1. Japan’s Bubble Economics 285 Fall 2000 Prof. Michael Smitka

2. Two key causes Management geared for high growth Interacting with Macroeconomic policy mistakes

3. As a result... Interest rates were 0% Firms overborrowed Projects that earned a mere 0% passed muster Banks overlent Collateral or track records were enough Asset prices proved unrealistic Projects didn’t earn 0% ex post Banks couldn’t collect on their loans

4. Japan’s Case - high-growth underpinnings of a bubble - Management had no need for financial controls –project selection was easy –failure was hard / recessions were few & far between But pricing long-lived assets was hard –Real estate grew faster than economy –Stock prices grew faster than economy –Growth industries grew very fast indeed!!

5. Why the “bubble”? - the lending side - Change undermines rules of thumb for banks –Change in types of industry / borrowers –Change in strategic environment / flow of funds –Change in regulatory environment Mistakes are made … –… and a shock produces crisis

6. Growth Dynamics Transition out of agriculture –Fast productivity growth in industry –Urbanization! Household formation Infrastructure, housing But it’s a one-time transition! –And eventually ends

7. Slowdown Industry no longer needs funds 1970s: 10% of GDP swing in under a decade!! But households keep saving Past savings were when incomes were low So accumulated wealth was modest So people needed to keep saving to fund old age Who then will borrow this funds? Paradox of Thrift!!

8. Shifts in Japanese Savings Flows

9. The Primary Shock 1970 vs 1976 Corporate investment fell 10% of GDP Savings rose! Banks were left to scramble

10. Interregnum Japanese fiscal deficits –created a new borrower for banks –MOF policy stopped that by 1982 Reagonomics: US consumption boom –Export-led growth from 1982 –Appreciation / Plaza Accord stopped that from 1986

11. Secondary Shock Bad macro policy –Easy money from 1986 –“Japan as Number One” psychology Just as banks sought new borrowers –Real estate … and more real estate! –Small business –Also international loans

13. Shocks, continued “Bubble” economy –Stock prices doubled –Urban real estate prices rose even more Fiscal policy mistakes accentuated –On-again, off-again policy built up debt Regulatory policy errors accentuated –Banks allowed to make more bad loans

14. Stock market - today’s market is no higher than in 1986!! -

16. Today’s Dilemmas Monetary policy doesn’t work Interest rates can’t be pushed below 0% But prices are falling ==> real rates are positive Banks (rightly) fear bad assets Outstanding loans are shrinking! Money growth is of cash… “Liquidity Trap” If monetary policy doesn’t work, how about fiscal??

17. ZIRP

18. Interest Rates Current lending rates: Short-term prime rate: 1.5% Long-term prime rate:2.25%

19. Credit Creation & Money

20. Fiscal Policy Repeated fiscal packages Short-term policies are discounted by consumers Higher temporary incomes are counteracted by stagnant consumption Credibility lost Permanent tax cuts?? Huge deficits already - 7% of GDP Demographic “old age” boom looms No room left to add fiscal stimulus?

21. Predictions Japan will underperform growth elsewhere Safety valve: exports? Real wages / labor costs remain high Must have counterpart capital flows Global capital markets are crippled Can’t sustain large trade surpluses / capital deficits Firms engaging in DFI - doesn’t help domestic GDP J will permanently underperform OECD