prevent prolonged periods of slow economic growth like those that occurred in the 1990s. In an economy characterized by steady and moderate levels of inflation, consumers and businesses may get encouragement to spend rather than hoard cash.

Helicopter Money

Unhappily, re-inflation is difficult to achieve, especially in circumstances when banks are unwilling or unable to lend. Milton Friedman, a prominent American economist, put out the idea that a liquidity trap may be sidestepped by going through financial intermediaries and giving money to consumers in the form of spending money directly. “Helicopter money” is the name given to this practice since it is possible for a central bank to distribute funds by dropping them from a helicopter. 8

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