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

What Was Japan's "Lost Decade" Real Estate Crisis?

Free markets economies are subject to cycles. Economic cycles consist of fluctuating periods of economic expansion and contraction as measured by a nation's gross domestic product (GDP).

The length of economic cycles (periods of expansion vs. contraction) can vary greatly. The traditional measure of an economic recession is two or more consecutive quarters of falling gross domestic product. There are also economic depressions, which are extended periods of economic contraction, such as the Great Depression of the 1930s.

From 1991 through 2001, Japan experienced a period of economic stagnation and price deflation known as "Japan's Lost Decade." While the Japanese economy outgrew this period, it did so at a much slower pace than other industrialized nations. During this period, the Japanese economy suffered from both a credit crunch and a liquidity trap.

Understanding Japan's "Lost Decade" Real Estate Crisis

Japan's economy was the envy of the world in the 1980s—it grew at an average annual rate (as measured by GDP) of 3.89% in the 1980s, compared to 3.07% in the United States. But Japan's economy ran into troubles in the 1990s.

Japan's equity and real estate bubbles burst starting in the fall of 1989. Equity values plunged 60% from late 1989 to August 1992, while land values dropped throughout the 1990s, falling an incredible 70% by 2001.

As a result, from 1991 to 2003, the Japanese economy, as measured by GDP, grew only 1.14% annually, well below that of other industrialized nations.

The Bank of Japan's Interest Rate Mistakes

It is generally acknowledged that the Bank of Japan (BoJ), Japan's central bank, made several mistakes that may have added to and prolonged the negative effects of the bursting of the equity and real estate bubbles.

For example, monetary policy was stop-and-go; concerned about rising prices called inflation and soaring asset prices. The Bank of Japan put the brakes on the money supply in the late 1980s, which may have contributed to the bursting of the equity bubble. As equity values fell, the BoJ continued to raise interest rates because it remained concerned with still-appreciating real estate values.

Higher interest rates contributed to the end of rising land prices, but they also pushed the overall economy into a downward spiral. In 1991, as equity and land prices fell, the Bank of Japan dramatically reversed course and cut interest rates. But it was too late, a liquidity trap had already been set, and a credit crunch was setting in.

The Liquidity Trap

A liquidity trap is an economic scenario in which households and investors sit on cash, either in short-term accounts or literally as cash on hand.

They might do this for a few reasons: they have no confidence that they can earn a higher rate of return by investing, they believe deflation—or falling prices—is on the horizon (cash will increase in value relative to fixed assets), or deflation already exists. All three reasons are highly correlated, and under such circumstances, household and investor beliefs become a reality.

In a liquidity trap, low-interest rates, as a matter of monetary policy, become ineffective. People and investors don't spend or invest. They believe goods and services will be cheaper tomorrow, so they wait to consume, thinking they can earn a better return by sitting on their money versus investing it. The Bank of Japan's discount rate was 0.5% for much of the 1990s, but it failed to stimulate the Japanese economy while deflation persisted.

Breaking out of a Liquidity Trap

There are fiscal and monetary measures that can be taken to break out of a liquidity trap, but households and businesses must be willing to spend and invest.

Fiscal Measures

One way of getting them to do so is through fiscal policy. Governments can give money directly to consumers through reductions in tax rates, issuances of tax rebates, and public spending.

Japan tried several fiscal policy measures to break out of its liquidity trap. However, it is generally believed that these measures were not executed well—money was wasted on inefficient public works projects and given to failing businesses. Most economists agree that for fiscal stimulus policy to be effective, money must be allocated efficiently. In other words, let the market decide where to spend and invest by placing money directly in the hands of consumers.

Increasing Money Supply

Another way to break out of the liquidity trap is to "re-inflate" the economy by increasing the actual supply of money instead of targeting nominal interest rates. A central bank can inject money into an economy without regard for an established target interest rate (such as the fed funds rate in the U.S.) through the purchase of government bonds in open-market operations.

This is when a central bank purchases a bond, in which case it effectively exchanges it for cash, which increases the money supply. This is known as the monetization of debt. (It should be noted that open-market operations are also used to attain and maintain target interest rates, but when a central bank monetizes the debt, it does so without regard for a target interest rate.)

In 2001, the Bank of Japan began to target the money supply instead of interest rates, which helped moderate deflation and stimulate economic growth. However, when a central bank injects money into the financial system, banks are left with more money on hand but also must be willing to lend that money out. This brings us to the next problem Japan faced: a credit crunch.

The Credit Crunch

A credit crunch is an economic scenario in which banks have tightened lending requirements and, for the most part, do not lend. Financial institutions may not lend for a few reasons, including:

1. Need to hold onto reserves to repair bank balance sheets after suffering losses, which happened to Japanese banks that had invested heavily in real estate.
   
   
2. Less risk-taking, which occurred in the United States in 2007 and 2008 as financial institutions that initially suffered losses related to subprime mortgage lending pulled back lending, deleveraged their balance sheets, and generally sought to reduce their levels of risk.

Calculated risk-taking and lending represent the life-blood of a free market economy. When capital is put to work, jobs are created, spending increases, efficiencies are discovered, leading to higher productivity and economic growth. On the other hand, when banks are reluctant to lend, it is difficult for the economy to grow.

In the same manner that a liquidity trap leads to deflation, a credit crunch is also conducive to deflation as banks are unwilling to lend. Therefore, consumers and businesses are unable to spend, causing prices to fall.

Solutions to a Credit Crunch

Similar to a liquidity trap, which leads to deflation, a credit crunch is also conducive to deflation as banks are unwilling to lend. Less lending means there's less new money being injected into the economy. As a result, consumers and businesses are unable to borrow and spend, despite low interest rates, causing prices to fall further. Below are a few possible solutions to a credit crunch.

Bank Restructuring

As Japan suffered from a credit crunch in the 1990s, Japanese banks were slow to take losses. Even though public funds were made available to banks to restructure their balance sheets, they failed to do so because of the fear of the stigma associated with revealing long-concealed losses and the fear of losing control to foreign investors.

Typically, bank losses need to be recognized to get out of a credit crunch, while the banking system needs to be transparent. Also, banks must have confidence in their ability to assess and manage risk.

Fighting Deflation

Deflation causes many problems because when asset prices fall, households and investors hoard cash since their cash will be worth more tomorrow than it is today. The result can lead to a liquidity trap. When asset prices fall, the value of collateral backing loans falls, leading to bank losses. When banks suffer losses, they cut lending, which can create a credit crunch.

Typically, inflation can be an economic problem, leading to rising prices and lowering the purchasing power of consumers. However, re-inflating the economy might be necessary for Japan to avoid prolonged periods of slow growth, as in the case of the 1990s. Steady and moderate inflation might trigger consumers and businesses to spend versus hoarding cash as they would in a deflationary environment.

Helicopter Money

Unfortunately, re-inflating an economy isn't easy, especially if banks are unwilling or unable to lend. Notable American economist Milton Friedman suggested that avoiding a liquidity trap can be achieved by bypassing financial intermediaries and giving money directly to individuals to spend. This process is known as "helicopter money" because the theory is that a central bank could drop money from a helicopter.