Lessons of Japan's economic downturn offered in new book

The stagnation that plagued the Japanese economy throughout the 1990s lasted twice as long as it should have, according to the coeditor of a new book that says Japan was hobbled by weak monetary policy and its own dysfunctional financial institutions.

Michael Hutchison, a leading authority on international finance and the Japanese economy, coedited Japan's Great Stagnation: Financial and Monetary Policy Lessons for Advanced Economies (Cambridge, MA: MIT Press, 2006) with Frank Westermann. Hutchison is a professor of economics at the University of California, Santa Cruz; Westermann is chair of international economic policy in the Department of Economics and Business Administration at the University of Osnabrueck, Germany.

The abrupt plunge of the Japanese economy, considered during the 1980s the "new economic powerhouse" of the global economy, provides a critical case study for other advanced industrialized nations, said Hutchison.

"In the 1980s, Tokyo was the center of the world, and there was no end in sight for growth," said Hutchison. "The industrial and economic power of Japan was considered unstoppable."

The book presents an in-depth discussion of the causes and effects of Japan's prolonged downturn by leading experts on the Japanese economy, including UCSC economics professor Kenneth Kletzer. The introduction by Hutchison and Westermann sets the stage for the chapters that follow.

They write that the stunning drop in the Japanese stock market on the last day of trading in 1989 signaled the beginning of a downturn that ushered in conditions as close to those of the Great Depression as any industrialized economy has faced since the 1930s. "No one saw it coming," said Hutchison.

No specific news triggered the stock market collapse--assets plunged more than 50 percent by 1992--but the drop, coupled with declining land prices and increasing unemployment, pushed the banking system to the brink of collapse. One precipitating factor was an unusual level of cooperation among government, banks, and industry in Japan known as the "iron triangle."

"The banking system was failing in every regard, and what was needed was a total overhaul of the regulatory structure," Hutchison said of a period marked by bank failures and the coining of the term "zombie banks" for institutions that were allowed to remain open despite shortages of capital. "Japanese bank regulators didn't have all the information they could have, and they hid or understated the information they did have, hoping the problem would go away."

Japanese policy makers reduced interest rates to zero, but the economy refused to budge: Banks were unable to make loans, investors lacked confidence, and the exchange rate plummeted. Faced with weak demand inside Japan, manufacturers turned to the United States, where a booming economy fueled the American appetite for Japanese exports, and China, where they sold goods and built factories.

Not until late 1997 did the Japanese government begin to make fundamental changes, stripping the Ministry of Finance of responsibility and establishing a separate regulatory agency, the Financial Services Agency. "They should have done that five years earlier," said Hutchison.

By contrast, the U.S. banking industry is heavily regulated and monitored. "Our own savings and loan crisis in the 1980s was resolved quickly because we took aggressive action, closed down bad banks, and paid off their loans," said Hutchison. Sweden's banking crisis in 1989 was resolved within 18 months by selling assets, mergers, and nationalizing some banks.

"What happened in Japan underscores how critical the financial system is to the workings of an advanced industrialized economy," said Hutchison. "The recession lasted twice as long as it would have because of the broken-down banking system."

"What had worked so well in Japan--decision making by consensus--became a problem because they couldn't reach consensus regarding how to handle the banking crisis," said Hutchison. "It had worked for years as a postwar development strategy that made Japan one of the richest countries in the world. But that policy impasse led to continued economic malaise and what we call the Great Stagnation."

Although monetary policy was sound--reducing interest rates was the right thing to do, noted Hutchison--the credibility of the policies was undermined by statements of officials, who failed to inspire confidence in the effectiveness of their own actions, said Hutchison. "They were very uncomfortable having rates so low, and they talked about it as a temporary measure," he said. "They should've acted decisively and with confidence to keep interest rates low."

The Japanese economy didn't emerge from the Great Stagnation until late 2005, noted Hutchison. "In modern societies, the banking system is critical to the smooth functioning of the economy," he said. "We take that for granted because it usually works so smoothly. But when it doesn't, the economic costs can be enormous."


Editor's Note: Michael Hutchison can be reached via e-mail at hutch@ucsc.edu. He is coauthor of The Political Economy of Japanese Monetary Policy and Financial Policy and Central Banking in Japan.