Asset Price Fluctuations,
Structural Adjustments, andSustained Economic Growth:
Lessons from Japan’s Experiencesince the Late 1980s
Kunio Okina and Shigenori Shiratsuka

In this paper, we examine implications of asset price fluctuations andresultant structural adjustments on sustained economic growth, based onJapan’s experience since the latter half of the 1980s. In doing so, we offer
the view that the protracted economic stagnation in Japan can be seen asa result of the incomplete economic adjustments to significant changes inrelative prices, in part triggered by the bursting of the asset price bubble.
Such changes in relative prices include movements in both intertemporaland cross-sectional dimensions, which interacted crucially to lower the
economy’s trend growth. This aspect of Japan’s asset price bubble, with its
consequences for structural adjustments since the 1990s, is importantbecause it illustrates the specific environment in which the Bank ofJapan has to conduct monetary policy: namely, not a standard stabilization policy around a stable growth trend. Rather, it has operated in anenvironment of unanswered policy management questions coupled withhampered sustained growth.
Keywords: Asset price bubble; Relative price changes; Structuraladjustments; Productivity growth
JEL Classification: C43, E44, E52, E58, O47
Kunio Okina: Director-General, Institute for Monetary and Economic Studies, Bank of Japan(E-mail: kunio.okina@boj.or.jp)
Shigenori Shiratsuka: Deputy Director and Senior Economist, Institute for Monetary andEconomic Studies, Bank of Japan (E-mail: shigenori.shiratsuka@boj.or.jp)
This paper, prepared for the 11th international conference, sponsored by the Institute for Monetaryand Economic Studies (IMES), Bank of Japan (BOJ), on July 5–6, 2004, extends part of ourpreliminary draft presented at the European Central Bank (ECB) workshop in December 2003.
We wish to acknowledge helpful comments from Charles L. Evans, Gregory D. Hess, Philip W.
Lowe, Bennett T. McCallum, Maurice Obstfeld, Garry Schinasi, the participants at the BOJ
international conference and the ECB workshop, and staff of IMES, BOJ. We thank Masayuki
Nakakuki, Hiroyuki Oi, and Akira Otani for their assistance. The views expressed in the paper are
those of the authors and do not necessarily reflect those of the BOJ or IMES.
MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004
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143

I. Introduction
In this paper, we examine the implications of asset price fluctuations and resultant
structural adjustments on sustained economic growth, based on Japan’s experiencesince the latter half of the 1980s.
Japan’s experience of the emergence, expansion, and bursting of an asset pricebubble since the latter half of the 1980s is typically seen as an example in which aboom-and-bust cycle of asset prices severely impacts the business cycle. This view,
however, does not capture the full story.1 That is, Japan’s economic predicament in
the 1990s is better understood as a significant downward shift in trend growth,beyond a boom-and-bust cycle, rather than an amplified business cycle alone.
Although the importance of cyclical aspects cannot be denied, further declines in
asset prices after the mid-1990s seem to reflect the downward shift in trend growth
beyond the boom-and-bust cycle of the asset price bubble.
In the late 1990s, excessive optimism, the main feature of a major asset pricebubble, induced businesses to build up their capital stocks, payrolls, and debts to an
extent that would have made sense only in a sustained environment of accelerated
growth. When the bubble burst, however, the ensuing adjustments were all the more
painful and prolonged. At the moment, mild deflation of less than 1 percent per annum
has attracted public attention, but it is asset price deflation, which has continued for
10 years at an annual rate of close to 10 percent, that has likely exerted the mostsignificant pressure on the economy.
We propose the view that the protracted economic stagnation in Japan can be seen
as a result of the incomplete economic adjustments to significant changes in relative
prices, partly triggered by the bursting of the asset price bubble. Such changes inrelative prices occur in intertemporal as well as cross-sectional dimensions. On the one
hand, relative prices in the intertemporal dimension are relative prices between current
and future prices. This is observed as changes in relative prices between consumer prices
and asset prices, as documented by Alchian and Klein (1973). On the other hand,relative prices in the cross-sectional dimension are relative prices across goods andservices as well as factors of production. Moreover, it should be noted that a crucial
interaction arises between intertemporal and cross-sectional relative prices which has
implications for how resources are allocated in the economy.
The above aspect of the asset price bubble, with its consequences for the structuraladjustment since the 1990s, is important because it illustrates the specific environment
in which the Bank of Japan (BOJ) has to conduct monetary policy.2 If a significant
and unforeseen slowdown in the potential output growth rate were due to structuralproblems, monetary policy would inevitably be required to differ greatly fromstabilization policy in normal circumstances.
This paper is organized as follows. Section II reviews asset price deflation in Japanand summarizes discussions on Japan’s economic stagnation. Section III examines
1. See Okina, Shirakawa, and Shiratsuka (2001) for a detailed examination of the emergence and expansion of theasset price bubble in the late 1980s.
2. See the series of our previous studies, including Fujiki, Okina, and Shiratsuka (2001), Fujiki and Shiratsuka (2002),
Okina (1999), and Okina and Shiratsuka (2002, 2003, 2004), for research on Japan’s monetary policy during this period.

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Asset Price Fluctuations, Structural Adjustments, and Sustained Economic Growth: Lessons from Japan’s Experience since the Late 1980s

interpreting the long-lasting stagnation from the viewpoint of misguided relative priceinformation both in the intertemporal dimension and the cross-sectional dimension.
Section IV explores the effects of insufficient structural adjustments on economic
growth, based on the extended framework of growth accounting under factor
market distortions; it also discusses the policy implications of structural adjustments.
Section V offers a concluding discussion.

II. Viewpoints on Japan’s Asset Price Deflation andEconomic Stagnation
In this section, we review the development of asset price deflation in Japan, andsummarize arguments as to what lies at the root of Japan’s economic predicament.
A. Asset Price Deflation and Reduced Growth Trend
Asset prices have continued to decline remarkably for a decade since the bursting of
the asset price bubble at the beginning of the 1990s, while consumer prices haveremained almost constant (Figure 1).
Figure 1 Asset Price Deflation

0.2

1989/IV = 0, in logarithm

0.0
–0.2
–0.4
–0.6
–0.8
–1.0
–1.2
–1.4
–1.6
–1.8

Land prices
Stock prices
Core CPI–2.0
1989 90

91

92

93

94

95

96

97

98

99 2000 01

02

03

04

Note: CPI excluding fresh food is seasonally adjusted by X-12-ARIMA with options of(0 1 2)(0 1 1) ARIMA model and level shifts in April 1989 and April 1997, when
the consumption tax was respectively introduced and subsequently hiked.
Sources: Bank of Japan, “Financial and Economic Statistics Monthly”; Ministryof Public Management, Home Affairs, Posts and Telecommunications,“Consumer Price Index”; Japan Real Estate Institute, “Urban Land
Price Index.”145

Among these developments, mild deflation of less than 1 percent per annum has
attracted public attention. However, we should stress that asset price deflation isdeemed far more significant than mild deflation. Stock prices plunged in the early
1990s and have since followed a downward trend, albeit with continual ups anddowns. Land prices started declining with a two-year lag relative to stock prices, andsubsequently have kept declining at an annual rate of around 10 percent.
In addition, the standard deviation of stock price changes across industries (Figure 2)
initially declined after the bursting of the bubble, while it has begun to increase since1997. Stock prices show more divergent movements since 1997, with a mild downward
trend and some weak cycles. Land prices also show fairly divergent movements by area
and type of usage (Figure 3).
Figure 2 Cross-Sectional Volatility of Equity Prices
Jan. 4, 1968 = 100

12

10

Stdv (left scale)Seven-month moving
average (left scale)
TOPIX (right scale)

3,000

2,500

8

2,000

6

1,500

4

1,000

2

500

0

0
1983 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03 04
Note: “Stdv” is the standard deviation of monthly changes in the Tokyo Stock
Price Index (TOPIX) by industry, categorized by 33 industries.
Source: Tokyo Stock Exchange (http://www.tse.or.jp/english/index.shtml).

146 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Asset Price Fluctuations, Structural Adjustments, and Sustained Economic Growth: Lessons from Japan’s Experience since the Late 1980s

Figure 3 Land Prices
Year-on-year change, percent
50
40
30
20

Commercial (six large urban areas)
Commercial (excluding six large urban areas)
Residential (six large urban areas)
Residential (excluding six large urban areas)
Industrial (six large urban areas)
Industrial (excluding six large urban areas)

10
0
–10
–20
–30
1980 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03 04

Source: Japan Real Estate Institute, “Urban Land Price Index.”

At the same time, trend growth tended to shift downward during the 1990s(Figure 4). The volatility of the output growth rate expanded in the 1990s, comparedwith that in the 1980s. Although some temporary high-growth periods were observed,
such cyclical upturns were not strong enough to lead to self-sustainable growth. The
average duration of expansions was short, and the growth rate declined remarkably, andas a result, the Hodrick-Prescott (HP) filtered trend kinked downward in the 1990s.
As of the writing of this paper, Japan’s economy has entered its third recovery
phase since the bursting of the bubble. The question remains as to whether thecyclical upturn this time will lead to self-sustaining higher growth, which did not
happen during the previous upturns in the 1990s.
B. Two Views on Japan’s Stagnant Economic Conditions
In considering monetary policy management in a period of continuing stagnation, it
is necessary to specify the most significant factor hampering sustainable economic
growth. Broadly speaking, there are two views on this.
One view considers insufficient aggregate demand as the essential problem. The
basis for this view seems to be that, even though there are structural problems, since
the economy will shortly return to a sustainable growth path as insufficient demandis resolved by expanding effective demand, structural policy should be implemented
pending recovery of the economy.
Based on the above view, it is important for Japan’s economy to create effective
demand. In this case, the problem boils down to the question of how economic policy
authorities, especially a central bank, which is bound by the non-negativity constraintof nominal interest rates, can create further effective demand.

147

Figure 4 Trend Growth Rate
[1] Real Output Level
13.3¥ trillions in logarithm
Original SA
HP-filtered

13.2
13.1
13.0
12.9
12.8
12.7
12.6

1982 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03 04[2] Real Output Growth8

Percent

6
4
2
0
–2

Original SA three-quarter
moving average
HP-filtered–4
1982 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03 04
Note: Real GDP on a 93SNA basis. The HP-filtered series is computed for the period
from 1980/I to 2002/III by using the smoothing parameter  = 1,600.
Sources: Bank of Japan, “Financial and Economic Statistics Monthly”; Cabinet Office,“National Accounts.”

Another view regards structural problems as the most important factor. If this is
the case, it is necessary to work steadily toward resolving structural problems to raise
the growth trend.
The list of structural problems in Japan includes rigid corporate governance, inefficiency of the non-manufacturing sector, the issue of nonperforming assets associatedwith the generation and bursting of the asset price bubble, and the savings-investment
imbalance.3 In addition, significant structural changes in the economic environment
also occurred during the 1990s: for example, the changing pattern of the division of
3. See Maeda, Higo, and Nishizaki (2001) for a more comprehensive analysis of structural problems. (Unfortunately,
this paper is available only in Japanese.)

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labor between Japan and its East Asian neighbors, a rapidly aging population, andadvances in information and communications technology.
To resolve the above problems, it is a crucial question whether the government
can continuously implement policy actions consistent with the overall picture ofstructural reform, including resolution of the nonperforming-loan (NPL) problem.
However, it is extremely difficult to fully carry out such structural policies, as they arevery likely to be accompanied by deflationary effects in the short term, even though
positive effects will follow in the medium to long term. Therefore, to execute all thenecessary structural policy measures, an important point at issue is their sequencing:in what order specific policies should be implemented. In this regard, macroeconomic
policy is required to maintain an expansionary stance capable of mitigating thedeflationary effects stemming from the pursuit of structural policies.
Given that mild deflation in Japan is associated with low economic growth, it isundeniable that insufficient aggregate demand was one of the major causes of weak
price development in the late 1990s. However, it should be noted that the nature of
insufficient demand is not just temporal but more persistent. In this case, separationof supply and demand factors in the medium to long term is incredibly difficult
because of their dynamic interaction.4
Notwithstanding which view is valid as to the most significant factor hampering
sustained economic growth, it is hard to deny that structural impediments affect thepersistent economic stagnation seen in Japan and that expansionary macroeconomic
policy is required. Economic stagnation, in turn, makes it increasingly difficult toresolve the structural problems. Although the necessary structural adjustments, suchas reorganization of corporate management and reallocation of economic resources,were deferred by the emergence of the asset price bubble, their resolution became
urgent when the bubble burst. In addition, the bursting of the asset price bubble not
only triggered the adverse effects but also amplified them as time passed, thereby
making such structural adjustments more difficult.
C. Structural Changes
Although it is hard to deny that the emergence and bursting of the bubble played an
important role in economic fluctuations from the early 1990s, the above observations
suggest that structural impediments to the smooth reallocation of economic resources
could be fundamental reasons for the current deflationary economic situation.
1. NPLs and the low profitability of Japanese firms
NPLs of major financial institutions continued to increase up until end-March 2002
(Figure 5). NPLs of major Japanese banks reached 11.9 percent of nominal GDP by
end-March 2002, calculated as the sum of risk management loans (5.5 percent) and
4. Mio (2002) estimates a bivariate output-price structural vector autoregression model for Japan to decompose theinflation rate time-series into two components, explained by aggregate demand (AD) and aggregate supply (AS)shocks. He finds that the coincidence of negative AS and AD shocks explains the combination of price stability
and output stagnation soon after the bursting of the asset price bubble in the early 1990s. We update his results
by using newly revised 93SNA (System of National Accounts) data, and succeed in reproducing qualitatively
equivalent results. We also produce similar but puzzling results for the dynamic response of prices due to AS
shocks. That is, it initially shows a negative response, but turns positive after about two years. These results seemto indicate the difficulty of identifying the effects of AD and AS shocks in the medium to long term because of
their dynamic interaction.

149

Figure 5 Nonperforming Loans

12

Ratio to nominal GDP, percent

10
8
Accumulated direct
write-offs
6
4
2

Risk management
loans

0
Mar.
1993

Mar.
94

Mar.
95

Mar.
96

Mar.
97

Mar.
98

Mar.
99

Mar.
2000

Mar.
01

Mar.
02

Mar.
03

Mar.
04

Notes: 1. Figures are summations of data for city banks, long-term credit banks, andtrust banks. (Data for all banks and all deposit-taking institutions are notavailable before March 1996.)
2. Risk management loans are summations of loans to borrowers in legal
bankruptcy, past-due loans in arrears for six months or more, and loans
in arrears by three months or more and less than six months.
Source: Financial Services Agency (http://www.fsa.go.jp); Cabinet Office,“National Accounts.”

the accumulated direct write-offs since fiscal 1992 (6.4 percent). Substantial progressin dealing with the NPL problem has occurred only very recently, during the past
year or so. Although the pace of disposal has varied across individual institutions, on
average major banks have made considerable progress in disposing of NPLs. Regionalbanks have also made progress in reducing NPLs, but the pace of disposal has beenmuch slower than that at major banks.
One of the major causes of Japan’s long-term stagnation since the early 1990s is
lending forbearance to inefficient firms that finally caused deterioration in the soundness and efficiency of Japan’s economy (as described by Sekine, Kobayashi, and Saita[2003] and Caballero, Hoshi, and Kashyap [2003]). Continued forbearance lendingthat permits “zombie” firms to exist indicates the existence of incentives to resist factor
reallocation, even though economic adjustments are necessary for the economy toreturn to its long-term sustainable growth path. In other words, the malfunctioningof financial intermediation prevents the resource allocation mechanism in financial
markets from working smoothly.
To examine the capital efficacy of the corporate sector in Japan, Figure 6 plots
the return on assets (ROA) and return on equity (ROE) for the manufacturing andnon-manufacturing sectors over time. We can see from this figure that profitability inthe corporate sector has remained low since the early 1990s, and does not yet show signsof recovery. This observation suggests that a structural shift in the Japanese economy

150 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Asset Price Fluctuations, Structural Adjustments, and Sustained Economic Growth: Lessons from Japan’s Experience since the Late 1980s

Figure 6 Profitability of Enterprises[1] ROA for Manufacturing
12[2] ROA for Non-Manufacturing

Percent

12

10

10

8

8

6

6

4

4
Large
Medium-sized
Small

2

0
1980 82 84 86 88 90 92 94 96 98 2000 02

1980 82 84 86 88 90 92 94 96 98 2000 02[3] ROE for Manufacturing

30

Large
Medium-sized
Small

2

0

35

Percent[4] ROE for Non-Manufacturing

Percent

35
Large
Medium-sized
Small

30

25

25

20

20

15

15

10

10

5

5

0

Percent
Large
Medium-sizedSmall01980 82 84 86 88 90 92 94 96 98 2000 02

1980 82 84 86 88 90 92 94 96 98 2000 02

Note: Definitions of ROA and ROE are as follows:
ROA = (operating profits + other profits)/(total assets).
ROE = (current profits)/(total equities), where total assets and equities are theaverage values at the beginning and end of the period.
Source: Ministry of Finance, “Financial Statements Statistics of Corporations
by Industry, Quarterly.”

from declining industries to growing industries is unlikely to proceed smoothly during
this period of continuing economic stagnation.
2. Globalization
Ongoing globalization, including the incorporation of the Chinese and other developing economies into the system of the international division of labor, influences
relative prices in the global economy. The rapid rise of the Chinese and other151

economies puts pressure on the global economy to reallocate production bases aswell as creates and destroys employment opportunities.5 To be sure, international
reallocation of production and employment is beneficial for all countries in the longrun. Nevertheless, such developments are often mistaken for the importation ofunemployment and deflation from these countries, especially from China.
To enjoy the benefit from reallocation, the Japanese economy is required to shift
its industrial structure in response to changes in its comparative advantages due tothe rise of these economies. Such adjustments in industrial structure will surely pay
off in the long term by improving the terms of trade. In the case of the rise of
the Chinese economy, for example, we expect that a broad range of products, suchas clothing, daily necessities, and agricultural and livestock products, will become
available at lower prices.
Some cautions, however, are in order regarding the adjustment process in the
short term. First, the pains of economic reform are most likely to be concentrated
among firms and employees in the declining industries. The prevention of changes torelative prices and forbearance lending to declining firms and industries tend to resultin locked-in resources in the declining industries, thereby hindering economic
growth. Second, international competition is less likely to function as pressure to
improve the productivity and efficiency in non-tradable goods industries.
Figure 7 is a scatter plot of general price levels against per capita GDP acrossmember countries of the Organisation for Economic Co-operation and Development(OECD). In this figure, general price levels and per capita GDP are defined as the ratioof PPP to exchange rates, and per capita nominal GDP deflated by PPP, respectively.6
This figure shows the so-called Balassa-Samuelson effect of a positive correlation
between domestic price level and per capita income.7 This effect arises because
economic growth induces a structural shift from manufacturing industries to nonmanufacturing industries with relatively low productivity. It is often pointed out that
non-manufacturing industries lack incentives to improve their efficiency, because
they are isolated from international competitive pressures due to regulation andother protections.
A closer look at Figure 7 offers the observation that Japan is an outlier located
far above the upward trend line. In other words, Japan’s price level is still far higher
than the international standard level, even after taking into account its high per
capita income. This implies the wide productivity differences between the manufacturing and non-manufacturing sectors in Japan, reflecting the low productivity andinefficiency of the non-tradable goods industries.
3. Population growth
Demographic factors, such as the rapid decline in the birth ratio and an aging society,are also often cited as factors behind declining trend growth.
5. Another often-cited example is U.S. firms in the information and communications industry that make active useof outsourcing to Indian firms in software development.
6. PPP is calculated using price and expenditure data collected by the Eurostat-OECD PPP Programme. The basketof goods and services is a sample of all goods and services covered by GDP, including consumer goods andservices, government services, equipment goods, and construction projects. PPP is computed as a geometric meanof price relatives of various products in the basket.
7. In the time-series dimension, a real exchange rate for a nation with higher economic growth tends to appreciate
more rapidly.

152 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Asset Price Fluctuations, Structural Adjustments, and Sustained Economic Growth: Lessons from Japan’s Experience since the Late 1980s

Figure 7 Per Capita GDP and Price Levels

160

General price levels, OECD average = 100
Japan

140

Switzerland
Denmark
Sweden120

NorwayLuxembourg

100

United States

80
60
40
20
20

40

60

80

100

120
140
160
180
200
Per capita GDP, OECD average = 100

Notes: 1. General price levels and per capita GDP are defined as the ratio of PPP to
exchange rates, and per capita nominal GDP deflated by PPP, respectively.
2. Figures are indexed to the United States (equal to 100), and averaged from1996 to 2002.
Source: OECD data (http://www.oecd.org).

Figure 8 plots the official projections of Japan’s future population, compiled by the
National Institute of Population and Social Security Research. The projections havebeen revised downward continually, as new projections are released every five years.
Based on the projections in January 2002,8 total population is projected to peak at
128 million in 2006 and continue to decline thereafter until it reaches 61 million at
the end of the projection in 2100 (Figure 8 [1]). The working-age population (15–64
years old) started declining after peaking at 87 million in 1995, and is projected to
decline by half to 43 million in 2072, and to 33 million in 2100 (Figure 8 [2]). As aresult, the dependent population index, defined as the ratio of the non-working-age
population (total population minus working-age population) to the total population,is projected to increase until 2053 when it peaks at 87.4 percent, and remain highafterward (Figure 8 [3]).
Even if the growth rate of per capita GDP remained unchanged, a population
decline in Japan would result in a slowdown in economic growth. The rise in thedependent population index implies a decline in the work force in the economy.
It suggests a constraint on economic growth, because more resources are shifted
into service sectors where it is difficult to improve productivity, such as the care ofaged persons.
8. In the baseline projection (median variant) published in January 2002, total fertility is assumed to decline initiallyfrom 1.36 in 2000 to 1.31 in 2007, and then gradually start reversing and reach 1.39 in 2049.

153

Figure 8 Population Projections[1] Total Population
Million persons
140
130
120
110
100
Projection in Jan. 2002
90
Projection in Jan. 1997
80
Projection in Sep. 1992
70
Projection in Dec. 1986
Realized
60
50
1980
90
2000
10
20
30

40

50

60

70

80

90

2100

40

50

60

70

80

90

2100

[2] Working-Age Population
Million persons
90
80
70
60

Projection in Jan. 2002
Projection in Jan. 1997
Projection in Sep. 1992
Projection in Dec. 1986
Realized

50
40
30
1980

90

2000

10

20

30

[3] Dependent Population Index
Percent
90
80
70
60

Projection in Jan. 2002
Projection in Jan. 1997
Projection in Sep. 1992
Projection in Dec. 1986
Realized

50
40
30
1980

90

2000

10

20

30

40

50

60

70

80

90

Note: Dependent population index is defined as 1 − (working-age population)/(total population).
Source: National Institute of Population and Social Security Research, “Population
Projections for Japan,” various issues.

154 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

2100

Asset Price Fluctuations, Structural Adjustments, and Sustained Economic Growth: Lessons from Japan’s Experience since the Late 1980s

III. Two-Dimensional Changes in Relative Prices andReduced Potential Output
Protracted economic stagnation in Japan is deeply related to the asset price deflationand structural changes mentioned above. The problems created by asset price deflationand structural changes (except for the population growth issue) can be seen as theincomplete economic adjustments to significant changes in relative prices.
Such changes in relative prices occur in both the intertemporal dimension and thecross-sectional dimension. On the one hand, relative prices in the intertemporaldimension are relative prices between the current prices of goods and services andtheir future prices.9 This is exactly the aforementioned observation of changes inrelative prices between consumer prices and asset prices. On the other hand, relative
prices in the cross-sectional dimension are relative prices among goods and services aswell as production factors, including terms of trade with foreign trading partners.
Moreover, it should be noted that a crucial interaction exists in the aforementioned
changes in relative prices in two dimensions.
A. Relative Price Changes in the Intertemporal Dimension
The first point regarding relative price changes concerns implications of changes inrelative prices in the intertemporal dimension. Asset price deflation has continued forthe last 10 years at an annual rate of close to 10 percent. As a result, relative prices
in the intertemporal dimension have dramatically changed under extremely stableconsumer prices since the mid-1980s.
As an inflation measure for incorporating the dynamic elements of price fluctuation, Alchian and Klein (1973) propose the idea of an intertemporal cost of living index(ICLI). This index traces the intertemporal changes in the cost of living that are
required to achieve a given level of intertemporal utility. Consumer behavior possesses
a dynamic nature such that current consumption depends on not only current prices
and incomes but also the future path of prices and incomes. When considering theintertemporal maximization problem for a household, it can be seen that its budget
constraint is its lifetime income.10 In this case, we can take asset prices as a proxy for the
future prices of goods and services.
More precisely, Alchian and Klein (1973) assume that consumer preference
depends on both current and future consumption expenditure, as expressed by thefollowing utility function:
U =U (x 11A , . . . , xn1A , . . . , x itA, . . .) for i = 1, . . . , n; t = 1, . . . , ,(1)where x itA represents the consumption expenditure for good i at time t with economic
condition A .

9. See Alchian and Klein (1973), Shibuya (1992), and Shiratsuka (1999) for details on measures for intertemporal
price changes.
10. A necessary condition for this discussion is that there exists a perfect capital market, which makes it possible toborrow money against collateral of all tangible and intangible assets.

155

The consumer’s budget constraint corresponds to total assets (W A ), including
both tangible and intangible assets as follows:nmt =1 i =1

j =1

W A = pitA x itA = q jA yjA,(2)

where pitA , q jA , and yjA represent the current price of good i at time t under economic
condition A,11 and the price and quantity of asset j at time t under economic
condition A .
Suppose that a price of a current or future good changes, and the new economic
condition B is realized. As a result, suppose also that the required asset value for the
consumer to achieve the same utility level as under economic condition A becomes
W B. The ICLI between the economic conditions A and B is defined as


n

p x
B
it

m

B
it

q y
B

B

j j
B
t =1 i =1
j =1
ICLI = W–––A = ––––––––=––––––.
m n
W
p Ax Aq Ay AABt =1 i =1

it

it


j =1

j

(3)

j

Shibuya (1992) extends the ICLI into a practical index formula, and names ita dynamic equilibrium price index (DEPI). To this end, he employs a one-goodand time-separable Cobb-Douglas utility function, instead of the general form ofpreference assumed in Alchian and Klein (1973). Then, he derives the DEPI asa weighted geometric mean of the changes in the current price index (the GDP
deflator: pt ) and the changes in asset prices (the value of the national wealth: qt ),12 asshown in equation (4):pt  qt 1−
DEPI 0t = ––
,
p ––
q

( )( )
0

0(4)

where  represents the weighting used for current goods and services  = /(1 + ),and  represents the time preference.13
Figure 9 shows the movements of the DEPI from 1957 to 2001, which updates theestimation in Shiratsuka (2001). This figure portrays the large divergence between
the DEPI and the GDP deflator during the late 1960s, the early and late 1970s, andthe early 1980s. Focusing on developments since the mid-1980s, the DEPI rises sharply
from 1986 to 1990 and then starts declining in 1991. During this period, although
11. This is the present value of the future product and service prices discounted by the discount factor.
12. In calculating the DEPI, we should use asset prices to represent the value of total assets, which includes all theintangible assets, such as human capital. Shibuya (1992) used the data on national wealth in the SNA statistics,
which have the broadest coverage among the readily available data sources. However, the coverage of intangible
assets, which consist largely of households’ assets, is very limited.

13.  can be written as  t = (1 + )− t/ s = 0(1 + )− s in general form. It corresponds to the standardizing factors of time
preference, which add up to one. Following Shibuya (1992), we assume the rate of time preference  as 0.03,
which deducts the rate of depreciation (0.06), the growth rate of labor (0.01), and the rate of technologicalprogress (0.03) from the real return on assets (0.13).

156 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Asset Price Fluctuations, Structural Adjustments, and Sustained Economic Growth: Lessons from Japan’s Experience since the Late 1980s

Figure 9 Dynamic Equilibrium Price Index (DEPI)

30

Year-on-year change, percent
DEPI
GDP deflator

25
20
15
10
5
0
–5
–10

–15
1957 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 2001
Note: For details on the calculation method for DEPI, see Shibuya (1992).
Source: Cabinet Office, “National Accounts.”

the GDP deflator remains relatively stable, the inflation rate measured by the GDP
deflator accelerates until 1991 and then remains subdued from 1992. This development of the DEPI can be interpreted as an understatement in conventional inflation
measures regarding the inflationary pressure that occurred in the late 1980s and the
deflationary pressure that has continued since the early 1990s.
Alternatively, the aforementioned development of the DEPI can be viewed as alarge swing in relative prices in the intertemporal dimension. Although current pricesof goods and services, measured by the consumer price index and GDP deflator,
remain stable, expected prices of future goods and services, observed by asset
prices, increased dramatically in the late 1980s and then continued to decline in the
1990s. An interpretation of this from the standpoint of intertemporal relative pricechanges suggests that the intertemporal misallocation of resources due to misguided
information on intertemporal relative prices was behind the emergence, expansion,and bursting of the asset price bubble.
B. Relative Price Changes in the Cross-Sectional Dimension
Let us next turn to the second point regarding changes in relative prices in the
cross-sectional dimension.
Figure 10 graphically depicts the relationship between output growth and pricechanges by industry. The horizontal and vertical axes plot annualized output growthand inflation by industry, respectively. Observations shown as circles and crosses,
respectively, indicate data for the period from 1980 to 1990 and that from 1991
to 2001. An overall negative relationship between output growth and inflationsuggests that supply-side factors play an important role in determining cross-sectional157

Figure 10 Output Growth and Inflation by Industry

8

Annualized inflation, percent
1980–90
1991–2001

6
4
2
0
–2
–4
–6
–8

Electrical machinery,equipment, and supplies

–10
–10

–5

0

5

10
15
20
Annualized output growth, percent

Source: Cabinet Office, “National Accounts.”

differences in the rate of inflation over the long term. Resources are allocated to
growing industries where relative prices are declining, reflecting their relatively higher
productivity growth.
A closer look at the figure, however, reveals that the above negative relationshipbetween output growth and inflation varies between two periods. The figure also
shows four regression lines through the scatter plots: thin and bold solid lines for theobservations for the periods 1980–90 and 1991–2001, respectively; and thin andbold dashed lines for the observations for the corresponding periods but excluding
electrical machinery, equipment, and supplies. The slopes of the observations forthe period 1980–90 are negative, regardless of inclusion or exclusion of the outlier
observation for electrical machinery, equipment, and supplies. In contrast, the slopeof the observations for the period 1991–2001 turns slightly positive, if the outlier
observation for electrical machinery, equipment, and supplies is excluded.
To gauge distortions in the cross-sectional dimension, Nakakuki, Otani, andShiratsuka (2004) propose an indicator for factors’ marginal productivity differential
across industries. Suppose the production function of each sector is homogeneous ofdegree one and is defined by the equation
Yi = Ai Fi (K i , L i ),158 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

(5)

Asset Price Fluctuations, Structural Adjustments, and Sustained Economic Growth: Lessons from Japan’s Experience since the Late 1980s

where the subscript i denotes the industry, and Y, A, K, and L represent output, totalfactor productivity (TFP), capital stock, and labor input, respectively. Dividing theabove equation by labor input yields labor productivity (y = Y/L), which can be
expressed by the capital-labor ratio (k = K/L) as follows:yi = A i fi (ki ),(6)

where fi (ki ) is Fi (K i /L i , 1).14 Since the ratio of wages (wi ) to rate of return on capital(ri ) in sector i is equal to the ratio of labor’s marginal productivity to capital’s marginal
productivity, the following equation holds:fi (ki ) − fi ′(ki )kiw––i = ––––––––––––.
fi ′(ki )ri(7)

The labor share in industry i (i ) equals 1 − fi ′(ki )ki /fi (ki ), and the capital share(1 − i ) equals fi ′(ki )ki /fi (ki ). Using these, equation (7) can be transformed as follows:w––i = ai ki ,ri

(8)where a i corresponds to i /(1 − i ). Under perfect factor markets, the ratios of wages
to rate of return on capital are identical in all industries. In the discussion below, we
assume the ratio of wages to rate of return on capital for industry i is 1/i times that of
the base industry (i = 1,  1 = 1). In this case, the ratio of relative factor prices in sector
i to the base sector can be expressed as follows:
a 1k–.
1
i = –––
a i ki(9)

The value i = 1 implies that the marginal condition holds between the two
industries. If i exceeds unity, then industry i has a lower capital-labor ratio than thebase industry. That is, the labor input is too large and/or the capital stock is too low.
Conversely, if i is less than unity, it means that the capital-labor ratio of industry i
is too high.
Figure 11 is a scatter plot of the estimates of  in each industry for both the bubble
period (1986–91) and the post-bubble period (1992–98).15 We can see from the figurethat the estimates of  for many industries in the non-manufacturing sector, such as
agriculture, forestry, and fisheries, construction, wholesale and retail trade, finance andinsurance, and services activities, increase in a range significantly higher than unity.
In contrast, those for the manufacturing sector, except food products and beverages,

14. In the following discussion, it is assumed that Inada’s condition holds, i.e., if k i → 0, f ′(k i ) →  and if k i → ,f ′(k i ) → 0.
15. Nakakuki, Otani, and Shiratsuka (2004) employ the electrical machinery industry as the base industry tocompute  , based on their presumption that this industry is the most efficient of all industries in Japan.

159

Figure 11 Changes in Estimates of  by Industry

7

Average for the period 1986–91

6
Agriculture,
forestry, and fisheries

54Construction
Finance and insurance

3

Wholesale and retail trade2

Food products and beverages
Services activities

1

0
0

1

2

3

4

5
6
7
Average for the period 1992–98

Note: i is the ratio of relative factor prices in sector i to the base industry. The value
i = 1 implies that the marginal condition holds between the two industries. If iexceeds unity, then industry i has a lower capital-labor ratio than the base industry.
That is, the labor input is too large and/or the capital stock is too low.
Source: Nakakuki, Otani, and Shiratsuka (2004).

remain almost unchanged in the range close to unity. Figure 12 shows the standard
deviation of  across industries for each year. We can see from this figure that thestandard deviation jumps in the early 1990s and remains high thereafter, reflecting
these larger deviations of  from unity in the non-manufacturing sector.
These observations imply that the capital-labor ratios for these sectors remain
considerably below the optimum level that the marginal condition indicates (either
capital accumulation has been too small or labor input has been too large).
C. Interaction of Relative Price Changes in Two Dimensions
As discussed above, protracted economic stagnation in Japan can be seen as the incomplete economic adjustments to significant changes in relative prices in two dimensions:the intertemporal and cross-sectional dimensions. In addition, it should be stressed thata crucial interaction exists in the aforementioned changes in relative prices in two
dimensions. The cross-sectional and intertemporal resource misallocation interacts toamplify the negative impacts of the structural factors on the economy as a whole.

160 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Asset Price Fluctuations, Structural Adjustments, and Sustained Economic Growth: Lessons from Japan’s Experience since the Late 1980s

In general, frictions and distortions in factor markets lead the economy to exhibit
inefficient resource allocations. Figure 13 illustrates the economic intuition for thispoint. Suppose that the economy produces two goods, denoted by M and N. To keep
the graph simple, assume further that the supplies of capital and labor are fixed. The
production possibilities frontier (PPF) shows all feasible pairs of two goods. Now
suppose that an economy is at the efficient allocation at point A under relative prices
Figure 12 Standard Deviation of Estimates of  across Industries
1.9
1.8
1.7
1.6
1.5
1.4
1.3
1.2
1.1
1.0
1975 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98
Note: Figures are the standard deviation of  across industries for each year, based on
the estimates in Nakakuki, Otani, and Shiratsuka (2004).

Figure 13 Production Possibilities Frontier
N

A

B
C

M

161

Pm /Pn , and relative price changes occur. Point C is attained if no frictions and distortions
exist, while point B is attained if frictions and distortions prevent resource reallocation.
The above argument implies that distortions in factor markets lead an inward
shift of the nation’s PPF and lower attainable output. In this case, without reallocating resources from declining sectors to ones enjoying high productivity, asset prices,which correspond to the discounted present value of future cash flow, can hardly be
expected to recover. As long as productivity growth rates remain stagnant, ROE willcontinue to be depressed.
Moreover, as discussed earlier, the relative price of asset prices to general prices
means intertemporal relative prices. Thus, the economic situation in which asset prices
drastically decline while general prices remain relatively stable can be interpreted as one
in which downward pressure on the prices of future goods works to influence intertemporal resource allocation. It follows that downward pressure on the trend growthrate strengthens as the capital accumulation in high-productivity sectors declines.
To sum up, in a situation in which inefficient firms survive and the economy’s
PPF continues to expand very slowly over the long term, not only does the trend growthrate fall but also downward pressure on the asset prices influences the economy.

IV. Structural Adjustments and Reduced Economic Growth
In this section, based on the empirical study by Nakakuki, Otani, and Shiratsuka(2004), we first summarize the extended framework of growth accounting to incorporate the effects of factor market distortions, and quantitative assessment of the
impacts of such distortions on Japan’s economic stagnation. We then discuss policy
implications of structural adjustments.
A. Effects of Factor Market Distortions on Economic Growth
Research on growth accounting in Japan, however, has not focused on the implicationsof structural impediments; rather, many studies assume perfect markets, thereby
regarding the difference between the observed output growth and the hypothetical
output growth under perfect utilization of resources as TFP growth. As a result, if
structural impediments do exist, then contributions of factor accumulations areoverstated, and TFP growth shows the sum of positive impacts of technology
growth and negative impacts of structural impediments. Thus, the contribution oftechnological progress in growth accounting is underestimated when the TFP is solely
attributable to technological progress.
For example, Hayashi and Prescott (2002) argue that economic stagnation in Japanin the 1990s is attributable to declines in both the TFP growth rate and working
hours. They then conjecture that policies to subsidize inefficient firms and declining
industries result in lower productivity, and discourage investment to improve productivity. It should be noted, however, that their analysis assumes the slowdown of TFP
growth as exogenous, and does not explicitly deal with structural impediments against
more efficient resource allocation.

162 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Asset Price Fluctuations, Structural Adjustments, and Sustained Economic Growth: Lessons from Japan’s Experience since the Late 1980s

B. Growth Accounting That Incorporates Factor Market Distortions
To quantify the impacts of distortions in factor markets during the period of continuing economic stagnation in the 1990s in Japan, Nakakuki, Otani, and Shiratsuka(2004) propose an analytical framework to incorporate factor market imperfections
into growth accounting.
Real GDP, denoted by Y, is expressed by using the labor input, labor input shareof each sector, and labor productivity of each sector, as follows.
n

n

i =1

i =1

Y = Yi = LSi A i fi (ki ),(10)

where Yi , L, and Si denote real output of sector i , labor input of the economy on a
man-hour basis, and the share of labor input in sector i , respectively. In addition, theproduction functions of each sector are assumed to be homogeneous of degree one.
Transforming equation (10) into growth rate form yields equation (11) below.
Y n Y A L n LSi A i fi (ki ) Si n LSi A i fi ′(ki )ki ki––– =  ––i –––i + ––– +  ––––––––––– +  –––––––––– –––.
i =1
i =1 Y
i =1
Ai
L
Y
Si
Y
ki
Y

(11)

Under imperfect factor markets, the ratios of wages to rate of return on capitaldiffer across sectors. By using a ratio of relative factor prices for sector i to a benchmark
sector, i , defined in equation (8), further decomposition of the terms of Si andki /ki yields equation (12) below.
kY n Y A L––– =  ––i –––i + ––– + (1 −  )–––
i =1 Y
Ai
L
k
Y

/

n
  n  Sj n Sm  j Y–  –––– ––– − ––i (1 − i ) –––i − –––i =1 Y i j =1  j a j m =1 m a m j 

(12)

/

n
n
 n  SjY 
Sm  Sj  Si –  ––––− ––i (1 − i )  –––
 ––––  − ––– .
i =1 Y j =1  j a j m =1 m a m Sj  Si 

In the above equation, the first to third terms on the right-hand side correspondto the growth accounting formula without any distortions. The fourth and fifthterms are added to reflect the effects of factor market distortions. The fourth term
represents the impact of intersectoral capital allocation induced by changes in  when
the capital-labor ratio for the economy is held constant. The fifth term indicates theeffect of changes in labor input share.16

16. The effect of the change in labor input shares consists of two parts. One is the indirect effect of the changes in labor
input on the GDP growth rate through the changes in the capital-labor ratio in individual sectors. The other is the
direct effect of labor share changes among high- and low-productivity sectors on the GDP growth rate.

163

Table 1 shows the results of decompositions of GDP growth in Japan sincethe 1980s, based on equation (12), shown in Nakakuki, Otani, and Shiratsuka(2004).17,18 We can see from the table that, in addition to the declines in TFP growthand in number of workers, capital accumulation and distortions in factor markets
contribute to lowering GDP growth in the 1990s. From the bubble period to thepost-bubble period, the total decline in GDP growth is –3.6 percent. The contribution from TFP growth is estimated at –1.6 percent, that from the capital deepening is–1.3 percent, that from the number of workers is –0.9 percent and that from factor
market distortions is estimated at –0.5 percent, respectively. In this sense, the results
are broadly in line with Hayashi and Prescott (2002).
Factor market distortions can account for one-seventh of the decline in the GDP
growth rate from the bubble period to the post-bubble period. On the face of it, acontribution of one-seventh of the decline in the GDP growth rate may look small,compared with other factors mentioned above. It should be noted, however, that theabove result shows the estimate of the direct impacts of factor market distortions, sothat it ignores the indirect impacts. As Hayashi and Prescott (2002) argue, inefficient
resource allocation results in lower productivity, and discourages investment that
could improve productivity. In other words, the cross-sectional resource misallocationinduces intertemporal resource misallocation, and then amplifies the negative impact
on the economy. In particular, downward pressure on the trend growth rate, partly
due to persistent distortions in factor markets, is likely to result in a decline incapital accumulation in high-productivity sectors. Thus, negative indirect effects ofdistortions in factor markets are likely to be counted as the effects of other factors
such as the decline in capital deepening.
Table 1 Effects of Distortion in Factor Markets on Labor Productivity

GDP growth

3.96

1986–91(bubble period)
(a)
4.82

TFP
Capital deepening
Number of workers
Working hours
Distortions
Relative MP
Labor input share

1.39
1.51
0.79
0.04
0.23
0.18
0.06

2.18
2.77
1.29
–1.85
0.44
0.11
0.32

1980–85

1992–98(post-bubble period)
(b)
1.24
0.61
1.45
0.34
–1.12
–0.03
–0.15
0.12

(b) – (a)
–3.58
–1.58
–1.32
–0.94
0.73
–0.47
–0.26
–0.21

Source: Nakakuki, Otani, and Shiratsuka (2004, table 2).

17. Data used in labor productivity decompositions are as follows: Y: real GDP (SNA), L : number of workers times
working hours (SNA), K: real capital stock times capital utilization rate (Japan Industry Productivity Database[JIP Database]),  : nominal compensation for workers divided by nominal gross domestic income (SNA). See
Fukao et al. (2003) for the details of the JIP Database. Note that capital stock and capital utilization rate in the
JIP Database are available only up to 1998.
18. It should be noted that the quality of workers is assumed to be constant over all industries. Thus, labor reallocationfrom a low-productivity sector to a high-productivity sector results in an increase in aggregate labor productivity.

164 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Asset Price Fluctuations, Structural Adjustments, and Sustained Economic Growth: Lessons from Japan’s Experience since the Late 1980s

C. Policy Implications of Structural Adjustments
The aforementioned aspect of Japan’s asset price bubble, with its consequences forstructural adjustments since the 1990s, is important because it illustrates the specificenvironment in which the BOJ has had to conduct monetary policy. What the BOJ
has faced is not a standard stabilization policy around a stable trend growth path, butunanswered policy management questions in an environment in which sustained
growth has been hampered due to insufficient structural adjustments in response
to significant changes in relative prices. In other words, the Japanese economy issuffering from a large-scale and quite persistent adverse shock within the frameworkof a standard macroeconomic model.
As we have emphasized up to now, the cross-sectional resource misallocationinduces intertemporal resource misallocation, which then amplifies the negative
impact on the economy. This observation implies that structural factors are more
important than cyclical factors as the major cause of the economy’s plunge into a
deflationary economic environment. It also suggests that the elimination of structural
factors themselves is a more effective policy response than measures taken to offset
cyclical factors. In other words, monetary policy is no panacea for the economic
decline and cannot substitute for policies designed to resolve the structural problems
that exist on the supply side.19
In the case of a downward shift in the potential growth rate, the economy is likely tofall into deflation and a zero interest rate environment again, since the rate of growth andthe natural rate of interest in the steady state are low. It should be noted, however, that
this does not necessarily mean that a central bank becomes powerless. Even in such asituation, a central bank can reduce the burden of transition to the new steady state bystimulating aggregate demand mainly through its policy commitments. It may be thecase that such structural policies trigger a significant adverse shock in the short term. A
central bank could make an unprecedented commitment to assist in correcting a distortion in the economy if the commitment helped the government and firms take consistentactions to restore the potential growth that could make monetary policy meaningful.
In this regard, it is crucial to understand the nature of the adverse shock to theeconomy. Japan’s experience indicates that the economy is suffering continuing
stagnation not only because the magnitude of the shock is quite large but also
because the shock is quite persistent. Although the central bank can alleviate any large
one-time adverse shock, it should be emphasized that it cannot offset a permanent
shock to the economy.

V. Concluding Remarks
In this paper, we have examined implications of asset price fluctuations and resultant
structural adjustments on sustained economic growth, based on Japan’s experiencesince the latter half of the 1980s.
19. See Yamaguchi (1999) and Shirakawa (2000) for further discussion in the context of Japan. As Bhagwati (1971)
discusses, the basic policy response to structural problems is to directly attack their sources and induce a transfer
of economic resources from agents that gain to those that lose, thereby promoting structural reform.

165

In doing so, we proposed that asset price deflation in Japan in the 1990s is better
understood as a reflection of a significant downward shift in trend growth rather thanthe bursting of a gigantic bubble which amplified the business cycle. A significant
downward shift in the growth trend can at least partly be seen as the result of incomplete economic adjustments to significant changes in relative prices in two dimensions:the intertemporal and cross-sectional dimensions. In this regard, it should be noted thata crucial interaction exists in the changes in relative prices in two dimensions, resulting
in a decline in the trend growth rate. Put differently, a downward shift in the growthtrend resulting from the incomplete economic adjustments to significant changes
in relative prices in the Japanese economy can be regarded as a large-scale and quitepersistent adverse shock.
The above observation implies that structural factors are more important thancyclical factors as the major cause of the Japanese economy’s plunge into a deflationary
economic environment. This aspect of the asset price bubble, with its consequences forthe structural adjustments in the 1990s, is important because it illustrates the specificenvironment in which the BOJ has had to conduct monetary policy.
The lesson from the BOJ’s experience since the 1990s is that, if a significant
and unforeseen slowdown of the potential output growth rate were due to structuralproblems, monetary policy would inevitably differ greatly from stabilization policy innormal circumstances. Under such circumstances, it is also stressed that the elimination of the structural impediments themselves is a more effective policy response than
measures taken for a sustained period to offset cyclical factors. Whether Japan’s current
economic recovery will turn into sustained economic growth and put an end todeflation depends on its progress in eliminating structural impediments. Of course,monetary policy could assist in correcting a distortion in an economy in transition,
but is no panacea for all types of economic maladies and cannot substitute for policies
designed to resolve the fundamental structural problems that exist on the supply side.

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167

Comment
CHARLES L. EVANS
Federal Reserve Bank of Chicago
The subject of this interesting paper by Kunio Okina and Shigenori Shiratsuka is the
protracted economic stagnation that has occurred in Japan since the late 1980s.
The source of this slowdown continues to be much debated, and following thecontributions of papers such as this one, will continue to be discussed for some time
to come. The secular slowing is captured well in Figure 4 [2] of the paper, where the
Hodrick-Prescott trend growth rate falls from above 4 percent in the late 1980s toaround 1 percent in 2004. The authors pursue an explanation that attributes thisslowing to incomplete adjustments in response to significant changes in relative
prices. This is a provocative explanation that puts changes in technology front andcenter in this debate.
In my comments on this paper, I want to take this technological explanation very
seriously. It is, after all, not the conventional viewpoint. There are two prominent
views of the Japanese economic stagnation. One perspective is that following thecollapse of the asset bubble economy, there was insufficient aggregate demand for the
economy to return to potential output growth rates, even with approximately nominalinterest rates of zero. A second perspective is that structural problems in the economy
were more important, and prevented the return to higher growth rates. Inefficiencies
in financial markets and lending undoubtedly contributed to this structural explanation. But the structural deficiencies could also be proxying for more fundamental
technological changes. Due to the similar findings of the authors and Hayashi and
Prescott (2002), I want to pursue the technological explanation a bit further.
With such an information disadvantage about the workings of the Japanese
economy, my approach is to simply fall back on the methods of an empirical macroeconomist. By looking at simple plots of the data, I will search for clues about thedriving process for economic fluctuations in Japan during the 1990s. This is also theempirical method of the authors.
My first figure displays times series in Japan for output (real GDP), labor hours,
labor productivity, the GDP deflator, the relative price of investment goods toconsumption goods, and a short-term nominal interest rate (Figure 1).20 Of course,
one of the first clues about the driving shocks involves the behavior of output and theprice level. The slowing in output growth and falling prices suggest that negative
aggregate demand shocks have been predominantly hitting the Japanese economy
since the collapse of the bubble economy. Another possible explanation, however, isthat substantial negative technology shocks have occurred. If these adverse supply
shocks are occupied by substantial endogenous falls in aggregate demand, then the
20. The data are from income and product accounts as reported by Haver Analytics. Output is real GDP; the pricelevel is the GDP deflator; labor hours are for the manufacturing sector; labor productivity is computed as
output per labor hour; the relative price of investment goods is the deflator for investment goods divided by the
consumption goods deflator, and the short-term interest rate is a three-month CD rate. As the text mentions,data mismatches in this analysis offer wide scope for improving the analysis here. For example, the assumptionthat aggregate hours moved proportionally to manufacturing hours may be false.

168 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Comment

Figure 1 Macroeconomic Data

[1] Output (Real GDP)

[2] Labor Hours

1,328

472

1,320

470

1,312

468

1,304

466

1,296
464

1,288

462

1,280

460

1,272

458

1,264
1980 82 84 86 88 90 92 94 96 98 2000 02[3] Labor Productivity
864

1980 82 84 86 88 90 92 94 96 98 2000 02[4] GDP Deflator
5

856

0

848
–5

840
832

–10

824

–15

816

–20

808

–25

800
792

–30
1980 82 84 86 88 90 92 94 96 98 2000 02[5] Relative Price of Investment Goods
to Consumption Goods

1980 82 84 86 88 90 92 94 96 98 2000 02[6] Three-Month CD Rate
12.8

15

11.2

10

9.6
5

8.0

0

6.4
4.8

–5

3.2
–10

1.6

–15

0.0
1980 82 84 86 88 90 92 94 96 98 2000 02

1980 82 84 86 88 90 92 94 96 98 2000 02

Source: Haver Analytics.

price level could fall as output growth is slowing. Taking this view seriously requires
looking at additional macroeconomic data beyond prices and output.
Other data in Figure 1 provide prima facie support for productivity explanations.
The level of productivity clearly slows beginning in the early 1990s. Labor hours
also fell sharply during this period and remained low throughout the decade. Theseobservations are important ingredients in the results of Hayashi and Prescott (2002).
They interpret the reductions in total factor productivity (TFP) and hours as
exogenous shocks for the Japanese economy. Working with a calibrated neoclassicalgrowth model for Japan, Hayashi and Prescott (2002) find that these two shocks
account for most of the reductions in aggregate output in the 1990s. In other words,

169

aside from the adverse consequences for aggregate demand that are generated fromthese shocks, only productivity and labor supply shocks are necessary to generate
substantial, persistent economic downturns. Their findings leave for further research
the matter of deducing more precisely the sources of this technological regress.
Okina and Shiratsuka (2004) provide a good bit of evidence on these additional
supply channels. Figure 10 in their paper shows the relationship between output
growth and price changes by industry. Technological innovations are typicallyassociated with falling relative prices within the industries that are growing rapidly.
Such a negative relationship is apparent in the 1980s, but the 1990s show a positive
relationship if electrical machinery, equipment, and supplies are excluded. If technological improvements have continued during this period, the positive relationshipsuggests an impediment between the innovation and the use of that technology inproduction. Rising relative prices are signs of obstacles or inefficiencies. Interestingly,
Figure 11 shows that most industrial sectors have smaller capital-labor ratios in the
1992–98 period relative to 1986–91. In their analysis, Okina and Shiratsuka (2004)
show that this is associated with either too little capital or too much labor relative tothe efficient frontier. This strongly suggests impediments to the implementation of
new technological innovations.
In Table 1 of their paper, the authors report calculations that confirm the negative
contributions of TFP and reductions in labor hours for Japan in the 1990s, alsofinding that factor market distortions contributed to this slowdown. Clearly, an economy
facing supply constraints of this sort is also facing gale-force negative aggregate
demand effects. In this context, stimulative aggregate demand policies would seemessential for averting disinflationary and deflationary consequences. In this sense, thesupply shock explanation is likely just one piece of the explanation for the post-bubble
experiences of Japan in the 1990s.
But this is the piece on which I want to focus a bit more. Returning to my
Figure 1, the plot of investment goods prices relative to consumption goods prices
shows a downward trend until the late 1980s. For several years into the 1990s, there
is an increase in investment goods prices. Research by Greenwood, Hercowitz, andKrusell (1997) and Fisher (2002) finds that this pattern may be indicative of negativetechnology shocks to the investment goods producing sector. Such a pattern of negative
shocks when combined with persistent propagation and additional negative aggregate
demand consequences could help account for the negative measured TFP shocks.
And for the United States, Fisher (2002) finds that negative investment-technology
shocks account for a large percentage of fluctuations in labor hours at business-cycle
frequencies. Neutral TFP shocks account for less than 10 percent of these fluctuations
in labor hours. So one question is what does the pattern of investment-technology
shocks look like for Japan during this period?
Fisher (2002) shows how these shocks can be identified within a vector autoregression (VAR) containing data on labor productivity, investment goods prices,and other macroeconomic variables. The identifying restrictions are relatively easy to
implement. The restrictions are that both neutral TFP and investment-technology
shocks are the only exogenous shocks that influence the long-run level of laborproductivity. In addition, only the investment-technology shock affects the long-run

170 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Comment

relative price of investment goods. Fisher (2002) provides a relatively standard
neoclassical analysis of an economy in which these restrictions hold. He also provides
a discussion about why other shocks, like capital tax shocks, are unlikely to haveempirically affected productivity in the long run for the United States. Using a VAR
with Japanese data, I estimated these I-shocks for Japan, and they are displayed in my
Figure 2. Positive shocks increase the relative price of investment goods and indicate
negative technological effects. Looking at the figure, contractionary I-shocks (positive)
hit the economy in the late 1980s, as would seem evident from the simple plot
showing that investment goods prices increased during this period. But then in the
Figure 2 Identified Investment-Technology Shocks[1] Investment-Technology Shock
2.0
1.5
1.0
0.5
0.0
–0.5
–1.0
–1.5
–2.0
1980 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03[2] Relative Price of Investment
15
10
5
0
–5
–10
–15
1980 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03[3] Productivity
864
856
848
840
832
824
816
808
800
792
1980 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01 02 03

171

early 1990s, expansionary I-shocks (negative) arrived. Presumably, these expansionary
I-shocks would have boosted the Japanese economy in the mid-1990s. Such anacceleration in real growth did not occur. So there are a number of issues that should
be addressed more fully to evaluate this channel.
(1) How likely is it that the contractionary 1980s shocks kicked off a series of
events that led to an unusually persistent period of decline? Could there havebeen an unusual confluence of events tied to the bursting of the asset bubble
and these I-shocks?
(2) Did negative aggregate demand shocks arrive in the 1990s to outweigh the
expansionary I-shocks during this period?
(3) The data underlying my analysis are very poor. For example, Fisher (2002) points
out that many methodological breakthroughs were necessary for Greenwood,
Hercowitz, and Krusell (1997) to measure investment goods prices well. My
quick analysis here does not benefit from access to appropriate quality-consistentgoods data throughout the period. Would better measurements improve or
refute this investment-shock channel?
I think these are interesting issues for further pursuit. They seem to be in a similar
spirit to the explanations offered by Okina and Shiratsuka (2004). More researchmight prove useful, and help flesh out the importance of the sluggish adjustment
channels in response to a variety of shocks.

References

Fisher, Jonas, “Technology Shocks Matter,” Federal Reserve Bank of Chicago Working Paper No. 02-14,
Federal Reserve Bank of Chicago, 2002.
Greenwood, Jeremy, Zvi Hercowitz, and Per Krusell, “Long-Run Implications of Investment-SpecificTechnological Change,” American Economic Review, 87 (3), 1997, pp. 342–362.
Hayashi, Fumio, and Edward C. Prescott, “The 1990s in Japan: A Lost Decade,” Review of Economic
Dynamics, 5, 2002, pp. 206–235.
Okina, Kunio, and Shigenori Shiratsuka, “Asset Price Fluctuations, Structural Adjustments, andSustained Economic Growth: Lessons from Japan’s Experience since the Late 1980s,” Monetaryand Economic Studies, 22 (S-1), Institute for Monetary and Economic Studies, Bank of Japan,
2004, pp. 143–167 (this issue).

Comment
PHILIP W. LOWE
Reserve Bank of Australia
I have always found papers by Kunio Okina and Shigenori Shiratsuka both enjoyable
to read and thought-provoking. This one is no exception!
Before commenting on the paper I should note, in the interest of full disclosure,that I am not an unbiased commentator. In particular, due to some previous workthat I have done, my position when I started reading this paper was that the problems
in Japan over the past decade or so are fundamentally rooted in the bursting of the asset

172 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Comment

price bubble and the resulting weakness in demand. My reading of this paper is thatit challenges this view, or at a minimum, it says things are much more complicated.
In particular, what is going on on the supply side of the economy is very important,perhaps the central story.
The basic argument of the paper is well spelled out in the introduction:
We propose the view that the protracted economic stagnation in Japan can beseen as a result of the incomplete economic adjustments to significant changes
in relative prices, partly triggered by the bursting of the asset price bubble.21
I find two aspects of this hypothesis intriguing. The first is that the real roots of theJapanese problem lie on the supply side—or in relative prices—not on the demandside. And the second—and I think quite novel idea—is that the problems with relative
prices and resource allocation that exist in Japan today are linked to the asset pricebubble. This means that the asset price bubble is by no means blameless, but that its
main harmful effect is not through hurting the demand side of the economy, but by
distorting the supply side of the economy.
In my comments, I would like to explore these two intriguing ideas.
The first issue that I would like to touch on is what are the relative prices thatmatter? The paper discusses at least four.
The first is the price of goods today relative to the prices of goods tomorrow.
For this relative price, asset prices are taken as a proxy. The second is the price ofgoods produced domestically relative to the price of goods produced overseas. The
third is the price of tradable goods relative to the price of non-tradable goods. And
the fourth is the price of labor relative to capital (although the paper focuses more on
the allocation of labor and capital between sectors).
So where have the really serious problems been, and where are they now?
The obvious starting point must be asset prices. The depressed level of prices
today suggests that the price of future goods is low relative to current goods. A
decade and a half ago, the reverse was the case. While I am not sure that I fully agreewith the idea that asset prices give us a good read on the relative price of goods today
and tomorrow, there can be no disputing the idea that the large swings in asset prices
have significantly distorted resource allocation. This distortion has come not so muchbecause people misjudged the price of goods and services today versus tomorrow, but
because the movements in asset prices—and the wave of optimism and pessimismthat has driven them—have greatly distorted the balance sheets of many firms,
households, and financial institutions. Correcting these distortions has turned out
to be a difficult and frustratingly slow process. Understanding the nature of thiscorrection is central to understanding the Japanese experience.
As the authors note, the other relative prices are cross-sectional prices. Where
Japan really stands out here is the relative price of non-tradable to tradable goods
and the relatively high use of labor—given relative factor prices—in a number ofthe non-tradable industries, as well as agriculture. The results in this paper seem to
21. Okina and Shiratsuka (2004, p. 144).

173

suggest that there is significant scope for a more efficient allocation of resources inthese areas. I suspect few would disagree.
But the paper also argues that it is difficult to achieve this reallocation because of
the ongoing effects of the movement in asset prices. As I noted before, this points toan often-ignored consequence of the bursting of asset price bubbles—that is, the sandthat it can throw in the wheels of ongoing structural adjustments in the economy.
When there is a need for considerable structural adjustments—as in the case ofJapan—this sand can cause, or at least amplify, a long-lasting slowdown in thegrowth rate of the economy.
While as a discussant one always hesitates to suggest that more be added to apaper, I would be interested to know what weight the authors give to the asset pricebubble as a factor inhibiting reform relative to other standard candidates, including
inflexibilities in the labor market, competition policy, and other structural rigidities.
Is there any way of assessing, or better still quantifying, the relative importance of
these various factors?
The second issue is the vexed debate over whether it is supply or demand. The
paper makes a convincing case that the potential growth rate of the Japanese economy
has slowed, partly because of problems with resource allocation. But is this the full
explanation of the outcomes over the past decade or so? I suspect the answer is no.
The reason I say this is because of what has happened to the prices of goods andservices. These are not discussed much in the paper, perhaps because the facts arewell known. Since 1990, consumer price index (CPI) inflation in Japan has averaged
0.5 percent, although since 1998 it has averaged –0.5 percent. The CPI today is
3.25 percentage points lower than its peak in late 1997; the GDP deflator is around
10 percentage points lower.
At a very simple—perhaps even simplistic—level, this seems to pose a challenge
to the view that the outcomes are largely due to the supply side. In the 1970s, when
productivity growth around the world slowed unexpectedly, we ended up with considerable inflation. And in the second half of the 1990s, when the reverse happened andproductivity growth unexpectedly accelerated in a number of countries—including
the United States and Australia—inflation turned out to be lower than expected. Theseexperiences suggest that when productivity growth slows unexpectedly, inflation is theoutcome, and when productivity growth accelerates unexpectedly disinflation is theoutcome. What has gone on in Japan, though, is the reverse of this: the productivity
slowdown—of which at least some part must be unexpected—has been associatedwith a decline, not only in inflation, but also in the price level.
What can explain this unusual outcome? Prima facie it suggests that the demandside of the economy has grown less quickly than the lowered growth of the supply
side of the economy. After all, prices fall if supply exceeds demand!
The fact that prices have fallen for a number of years seems to give extra weight tothe argument that, whatever has been going on on the supply side, demand has been
weaker still. I think it would be interesting to explore why this is so.
One answer is that the reconstruction of balance sheets has been tremendously
difficult, particularly in an environment of low potential growth. Another morenuanced argument is that confidence and demand have been held down by the

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General Discussion

enormity of the structural issues in Japan. A third is that real interest rates haveremained positive, despite the problems. With official rates having been at zero forsome time, the scope for demand stimulus through conventional channels has been
largely exhausted. There are no doubt other explanations as well.
So after reading, have I changed my preexisting views? The answer is somewhat,
but not completely. What I have learned is that there is a new mechanism throughwhich unwinding of bubbles can harm the economy—that is, the effect that theunwinding can have in inhibiting structural reform. In my opinion, that just adds tothe case for doing something about imbalances in credit and asset markets before
they become too large.
I say not completely, because I am struggling to understand why prices have been
so weak if the story is mainly one about supply. And I am not sure how importantthe unwinding of the boom is in delaying structural adjustments, relative to othercandidate explanations. Perhaps the discussion will be useful here!

Reference

Okina, Kunio, and Shigenori Shiratsuka, “Asset Price Fluctuations, Structural Adjustments, and Sustained
Economic Growth: Lessons from Japan’s Experience since the Late 1980s,” Monetary andEconomic Studies, 22 (S-1), Institute for Monetary and Economic Studies, Bank of Japan, 2004,
pp. 143–167 (this issue).

General Discussion
As a rejoinder to the discussants, Kunio Okina stated that both of them referred toinsufficient aggregate demand in Japan in the late 1990s as the cause of weak pricedevelopments. He stressed that the paper focused mainly on the supply side of theeconomy, but did not deny the importance of demand factors. Rather, he added thatsince the late 1980s, the weak response of consumer prices to demand conditions
was puzzling.
In addition, Shigenori Shiratsuka emphasized the difficulty of separating supply
and demand factors in the long term because of their dynamic interaction. He
expressed his uncertainty regarding Hayashi-Prescott’s assumptions in estimating
total factor productivity (TFP), including a one-sector model with no friction. This
motivated him to quantify other factors in the latter stages of the lost decade. Alongthose lines, he mentioned work by Takuji Kawamoto that showed no slowdown intechnological growth, and how other structural factors worked in the 1990s.22
In the general discussion, Hiroyuki Hino (International Monetary Fund) agreed
with the authors that the supply side of the Japanese economy had not been
sufficiently analyzed. He also suggested that the decline in asset prices reduced
productivity growth through reduced investment expenditures. Gregory D. Hess
22. See Takuji Kawamoto, “What Do the Purified Solow Residuals Tell Us about Japan’s Lost Decade?” IMES
Discussion Paper No. 2004-E-5, Institute for Monetary and Economic Studies, Bank of Japan, 2004.

175

(Claremont McKenna College) insisted that supply and demand factors were
hard to separate in Japan, because it had two economies: an extremely efficient
export sector and a distorted non-tradable goods sector. Meanwhile, Jean-Philippe
Cotis (Organisation for Economic Co-operation and Development) pointed outthat similar movement in return on equity (ROE) in the manufacturing andnon-manufacturing sectors seemed to contradict arguments in the paper about
insufficient factor mobility across sectors.
Stefan Gerlach (Hong Kong Monetary Authority) cautioned that output gaps
were very difficult to estimate under protracted adverse shocks to aggregate demand.
Assaf Razin (Tel Aviv University and Cornell University) pointed out that TFP wasbasically a mixture of technology shocks and changes in markups. He called for a
research strategy that would tease out the effects of technological changes from theresiduals, otherwise the changes in markups could be misconstrued as technologicalchanges. Shiratsuka responded that analysis in the paper focused on distortions infactor markets, while Kawamoto focused on distortions in product markets, including
the effects of markups.
Regarding problems with structural adjustment and the role of monetary policy,
Hino pointed out that the effects of a forbearance policy in banking system problems
seemed to be larger than previously thought. Okina replied that this point was closely
related to the previous day’s discussion of Franklin Allen and Hiroko Oura’s paper.
Vincent R. Reinhart (Board of Governors of the Federal Reserve System) pointed
out that there were escalating outsized earning expectations behind Japan’s asset
bubble of the late 1980s, which were created by the economic environment of thetime. Shiratsuka agreed that Japan’s asset price bubble of the late 1980s was backed byextremely bullish expectations for future economic activities. Otmar Issing (European
Central Bank) noted that the decline in asset prices over a decade in Japan contrasted
sharply with the case of the U.S. collapse in 1929. Okina responded that the Japanesecase was one of prolonged adjustments and therefore not easily compared directlywith the United States in 1929. Shiratsuka added that the decade-long decline in asset
prices in Japan resulted from the amplified adverse effects of incomplete adjustments
to intertemporal and cross-sectional relative price changes.
Robert H. Rasche (Federal Reserve Bank of St. Louis), the chairperson of thesession, expressed his concerns about what had occurred before and after the late1980s in Japan since the standard deviation of the ratio of relative factor prices acrosssectors increased after the mid-1980s. Okina agreed and suggested that the asset pricebubble in Japan might have created a misallocation of resources both before thebubble developed and after it burst.
To analyze asset prices from a viewpoint of the intertemporal dimension, Gerlach
proposed testing the information content of asset prices as proxies for future
inflation. Simon Price (Bank of England) agreed with the authors by stating that land
prices reflected expected future prices. On the other hand, noting that high relative
asset prices in Japan in the late 1980s did not seem to indicate inflationary pressure
afterward, Cotis insisted that an intertemporal interpretation of asset prices was notvery conclusive. Okina stated the need for further research regarding the relationships
between asset prices and future prices.

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Hermann Remsperger (Deutsche Bundesbank) asked how to interpret the current
upturn in the Japanese economy and the role played by the financial industry. Okina
responded that one major difference from previous recoveries in the 1990s was that
resolution of the nonperforming-loan problem had advanced significantly. Finally,
Okina stressed that even if monetary policy could not offset all shocks, we shouldfind ways that work.

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178 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004