Japan's Economic Crisis Term Paper

  • Length: 10 pages
  • Subject: Economics
  • Type: Term Paper
  • Paper: #29425681

Excerpt from Term Paper :

Japan's Economic Crisis

Japan is currently in its worst recession since World War II. The country's economy slowed dramatically in the early 1990s after the bubble economy of the 1970s and 1980s. Section 2.0 takes a detailed look at what caused Japan's economic crisis and subsequent problems related to declining Gross Domestic Product (GDP), failed stimulus packages, banking inefficiencies, ineffective interest rate policies, deflation, currency devaluation and Japan's aging population. Given a consideration of all these factors, Section 3.0 makes recommendations most likely to have a positive impact in rejuvenating Japan's struggling economy. The paper concludes that Japan's best course of action includes raising its nominal GDP by increasing its monetary base, engaging in massive bank restructuring, using inflation targeting techniques and putting distressed real estate and other foreclosed collateral on the market.

Literature Review

Japan has been in recession for more than ten years. The economy that dazzled the world with growth of ten percent in the '60s, five percent in the '70s, and four percent in the 80's slowed to zero in the '90s and is now stuck there - despite the government spending 100 trillion yen to create jobs and kick start growth. However stimulus packages haven't worked and as a result:

due to massive spending, Japan's deficit is the highest of the G7 nations;

the finance minister describes the situation as "near collapse";

the banking sector is tottering under the weight of $102 billion in bad loans;

the stock market is at a sixteen-year low;

unemployment and bankruptcies are at record highs

Growth slowed markedly in the 1990s largely because of the after effects overinvestment during the late 1980s and Japan's response of using contractionary domestic policies intended to wring speculative excesses from the stock and real estate markets. Government efforts to revive economic growth have met with little success and were further hampered in 2000-2002 by the slowing of the U.S. And Asian economies.

Japan is now suffering from zero interest rates, deflation and a slow down in economic performance as well as its troubled financial structures, massive government debt and an aging population.

In early 1990, the Bank of Japan raised interest rates and put a squeeze on credit. But it was done too abruptly. As a result, the Stock Exchange soon lost half its value and property prices dropped by sixty percent to eighty percent. The banks, finding themselves with a mountain of bad debt, drastically cut back credit. This in turn led to the collapse of thousands of small and medium-sized companies. All this has created a profound sense of shock contributing to negative growth. The Unemployment rate of 5.4% in 2002 now stands higher than at any point since 1953.

The single most important problem for the financial sector has been the anemic growth of the Japanese economy over the last decade. Figure 1 shows GDP growth over the last forty-five years to put recent performance in context. After averaging almost four percent between 1974 and 1991, growth dropped to nearly one percent over the last decade. If there had been more growth in the 1990s, the Japan would have been in much better shape today.

Source: Anil Kashyap, "Sorting Out Japan's Financial Crisis"

In response to the flat-to-negative growth rate in the 1990s, Japan has sought to rejuvenate the economy by adopting stimulus packages -- at least ten of them -- that have provided money for additional public works projects, small business loan guarantees, and similar government spending measures. Each year, new legislation has been introduced to supplement the main budget with additional funds of $40-94 billion. As a result, the national debt ballooned to $5.5 trillion in 2001 and approached 150% of GDP in 2002, the highest level of public debt of any industrialized nation. However, one analysis says, "All the stimulus packages have done is create the real possibility that the Japanese economy could be crushed under the weight of its public debt...What is really needed is wide and deep structural reform."

Fiscal stimulus through supplementary budgets in the mid-1990's was applied: too little, too late, and too grudgingly. Policy stimulus failed to inspire confidence in businesses and consumers. Each policy package, especially the tax cut component, was presented by the government as only temporary, and incorporated offsetting policies which made impacts on stimulus ambiguous. The credibility of each fiscal stimulus package was undermined both by the exaggerated statements concerning the real amount of stimulus and by the focus on public works construction that was increasingly unproductive - "roads, railroads, bridges to nowhere."

While banking reform is one of the areas that Japan needs to focus, its policies have been woefully inadequate. Since the early 1990s, banks have struggled with bad loans that were the result of its poor lending decisions. In 1998, the Japanese government established the Financial Reconstruction Commission, an emergency agency that subsequently poured $80 billion into cash-strapped banks. Despite this massive bailout, the banking crisis remained and continued to get worse. Japanese banks still had to come up with an additional $458 billion to cover bad loans, putting the total amount of debt on the lender books at more than a trillion dollars. The banking crisis was further exacerbated by falling asset prices, especially property where urban land prices were down as much as eighty percent from the early 1990s and a weak stock market that cut into the value of the banks' share portfolios.

Japan has had interest rates close to zero for some time, yet its economy is still mired in recession. When the equity and real-estate bubble burst in the early 1990s, the Japanese never let the painful restructuring that typically accompanies recessions occur. One consequence of this is that the Japanese banks are so saddled with bad loans that there are incapable of playing the intermediary role whereby interest rate cuts feed into the economy. As a result, nominal interest rates were not reduced enough and the real interest rate remained at relatively a high rate of two percent before 1995. The Bank of Japan did reduce the nominal interest rate to the near -zero level after 1995, but by then it was too late to prevent deflation from happening. Although money in Japan is practically free, banks can't seem to find any takers. Companies have no incentive or desire to borrow and invest, and individuals would rather hold on to cash as prices decline. What's worse, the few companies that are actually borrowing money from the banks are using it to invest abroad. With no capital spending or investing within Japan, its economy continues to stagnate.

Another issue with low interest rates is that Japan had relied too excessively on easy monetary policy in the mid-1990s. "This extreme imbalance between fiscal and monetary policy has virtually shackled the latter, making it very difficult to stimulate demand." While zero interest rates have helped banks and borrowers, in effect they simply postponed the resolution of the bad loan and corporate bankruptcy problems at high economic and political costs. The low interest rate policy has help to generate an excessively weak yen. And, savers are increasingly seeking higher yields in foreign assets. Returns on pension funds have been seriously inadequate, so that virtually all pension programs are substantially under funded. If and when interest rates do rise to a more normal level, the prices of government bonds and similar financial assets will drop, imposing huge capital losses on holders.

One of the many negative characteristics of Japan's economic decline is the dramatic progress of deflation. The inflation rate had remained low since 1992, and it became deflation after 1998. There are three major factors that have contributed to Japan's deflation. The first is the structural factor of the supply side. Imports of some goods have been increasing rapidly since 1999 and have pushed down the prices of finished products. Furthermore, technological innovation and a revamping of distribution systems had reduced price levels. Japan's distribution system that involved a myriad middlemen and government regulations favoring giant, established companies with bloated staff over new ones had once artificially inflated prices by eliminating competition.

Second, the demand side of Japan's economy is weak because of poor business conditions. Under these circumstances, people's expectations for lower prices in the future are rising. Third is the financial factor. With the excessive debt obligation of Japan's companies combined with declining prices and low consumer demand, businesses are not trying to raise capital funds, and the intermediary functions of the financial institutions are not working soundly. Persistent deflation continues to reinforce itself by limiting monetary policy flexibility, increasing real debt burden and providing incentives to delay spending.

Japan has resorted to currency devaluation - traditionally the last resort of a government in crisis to reverse deflation and to make its exports more competitive. But Japan's devaluation tactics had little impact. This is because it would take a hefty tumble in the currency to produce even a modest upturn in prices and economic output. "Without a devaluation of at least…

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