Japan's Deleveraging since the 1990s and the Bank of Japan's Monetary Policy: Some Comparisons with the U.S. Experience since 2007

This paper discusses the backgrounds for the stagnant behavior of the Japanese economy during the last two decades and the failure of the Bank of Japan (BOJ) to turn the economy around. I argue that the policy authorities did not act quickly enough to mitigate the pain of the deleveraging process in the aftermath of the burst of land and stock price bubble in the early 1990s. Thus, the process became overly severe and protracted. The economy increasingly became vulnerable to negative external shocks and the decline in its population. Use of non-conventional monetary policy measures after deflationary expectations became entrenched substantially weakened their power to stimulate the economy. The U.S. economy since 2007 has exhibited many of the features seen for the Japanese economy during the last two decades; hence, the talk of the Japanization of the U.S. economy. There are, however, many dissimilarities as well as similarities between the two episodes. These are also discussed along with the analysis of Japan's two lost decades.Popular discussions of Japan's stagnation often focus on persistent deflation. Figure 1 shows core CPI inflation and a representative property price index for Japan and the U.S. since the peak of property prices, with the peak (T=0) assumed to be 1990 for Japan and 2006 for the U.S. In addition, it also plots investment in structures relative to GDP in Japan. Inflation in Japan has been in negative territory since 1998.1 There has been, however, no tendency for the deflation to accelerate. The cumulative decrease in the index since the late 1990s has been only about 5%. Thus, the classic debt-deflation type dynamic has not been a major cause of economic stagnation. In contrast, declines in property prices in Japan since the peak has been large and protracted-cumulating in a 60% decline at the time of writing. They led to significant deleveraging by financial institutions and non-financial corporations, which put downward pressure on aggregate demand for goods and services, especially, investment in structures, the component of aggregate demand most sensitive to property prices. The figure shows that its movements have been highly correlated with those of property prices.2 As may be seen from the figure, this component of aggregate demand alone subtracted about 0.4% per year from GDP growth during the 1990s. Such a negative feedback loop among asset prices, economic activity and, as we discuss below, financial instability has been the key feature of Japan's stagnation. It is also interesting to note that both CPI inflation and property prices in the U.S. since the recent financial crisis have followed closely that of Japan in the 1990s, but inflation has so far avoided plunging into negative territory. Adjustment in asset prices and real investment were to some extent inevitable given the extent of the excesses created during the bubble period. The deleveraging process, however, became extremely protracted as a result of a forbearance game played by policymakers and financial institutions. Banks kept lending for a while to zombie companies in order to avoid recognition of losses on their balance sheets, and the authority stayed away for years from making the tough decision to recapitalize the banks. This resulted in a huge buildup of bad loans and eventually in a serious credit crunch in the late 1990s, which aggravated the declines in asset prices and deleveraging by banks and nonfinancial corporations. Banks increasingly became risk averse and stopped lending to risky, but promising projects. The economy slowly, but steadily lost momentum and could not grow out of the negative shocks generated by external financial crises in the late 1990s and 2000s, and the declines in its population that started in the 2000s. Deflation of the general price level did play a part in this process as well. It has hindered the effectiveness of monetary easing. This is ironic because monetary policy normally is a tool for avoiding deflation. Either the deleveraging forces outweighed the capacity of monetary policy to stimulate the economy or the BOJ easing came a bit too late. The BOJ tried to reverse the disinflation trend with fairly aggressive rate cuts - a conventional monetary policy tool-- and brought the policy rate to near zero by late 1995, effectively hitting the zero lower bound (ZLB) constraint on interest rates. Deflation, however, developed in response to economic weakness. The real interest rate has stayed at higher levels than desirable, and undermined the power of a zero interest rate to stimulate the economy, although it did not throw the economy into a deflationary spiral. Since the late 1990s, the BOJ has adopted a variety of non-conventional monetary policy measures. They have supported the financial system and prevented deflation from becoming worse, but have not turned the economy around. As I argue below, non-conventional measures work by reducing risk premiums and long-short interest rate spreads. The long period of economic stagnation had lowered these spreads to minimum levels and limited the effectiveness of such measures as was the case for conventional measures. In the following I will describe in more detail the deleveraging experience in Japan and then turn to discussing the experience of the BOJ to turn the economy around. Comparisons with the U.S. experience since 2007 are offered at each stage of the discussion