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

What is the real estate crisis in Japan’s “lost decade”?

Free market economies are affected by cycles. The business cycle includes periods of fluctuations in economic expansion and contraction, as measured by the country’s gross domestic product (GDP).

The length of the business cycle (expansion and contraction) can vary greatly. The traditional measure of economic recession is the decline in GDP for two or more consecutive quarters. There is also an economic depression, which is an extended period of economic contraction, such as the Great Depression of the 1930s.

From 1991 to 2001, Japan experienced a period of economic stagnation and price deflation known as “Japan’s Lost Decade”. Although Japan’s economic growth has exceeded this period, its growth rate is much slower than that of other industrialized countries. During this period, the Japanese economy suffered from both a credit crunch and a liquidity trap.

Key points

  • Japan’s “lost decade” is a period from approximately 1991 to 2001, when Japan’s previously prosperous economy slowed significantly.
  • Part of the reason for the economic slowdown is that the Bank of Japan (BOJ) raised interest rates to cool the real estate market.
  • The Bank of Japan’s policies have created a liquidity trap, while the credit crunch is unfolding.
  • The lessons of Japan’s “lost decade” include using public funds to restructure bank balance sheets to prevent stagnation caused by deflation and inflation.

What is a liquidity trap?

Understanding the real estate crisis in Japan’s “lost decade”

Japan’s economy was the envy of the world in the 1980s—its average annual growth rate (measured by GDP) in the 1980s was 3.89%, compared with 3.07% in the United States. But the Japanese economy was in trouble in the 1990s.

Japan’s stock and real estate bubble began to burst in the fall of 1989. From the end of 1989 to August 1992, the value of stocks plummeted by 60%. The value of land declined throughout the 1990s, and by 2001 it had fallen by an incredible 70%.

Therefore, from 1991 to 2003, Japan’s economy as measured by GDP grew by only 1.14% per year, which was much lower than that of other industrialized countries.

The Bank of Japan’s interest rate lapses

It is widely acknowledged that the Bank of Japan (BoJ), the central bank of Japan, has made some mistakes that may exacerbate and prolong the negative effects of the bursting of the stock and real estate bubble.

For example, monetary policy is stop-and-go; worrying about rising prices is called inflation and soaring asset prices. The Bank of Japan braked the money supply in the late 1980s, which may have caused the stock market bubble to burst. As the value of stocks fell, the Bank of Japan continued to raise interest rates because it was still worried about the value of real estate that was still appreciating.

Higher interest rates help end land price increases, but also push the overall economy into a downward spiral. In 1991, following the decline in stock and land prices, the Bank of Japan dramatically changed direction and lowered interest rates. But it is too late, the liquidity trap has been set, and the credit crunch is taking shape.

Liquidity trap

A liquidity trap is an economic scenario in which households and investors hold cash, whether in short-term accounts or cash on hand.

They might do this for several reasons: they don’t believe they can get a higher rate of return through investment, they believe that deflation or price drops are coming (the value of cash relative to fixed assets will increase), or deflation already exists. These three reasons are highly correlated. In this case, the beliefs of families and investors become a reality.

In the liquidity trap, low interest rates as a monetary policy issue become ineffective. People and investors do not spend money or invest. They believe that goods and services will be cheaper tomorrow, so they wait for consumption, believing that they can get better returns by sitting back instead of investing. For most of the 1990s, the Bank of Japan had a discount rate of 0.5%, but it failed to stimulate the Japanese economy while deflation continued.

Break the liquidity trap

Fiscal and monetary measures can be taken to break the liquidity trap, but households and businesses must be willing to spend money and invest.

Fiscal measures

One way for them to do this is through fiscal policy. The government can directly provide funds to consumers by lowering tax rates, issuing tax rebates and public expenditures.

Japan has tried a number of fiscal policy measures to break its liquidity trap. However, it is generally believed that these measures have not been implemented well-funds were wasted on inefficient public works projects and flowed to failed enterprises. Most economists agree that for fiscal stimulus to be effective, funds must be allocated effectively. In other words, let the market decide where to spend and invest by putting money directly in the hands of consumers.

Increase the money supply

Another way to break the liquidity trap is to “re-inflate” the economy by increasing the real money supply instead of targeting nominal interest rates. Central banks can purchase government bonds in open market operations and inject funds into the economy without considering a set target interest rate (for example, the federal funds rate in the United States).

This is when the central bank buys bonds, it effectively converts them into cash, thereby increasing the money supply. This is called debt monetization. (It should be noted that open market operations are also used to reach and maintain target interest rates, but when the central bank monetizes debt, it does so without considering the target interest rate.)

In 2001, the Bank of Japan began to target money supply rather than interest rates, which helped ease deflation and stimulate economic growth. However, when the central bank injects funds into the financial system, the bank has more money on hand, but it must also be willing to lend it out. This brings us to the next problem facing Japan: the credit crunch.

Credit crunch

Credit crunch is an economic situation in which banks tighten loan requirements and do not lend in most cases. Financial institutions may not lend for several reasons, including:

  1. It is necessary to keep reserves to repair the bank’s balance sheet after suffering losses. This happened in Japanese banks that invest heavily in real estate.
  2. There was less risk taking in the United States in 2007 and 2008, because financial institutions that initially suffered losses due to subprime mortgages withdrew their loans, lowered the leverage ratio of their balance sheets, and generally sought to reduce the level of risk.

Calculated risk-taking and loans represent the lifeblood of a free market economy. When capital is invested in work, it will create jobs, increase expenditures, find efficiency, and thereby increase productivity and economic growth. On the other hand, when banks are unwilling to lend, it is difficult for the economy to grow.

Just as the liquidity trap leads to deflation, the credit crunch is also conducive to deflation because banks are unwilling to lend. As a result, consumers and companies cannot consume, leading to price drops.

The solution to the credit crunch

Similar to the liquidity trap that leads to deflation, credit crunch is also conducive to deflation because banks are reluctant to lend. Decrease in loans means less new funds injected into the economy. As a result, despite the low interest rates, consumers and companies are still unable to borrow and consume, causing prices to fall further. Here are a few possible solutions to the credit crunch.

Bank restructuring

Since Japan suffered a credit crunch in the 1990s, the Bank of Japan was slow to act in terms of losses. Although banks can use public funds to restructure their balance sheets, they have failed to do so because of concerns about the stigma of exposing long-term hidden losses and fear of losing control of foreign investors.

Usually, bank losses need to be confirmed to get rid of the credit crunch, and the banking system needs to be transparent. In addition, banks must be confident in their ability to assess and manage risks.

Fight against deflation

Deflation can cause many problems because when asset prices fall, households and investors will hoard cash because their cash will be more valuable tomorrow than it is today. The result can lead to a liquidity trap. When asset prices fall, the value of mortgage loans falls, causing bank losses. When banks suffer losses, they will cut loans, which may result in a credit crunch.

Generally, inflation can be an economic problem, causing prices to rise and reducing consumers’ purchasing power. However, Japan may need to reinflate the economy to avoid long-term slow growth, as was the case in the 1990s. Stable and moderate inflation may prompt consumers and businesses to spend money instead of hoarding cash as they did in a deflationary environment.

Helicopter money

Unfortunately, it is not easy to reinflate the economy, especially when banks are unwilling or unable to lend. The well-known American economist Milton Friedman (Milton Friedman) suggested that bypassing financial intermediaries and directly spending money on individuals can avoid liquidity traps. This process is called “helicopter money dropping” because theoretically the central bank can throw money from the helicopter.


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